Die Inhalte der verlinkten Blogs und Blog Beiträge unterliegen in vielen Fällen keiner redaktionellen Kontrolle.
Warnung zur Verfügbarkeit
Eine dauerhafte Verfügbarkeit ist nicht garantiert und liegt vollumfänglich in den Händen der Blogbetreiber:innen. Bitte erstellen Sie sich selbständig eine Kopie falls Sie einen Blog Beitrag zitieren möchten.
In economics. Reader JohnH disparages attempts to measure r* (and r* plus expected inflation): Question is, would anyone recognize the neutral rate if it stared them right in the face? And if it could be identified, would it be wearing its real face, a nominal one, or a "natural" one? In macroeconomics, we try to […]
Die Inhalte der verlinkten Blogs und Blog Beiträge unterliegen in vielen Fällen keiner redaktionellen Kontrolle.
Warnung zur Verfügbarkeit
Eine dauerhafte Verfügbarkeit ist nicht garantiert und liegt vollumfänglich in den Händen der Blogbetreiber:innen. Bitte erstellen Sie sich selbständig eine Kopie falls Sie einen Blog Beitrag zitieren möchten.
SPD-Mitglieder erkaufen Zeit. Die Linken müssen sie nutzen (OXI Blog)
Regierungsbildung
Merkels Ministerinnen und Minister (Tagesschau) Alexander Will (Facebook) Frohnatur und Generalisten (Spiegel online) "Das Verkehrsministerium fühlt sich der Autoindustrie verbunden" (Süddeutsche Zeitung) ZDF heute (Facebook) "Neue Förderstrategie": GroKo gibt Dobrindts Breitband-Ziel auf (ZDF) Nils Maurice (Twitter) UBA-Studie
Deutschland entgehen 1,2 Milliarden Euro wegen falscher CO2-Werte (Süddeutsche Zeitung) Wie wir euer Leben schöner machen! (MOIA) Fahrzeugemissionen: Kommission eröffnet Vertragsverletzungsverfahren gegen sieben Mitgliedstaaten wegen Nichteinhaltung von EU-Vorschriften (European Commission) Keine Diesel mehr in Europa (Frankfurter Allgemeine) Wie sehr beeinträchtigt Stickstoffdioxid (NO2) die Gesundheit der Bevölkerung in Deutschland? (Umwelt Bundesamt) Absurde Idee vom kostenlosen ÖPNV ist krachend gescheitert (Welt) Stuttgart und Düsseldorf sind erst der Anfang (Spiegel online) Trump verhängt Strafzölle
«Das Problem ist sicher nicht der Feminismus» (Republik) The Macroeconomics of Trade War (The New York Times) "Das Widerlichste ist Trumps Angriff auf Verbündete" (Spiegel online) Bundes-Hack
Microsoft just edged out Facebook and proved that it's changed in an important way (Business Insider Deutschland) So schleusten die Hacker Daten aus dem Auswärtigen Amt (Süddeutsche Zeitung) Diese Gruppe soll hinter dem Bundeshack stecken (Süddeutsche Zeitung) Na, wer hat hier gehackt? (Süddeutsche Zeitung) Feedback Hartz IV/Essener Tafel
Wieso Hartz IV tatsächlich zu wenig zum Leben ist (Spiegel online) Ein Drittel der Hartz-IV-Sanktionen trifft Kinder (Zeit online) THS (Twitter) "Jetzt bin ich dran!" (Spiegel online) Ausgeloste Ordnung für Bedürftige (Tagesspiegel) Die Vermessung der Armut (Spiegel online) Feedback
Erlangen will Modellstadt für kostenlosen Nahverkehr werden (Stadt Erlangen) Verabschiedung
Rabatt T-Shirt (kuechenstud.io) Gültig vom 12.03.2018 bis 16.03.2018 T-Shirts - Aktionscode: SAVE5
Hausmitteilung
Lagezentrum (Community-Redaktion) Spenden: Bankverbindung Spenden: Banking-Program mit BezahlCode-Standard Kuechenstud.io-Newsletter Kuechenstud.io Shop "Lage der Nation" bei iTunes bewerten "Lage der Nation" bei Youtube "Lage der Nation" bei Facebook "Lage der Nation" bei Instagram "Lage der Nation" bei Twitter "Lage der Nation" in der Wikipedia
Die Inhalte der verlinkten Blogs und Blog Beiträge unterliegen in vielen Fällen keiner redaktionellen Kontrolle.
Warnung zur Verfügbarkeit
Eine dauerhafte Verfügbarkeit ist nicht garantiert und liegt vollumfänglich in den Händen der Blogbetreiber:innen. Bitte erstellen Sie sich selbständig eine Kopie falls Sie einen Blog Beitrag zitieren möchten.
My first post described a few anecdotes about what a warm person Bob Lucas was, and such a great colleague. Here I describe a little bit of his intellectual influence, in a form that is I hope accessible to average people.The "rational expectations" revolution that brought down Keynesianism in the 1970s was really much larger than that. It was really the "general equilibrium" revolution. Macroeconomics until 1970 was sharply different from regular microeconomics. Economics is all about "models," complete toy economies that we construct via equations and in computer programs. You can't keep track of everything in even the most beautiful prose. Microeconomic models, and "general equilibrium" as that term was used at the time, wrote down how people behave — how they decide what to buy, how hard to work, whether to save, etc.. Then it similarly described how companies behave and how government behaves. Set this in motion and see where it all settles down; what prices and quantities result. But for macroeconomic issues, this approach was sterile. I took a lot of general equilibrium classes as a PhD student — Berkeley, home of Gerard Debreu was strong in the field. But it was devoted to proving the existence of equilibrium with more and more general assumptions, and never got around to calculating that equilibrium and what it might say about recessions and government policies. Macroeconomics, exemplified by the ISLM tradition, inhabited a different planet. One wrote down equations for quantities rather than people, for example that "consumption" depended on "income," and investment on interest rates. Most importantly, macroeconomics treated each year as a completely separate economy. Today's consumption depended on today's income, having nothing to do with whether people expected the future to look better or worse. Economists recognized this weakness, and a vast and now thankfully forgotten literature tried fruitlessly to find "micro foundations" for Keynesian economics. But building foundations under an existing castle doesn't work. The foundations want a different castle. Bob's "islands" paper is famous, yes, for a complete model of how unexpected money might move output in the short run and not just raise inflation. But you can do that with a half a page of simple math, and Bob's paper is hard to read. It's deeper contribution, and the reason for that difficulty, is that Bob wrote out a complete "general equilibrium" model. People, companies and government each follow described rules of behavior. Those rules are derived as being the optimal thing for people and companies to do given their environment. And they are forward-looking. People think about how to make their whole lives as pleasant as possible, companies to maximize the present value of profits. Prices adjust so supply = demand. Bob said, by example, that we should do macroeconomics by writing down general equilibrium models. General equilibrium had also been abandoned by the presumption that it only studies perfect economies. Macroeconomics is really about studying how things go wrong, how "frictions" in the economy, such as the "sticky" wages underlying Keynesian thinking, can produce undesirable and unnecessary recessions. But here too, Bob requires us to write down the frictions explicitly. In his model, people don't see the aggregate price level right away, and do the best they can with local information. That is the real influence of the paper and Bob's real influence in the profession. (Current macroeconomic modeling reflects the fact that the Fed sets interest rates, and does not control the money supply.) You can see this influence in Tom Sargent's textbooks. The first textbook has an extensive treatment of Keynesian economics. It's about the most comprehensible treatment there is — but it is no insult to Tom to say that in that book you can see how Keynesian economics really doesn't hang together. Tom describes how, the minute he learned from Bob how to to general equilibrium, everything changed instantly. Rational expectations was, like any other advance, a group effort. But what made Bob the leader was that he showed the rest how to do general equilibrium. This is the heart of my characterization that Bob is the most important macroeconomist of the 20th century. Yes, Keynes and Friedman had more policy impact, and Friedman's advocacy of free markets in microeconomic affairs is the most consequential piece of 20th century economics. But within macroeconomics, there is before Lucas and after Lucas. Everyone today does economics the Lucas way. Even the most new-Keynesian article follows the Lucas rules of how to do economics. Once you see models founded on complete descriptions of people, businesses, government, and frictions, you can see the gaping holes in standard ISLM models. This is some of his stinging critique, such as "after Keynesian macroeconomics." Sure, if people's income goes up they are likely to consume more, as the Keynesians posited. But interest rates, wages, and expectations of the future also affect consumption, which Keynesians leave out. "Cross equations restrictions" and "budget constraints" are missing. Now, the substantive prediction that monetary policy can only move the real economy via unexpected money supply growth did not bear out, and both subsequent real business cycles and new-Keynesianism brought persistent responses. But the how we do macroeconomics part is the enduring contribution. The paper still had enduring practical lessons. Lucas, together with Friedman and Phelps brought down the Phillips curve. This curve, relating inflation to unemployment, had been (and sadly, remains) at the center of macroeconomics. It is a statistical correlation, but like many correlations people got enthused with it and started reading it as stable relationship, and indeed a causal one. Raise inflation and you can have less unemployment. Raise unemployment in order to lower inflation. The Fed still thinks about it in that causal way. But Lucas, Friedman, and Phelps bring a basic theory to it, and thereby realize it is just a correlation, which will vanish if you push on it. Rich guys wear Rolexes. That doesn't mean that giving everyone a Rolex will have a huge "multiplier" effect and make us all rich. This is the essence of the "Lucas critique" which is a second big contribution that lay readers can easily comprehend. If you push on correlations they will vanish. Macroeconomics was dedicated to the idea that policy makers can fool people. Monetary policy might try to boost output in a recession with a surprise bit of money growth. That will wok once or twice. But like the boy who cried wolf, people will catch on, come to expect higher money growth in recessions and the trick won't work anymore. Bob showed here that all the "behavioral" relations of Keynesian models will fall apart if you exploit them for policy, or push on them, though they may well hold as robust correlations in the data. The "consumption function" is the next great example. Keynesians noticed that when income rises people consume more, so write a consumption function relating consumption to income. But, following Friedman's great work on consumption, we know that correlation isn't always true in the data. The relation between consumption and income is different across countries (about one for one) than it is over time (less than one for one). And we understand that with Friedman's theory: People, trying to do their best over their whole lives don't follow mechanical rules. If they know income will fall in the future, they consume a lot less today, no matter what today's current income. Lucas showed that people who behave this sensible way will follow a Keynesian consumption function, given the properties of income overt the business cycle. You will see a Keynesian consumption function. Econometric estimates and tests will verify a Keynesian consumption function. Yet if you use the model to change policies, the consumption function will evaporate. This paper is devastating. Large scale Keynesian models had already been constructed, and used for forecasting and policy simulation. It's natural. The model says, given a set of policies (money supply, interest rates, taxes, spending) and other shocks, here is where the economy goes. Well, then, try different policies and find ones that lead to better outcomes. Bob shows the models are totally useless for that effort. If the policy changes, the model will change. Bob also showed that this was happening in real time. Supposedly stable parameters drifted around. (This one is also very simple mathematically. You can see the point instantly. Bob always uses the minimum math necessary. If other papers are harder, that's by necessity not bravado.) This devastation is sad in a way. Economics moved to analyzing policies in much simpler, more theoretically grounded, but less realistic models. Washington policy analysis sort of gave up. The big models lumber on, the Fred's FRBUS for example, but nobody takes the policy predictions that seriously. And they don't even forecast very well. For example, in the 2008 stimulus, the CEA was reduced to assuming a back of the envelope 1.5 multiplier, this 40 years after the first large scale policy models were constructed. Bob always praised the effort of the last generation of Keynesians to write explicit quantitative models, to fit them to data, and