The NRH is Wrong

Here is an excerpt from Chapter 3, pages 32-33, of Prosperity for All. (Link to Amazon US, Link to Amazon UK, Amazon Kindle).

"The natural rate hypothesis (NRH) is the idea that unemployment has an inherent tendency to return to some special “natural rate” that is a property of the available technology for finding jobs. It is a fact of nature, a bit like the gravitational constant in celestial mechanics. The theory of the NRH natural rate hypothesis has been taught to every economist in every top economics department for the past thirty years. As part of the package, economists learn that the natural rate cannot be influenced by fiscal or monetary policy."

"Even today, the NRH is a central component of New Keynesian economics and, with very few exceptions, central bankers, politicians, and economic talking heads use the theory of the natural rate of unemployment to explain their views on the appropriate stance of monetary policy. I believe that the NRH  is false, and this fact has important consequences. If central bankers are working with a false theory, they are likely to make bad decisions that affect all of our lives."

(c) Oxford University Press

Prosperity for All

The Western World is emerging from the largest economic crisis since the Great Depression. Economic crises are terrible, painful events that affect us all. Sometimes they are accompanied by large and persistent long-term job losses as in the Great Depression of the 1930s or the Great Recession of 2006—2009.  At other times they are accompanied by hyperinflations as in Germany following World War I when prices increased by a factor of almost four million in the space of five months.

The human being in me is deeply disturbed by every crisis. The economist in me recognizes the invaluable opportunity that is provided by every crisis to disentangle one economic theory from another. Just as the astrophysicist learns by observing the explosion of a supernova; so the economist learns from observing the fallout from a major economic catastrophe. The Great Recession has both taught and reminded us that the existing economic theory that guides policy-makers in treasuries and central banks is deeply flawed. It is time for a paradigm change.

The Great Depression led to a revolution in economic theory and to a change in policy. The theoretical revolution was initiated by the English economist John Maynard Keynes who, writing in 1936, in The General Theory of Employment Interest and Money, overturned the deeply held conviction that capitalist economies are self-stabilizing. To the contrary, he claimed a role for national treasuries and central banks to ensure that everyone who wanted to work would be able to find employment. His ideas were enshrined, in the United States, in the Employment Act of 1946, and they transformed the political landscape in ways that have persisted to this day.

Following the Great Depression, macroeconomics was dominated by Keynesian ideas. But in the 1960s and 1970s, western economies experienced stagflation; a period of high inflation and high unemployment at the same time. Stagflation was deeply subversive of Keynesian economics because according to the textbook interpretation of Keynes’ ideas, an economy can experience high inflation or high unemployment; but not both.

Following the Great Stagflation of the 1970s, economists backtracked and revived the classical economic theory that had dominated academic economics for a hundred and fifty years, beginning with Adam Smith in 1776 and culminating in the business cycle theory described by Keynes’s contemporary Arthur Pigou in his 1927 book, Industrial Fluctuations. That backtrack was a big mistake. It is time to realize that much, but not all, of Keynesian economics is correct. Capitalism is better than any other economic system yet devised for maintaining living standards for billions of people. But it is not perfect. We must redesign the rules under which markets operate to take advantage of what works and eliminate what does not. 

Not every crisis is transformative: but some are. There have been four transformative crises in the last century. The first was the US financial panic of 1907. The second was the Great Depression of the 1930s. The third was the Great Stagflation of the 1970s, and the fourth is one we are only now emerging from; the Great Recession of 2006—2009. Each of the first three crises was associated either with a transformation in economic thought or with a transformation in economic policy. Some were associated with both.

The panic of 1907 was not the worst crisis to hit the US economy; there had been deeper and more persistent recessions in the nineteenth century, for example, the long depression of 1873 which lasted for 6 years. But the 1907 panic was the straw that broke the camel’s back. It led to the creation of the Federal Reserve System in 1913 and to the widespread acceptance that government has a role in setting the price at which private banks can borrow and lend to each other.

Keynes caricature in Stalin-Wells Talk by David Low, 1934. Public domain via Wikimedia Commons

Will the Great Recession be followed by a theoretical revolution or a policy innovation of the same magnitude as the upheavals of the panic of 1907, the Great Depression of the 1930s and the stagflation of the 1970s? I believe so. Like the Great Depression, the Great Recession is a transformative event that will lead both to a paradigm shift and to a fundamental change in economic policy.

