NK models and Unemployment as Vacations

Franco Modigliani famously quipped that he did not think that unemployment during the Great Depression should be described, in an economic model, as a "sudden bout of contagious laziness". Quite. For the past thirty years we have been debating whether to use classical real business cycle models (RBC), or their close cousins, modern New Keynesian (NK) models, to describe recessions. In both of these models, the social cost of persistent unemployment is less than a half a percentage point of steady state consumption.

What does that mean? Median US consumption is roughly $30,000 a year. One half of one percent of this is roughly 50 cents a day. A person inhabiting one of our artificial model RBC or NK model worlds, would not be willing to pay more than 50 cents a day to avoid another Great Depression. That is true of real business cycle models. It is also true of New Keynesian models.

That is the background for an exchange between me and Stephen Williamson on the comment pages of this blog. 

Here is Stephen:

I'm agnostic about the self-correcting nature of the economy. I do think inefficiency isn't observable (except in the behavior of my colleagues) - we need models to measure it.

and my response

It is true that in both classical and NK models, the cost of business cycles is small. In my view, it is not true in the real world and it is not true in the search models I work with where the unemployment rate is determined, in steady state, by, what I call, 'the belief function'.

I'm not even sure we should call the fluctuations that concern me 'business cycles'. They are low frequency correlations in asset prices and unemployment that are absent from data that has been HP filtered. It is possible, of course, that the persistent increase in unemployment that follows a financial crisis, is caused by the factors that a conventional search theorist would identify as fundamental. For example, increased government regulation or changes in technology that render existing skills obsolete.

I have a different explanation. The persistent increases in the unemployment rate that follow a financial crisis are caused by waves of optimism and pessimism that are driven by psychology: so called 'animal spirits'. You would probably refer to these correlated movements in asset prices and unemployment as, random shocks to the equilibrium selection device. I prefer to say that the object that drives market sentiment is a new fundamental in an economic model that would otherwise contain a continuum of multiple equilibria. Once the belief function is introduced as a new fundamental: equilibrium is unique.

Stephen responds

“Your models don’t take a stand on high frequency vs. low frequency fluctuations in inefficiency. Indeed, you can have equilibria in which the inefficiency is permanent. So that’s very different from what’s going on in standard NK/RBC exogenous shock models.”

Precisely. That's why I eschew NK and RBC models. They are both wrong. The high unemployment that follows a financial crisis is not the socially efficient response to technology shocks. And the slow recovery from a financial melt-down has nothing to do with the costs of reprinting menus that underpins the models of NK economists. It is a potentially permanent failure of private agents to coordinate on an outcome that is socially desirable. Much more on this in my new book, "Prosperity for All" available September 1st from Oxford University Press.

Neo Fisherianism: Crazy Trick or the Right Way Forward?

A debate has broken out on the blogs over the wisdom of an interest rate increase. Stephen Williamson, who identifies as a ‘new-monetarist’ thinks that we need to raise rates to generate inflation. Narayana Kocherlakota, who once advanced this idea himself, has now reversed his position and calls it a ‘crazy trick’.

These are two very smart people. Stephen is  a Vice President at the Federal Reserve bank of St Louis and  the author of one of the leading undergraduate textbooks in macroeconomics that is now in its 5th edition. Narayana is the former President of the Federal Reserve Bank of Minneapolis and now the Lionel W. McKenzie Professor at the University of Rochester. The fact that they have both entertained this idea at one point in the recent past suggests that it is not such a crazy trick as Narayana now suggests.

In his argument against raising rates, Narayana points out that new-monetarists, like Stephen, see the economy as self-stabilizing. Raise rates now, and the economy will soon find its way back to full employment. Perhaps there will be some minor pain along the way. But keeping rates low, or even lowering them into negative territory, is a much worse option. Just look at Japan.

According to Narayana

“…., it would be remarkably irresponsible to take the risk of raising rates based purely on a theoretical belief in macroeconomic self-stabilization.”

I am on Stephen’s side in this debate. But I do not, I repeat I DO NOT, believe that the economy is self-stabilizing. If the Fed raises rates before the private sector has begun to recover, and if that is the only change to either monetary or fiscal policy, Narayana would be right: the Fed action would derail a nascent recovery. To prevent this from happening; a rate rise must be accomplished by a simultaneous intervention in the asset markets to prevent the crash in the values of other risky and long dated asset classes that will inevitably accompany a Fed increase in the policy rate. This is what Willem Buiter has called ‘Qualitative Easing’.

Inflation is persistent in historical data. But it is not persistent because private actors are prevented from changing prices by what New-Keynesian economists refer to as ‘sticky prices’. As I explain in my forthcoming book, inflation is persistent because people's beliefs about future NGDP growth are persistent. We ARE in a low inflation trap. The way out is not through further interest rate cuts, as some have advocated. It is through a rate rise, accompanied by a fiscal/asset market intervention.