to make numerical predictions of various policies. He hoped to improve that effort. It didn't work out that way, but not by intention. This affair explains a lot of why economists flocked to the general equilibrium camp. Behavioral relationships, like what fraction of an extra dollar of income you consume, are not stable over time or as policy changes. But one hopes that preferences, — how impatient you are, how much you are willing to save more to get a better rate of return — and technology — how much a firm can produce with given capital and labor — do not change when policy changes. So, write models for policy evaluation at the level of preferences and technology, with people and companies at the base, not from behavioral relationships that are just correlations. Another deep change: Once you start thinking about macroeconomics as intertemporal economics — the economics that results from people who make decisions about how to consume over time, businesses make decisions about how to produce this year and next — and once you see that their expectations of what will happen next year, and what policies will be in place next year are crucial, you have to think of policy in terms of rules, and regimes, not isolated decisions. The Fed often asks economists for advice, "should we raise the funds rate?" Post Lucas macroeconomists answer that this isn't a well posed question. It's like saying "should we cry wolf?" The right question is, should we start to follow a rule, a regime, should we create an institution, that regularly and reliably raises interest rates in a situation like the current one? Decisions do not live in isolation. They create expectations and reputations. Needless to say, this fundamental reality has not soaked in to policy institutions. And that answer (which I have tried at Fed advisory meetings) leads to glazed eyes. John Taylor's rule has been making progress for 30 years trying to bridge that conceptual gap, with some success. This was, and remains, extraordinarily contentious. 50 years later, Alan Blinder's book, supposedly about policy, is really one long snark about how terrible Lucas and his followers are, and how we should go back to the Keynesian models of the 1960s. Some of that contention comes back to basic philosophy. The program applies standard microeconomics: derive people's behaviors as the best thing they can do given their circumstances. If people pick the best combination of apples and bananas when they shop, then also describe consumption today vs. tomorrow as the best they can do given interest rates. But a lot of economics doesn't like this "rational actor" assumption. It's not written in stone, but it has been extraordinarily successful. And it imposes a lot of discipline. There are a thousand arbitrary ways to be irrational. Somehow though, a large set of economists are happy to write down that people pick fruit baskets optimally, but don't apply the same rationality to decisions over time, or in how they think about the future. But "rational expectations" is really just a humility condition. It says, don't write models in which the predictions of the model are different from the expectations in the model. If you do, if your model is right, people will read the model and catch on, and the model won't work anymore. Don't assume you economist (or Fed chair) are so much less behavioral than the people in your model. Don't base policy on an attempt to fool the little peasants over and over again. It does not say that people are big super rational calculating machines. It just says that they eventually catch on. Some of the contentiousness is also understandable by career concerns. Many people had said "we should do macro seriously like general equilibrium." But it isn't easy to do. Bob had to teach himself, and get the rest of us to learn, a range of new mathematical and modeling tools to be able to write down interesting general equilibrium models. A 1970 Keynesian can live just knowing how to solve simple systems of linear equations, and run regressions. To follow Bob and the rational expectations crowd, you had to learn linear time-series statistics, dynamic programming, and general equilibrium math. Bob once described how tough the year was that it took him to learn functional analysis and dynamic programming. The models themselves consisted of a mathematically hard set of constructions. The older generation either needed to completely retool, fade away, or fight the revolution. Some good summary words: Bob's economics uses"rational expectations," or at least forward-looking and model-consistent expectations. Economics becomes "intertemporal," not "static" (one year at a time). Economics is "stochastic" as well as "dynamic," we can treat uncertainty over time, not just economies in which everyone knows the future perfectly. It applies "general equilibrium" to macroeconomics. And I've just gotten to the beginning of the 1970s. When I got to Chicago in the 1980s, there was a feeling of "well, you just missed the party." But it wasn't true. The 1980s as well were a golden age. The early rational expectations work was done, and the following real business cycles were the rage in macro. But Bob's dynamic programming, general equilibrium tool kit was on a rampage all over dynamic economics. The money workshop was one creative use of dynamic programs and interetempboral tools after another one, ranging from taxes to Thai villages (Townsend). I'll mention two. Bob's consumption model is at the foundation of modern asset pricing. Bob parachuted in, made the seminal contribution, and then left finance for other pursuits. The issue at the time was how to generalize the capital asset pricing model. Economists understood that some stocks pay higher returns than others, and that they must do so to compensate for risk. The understood that the risk is, in general terms, that the stock falls in some sense of bad times. But how to measure "bad times?" The CAPM uses the market, other models use somewhat nebulous other portfolios. Bob showed us that at least in the purest theory, that stocks must pay higher average returns if they fall when consumption falls. (Breeden also constructed a consumption model in parallel, but without this "endowment economy" aspect of Bob's) This is the purest most general theory, and all the others are (useful) specializations. My asset pricing book follows. The genius here was to turn it all around. Finance had sensibly built up from portfolio theory, like supply and demand: Given returns, what stocks do you buy, and how much to you save vs. consume? Then, markets have to clear find the stock prices, and thus returns, given which people will buy exactly the amount that's for sale and consume what is produced. That's hard. (Technically, finding the vector of prices that clears markets is hard. Yes, N equations in N unknowns, but they're nonlinear and N is big.) Bob instead imagined that consumption is fixed at each moment in time, like a desert island in which so many coconuts fall each day and you can't store them or plant them. Then, you can just read prices from people's preferences. This gives the same answer as if the consumption you assume is fixed had derived from a complex production economy. You don't have to solve for prices that equate supply and demand. Brilliantly, though prices cause consumption to individual people, consumption causes prices in aggregate. This is part of Bob's contribution to the hard business of actually computing quantitative models in the stochastic dynamic general equilibrium tradition. Bob, with Nancy Stokey also took the new tools to the theory of taxation. (Bob Barro also was a founder of this effort in the late 1980s.) You can see the opportunity: we just learned how to handle dynamic (overt time, expectations of tomorrow matter to what you do today) stochastic (but there is uncertainty about what will happen tomorrow) economics (people make explicit optimizing decisions) for macro. How about taking that same approach to taxes? The field of dynamic public finance is born. Bob and Nancy, like Barro, show that it's a good idea for governments to borrow and then repay, so as to spread the pain of taxes evenly over time. But not always. When a big crisis comes, it is useful to execute a "state contingent default." The big tension of Lucas-Stokey (and now, all) dynamic public finance: You don't want any capital taxes for the incentive effects. If you tax capital, people invest less, and you just get less capital. But once people have invested, a capital tax grabs revenue for the government with no economic distortion. Well, that is, if you can persuade them you'll never do it again. (Do you see expectations, reputations, rules, regimes, wolves in how we think of policy?) Lucas and Stoney say, do it only very rarely to balance the disincentive of a bad reputation with the need to raise revenue in once a century calamities. Bob went on, of course, to be one of the founders of modern growth theory. I always felt he deserved a second Nobel for this work. He's absolutely right. Once you look at growth, it's hard to think about anything else. The average Indian lives on $2,000 per year. The average American, $60,000. That was $15,000 in 1950. Nothing else comes close. I only work on money and inflation because that's where I think I have answers. For us mortals, good research proceeds where you think you have an answer, not necessarily from working on Big Questions. Bob brilliantly put together basic facts and theory to arrive at the current breakthrough. Once you get out of the way, growth does not come from more capital, or even more efficiency. It comes from more and better ideas. I remember being awed by his first work for cutting through the morass and assembling the facts that only look salient in retrospect. A key one: Interest rates in poor countries are not much higher than they are in rich countries. Poor countries have lots of workers, but little capital. Why isn't the return on scarce capital enormous, with interest rates in the hundreds of percent, to attract more capital to poor countries? Well, you sort of know the answer, that capital is not productive in those countries. Productivity is low, meaning those countries don't make use of better ideas on how to organize production. Ideas too are produced by economics, but, as Paul Romer crystallized, they are fundamentally different from other goods. If I produce an idea, you can use it without hurting my use of it. Yes, you might drive down the monopoly profits I gain from my intellectual property. But if you use my Pizza recipe, that's not like using my car. I can still make Pizza, where if you use my car I can't go anywhere. Thus, the usual free market presumption that we will produce enough ideas is false. (Don't jump too quickly to advocate government subsides for ideas. You have to find the right ideas, and governments aren't necessarily good at subsidizing that search.) And the presumption that intellectual property should be preserved forever is also false. Once produced it is socially optimal for everyone to use it. I won't go on. It's enough to say that Bob was as central to the creation of idea-based growth theory, which dominates today, as he was to general equilibrium macro, which also dominates today.Bob is an underrated empiricist. Bob's work on the size distribution of firms (great tweet summary by Luis Garicano) similarly starts from basic facts of the size distribution of firms and the lack of relationship between size and growth rates. It's interesting how we can go on for years with detailed econometric estimates of models that don't get basic facts right. I loved Bob's paper on money demand for the Carnegie Rochester conference series. An immense literature had tried to estimate money demand functions with dynamics, and was pretty confusing. It made a basic mistake, by looking at first differences rather than levels and thereby isolating the noise and drowning out the signal. Bob made a few plots, basically rediscovered cointegration all on his own, and made sense of it all. And don't forget the classic international comparison of inflation-output relations. Countries with volatile inflation have less Phillips curve tradeoff, just as his islands model featuring confusion between relative prices and the price level predicts. One last note to young scholars. There is a tendency today to value people by the number of papers they produce, and how quickly they rise through the ranks. Read Bob's CV. He wrote about one paper a year, starting quite late in life. But, as Aesop said, they were lions. In his Nobel prize speech, Bob also passed on that he and his Nobel-winning generation at Chicago always felt they were in some backwater, where the high prestige stuff was going on at Harvard and MIT. You never know when it might be a golden age. And the AER rejected his islands paper (as well as Akerlof's lemons). If you know it's good, revise and try again. I will miss his brilliant papers as much as his generous personality. Update: See Ivan Werning's excellent "Lucas Miracles" for an appreciation by a real theorist.