In my book Prosperity for All: How to Prevent Financial Crises, I draw on evidence not just from the 1930s, but also from later decades, to build a theory that accounts not just for depressions, but also for stagflation. Unlike Keynes, I do not conclude that more government spending is the right way to cure a depression. Instead, I argue for a new policy in which central banks and national treasuries systematically intervene in financial markets to prevent the swings in asset prices that have such debilitating effects on all of our lives.

The control of asset prices will seem like a bold step to some, but so too did the control of the interest rates by the Open Market Committee of the Federal Reserve System when it was first introduced in 1913. We do not have to accept hyperinflations of the kind that occurred in 1920s Germany. Nor should we be content with the 50% unemployment rates that plague young people in Greece today. By designing a new institution, based on the modern central bank, we can and must ensure Prosperity for All.

Prosperity for All will be published in the UK on November 24th and is available here.  It is available in the US here. This blog is mirrored on the OUP site here.

Not Keen on more Chaos in the Future of Macroeconomics

Steve Keen argues that we should use chaos theory as a future foundation for macroeconomics. We tried that thirty-five years ago and rejected it. Here’s why.  

In response to Olivier Blanchard’s recent attempt to move towards a consensus in macroeconomics, Steve Keen has launched a blistering attack on the DSGE approach. His thesis is that the economy is best modeled as a complex adaptive system. I am, or at least was, very receptive to that idea. But in contrast to Steve, I believe that DSGE models are here to stay, just not New Keynesian DSGE models.

Complexity theory is not a new idea in economics. In June of 1985, Jean-Michel Grandmont and Pierre Malgrange organized a conference in Paris. The conference was dedicated to the idea that the economy is inherently non-linear and that the applications that Steve Keen cites as successful examples of non-linear theory in the physical sciences could be extended to economics.  I was privileged to attend that conference and to present a paper on non-linear business cycles. Many of the conference papers were published in the Journal of Economic Theory.

Among the highlights at the 1985 conference were an important paper by Michele Boldrin and Luigi Montruchio which demonstrated that the representative agent growth model can display chaotic dynamics. Michael Woodford presented a paper entitled “Stationary Sunspot Equilibria in a Finance Constrained Economy”. Roger Guesnerie, Jean Michel Grandmont, Donald Saari, Steven R. Williams, Roes-Anne Danna, Guy Laroque, Raymond Deneckere, Steve Pelikam and Pietro Recclin all presented papers that appeared in the conference volume. Frank Hahn attended and was his usual perceptive and boisterous self. Karl Shell presented a paper that Grandmont later rejected for JET (a somewhat ballsy decision since Karl was editor of JET at the time).  This was also the first time I met Jess Benhabib. We went on to write our classic paper on indeterminacy.

The attendees were a relative who’s who of European and American mathematical economists and the agenda was clear. Can we translate the success of chaos theory and non-linear dynamics from the physical sciences into economics? The answer was very clear. Non!

For me, and I believe for many others, the highlight of the conference was a paper by the American economist William (Buzz) Brock with the title “Distinguishing Random and Deterministic Systems”.  This is a wonderful paper and I recommend you read it. In his conference presentation, Buzz described an experiment that changed the world of fluid dynamics. At one time, physicists described the motion of turbulence in fluids with a high dimensional linear system hit by random shocks. It turns out, the world is not like that. And physicists can prove it.

Buzz described an experiment, conducted by physicists, in which they take two cylinders and put a colored fluid between them. As they rotate the inner cylinder, the motion of the fluid moves from calm motion through cycles to chaos. To measure this transition, they shine a strobe light through the fluid and record a sequence of dots. As the speed of rotation increases, there comes a point where the sequence of dots is well described by a three dimensional differential equation system with a chaotic attracting set. The path of any given sequence is completely deterministic but any given path is sensitive to initial conditions. Paths that initially start close together begin to diverge. This is the ‘butterfly wings’ phenomenon. A butterfly flapping its wings in Brazil can cause a hurricane in the Caribbean.

The obvious question that Buzz asked was: are economic systems like this? The answer is: we have no way of knowing given current data limitations. Physicists can generate potentially infinite amounts of data by experiment. Macroeconomists have a few hundred data points at most. In finance we have daily data and potentially very large data sets, but the evidence there is disappointing. It’s been a while since I looked at that literature, but as I recall, there is no evidence of low dimensional chaos in financial data.