How would that be achieved? Some have argued for a money financed program of new federal and state expenditure on infrastructure. Some have argued for printing money and distributing it to the public, so-called helicopter money. I have argued for a central bank  intervention that boosts the value of risky and long-dated assets and that would increase private demand through a wealth effect. The details are secondary. The main point is that the economy is NOT self-stabilizing. Treasury actions AND the way those actions are financed, are BOTH important determinants of economic activity. If we  wait for the private sector to recover on its own; we may be waiting for a very long time.

New Comment Format

I am now using Disqus to manage blog comments.  Disqus should allow embedded urls and I am hoping it will be a significant improvement. Unfortunately, the move appears to have caused comments that were posted under the previous format to evaporate into cyberspace. I am working to see if I can recover them. Stay tuned.

Property Rights, the Income Distribution and China

In my post, The UK and Europe: The Way Forward, I say that

"A persistent free fall in the financial markets will, if allowed to occur, cause a major recession. [ ... ] My recommendation is based on empirical research that shows a stable persistent connection between the value of financial assets and the unemployment rate."

Commenting on this blog, Blissex Walex replies,

"This seems to me the best and clearest yet expression of the neoliberal trickle-down policies aimed at redistribution from workers to asset owners.

It even goes further than B DeLong "suggestion" that Keynes would have added a fourth, one known to us today as the “Greenspan put" – using monetary policy to validate the asset prices reached at the height of the bubble"

There are two issues here that should not be confounded. 

First: Can central banks and national treasuries intervene in either asset markets or goods markets, or both, in a way that improves upon unregulated private markets? By 'improves upon' I mean: is there a feasible policy that can make everyone better off; both workers and capital owners? Keynes thought so. So do I, for the reasons I explain in my forthcoming book, Prosperity for All.

Second: why has the distribution of income, in the United States and Europe, tilted towards capital and away from labor over the past few decades? There is growing evidence that this redistribution is connected with the opening of trade with China. Globalization has lifted a billion Chinese workers out of poverty and it has led to huge income gains for Americans and Europeans at the top of the income and wealth distributions. These gains have not been shared with middle class and working class people in the US and Europe. This second issue is hugely important, but it is distinct from the question of asset price stabilization. Nobody will gain from a global depression. 

My own view is that solving the first issue at a national level will lead to a reformation of world capital markets and a redesign of global financial institutions. It is also possible to conceive of alternative forms of democracy that would provide greater rights to workers. Workers councils, for example, have proved to be relatively successful in Germany. 

The concept of private property is contingent on rights that are defined and enforced by national governments. Those rights are constantly evolving. When the US founding fathers signed the Declaration of Independence, it was still possible to buy and sell human beings. The idea that a national government would enforce the property rights of a slave owner is, to today's sensibilities, abhorrent. It is entirely possible that a system of property rights that allows a factory owner to close down a large manufacturing plant without consulting the workers whose livelihoods depend on its continued operation, will, in another two hundred years, appear to be equally abhorrent.

You can read more about these ideas in my new book, Prosperity for All.

Should we Target NGDP?

In my last post, The UK and Europe, the Way Forward, I wrote that 

"The Bank of England should make clear that a catastrophic drop in the financial markets will not be permitted. I recommend a statement that the Bank will, if necessary, buy shares in an  exchange traded fund to support the value of the FTSE and that it will pay for those shares by selling short-term treasury securities. As I argued here, if necessary, the Treasury should support that action by providing the Bank with the authority to borrow on its behalf."

Thomas Hutcheson, commenting on my blog writes,

"This is fine so far as it goes, but we should deal as well with the policy response of the ECB and the Fed, as well. Whatever long term damage may occur from slightly less free trade (including investment to trade) cannot be prevented by central banks, but they can prevent the damage that comes from uncertainty about the future course of NGDP. It is expectations about that they should seek to stabilize."

Here is my response. 

I am in broad agreement with the proposal to stabilize expectations of future NGDP growth and, in the simple models that guide my thinking, stabilizing asset price growth and stabilizing expectations of NGDP growth amount to the same thing. The question is: how to achieve that goal?

If central banks simply substitute NGDP targeting for inflation targeting, and if they continue to try to achieve their objective by adjusting short term interest rates, not much will have been achieved. Scott Sumner has proposed instead, that central banks should trade NGDP futures. Robert Shiller goes further and advocates that national governments finance their borrowing requirements by issuing equity-like instruments that pay a trillionth of GDP: Shiller calls these 'trills'. I wholeheartedly endorse both of these proposals. Creating a market for nominal GDP futures, and actively trading trills for Tbills would have much the same effect as stabilizing asset price growth. 

I differ from Scott in one important respect. Whereas Scott sees NGDP targeting as a substitute for inflation targeting, for me, it is a complement. Central banks should set interest rates to target inflation, and they should set the growth rate of some other object, be it asset prices, NGDP futures, or the price path for trills, to target the unemployment rate.

You can read more about these ideas in my new book, Prosperity for All.