Die Inhalte der verlinkten Blogs und Blog Beiträge unterliegen in vielen Fällen keiner redaktionellen Kontrolle.
Warnung zur Verfügbarkeit
Eine dauerhafte Verfügbarkeit ist nicht garantiert und liegt vollumfänglich in den Händen der Blogbetreiber:innen. Bitte erstellen Sie sich selbständig eine Kopie falls Sie einen Blog Beitrag zitieren möchten.
By the standards of mainstream media coverage of technical economics, Peter Coy's coverage of HANK (Heterogeneous Agent New Keynesian) models in the New York Times was actually pretty good. 1) Representative agents and distributions. Yes, it starts with the usual misunderstanding about "representative agents," that models assume we are all the same. Some of this is the standard journalist's response to all economic models: we have simplified the assumptions, we need more general assumptions. They don't understand that the genius of economic theory lies precisely in finding simplified but tractable assumptions that tell the main story. Progress never comes from putting more ingredients and stirring the pot to see what comes out. (I mean you, third year graduate students looking for a thesis topic.) But in this case many economists are also confused on this issue. I've been to quite a few HANK seminars in which prominent academics waste 10 minutes or so dumping on the "assumption that everyone is identical." There is a beautiful old theorem, called the "social welfare function." (I learned this in graduate school in fall 1979, from Hal Varian's excellent textbook.) People can have almost arbitrarily different preferences (utility functions), incomes and shocks, companies can have almost arbitrarily different characteristics (production functions), yet the aggregate economy behaves as if there is a single representative consumer and representative firm. The equilibrium path of aggregate consumption, output, investment, employment, and the prices and interest rates of that equilibrium are the same as those of an economy where everyone and every firm is the same, with a "representative agent" consumption function and "representative firm" production function. Moreover, the representative agent utility function and representative firm production function need not look anything like those of any particular individual person and firm. If I have power utility and you have quadratic utility, the economy behaves as if there is a single consumer with something in between. Defining the job of macroeconomics to understand the movement over time of aggregates -- how do GDP, consumption, investment, employment, price level, interest rates, stock prices etc. move over time, and how do policies affect those movements -- macroeconomics can ignore microeconomics. (We'll get back to that definition in a moment.) Now uniting macro and micro is important. Macro estimation being what it is, it would be awfully nice to use micro evidence. The program kicked off by Kydland and Prescott to "calibrate" macro models from micro evidence would be very useful. Kydland and Prescott may have had a bit of grass-is-greener optimism about just how much precise evidence macroeconomists have on firms and people, but it's a good idea. Adding up micro evidence to macro is hard, however. Here "aggregation theory," often confused with the "social welfare function" theorem comes up, more as a nightmare from graduate school. The conditions under which the representative agent preferences look like individual people are much more restricted. Like all good theorems, this one rests on assumptions, and the assumptions are false. The crucial assumption is complete markets, and in particular complete risk sharing: There is an insurance market in which you can be compensated for every risk, in particular losing your job. A generalized form still works, however. There is still a representative agent, but it cares about distributions. The representative agent utility function depends on aggregate consumption, aggregate labor supply but now also statistics about the distribution of consumption across people. In asset pricing, the Constantinides-Duffie model is a great example: the cross-sectional variance of consumption becomes a crucial state variable for the value of the stock market, not just aggregate consumption. All economic theorems are false of course, in that the assumptions are not literally true. The question is, how false? Conventional macroeconomics comes down to a description of how aggregates evolve over time, based on past aggregates: [aggregate income, consumption, employment, inflation... next year ] = function of [aggregate income, consumption, employment, inflation, policy variables... this year ] + unforecastable shocks. That's it. That's what macroeconomics is. Theory, estimation and calibration to figure out the function. [Update. I added policy variables, e.g. interest rates, to the function. And, the point of macro is to figure out how policies affect the economy, and furthermore with an objective in hand to derive optimal policies. Thanks François Velde for pointing out the omissions in comments.] If HANK is useful to macroeconomics, then, it must be that adding distributional statistics helps to describe aggregate dynamics. Reality must be [aggregate income, consumption, employment, inflation... next year ] = function of [aggregate income, consumption, employment, inflation, distribution of consumption, employment, etc., policy variables,... this year ] + unforecastable shocks. So here is a central question I have for HANK modelers: Is that true? Do statistics on the distribution across people of economic variables really help us to forecast or understand aggregate dynamics? So far, my impression is, not much. The social welfare function theorem can be wrong in its assumptions, yet still a pretty good approximation. And "heterogeneity" has been around macro for a long time, but never has seemed to matter much in the end. (The investment literature of the early 1990s is a great example.) But I would be happy to be proved wrong. This post is as much a suggestion for HANK modelers as a critique. Another possibility: Maybe HANK is about aggregation after all. Can we actually use micro evidence, and add it up constructively, to learn what the representative agent - social welfare function is? Even before HANK, there were good examples. For example, the literature on labor supply: Macro models want people to work more in response to temporarily higher wages. Most individual people work 8 hours a day or zero, so micro evidence finds a small response. But a small number of people move from non-work to work as wages rise. So the representative agent can have a much larger elasticity than individual people. And, you have to understand labor market structure, and the distribution of who is available to work to add up from micro to macro evidence. Here, I would like to know the basic functional form -- how much does the SWF care about today vs. tomorrow, risk, work vs leisure, as well as any distributional effect? 2) Income effectsCoy also goes on with the usual New York Times schtick about how dumb and irrational all the little hoi polloi are. (Of course we of the elite and the federal government handing out nudges would never be behavioral.) But you don't need HANK to assume that the representative investor is dumb either. He goes on to describe pretty well where the current literature is. Behind this is, however, one of the major features of HANK models so far. One of its most important uses has been to put current income in the IS equation. (Economists talk amongst yourselves for a bit while I explain this to regular people. So far, the central description of demand in new Keynesian models is based on "intertemporal substitution:" When the real interest rate is higher, you consume a bit less today, save a bit more, so that you can consume a lot more tomorrow. That is the crucial mechanism by which higher real interest rates (say, induced by the Fed) lower demand today. Old Keynesian models didn't have people in them at all, but hypothesized that consumption simply follows income. That adds a more powerful mechanism, the "multiplier:" an initial income drop lowers consumption, which lowers income and around we go. )HANK models often add some "hand to mouth" consumers. Some people think about today vs. the future, but others just eat what income they make today. You can get this out of "rational, liquidity constrained" people, but that's typically not enough. To get significant effects, you need people who just behave that way. So, there is this little bit of behaviorism in many HANK models. But it's a little spice in the otherwise Lucas soup. In equations, the standard model says consumption today = expected consumption tomorrow - (number) x real interest rateAfter an immense amount of algebra and computer time, HANK models allow you to writeconsumption today = (number) x income today + (number) x expected consumption tomorrow - (number) x real interest rate New Keynesian models were invented on the hope they would turn out to be holy water sprinkled on old-Keynesian thinking, for example justifying big spending multipliers and strong monetary policy. They turned out to be nothing at the sort once you read the equations. A movement is underway to modify (torture?) new-Keynesian models to look like old-Keynesian models, to bring macro back to roughly the 1976 edition of Dornbush and Fisher's textbook. Complex expectation formation theories and this aspect of HANK can be digested that way. So here is my second question for HANK modelers: Is this it? When we boil it all down to the linearized equations of the model you take to data, to explain aggregates and monetary and fiscal policy, is there a big bottom line beyond an excuse to revive bits of the Keynesian consumption function? That too is an honest question, and perhaps a suggestion--show us the textbook back of the envelope bottom line model. (It would be awfully nice if distributions mattered here too, theoretically, empirically, and quantitatively.) 3) Micro implications of macro Maybe you disagreed a few paragraphs ago with my definition of macroeconomics, as only concerned with the movement of aggregates over time. Talking with some of my HANK colleagues, a different purpose is at work -- figuring out the effects of macroeconomics on different people. Recessions fall harder on those who lose jobs, and certain income and other groups; harder on some industries and areas than others. Here HANK dovetails with concerns over income diversity and "equity." That's a perfectly good reason to study it, but let's then be clear. If that's the case, HANK really doesn't change our understanding of how policies and events move aggregates around, it is really just about understanding how those aggregates affect different people differently. That may change calculations of optimal monetary policy. If the objective function cares negatively about income diversity, then adding HANK may produce a model that makes no difference at all for the effect of monetary policy on aggregates, but gives a greater weight to employment vs. inflation. ("May!" Inflation also falls harder on people experiencing low incomes, so concerns for equity could go the other way too. Thanks to a correspondent for pointing that out.) Many models have observationally equivalent predictions for aggregates but different welfare implications, and the same model can have different welfare implications if you put in different preferences for distributions across people. But surely HANK has more to offer than a long-winded excuse for dovishness towards tolerating inflation in place of unemployment. Also, in the big picture this seems like a classic answer in search of a question. If you care about the less fortunate, you start with the big issues: crime, awful schools, family breakdown, opportunity. The additional benefit for the less fortunate from the level of the overnight federal funds rate might be fun to isolate in a model, but we are really staring at a caterpillar on a leaf of a tree and missing the forest of economic misfortune. 4) Last thoughtsI hesitate to write, as I am a consumer not a producer of HANK research, and thus will probably get things wrong or show my limited knowledge of the literature. Please fill the comments with corrections, amplifications, pointers to good papers, etc. There is a tendency in economics to pursue a new technical possibility without really knowing where it's going or why. That's not unhealthy; figure out what you can do first, and what to do later. The why always does come later. This was true of rational expectations, real business cycles, new-Keynesian models and more. Now that HANK is pretty well developed and is coming out in public, with admiring New York Times articles, it is worth assessing the why, the bottom line, what it does. I'm also hesitant to write and especially too critically. I vividly recall being in grad school, and some speaker (I mercifully forgot who) went on a tirade about all these young whippersnappers using too much math and not enough intuition and just being in love with building models. I vowed if I ever thought that I would retire. What do we say to the angel of old age? Not today. Bring it on, and let's all figure out what it means.Update: Alessandro Davis comments below, reminding me of their recent QJE paper "Imperfect Risk Sharing and the Business Cycle." This paper evaluates directly the question, how much does heterogeneity matter for aggregate dynamics? The headline answer is "not much, though maybe more at the zero bound." deviations from perfect risk sharing implied by this class of models account for only 7% of output volatility on average but can have sizable output effects when nominal interest rates reach their lower bound. Now, 7% might actually be a lot. A little secret of contemporary macro models is that none of them explain a lot of output volatility. In my above characterization aggregates next year = function of aggregates today + shocks, the shocks are big and account for most variation in aggregates. Most inflation comes from inflation shocks, not movements in other variables like employment, especially as fed through a model. This isn't necessarily a failing of models. New Keynesian models are designed to understand how monetary policy affects output, not to explain why output varies. Milton Friedman thought that most business cycles were due to monetary policy mistakes, so understanding the former is the same as the latter, but he seems to have been wrong about that, at least since 1982. Or maybe not. The paper's computation takes heterogene in the data, and asks how much does that affect the new-Keynesian model's predictions for output, employment, etc. I have in mind a slightly different question: Even without much theory, how much can data on heterogeneity actually improve forecasts of output, employment, etc. Do distributional variables improve VAR forecasts? Let me know if you have an answer to that one. The paper has a crystal clear summary of the representative agent theorem, and its important extension. They show how distributional variables enter in to a representative agent representation as simple "wedges." Using a representative agent does not mean you assume all people are identical! There is also a great literature review on the general understanding that distributional variables don't matter much for aggregates, starting with Krussell and Smith. A parallel literature in finance qualitatively examined the beautiful Constantinides-Duffie mechanism, finding that uninsured idiosyncratic risk isn't large enough or variable enough to account for asset pricing puzzles. So far -- that's all from the 1990s and a lot of the point of HANK is to reverse that impression. UpdateSee Matthew Rognlie's superb answer below. I ask a lot of questions but seldom get such clear and detailed answers! Thanks for the short course on Hank model big picture! Update 2 Ben Moll writes Hi John, thanks a lot for the very thoughtful post. Lots of great food for thought. In case you hadn't seen it, Tom Sargent posted a new paper a few days ago that has a really great discussion of the main takeaways from HANK. See in particular sections 5 and 7. For example, see the point that HANK "challenges the neoclassical synthesis and a widely-believed prescription for separating macro policy design from policies to redistribute income and wealth." But plenty of other great points there too. Finally, yes, Matt Rognlie's response is really fantastic.Sargent's paper is here. It's fantastic. I'm going to save a review for a separate blog post.