Where does that leave non-linear theory and chaos theory in economics? Is the economic world chaotic? Perhaps. But there is currently not enough data to tell a low dimensional chaotic system apart from a linear model hit by random shocks. Until we have better data, Occam’s razor argues for the linear stochastic model.

If someone can write down a three equation model that describes economic data as well as the Lorentz equations describe physical systems: I'm all on board. But in the absence of experimental data, lots and lots of experimental data, how would we know if the theory was correct?

The Liquidity Trap and How to Escape It: Time for a New Approach

We are stuck in a low inflation liquidity trap, caused by the fact that money and short term securities are currently perfect substitutes. The way out of the liquidity trap is to raise the interest rate; an argument that has been called neo-Fisherian in recent blog posts by Stephen Williamson and Noah Smith. Raising the interest rate however, and doing nothing else, will generate a recession; possibly a large and persistent recession. To prevent that from happening, the Treasury must engage in a simultaneous fiscal expansion. That fiscal expansion could be achieved through a money financed transfer to households; it could also be more efficiently achieved through a government guarantee to support asset prices.

A fiscal expansion can occur through infrastructure expenditure, through a tax cut, or a cash transfer to households. And any given expansion can be paid for by printing money or by issuing short-term or long-term government bonds. According to conventional wisdom, it doesn’t matter whether the government borrows by issuing short-term bonds or long-term bonds. Conventional wisdom is wrong as I have shown in a series of books and papers, for example, see here.

Some have argued that the government should build roads and bridges and that this new infrastructure expenditure should be paid for by issuing long-term debt. That argument makes sense. But it is logically distinct from the argument for a fiscal stimulus. Build roads and bridges to support private sector growth; the Northern Powerhouse of George Osborne. And, by all means, pay for these investments by issuing long-term bonds. New projects of this kind should be weighed carefully and a case must be made that they have positive net present value.

Do not build roads and bridges as a temporary stimulus. A better way to prevent the recession that might otherwise occur when the Bank raises the Bank Rate would be an explicit commitment by the Financial Policy Committee of the Bank of England, to support the value of the stock market. This could be achieved by offering to buy or sell shares in an Exchange Traded Fund at a value linked to the performance of the unemployment rate. [1]

The private sector does not typically find the right price for stocks and shares. Animal spirits represent a separate independent fundamental of the economy; they are like technology or preferences. And the state of animal spirits is reflected in the price that households are prepared to pay for stocks and shares.

The role of fiscal policy is to counteract the influence of animal spirits by helping markets to coordinate on a ‘good equilibrium’. In the absence of the direction of the Treasury or the Central Bank, asset markets are often trapped like the proverbial prisoner in the ‘prisoners’ dilemma’ who confesses to avoid the fate that would await him if his partner in crime were to confess first.

My argument is not made lightly. My recent books and articles provide a coherent alternative to the conventional New Keynesian paradigm and I provide empirical evidence that demonstrates a stable link between asset prices and the unemployment rate.

Conventional wisdom argues that the path to higher inflation lies through lowering interest rates. That path is supposed to trigger a demand expansion, higher employment and higher wages and prices. But the link from unemployment to wage inflation, the so-called ‘Phillips Curve’ has not existed since Phillips published his eponymous article in 1958. It was an artifact of the gold exchange standard when monetary policy operated very differently from the way it operates today.

The evidence from twenty years of stagnation in Japan does not inspire confidence in a policy of lowering interest rates further. It’s time for new approach.

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

_____________________

[1] A second best fiscal policy, that has a greater political chance of happening in the current climate, is a cash transfer to households paid for by printing money. I would support this policy as a way of preventing a recession; but it is not ideal because it does not correct the problem that assets may be incorrectly priced.  

My Slides for the SNB Research Conference

Karl Brunner: 1916 -- 1989 

I had the privilege of attending a conference in Zurich yesterday in honor of what would have been Karl Brunner's 100th birthday. This is the first of a series the Swiss National Bank (SNB) has established, kicked off with a keynote address from Ken Rogoff. 

The celebration of Karl's contribution to economics was followed up by the 10th in a series of terrific SNB research conferences. We're currently at the end of the first day and I've learned a lot from interacting with academics and central bankers in a beautiful environment on the edge of Lake Zurich. 

I presented my paper with Pawel Zabczyk, "The Theory of Unconventional Monetary Policy". Here is a link to my paper, and here is a link to my slides (easier to follow and more fun than the paper itself).