Expectations Employment and Prices

I am teaching two graduate classes this quarter, and that gives me the opportunity to publicize some ideas that I'm teaching in my classes, and that I have been working on for some time. I plan to put up a series of posts explaining the ideas in my 2010 book, Expectations Employment and Prices. I will also talk about extensions of the book that I have subsequently published in peer reviewed journals.

Here is how I characterized the project in the preface to EEP.
I have long believed that modern interpreters of Keynes missed the main point of The General Theory; high unemployment is an equilibrium phenomenon that can persist for a very long time if nothing is done by a government to correct the problem. This was the point of my 1984 paper, which argued that the natural rate hypothesis is false. In the intervening years, I had time to refine this idea. Expectations Employment and Prices is the result.
I began thinking about a book on Keynesian economics, based on a search theory of the labor market, in 2003. I have had many conversations with friends and colleagues along the way and the question I hear again and again is: why write a book? It has become the norm for serious economists to convey their ideas in articles.
There is a benefit to this approach since publishing an idea in a journal subjects it to a process of peer review. But there is also a downside to publishing in refereed journals, particularly when the goal is as ambitious as the project that I am engaged in. Even the very best journals (perhaps, particularly the very best journals) are biased towards publishing very good articles that contribute to what Thomas Kuhn in his 1962 book, The Structure of Scientific Revolutions, called 'normal science'.
A successful article in a top journal takes an established paradigm and solves a puzzle that researchers can identify as a valid question. I have a more ambitious goal: I want to overturn a way of thinking that has been established amongst macroeconomists for twenty years. The rejection of several different core assumptions at the same time poses a problem if one wants to publish journal articles since the pieces stand or fall together and there is no space in a twenty-page article to explain why.

I have always found, in writing research papers, that no idea is ever complete and the same is true of a book; but more so. As this project developed I added new pieces and changed old ones. The project gained new urgency when the world economy began to disintegrate at an alarming rate in the fall of 2008. I decided at that point that it was important to publish the ideas in whatever form they were currently in and to worry about polishing them later. The theory I develop here has direct relevance to the world economic crisis and it suggests a new and potentially important solution to the problem of maintaining global stability
In subsequent posts, I will chronicle the main ideas from Expectations, Employment and Prices and talk about the ways in which my ideas about alternative policy solutions have developed.

Regime Switching at the Lower Bound: A Research Topic for Students

I just returned from a conference at the San Franciso Fed on Monetary Policy and Financial Markets HERE where I discussed a paper by Fumio Hayashi and Junko Koeda. They use a novel way of identifying the effects of policy during periods of Quantitative Easing which recognizes that policy is different when interest rates are at the lower bound. An interesting take away from their paper is that QE is effective at reducing the output gap.

The Hayashi-Koeda paper suggests the following research topic for Ph.D. Students. H-K use an SVAR, i.e. a vector autoregression that is identified by making assumptions about the covariances of the variables. See Stock and Watson here for a summary of what that means.

The novelty in Hayashi Koeda is to allow for different coefficients of the VAR when the interest rate is at the lower bound. The pitfall here, is that although SVAR stands for "structural vector autoregression", there really isn't anything structural about it. An SVAR is just the reduced form of a DSGE model. And that means that the coefficients of the equations cannot be relied upon to remain constant if the policy rule changes.

Nothing new there -- we've known that for a long time. I was asked to discuss the paper because I've worked here (with Dan Waggoner and Tao Zha) on DSGE models where the parameters switch occasionally from one regime to another. Here is the interesting research topic. How are Regime switching SVARs of the kind estimated by Hayashi and Koeda, related to the Markov switching DSGE models that I studied with Dan and Tao?

Labor Markets Don't Clear: Let's Stop Pretending They Do

Beginning with the work of  Robert Lucas and Leonard Rapping in 1969, macroeconomists have modeled the labor market as if the wage always adjusts to equate the demand and supply of labor.

I don't think thats a very good approach. It's time to drop the assumption that the demand equals the supply of labor. 

Why would you want to delete the labor market clearing equation from an otherwise standard model?  Because setting the demand equal to the supply of labor is a terrible way of understanding business cycles.

Hours spent in employment varies over time for three reasons.