Die Inhalte der verlinkten Blogs und Blog Beiträge unterliegen in vielen Fällen keiner redaktionellen Kontrolle.
Warnung zur Verfügbarkeit
Eine dauerhafte Verfügbarkeit ist nicht garantiert und liegt vollumfänglich in den Händen der Blogbetreiber:innen. Bitte erstellen Sie sich selbständig eine Kopie falls Sie einen Blog Beitrag zitieren möchten.
The standards of modern journalism: Wages in the United Kingdom grew 7.8% in the three months to June, the fastest annual rate since records began, the Office for National Statistics said Tuesday."Coupled with lower inflation, this means the position on people's real pay is recovering," said ONS director of economic statistics Darren Morgan.UK consumer prices rose 7.9% in June compared with June 2022.Sigh. If wages are rising slower than inflation then real wages are falling, not growing at all. Given that we have had real wage rises within living memory this also isn't the fastest wages have grown since records began, either. As to why wages aren't growing as we'd hope and expect them to this is not, sadly, some aberration of macroeconomics and the fiscal stance. Instead it's because the country is beclowned with people insisting that they're creating jobs. With solar and boilers and wind mills and low traffic zones and ULEZs and all the rest. All of these things - and many more - could be good things to do. We don't think so but that's us not some insistence of the universe. What is absolutely true though is that the benefits of these things, even by the definitions of those promoting them, are not in hard cash numbers. They're in things we do not include in GDP, they're about externalities to market prices and processes. OK, but that means that the benefits of them do not arrive in wages, one of those hard cash numbers which are market prices. We're deliberately spending our wealth and effort on things which even if they have benefits do not, by definition, benefit real wages. Because, by definition again, those externalities are not things that we spend our wages upon. Then people wonder why wages aren't rising.It's not just journalism that gets wages wrong. Sadly, it's the entire body politic. Everyone shouting that solar provides more jobs than nuclear - something which is both true and which many people do say - and therefore we must have more solar is pushing down labour productivity and thus all the wages in the entire country. That's just the way reality works.
Die Inhalte der verlinkten Blogs und Blog Beiträge unterliegen in vielen Fällen keiner redaktionellen Kontrolle.
Warnung zur Verfügbarkeit
Eine dauerhafte Verfügbarkeit ist nicht garantiert und liegt vollumfänglich in den Händen der Blogbetreiber:innen. Bitte erstellen Sie sich selbständig eine Kopie falls Sie einen Blog Beitrag zitieren möchten.
I was recently chatting with someone who teaches introductory macroeconomics (not using my favorite textbook). He does not teach the students about money creation under fractional reserve banking, which he considers an unnecessary technicality, but he does teach them the following two statements about inflation.
If the Fed lowers the interest rate on reserves, that policy stimulates economic activity in the short run and, via the Phillips curve, increases inflation. In the long run, the quantity theory of money explains inflation.
I agree with both of these statements, and I consider them critical for students to understand. But consider: How does one explain the transition from the short run to the long run?
The only way I know to answer this question is that a lower interest rate on reserves increases bank lending and expands the money supply by increasing the money multiplier. But if students don't know about how banks create money under fractional reserve banking, they are not equipped to understand this logic.The bottom line: The traditional pedagogy about how banks influence the money supply remains important if students are to understand the economics of inflation.Update: This post generated more than the usual amount of confusion and misdirection on Twitter. So let me explain my logic more slowly:
It is useful to teach the quantity theory of money (M and P are parallel) as a long-run equilibrium condition, regardless of which direction causality runs. It is useful for students to know that cutting the interest rate on reserves is expansionary for aggregate demand and, over time, inflationary. That is, it raises P. To complete the story, you need to explain how cutting the interest rate on reserves raises M. To be sure, lower interest rates increase the quantity of money demanded. But you also must explain the quantity of money supplied. The money supply M equals m*B, where m is the money multiplier and B is the monetary base (currency plus reserves). Cutting the interest on reserves (unlike open-market operations) does not change B. So if it changes the money supply M, it must work through the money multiplier m. One cannot understand the money multiplier m without understanding fractional reserve banking. (Under 100-percent-reserve banking, m is fixed at 1.)
Die Inhalte der verlinkten Blogs und Blog Beiträge unterliegen in vielen Fällen keiner redaktionellen Kontrolle.
Warnung zur Verfügbarkeit
Eine dauerhafte Verfügbarkeit ist nicht garantiert und liegt vollumfänglich in den Händen der Blogbetreiber:innen. Bitte erstellen Sie sich selbständig eine Kopie falls Sie einen Blog Beitrag zitieren möchten.
I just got the sad news that Bob Lucas has passed away. He was truly a giant among economists, and a wonderful warm person. I will only pass on three remembrances that others will not likely mention. Bob was incredibly welcoming to me, a young brash and fairly untutored young economist from Berkeley. In the fall of 1985 I gave what was no doubt the most disastrous first seminar by a new assistant professor in the Department's history. It was something about random walks and real business cycles, and was going nowhere. Bob stopped by my office, and expressed doubt about this random walk stuff. He said, if you look at longer and longer horizons, GNP volatility goes down. At least I had the wit to recognize what had just been handed to me on a silver platter, dropped everything and wrote the "Random walk in GNP," my first big paper. Without that, I doubt I would be where I am today. Thank you Bob. He and Nancy were kind to us socially as well. The first Lucas paper that I recall reading, while I was still at Berkeley, was his review of a report to the OECD. I don't think anyone else writing about Bob will mention this masterpiece. If you get annoyed by policy blather, read this article. Reading it as a grad student, I loved the way he sliced through loose prose like warm butter. No BS with Bob. Only clear thinking please. I mentioned it later, and he laughed saying he wrote it in a bad mood because he was getting divorced. Like "After Keynesian Macroeconomics," Bob could wield a pen. Much later, I attended a revelatory money workshop. Bob presented an early version of, I think, "Ideas and growth." In the model, people have ideas, and bump into each other randomly and share ideas. Questioner after questioner complained that there wasn't any economics in the model. Why not put in some incentive for people to bump in to each other, or something non mechanical. Time after time, Bob answered each suggestion that he had tried it, but it didn't make much difference to the outcome, so he stripped it out of the model. Clearly, he had been playing with this model over a year, working to eliminate needless ingredients, not to add more generality. It's great to see the production function at work. Bob is known as a theorist, but he had a great handle on empirical work as well. His Carnegie Rochester money demand paper basically reinvented cointegration, and saw clearly what dozens of others missed. "Mechanics of economic development" starts by putting together facts. "International evidence on inflation-output tradeoffs" 1973 makes one stunning graph. And more. There is so much to say about Bob the great economist, superb colleague and tremendous human being, but I will stop here for now. RIP Bob. And thank you. Update:Ben Moll has a lovely twitter thread about Bob as a thesis adviser. Bob covered Ben's thesis draft with useful comments. Bob read my early papers and did the same thing. This encouraged a culture of comments. Though a young assistant professor, I took it as a duty to write comments on Bob's papers! And some of them actually helped. This was the culture of the economics department in the 1980s, not common. Bob helped quite a few people and JPE authors to see what their papers were really about, making dramatic improvements. The outpouring on twitter is remarkable. More remarkable, here is a man for whom we could celebrate every single paper as pathbreaking. Yet the outpouring is all about his wonderful personal qualities. A correspondent reminds me of one last story. Bob's divorce agreement specified half of his Nobel prize, which he paid. Asked by a reporter if he had regrets, he answered "A deal's a deal." Next post, focused on intellectual contributions.
Die Inhalte der verlinkten Blogs und Blog Beiträge unterliegen in vielen Fällen keiner redaktionellen Kontrolle.
Warnung zur Verfügbarkeit
Eine dauerhafte Verfügbarkeit ist nicht garantiert und liegt vollumfänglich in den Händen der Blogbetreiber:innen. Bitte erstellen Sie sich selbständig eine Kopie falls Sie einen Blog Beitrag zitieren möchten.
Governments around the world are facing increasing constraints on their resources, but they must provide better public services. At the same time, there are increasing concerns about mismanagement of funds, lack of transparency, and prevalence of corruption. As part of the efforts to tackle these challenges, the World Bank is supporting countries in modernizing their public financial management (PFM) and implementing financial management information systems (FMIS).
A recently released World Bank Operational Guidance Note provides policymakers with operational guidance on how to ensure that FMIS projects better achieve the desired improvements in PFM outcomes while contributing to good governance. It draws on an extensive body of diagnostic and analytical work and more importantly, the lessons learned from FMIS implementation in more than 80 countries over the last 30 years.
Given its extensive coverage of the three phases of FMIS projects, i.e. the diagnostic, systems development life cycle, and coverage and utilization phases, the Note can be used by policymakers and practitioners to develop their strategies for any stage of FMIS implementation. It includes detailed guidance on how to avoid mistakes in procurement and contract management. It also discusses the potential use of disruptive technologies to maximize returns on existing investments.
Here are some key messages:
An adequate diagnosis of all aspects of budget management – not just accounting and reporting – is fundamental. This review should be undertaken to identify the needs that the system is intended to address before procuring and implementing a new FMIS.
The policy and institutional framework under which FMIS will operate is very important. The effectiveness of an FMIS as a budget management tool depends on its technical robustness as well as the policy and institutional environment, including a comprehensive single treasury account and the accompanying banking arrangements for government funds. It also depends on an appropriate budget classification structure and financial regulations that ensure budgetary compliance. According to the 2016 World Development Report on Digital Dividends, FMIS also needs analog complements to make them effective and protect against downside risks.
Strong government commitment must be sustained throughout the process. This can be fostered through well-designed project management structures, complemented with adequate considerations for training and change management.
System design should be cognizant of larger budget management issues and follow functional and business process requirements of government. System designs that follow predominantly technical considerations will be less effective in solving budget management problems. System implementation strategies should strategically take a phased approach rather than simultaneously implementing a wide set of functionalities that may overstretch client capacity. A modular approach can be more cost-effective, and could prioritize budget execution and reporting to achieve significant progress on budgetary control and cash management.
Transaction processing through FMIS needs to be comprehensive to ensure credible and complete information for financial operations and management reporting. The benefits from an FMIS pertain only to transactions processed through it.
It is important to understand the transaction ecosystem. While ultimately all transactions should be processed through FMIS, first targeting high-value transactions in system deployment will strengthen fiscal discipline. The following principles could help achieve ample coverage (and expenditure control):
All transactions generated at the central Ministry of Finance such as fiscal transfers, subsidies, and debt service payments, should be processed through FMIS; All payroll and civil service pension payments calculated by a central system should be processed through FMIS (these would likely constitute some 30-40% of the total budget); All payments from line ministries or spending units above the transaction threshold should be processed through FMIS While low-value payments should also be processed through FMIS, they can be disbursed through innovative FinTech products such as mobile money or smart cards.
Accountability and budget compliance are necessary for FMIS to be effective in managing public expenditures. This requires significant political commitment to overcome resistance from vested interests.
Governments can take advantage of disruptive technologies and FMIS innovations. There are tremendous opportunities to deploy technologies such as cloud computing, big data, and machine learning, and robotic process automation to improve budget management. When adopting disruptive technologies, it is important to follow good GovTech principles, such as: a citizen-centric approach, and whole-of-government approach rather than ministry-specific solutions.
Ed Olowo-Okere Senior Advisor in the Equitable Growth, Finance, and Institutions (EFI) Vice Presidency at the World Bank. More Blogs By Ed
1
Dr Mitrajeet D.MARAYE
September 11, 2020
That appears to be an excellent tool to improve on good governance in the affairs of government and what is more important is total transparency. It is most important for governments to implement a clear legal requirement to ensure "effective FREEDOM OF INFORMATION". Unfortunately in many developing countries opacity in the affairs of governments and state owned enterprises is a major source of corruption throughout the system.
Die Inhalte der verlinkten Blogs und Blog Beiträge unterliegen in vielen Fällen keiner redaktionellen Kontrolle.
Warnung zur Verfügbarkeit
Eine dauerhafte Verfügbarkeit ist nicht garantiert und liegt vollumfänglich in den Händen der Blogbetreiber:innen. Bitte erstellen Sie sich selbständig eine Kopie falls Sie einen Blog Beitrag zitieren möchten.
Robert Wade on Zombie Ideas, Being inside the World Bank, and the Death of Ethics in Economics after the Marginal Revolution
The global economy is at the core of some of the main issues in contemporary International Relations. But how do we understand the global economy and what impact does that have on how we deal with the power politics around it? A fault line seems to have emerged between those who take economic theory seriously and those who denounce it for being part of the problem. Informed by his training as an anthropologist, Robert H. Wade—professor at the LSE—takes a different tack: he bases his engagement with the way in which Adam Smith has been appropriated to advocate for a dominant view of 'free markets' on real-world economics and in-depth accounts of insiders. In this Talk, Wade—among others—discusses experimentation in international economic regimes, why the International Financial Institutions don't fight economic crises, and the powers and perils of being inside the World Bank.
Print version of this Talk (pdf)
What is, according to you, the biggest challenge / principal debate in current International Relations? What is your position or answer to this challenge / in this debate?
If we'd reframe your question as being more broadly about global studies, I think that one of the really fundamental questions is how and why it is that the precepts of neoliberalism have penetrated into every nook and cranny of Western societies, and have penetrated to a very large extent many non-Western countries.
This has happened especially, but not only, through the agency of the IMF and the World bank, which have imbued these neoliberal principles; through the mechanism of graduate education: children of the elites in developing countries go out to American, British, other Western universities, and they learn that this is 'true' economics, or 'true' IPE, or 'true' Political Science, and then they come back and implement these same principles and make them a reality back home. But across the globe, this even holds for the Nordic countries. In Iceland and other Nordic countries, from the 1980s, networks of people sharing a belief in neo-liberal precepts, began to form and sort of place each other in key positions within the state, and in politics, and built a momentum in this direction. These precepts have become understood as just natural, as in Margaret Thatcher's 'there is no alternative'.
I live in the UK, and the great bulk of the British public really does believe that the government is just like a household writ large, and the same rules of budgeting that apply to the household should apply to the state. That when times are tough the household has to tighten its belt, cut back on spending, and it is only fair that the government does the same, and if the government does not, if the government runs a deficit in hard times, then the government is being irresponsible. And this is a completely mistaken and pre-Keynesian idea, but it is a 'zombie idea'—that is, however much arguments and evidence may be mounted against it, it just keeps coming up and up and up, and governments come to power riding on this zombie idea and a flotilla of related ideas.
The persistence of this zombie idea is all the more amazing as we just had a global financial crisis in 2007/8, which would prompt a rethinking of these ideas. But these neoliberal precepts have been, if anything, more strongly reinforced. In previous hard times—and obviously the 1930s depression is the exemplary case—there has been a stronger move towards, what you could call, social democratic precepts. But not this time! Indeed, even after the crisis, the whole of the European Union with 500 million people is even more thoroughly structured on the basis of these ideas. I am thinking of what is popularly known as the Fiscal Compact signed by the EU Member States in 2012, which commits all governments to balance budgets all the time—that is, first, the structural deficit may not rise above 0.5 percent of GDP. Second, the public debt may not rise above 60 percent of GDP. Third, automatic financial sanctions are levied on governments that exceed these two thresholds. Fourth, the whole procedure is supervised by the European Commission, and this is presented as in the name of sound budgeting. This package is presented as justified by the proposition that government is a household writ large. The most elementary principles of Keynesian macroeconomics show why this is not simply mistaken, but a disaster, and will keep generating recessionary pressures. It is sold as a kind of excuse for avoiding to put in place the essential conditions for the monetary union, namely, a common budget and a sizable transfer mechanism to the regions just as exists in the United States. But they do not want to do that, but still they call this agreement 'cooperation', which is all about not cooperation, but about writing these dictates around this zombie idea written into the very basic architecture of the EU. Beyond EU politics, it materializes all the way down to, I don't know, the function of the privatization of the Post Office, it goes all the way down to the sort of capillaries of how universities are run, and the incentive systems that have placed upon academics, and there is very little pushback. The one reason, why I am almost completely delighted about Jeremy Corbyn's election as the leader of the Labour party, is that this is one small case of where there seems to be some concerted pushback against these zombie ideas. The point being that the established Labour party basically bought into this whole set of neo-liberal ideas. It combined maintaining the overall structure of inequality in society with more emphasis on providing some help to the poor, but they had to be hardworking poor.
Yet, one knows that there can be dramatic changes in the prevailing zeitgeist of norms. One knows that there can be big changes in the space of a few decades and the question is can one imagine a scenario in which they might be a big change in norms back to a more kind of social-democratic direction. So where will this take place? Because of technological change in the labor market, there is a real big crisis of employment with many middle-class jobs cut out and polarization in the labor market. This might then induce a political movement to have a much bigger change in income distribution than anybody with power is now talking about. Talk of re-distribution these days is really almost entirely around redistribution through the state, but the point I would make is that if there is to be any significant reduction of inequality, especially inequality at the top, there has to be more attention to changes in market-income distribution.
Let me explain. The share of profits in national income has been going up and the share of labor income has been going down. So we should harness the shareholder structure of the market to affect a more equal income distribution by enabling a much wider section of the population to buy into the profit share. At the moment the profit share goes to senior executives and equity holders, but equity holders are highly concentrating at the top of the income and wealth distribution. If equity earners could be spread much more equally, then a much wider section of the population would get income, while they sleep so to speak. We could institute something like trusts, whose members could be the employees of a company, the customers, the neighbors of the company, and the trust would borrow on capital markets and take out insurance against the repayment of the lending of loan and then it would buy shares, it would use that borrowed money to buy shares in the company, and the company would pay out dividends on the shares and then that dividend income coming out of profits would be distributed to the members of the trust. That would be a way of getting the rising share of profits in national income distributed out to the population at large. I particularly like this metaphor of "earning income while you sleep", since at the moment it is only the rich people, who are earning income while they sleep. Somehow that facility of earning income while you sleep has to be made much more widely and available—by using the market against itself, so to speak.
How did you arrive at where you currently are in your thinking about International Relations?
I suppose the starting point was really this; my father was a New Zealand diplomat, so we moved quite often. By that time I was twelve my parents were posted to Colombo, Ceylon as it was called then. After having lived just in Western countries, I suddenly encountered at this very formative age Colombo and Sri Lanka. I was just amazed by that experience; by the color, the taste, the exoticness, but I was also very struck by how the many boys at the same age as me, were walking around with no shoes. I particular remember this boy carrying a baby on his shoulder, the baby looked half-dead and covered in scabs, and I think it was then I got the idea of just how unequal the world was. Then at university I studied economics, but I also visited my parents in Kuala Lumpur, Malaysia and I got another sense of that great disparity in wealth and living standards. At this time I had come across Adam Smith and the wealth of nations question and that helped to encapsulate or to crystalize my interests. So I wanted to go the Institute of Development Studies in Sussex and got enrolled for a PhD in economics, but en route I spent several weeks in India and during that time I began to dwell upon just how boring and how useless everything I studied under the name of microeconomics. I kept thinking of these dreadfully dry textbooks of marginal cost curves and marginal revenue curves and utility function and difference curves etc., which I had forced myself to sit exams in. By this time I had done a little bit of fieldwork, living on Pitcairn Island in the middle of the Pacific.