First, people enter or leave the labor force.  Second, some people lose jobs and others find jobs. Third, people work longer or shorter hours. Most economists confound all three reasons by using only one data series; hours spent in paid employment. That's not a good idea.

Here's data on participation in blue on the right axis against unemployment in red on the left axis. The grey areas are recessions. Participation is smooth; it trends up until 2000 and then trends down.   All the action during recessions is in the unemployment rate.

Participation and Unemployment
Perhaps its variation in hours that explains demand and supply variations?  Nope.  Here is data on average weekly hours (in blue on the right scale) and the same series on unemployment for comparison.

Hours and Unemployment

Why is this a big deal? Because 90% of the macro seminars I attend, at conferences and universities around the world,  still assume that the labor market is an auction where anyone can work as many hours as they want at the going wage.  Why do we let our students keep doing this? 

Asset Prices in a Lifecycle Economy

I have just completed a new paper on asset prices, "Asset Prices in a Lifecycle Economy".  The paper is available here from the NBER or here from my website.  This is a good time to comment on asset price volatility and the apparently contradictory findings of two of the 2013 Nobel Laureates because my paper sheds light on this issue. 

In 2013, Gene Fama, Lars Hansen and Robert Shiller, shared the Nobel Prize for their empirical analysis of asset prices.1 

Fama won the Nobel Prize for showing that financial markets are efficient. He meant, that it is not possible to make money by trading financial assets because markets already incorporate all available information. 

Shiller won the Nobel Prize for showing that financial markets are inefficient. He meant that the ratio of the price of a stock to the dividends it earns, returns to a long run average value; hence, an investor can profit by holding undervalued stocks for very long periods. 

These apparently contradictory results are consistent  because Fama and Shiller are referring to different concepts of efficiency.

When Fama says that financial markets are efficient, he means informational efficiency. There is a second concept that economists call Pareto efficiency. This means that there is no possible intervention by government that can improve the welfare of one person without making someone else worse off. The fact that markets are informationally efficient does not necessarily mean that they are Pareto efficient and that fact helps to explain why financial markets appear to do such crazy things over short periods of time.

Long-run predictability is not the only feature of asset prices that is hard to understand. Economists also have a hard time explaining why asset prices are so volatile (the excess volatility puzzle) and why the return to equity has historically been six percentage points higher than the return to holding government debt, (the equity premium puzzle).

My new working paper explains both these asset pricing puzzles.  I don't need to assume that there are financial frictions, sticky prices or irrational behavior.  The only thing that is different about my work from standard macroeconomic models is birth and death. Rather than assume, as do many models, that there is a single representative agent in the world,  I assume instead that people are born, they work, they retire and they die. 
Figure 1 Source "Asset prices in a Lifecycle Economy", (c) Roger E. A. Farmer
Figure 1 compares simulated data from my model (left panel) with US data (right panel). The blue line in both cases is the safe rate of return and the green line is the stock market return. 

In the simulated data, like the actual data, the stock market is risky with a higher average return than a safe short asset.  What explains my results?

Financial markets are like insurance markets. If you own a house you will insure the house against fire. And since not all houses burn down at the same time, the premiums we all pay for fire insurance can be used to compensate the unlucky few who suffer from a loss in any given year. But to benefit from insurance, you must purchase the insurance before your house burns down.

Oreopolous and coauthors have shown that people who start their working life in a recession are worse off for their entire lives than people born in a boom. Given the opportunity, we would all choose to purchase insurance over the state of the world into which we are born, for the same reason that we buy fire insurance on our house. I call our inability to purchase this insurance, the absence of prenatal financial markets. It is the inability of the young to trade in prenatal financial markets that explains why the financial markets are not Pareto Optimal.

In my model, huge inefficient asset price fluctuations occur because the unborn are not around to profit from them. Risky assets trade at a premium because retirees have no other source of income and cannot afford to gamble away their savings.  If our children's children's children could trade in the markets, they would short stocks that are overvalued, and buy those that are undervalued. But for those of us with finite horizons, life is too short to make those trades. As Keynes quipped; Markets can remain irrational for longer than you or I can remain solvent. 
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1. Lars Hansen won for his work on estimation and I will not have a lot here to say about his contribution. It has already become a part of the curriculum for every Ph.D. student in economics.