When I got back to Sussex after fieldwork I announced that I wished to not do a PhD in economics, but to do one in anthropology thinking all the time, that this would actually be more use for understanding why for example India, where I had been, was so very poor. So that's what I did: a PhD in anthropology… In some ways I regard that as having been a mistake, because the sort of mainstream of anthropology is very far away from the Adam Smith questions. Having done the degree in anthropology, pretty soon I began to change direction and pay much more attention to the state, to the state bureaucracy. I went to India and I studied the Irrigation Department and other related departments. I went to South Korea and I studied state irrigation agencies and I went to Taiwan and I studied the state more broadly. So I was kind of moving up from my Italian village, moving kind of up the scale in terms of state agencies and then the state as a whole.
Then I went to work for the World Bank in the 1980s and my main reason for doing that was not to do the research the World Bank wanted me to do, but rather to study the World Bank from the inside as fieldwork. If in some ways switching to anthropology was a mistake, in other ways it was not, because I approached those kind of Wealth-of-Nations-questions in a way very different from how economists approached them. For example when I went to Taiwan and studied the trade regime, the first thing I did was to go and talk to people who operated through the trade regime, whereas I noticed that the published works by economists celebrating Taiwan's free trade regime was based on what the rules said and what certain government officials told them was the case. They had never actually talked to people who traded through the trade regime. If they would have, they would have learned about all the covert controls that went on such that there was quite a distinction between the liberal face of the trade regime and the reality of the trade regime. The reality was that the government was managing trade in line with industrial policy, but the government absolutely did not want the world to know that. So all this was kept hidden and I was really regarded as rather unwelcome visitor—and in fact to this day my book Governing the Market (1990, read the introduction here) is not well received in Taiwan. It says the government of Taiwan did a good job of managing the market, but they want the world to believe that Taiwan is a free trade country. So that is the kind of intellectual trajectory that I have been on.
So I think that the value of the anthropology PhD was that it really taught me, in practical terms, the meaning of the anthropological maxim, which is 'soaking and poking'. To put it another way—I love this—anthropologists are social scientists, who believe that the plural of anecdote is evidence. And indeed I place a lot of weight on anecdotes, on gossip, on the stories people tell, whereas economists would be much happier reducing, let us say, South Korea's trade regime to one data point in a matrix, and then compare that data point with, let us say, Malaysia's data point to see how the trade regimes are correlated with growth, or something like that, and that is really not my interest.
What would a student need to become a specialist in IR or understand the world in a global way?
Despite what I've just said, I do think that a graduate training in economics is very useful, provided one does not believe it. And that is really difficult, because the socialization pressures are intense: if you do not say the right things—which are neoliberal type things on the whole—then you will likely not get a high grade. But I have noticed that economists tend to know how to think, how to make arguments, they tend to understand the idea of causality, and that may seem an astonishing thing to say on my part, because it implies that students coming from other disciplines are often weak in understanding the very basic ideas of causality, but that is my experience. I had many students coming from, who knows, IR or Political Science or Sociology or Anthropology, who clearly do not have much idea of causality; they can describe things, but they find thinking in terms of cause and effect, in terms of independent and dependent variables, in terms of left and right side, they just find it difficult. So I do think that there is a lot to be said for studying economics, and mastering the maths, provided that the critical facility is not lost. That is point number one.
Point number two is that I think that there is a huge premium on doing fieldwork, and the field work maybe in developing countries, but when I say field work, I don't just mean going out to villages, going out to see poor people 'over there'. I am talking of fieldwork inside bureaucracies: to try and understand the culture, the incentive systems that people are working under—fieldwork at home so to speak, in the countries one comes from. From the students' point of view, it is clearly much easier to sit in the LSE library to do the research. So in my marking I give quite a premium to a student actually doing fieldwork, going out and interviewing, and having the experience of writing up and interpreting the interviews and somehow fitting it back into a larger argument—but really few students actually do that, and I think that that is a real, real big mistake. Mind you, the same risk holds for fieldwork in economics as it does for studying economics: I encourage students to work for (do fieldwork in, experience) the World Bank; and several have—but to the best of my knowledge almost none of them has kept their critical perspective. They really come to buy into it.
The relations between states are settled either through diplomacy or warfare. Why would we have to focus on economics to understand IR?
Because economics—such as for example balances of payment, surpluses and deficits—set the constraints and incentives on countries in terms of their relationships with each other. A great deal of diplomacy is driven by economic pressures: diplomacy to get other countries to for example open their markets, or to cut deals with countries—'if you do this, we will do that'—deals that may relate to areas that are rather different, for instance if you buy more of these of our exports, we will help you fight such and such country, because the manufactures are in my constituency.
So, in a way, the way you framed the question is part of the reason why I react against the discipline of IR: because it tends to treat diplomacy, war, and so on, as somehow rather separate from economic pressures, and I see these economic pressures as very powerful drivers of both of the other two things. As another example, one of the drivers of the Syrian conflict was that there was an acute drought (like Weizman observed in Theory Talk #69, red), which meant that many people were rendered destitute; rural areas flooded into the cities, and the Assad regime just was—understandably—unable to cope; and large numbers of young men, concentrated in cities, rootless and with no jobs, just were recruiting fodder for the Wahhabi sect. I have always thought of economics—not so much as in the making choices in conditions of scarcity, that is sort of Lionel Robin's definition—in the sense of Alfred Marshal, about how people make a living, as a very fundamental driver of a lot of what happens in International Relations.
Pikkety recently published Capital in the 21st Century, causing quite the stir. But why would inequality between people matter for IR?
Let me comment by invoking a very contemporary exhibit—the migration crisis in Europe now. Maybe a decade ago I looked at the figures and if you took the average income of the EU-15 prior to latest extensions and then expressed the average income of countries outside of the EU—including sub-Sahara Africa—as a percentage, then there was a really dramatic falling away of income levels relative to the EU, in countries all around the EU and whether you took market exchange rates or purchasing power parity. If you went round to sub-Sahara Africa and took the average, it was more like two percent in market exchange rates and seven percent in purchasing power parity; and the 'problem' is that there is certainly here a rather thin slither of sea between Africa and the promised land of Europe and to the east there are these great open planes, where armies can go up and down to the speed of light, so to speak, but people can also move pretty quickly across these planes.
So all one has to do—and this might just be only a bit of an exaggeration—if one is on the poor end of this poverty pyramid is hop across the border and you have a chance at least of getting a very appreciable increase in living conditions and income, with which you can then get savings to remit back to home. So the migrations pressures are just huge. So that is one reason for linking inequality to issues in International Relations—really fundamental issues, and very very difficult to dissolve.
You've done anthropological fieldwork inside the World Bank—an institution drawing a lot of criticism from its detractors in IR. Can you shed some kind of light about what kind of 'animal' the World Bank is?
First of all, let me say that at the micro-level—the level of the people you know and the people I know inside the World Bank—I agree that there are people doing a lot of good work. But if you look at the organization more generally—the World Bank and also the IMF—they are clearly instruments mainly of US foreign policy—and any number of US senators, members of the House, have basically said that. When they are defending the International Financial Institutions (they often criticize them), they do so by saying they are important for US foreign policy. And you have to look at the governance structures to see how it is that the US in particular—but Western states more generally—have from the beginning, through the very Articles of Agreement, created a structure which locks in their power, and has made it very difficult for other countries (including Japan) to significantly increase their shareholdings. The US has kept the presidency of the Bank and the much less recognized Number Two position of the IMF, and has used these positions to have a very strong influence.
Just to illustrate what the Bank and the Fund do: at the time of the East-Asian crisis—specifically the Korean crisis in 1997-1998—the IMF mission was in Seoul. The negotiations were in a hotel there. David Lipton from the US Treasury (and a former student of Larry Summers who was by then Deputy Secretary) was just down the corridor of where the negotiations took place, and every so often the IMF people would walk out of the negotiations and consult with David Lipton, then come back in and—as Paul Blustein reports in his book called The Chastening—often said something rather different from what they had been saying before they consulted with David Lipton.
Just to take another example, the US being able to appoint the president of the Bank—to appoint a person known personally to the Treasury Secretary or to the Secretary of the State, or both—is really of great value: when there is a 'trustful relationship'—or a relationship of dependency, the president being dependent on those who appointed him in the Administration—it is possible for those people in the Administration, or people close to them, to just ring up the president of the Bank, and talk in a very informal, confidential, trustful way about what is happening in Latin America, or what is happening in the Middle East, and what the US thinks the Bank should or should not be doing in those places. Larry Summers appointed a protégé of his to one of the regional development banks, and this person—who is very senior in the bank—told me that Larry would frequently ring him, while he is being driven home in the evening from the Treasury, just to have a chat about how things were going in her region, and to pass on suggestions about what the Bank should be doing there, and to get intelligence from her about what was happening in the region, and so on. The point is that, making these personal connections is of immense value, but at the same time, the US Congress, in particular, is very much against having a big Bank against allowing a capital increase for the World Bank—so that the bank could, as it should be doing, increase its lending for infrastructure investment ten times. It is just a complete scandal how little the Bank has been lending for the past 20 years or more for infrastructure, for roads and power stations and so on. The US does not want the Bank providing socialistic competition with the private sector: it says these things are for the private sector to do, and the Bank has to take care of poverty, because the private sector is not interested in poverty.
So the US wants to keep the presidency of the Bank, it wants to keep, secondly, its unique veto right on the big decisions, such as decisions on whether to increase the capital base—but provided those two things are met it does not care that much about the Bank. In the case of the Fund, the US is also very powerful, but of course the Europeans have a bit more relative power. Right now I think the world is in an even more dangerous sort if financial condition than might appear, because the IMF is acutely short of secure or guaranteed lending resources, so if there is to be another round of crisis—as I think is entirely likely within the next five years—the Fund depends upon borrowing short-term from member countries, like on six months terms, but member countries can say 'no', and that means that the Fund's ability to fight crises is quite constrained. The Fund should implement what was agreed in 2010 by all the member countries represented on the board of the IMF: to roughly double the quote of the guaranteed lending resources, that is, resources the countries actually hand over to the Fund, over which they actually give up country control. All the relevant capitals ratified it with one exception—the US—because Congress refused because the individual barons, who are not under that much party discipline, each said to the Treasury: 'look, the question of the IMF is of zero significance to my electorate, so if you want my vote on the IMF, you have to give me things that I want like projects in my constituency and so on'. The Treasury added up the demands of the people, whose vote had to be won, and it considered those demands were just way, way, way over the top. As long as a Democrat is in the presidency, while the House is controlled by Republicans the world is sort of held hostage to this. Beyond this example, this actually entails a structural problem: the US blocking or producing a gridlock in international organizations, because the Congress is hostile to international organizations, because Congress sees it to imply a loss of US sovereignty. The only way to end this gridlock is to end the US veto in the Fund and the Bank, but the problem is that the US can veto any measures.
One response of the big developing countries is to create bypass organizations—such as the Asian Infrastructure Investment Banks, such as the new Development Bank, such as the Contingent Reserve arrangement the BRICs have established, and then a growing number of sort of regional development banks. And I think that that is a good thing, but it does raise questions about coordination, about who is looking after, if you will, the global interests, global issues such as climate change. In short, we need a genuine World Bank, rather than the American-Bank-in-the-World we have today.
You engage thoroughly with economics and economic theory. Now there seem to be two kinds of critical approaches to economics in IPE: one criticizes its rationality as flawed, and another buys into its rationality but attempts to point out where actual policy gets it wrong. Where do you stand in this?
If you take the example of how the EU attempted to impose fiscal rules on Greece, you see a notion of rationality which draws upon these very primitive notions that I referred to right at the beginning, where the government is just a household writ large, and the same set of rules that apply to the budgeting of the household must apply to the government as well. Here, the assumption is that any macroeconomic proposition must have microeconomic foundations, that it must be derivable from propositions about microeconomic agents acting in this sort of self-maximizing way, and if you cannot derive macroeconomic propositions from those micro foundations, then there is something unreliable, un-rigorous about your macroeconomics. So what are then the sources of these micro-economic assumptions?
This leads us to one fundamental and almost completely unaddressed weaknesses of economics can be traced back to the Marginal Revolution in the late 19th century. From that moment onwards, there has been an attempt to model economics on physics, and that was very explicit on the part of people like Pareto and Walras, and Jevons, early Marginalist thinkers. They even drew up tables with terms of physics, like velocity, on one side, and then corresponding terms in economics on the other. That had a huge benefit in terms of the 'science' of economics, because it cut economics loose from Adam Smith's and other classical economists' preoccupations with issues of morality and ethics. Adam Smith thought his most important book was not the Wealth of Nations but his Theory of Moral Sentiments, on which he was working, revising yet again, when he died. For Smith, economics and morals were never separate worlds, but intimately related. So for him, the Theory of Moral Sentiments and the Wealth of Nations were just twins. The point about the marginalist revolution, and the embrace of physics as the model, was that it cut economics free of all that sort of subjective stuff about values. So economics after the marginalist revolution set off with the assumption that not production, but the movement of individuals in markets engaged in trading with each other became the center of gravity of economics. Making the study of exchange rather than the study of production central was analogous to, say, Boyle's Law in physics. Boyle's Law in physics explained the movement of molecules in gasses, as a function of the pressure applied to the gas. So why did they make that analogy?
The point of likening of individuals in microeconomic actions with molecules in gasses was the following. Everybody knows that we do not apply any consideration of ethics or moral sentiments to the movement of the molecules in gas, so neither should we apply any notions of ethics or moral sentiments to the movements of individuals in market exchanges. And that was the way that all considerations of ethics, of morality were just removed from economics. I for instance asked the question to well-known American growth theorist, as we were walking down the street in Providence at Brown University: 'is it moral for people to freeride?' And he said, 'yes of course, provided they do not break the law'. So ethics and questions of morality have been almost completely expunged from economics in a way that would horrify classical economists including Smith; and a particular idea of rationality has been an important part of cleansing economics from those moral considerations. George DeMartino, editor of the Oxford Handbook of Professional Economics Ethics which just appeared has a wonderful phrase to capture this—'econogenic harm': the harm built into the way that economics, professional economists work.
Haven't specific fields, like development economics—a field you engage with yourself—advanced to overcome these weaknesses in economic theory?
Let me root my answer again in observations about the linkages between theory and practice, for it is in practice that economic theory really does its work and its politics becomes visible. It always amazes me we have had a development industry in place for roughly the past 70 years with vast numbers of people, organizations, money all orchestrated underneath this umbrella of development; yet if you go back and read what the early writers about development and economic growth said—I am thinking of people like Paul Rosenstein-Rodan, Myrdal, Hirschman, Prebisch, but also Moses Abramovitz. If you go back and look at what they were saying, it seems to me that we have not advanced all that much. Sure, we have advanced a lot in terms of econometric techniques, but in terms of substance we have not. One conclusion I draw from that is that it is really important that international regimes—for example, World Bank and IMF loan conditions, but also WTO regimes—give room for experimentation, because it is really not the case that 'there is no alternative'. This Washington Consensus agenda has clearly not been effective in accelerating production, upgrading it, and production diversification, or export upgrading, or export diversification. So, there should be written into the regimes a lot of room for experimentation. But this isn't there because of the political origin of these regimes; because of what western countries want for the rest world, namely, to open the rest of the world to their markets.
In the 80s there were a lot of experts in industrial development in the World Bank and they did good work, promoting industrial growth and investment in productive infrastructure. But then Anne Krueger came in as chief economist, and brought in a whole lot of people with her—who, like here, were arch-neoliberals. The industrial growth people were invited to find employment elsewhere, or to rebrand themselves as experts in who knows what, environmental assessment, primary education, or good governance. There was no room for them. This also fitted well with some bad experiences the Bank had had with investing in infrastructure. It had gotten into a lot of trouble with large-scale infrastructural interventions such as roads and dams and the like from, especially, US NGOs mobilizing Congress—which then put pressure on the Treasury and so on. My lament throughout this whole conversation has been that we seem to have become just locked into this direction that was set in the 1980s, and it is very difficult to see what kind of economic catastrophe would be necessary to give a sufficient shock to reroute the global system of economic governance.
So after the 1980s, the Bank sort of backed off and began saying that development, economic development, was about poverty reduction—the slogan of the Bank became, 'our dream is a world free of poverty'. You can understand that shift partly in terms of pulling out of the concern with production to get into safe territory, but also because poverty reduction seemed to sort of take care of inequality, because you reduced inequality to poverty—to the poor 'over there', and we can feel good about helping them; but we do not want talk about inequality, which involves us, because then there is the question of justice of our income.
But then the most recent turn is that we're seeing a renewed push for infrastructure in the World Bank and western development agencies. I think that you can link this recent infrastructure push to uncertainty about the sources of economic growth. In the West there is a real question about sustaining economic growth without housing bubbles and stock market bubbles—in other words, without endogenously building financial instability. There may well be a similar sort of issue in terms of the growth of developing countries.
Last question. Adam Smith seems to be constantly present in your work as a critical interlocutor. How come?
I kind of engage in a critical debate with Adam Smith, but especially with people today, who believe his ideas. I often start to frame arguments in terms of his famous 40 word summary of the causes of the relative wealth of nations, which he actually wrote in 1755, which is to say long before the first edition of the Wealth of Nations. I will just tell you what these 40 words say, and then I will tell you the significance of them. He said:
'Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism than peace, easy taxes, and tolerable administration of justice; all the rest being brought about by the natural course of things.'
So I am struck by how today many economists say or imply that this is essentially right; you need some qualifications of course, but essentially that is the nub of it. You might have to translate peace, easy taxes, tolerable administration of justice into more modern terms, but that is the essence of it. For example, Gregory Mankiw—Professor of economics at Harvard, former chair of the National Council of Economic Advisers during the Bush administration, and author of a very popular textbook in economics—said in the Wall Street Journal in 2006: Adam Smith was right to say that – and then he gave the 40 word quote. The renowned economists Timothy Besley and Torsten Persson wrote Pillars of Prosperity, which also begins with Smith's 40 words, and they even see the book as a kind of elaboration, but in that same kind of spirit, of Smith's basic idea. So my point is that these ideas are still current; they are still the sort of front of a lot of neoliberal thinking. I am just astonished these ideas all these centuries later remain so powerful. I have had at the back of my mind the idea of organizing an international competition to provide a contemporary 40 word statement, which is sort of equivalent to Smith's, which would obviously have to be of a more global character, encompassing the globalized world economy.
Robert Hunter Wade worked at the Institute of Development Studies, Sussex, 1972-95, World Bank, 1984-88, Princeton Woodrow Wilson School 1989/90, MIT Sloan School 1992, Brown University 1996-2000. Fellow of Institute for Advanced Study, Princeton 1992/93, Russell Sage Foundation 1997/98, Institute for Advanced Study, Berlin 2000/01. Fieldwork in Pitcairn Is., Italy, India, Korea, Taiwan. Research on World Bank 1995-continuing. Author of Irrigation and Politics in South Korea (1982), Village Republics: The Economic Conditions of Collective Action in India (1988, 1994), Governing the Market: Economic Theory and the Role of Government in East Asia's Industrialization (1990, 2003). Latter won American Political Science Association's award of Best Book in Political Economy, 1992.
Related links
Faculty profile at LSE Read Wade's The Piketty phenomenon and the future of inequality (2014, real-world economics review) here (pdf) Read Wade's Capitalism and Democracy at Cross-Purposes (2013, Challenge) here (pdf) Read Wade's Rethinking Industrial Policy for Low Income Countries (2007 ADB Conference paper) here (pdf) Read Wade's Bringing the State Back In (2005, IPG) here (pdf) Read Wade's Is Globalization Reducing Poverty and Inequality? (2004, World Development) here (pdf) Read Wade's Creating Capitalisms (Introduction to 2003 book 'Governing the Market') here (pdf)
Die Inhalte der verlinkten Blogs und Blog Beiträge unterliegen in vielen Fällen keiner redaktionellen Kontrolle.
Warnung zur Verfügbarkeit
Eine dauerhafte Verfügbarkeit ist nicht garantiert und liegt vollumfänglich in den Händen der Blogbetreiber:innen. Bitte erstellen Sie sich selbständig eine Kopie falls Sie einen Blog Beitrag zitieren möchten.
This post takes up from two previous posts (part 1; part 2), asking just what do we (we economists) really know about how interest rates affect inflation. Today, what does contemporary economic theory say? As you may recall, the standard story says that the Fed raises interest rates; inflation (and expected inflation) don't immediately jump up, so real interest rates rise; with some lag, higher real interest rates push down employment and output (IS); with some more lag, the softer economy leads to lower prices and wages (Phillips curve). So higher interest rates lower future inflation, albeit with "long and variable lags." Higher interest rates -> (lag) lower output, employment -> (lag) lower inflation. In part 1, we saw that it's not easy to see that story in the data. In part 2, we saw that half a century of formal empirical work also leaves that conclusion on very shaky ground. As they say at the University of Chicago, "Well, so much for the real world, how does it work in theory?" That is an important question. We never really believe things we don't have a theory for, and for good reason. So, today, let's look at what modern theory has to say about this question. And they are not unrelated questions. Theory has been trying to replicate this story for decades. The answer: Modern (anything post 1972) theory really does not support this idea. The standard new-Keynesian model does not produce anything like the standard story. Models that modify that simple model to achieve something like result of the standard story do so with a long list of complex ingredients. The new ingredients are not just sufficient, they are (apparently) necessary to produce the desired dynamic pattern. Even these models do not implement the verbal logic above. If the pattern that high interest rates lower inflation over a few years is true, it is by a completely different mechanism than the story tells. I conclude that we don't have a simple economic model that produces the standard belief. ("Simple" and "economic" are important qualifiers.) The simple new-Keynesian model The central problem comes from the Phillips curve. The modern Phillips curve asserts that price-setters are forward-looking. If they know inflation will be high next year, they raise prices now. So Inflation today = expected inflation next year + (coefficient) x output gap. \[\pi_t = E_t\pi_{t+1} + \kappa x_t\](If you know enough to complain about \(\beta\approx0.99\) in front of \(E_t\pi_{t+1}\) you know enough that it doesn't matter for the issues here.)Now, if the Fed raises interest rates, and if (if) that lowers output or raises unemployment, inflation today goes down. The trouble is, that's not what we're looking for. Inflation goes down today, (\(\pi_t\))relative to expected inflation next year (\(E_t\pi_{t+1}\)). So a higher interest rate and lower output correlate with inflation that is rising over time. Here is a concrete example: The plot is the response of the standard three equation new-Keynesian model to an \(\varepsilon_1\) shock at time 1:\[\begin{align} x_t &= E_t x_{t+1} - \sigma(i_t - E_t\pi_{t+1}) \\ \pi_t & = \beta E_t \pi_{t+1} + \kappa x_t \\ i_t &= \phi \pi_t + u_t \\ u_t &= \eta u_{t-1} + \varepsilon_t. \end{align}\] Here \(x\) is output, \(i\) is the interest rate, \(\pi\) is inflation, \(\eta=0.6\), \(\sigma=1\), \(\kappa=0.25\), \(\beta=0.95\), \(\phi=1.2\). In this plot, higher interest rates are said to lower inflation. But they lower inflation immediately, on the day of the interest rate shock. Then, as explained above, inflation rises over time. In the standard view, and the empirical estimates from the last post, a higher interest rate has no immediate effect, and then future inflation is lower. See plots in the last post, or this one from Romer and Romer's 2023 summary:Inflation jumping down and then rising in the future is quite different from inflation that does nothing immediately, might even rise for a few months, and then starts gently going down. You might even wonder about the downward jump in inflation. The Phillips curve makes it clear why current inflation is lower than expected future inflation, but why doesn't current inflation stay the same, or even rise, and expected future inflation rise more? That's the "equilibrium selection" issue. All those paths are possible, and you need extra rules to pick a particular one. Fiscal theory points out that the downward jump needs a fiscal tightening, so represents a joint monetary-fiscal policy. But we don't argue about that today. Take the standard new Keynesian model exactly as is, with passive fiscal policy and standard equilibrium selection rules. It predicts that inflation jumps down immediately and then rises over time. It does not predict that inflation slowly declines over time. This is not a new issue. Larry Ball (1994) first pointed out that the standard new Keynesian Phillips curve says that output is high when inflation is high relative to expected future inflation, that is when inflation is declining. Standard beliefs go the other way: output is high when inflation is rising. The IS curve is a key part of the overall prediction, and output faces a similar problem. I just assumed above that output falls when interest rates rise. In the model it does; output follows a path with the same shape as inflation in my little plot. Output also jumps down and then rises over time. Here too, the (much stronger) empirical evidence says that an interest rate rise does not change output immediately, and output then falls rather than rises over time. The intuition has even clearer economics behind it: Higher real interest rates induce people to consume less today and more tomorrow. Higher real interest rates should go with higher, not lower, future consumption growth. Again, the model only apparently reverses the sign by having output jump down before rising. Key issuesHow can we be here, 40 years later, and the benchmark textbook model so utterly does not replicate standard beliefs about monetary policy? One answer, I believe, is confusing adjustment to equilibrium with equilibrium dynamics. The model generates inflation lower than yesterday (time 0 to time 1) and lower than it otherwise would be (time 1 without shock vs time 1 with shock). Now, all economic models are a bit stylized. It's easy to say that when we add various frictions, "lower than yesterday" or "lower than it would have been" is a good parable for "goes down over time." If in a simple supply and demand graph we say that an increase in demand raises prices instantly, we naturally understand that as a parable for a drawn out period of price increases once we add appropriate frictions. But dynamic macroeconomics doesn't work that way. We have already added what was supposed to be the central friction, sticky prices. Dynamic economics is supposed to describe the time-path of variables already, with no extra parables. If adjustment to equilibrium takes time, then model that. The IS and Phillips curve are forward looking, like stock prices. It would make little sense to say "news comes out that the company will never make money, so the stock price should decline gradually over a few years." It should jump down now. Inflation and output behave that way in the standard model. A second confusion, I think, is between sticky prices and sticky inflation. The new-Keynesian model posits, and a huge empirical literature examines, sticky prices. But that is not the same thing as sticky inflation. Prices can be arbitrarily sticky and inflation, the first derivative of prices, can still jump. In the Calvo model, imagine that only a tiny fraction of firms can change prices at each instant. But when they do, they will change prices a lot, and the overall price level will start increasing right away. In the continuous-time version of the model, prices are continuous (sticky), but inflation jumps at the moment of the shock. The standard story wants sticky inflation. Many authors explain the new-Keynesian model with sentences like "the Fed raises interest rates. Prices are sticky, so inflation can't go up right away and real interest rates are higher." This is wrong. Inflation can rise right away. In the standard new-Keynesian model it does so with \(\eta=1\), for any amount of price stickiness. Inflation rises immediately with a persistent monetary policy shock. Just get it out of your heads. The standard model does not produce the standard story. The obvious response is, let's add ingredients to the standard model and see if we can modify the response function to look something like the common beliefs and VAR estimates. Let's go. Adaptive expectations We can reproduce standard beliefs about monetary policy with thoroughly adaptive expectations, in the 1970s ISLM form. I think this is a large part of what most policy makers and commenters have in mind. Modify the above model to leave out the dynamic part of the intertemporal substitution equation, to just say in rather ad hoc way that higher real interest rates lower output, and specify that the expected inflation that drives the real rate and that drives pricing decisions is mechanically equal to previous inflation, \(E_t \pi_{t+1} = \pi_{t-1}\). We get \[ \begin{align} x_t &= -\sigma (i_t - \pi_{t-1}) \\ \pi_t & = \pi_{t-1} + \kappa x_t .\end{align}\] We can solve this sytsem analytically to \[\pi_t = (1+\sigma\kappa)\pi_{t-1} - \sigma\kappa i_t.\]Here's what happens if the Fed permanently raises the interest rate. Higher interest rates send future inflation down. (\(\kappa=0.25,\ \sigma=1.\)) Inflation eventually spirals away, but central banks don't leave interest rates alone forever. If we add a Taylor rule response \(i_t = \phi \pi_t + u_t\), so the central bank reacts to the emerging spiral, we get this response to a permanent monetary policy disturbance \(u_t\): The higher interest rate sets off a deflation spiral. But the Fed quickly follows inflation down to stabilize the situation. This is, I think, the conventional story of the 1980s. In terms of ingredients, an apparently minor change of index from \(E_t \pi_{t+1}\) to \(\pi_{t-1}\) is in fact a big change. It means directly that higher output comes with increasing inflation, not decreasing inflation, solving Ball's puzzle. The change basically changes the sign of output in the Phillips curve. Again, it's not really all in the Phillips curve. This model with rational expectations in the IS equation and adaptive in the Phillips curve produces junk. To get the result you need adaptive expectations everywhere. The adaptive expectations model gets the desired result by changing the basic sign and stability properties of the model. Under rational expectations the model is stable; inflation goes away all on its own under an interest rate peg. With adaptive expectations, the model is unstable. Inflation or deflation spiral away under an interest rate peg or at the zero bound. The Fed's job is like balancing a broom upside down. If you move the bottom (interest rates) one way, the broom zooms off the other way. With rational expectations, the model is stable, like a pendulum. This is not a small wrinkle designed to modify dynamics. This is major surgery. It is also a robust property: small changes in parameters do not change the dominant eigenvalue of a model from over one to less than one. A more refined way to capture how Fed officials and pundits think and talk might be called "temporarily fixed expectations." Policy people do talk about the modern Phillips curve; they say inflation depends on inflation expectations and employment. Expectations are not mechanically adaptive. Expectations are a third force, sometimes "anchored," and amenable to manipulation by speeches and dot plots. Crucially, in this analysis, expected inflation does not move when the Fed changes interest rates. Expectations are then very slowly adaptive, if inflation is persistent, or if there is a more general loss of faith in "anchoring." In the above new-Keynesian model graph, at the minute the Fed raises the interest rate, expected inflation jumps up to follow the graph's plot of the model's forecast of inflation. As a simple way to capture these beliefs, suppose expectations are fixed or "anchored" at \(\pi^e\). Then my simple model is \[\begin{align}x_t & = -\sigma(i_t - \pi^e) \\ \pi_t & = \pi^e + \kappa x_t\end{align}\]so \[\pi_t = \pi^e - \sigma \kappa (i_t - \pi^e).\] Inflation is expected inflation, and lowered by higher interest rates (last - sign). But those rates need only be higher than the fixed expectations; they do not need to be higher than past rates as they do in the adaptive expectations model. That's why the Fed thinks 3% interest rates with 5% inflation is still "contractionary"--expected inflation remains at 2%, not the 5% of recent adaptive experience. Also by fixing expectations, I remove the instability of the adaptive expectations model... so long as those expectations stay anchored. The Fed recognizes that eventually higher inflation moves the expectations, and with a belief that is adaptive, they fear that an inflation spiral can still break out.Even this view does not give us any lags, however. The Fed and commenters clearly believe that higher real interest rates today lower output next year, not immediately; and they believe that lower output and employment today drive inflation down in the future, not immediately. They believe something like \[\begin{align}x_{t+1} &= - \sigma(i_t - \pi^e) \\ \pi_{t+1} &= \pi^e + \kappa x_t.\end{align}\] But now we're at the kind of non-economic ad-hockery that the whole 1970s revolution abandoned. And for a reason: Ad hoc models are unstable, regimes are always changing. Moreover, let me remind you of our quest: Is there a simple economic model of monetary policy that generates something like the standard view? At this level of ad-hockery you might as well just write down the coefficients of Romer and Romer's response function and call that the model of how interest rates affect inflation. Academic economics gave up on mechanical expectations and ad-hoc models in the 1970s. You can't publish a paper with this sort of model. So when I mean a "modern" model, I mean rational expectations, or at least the consistency condition that the expectations in the model are not fundamentally different from forecasts of the model. (Models with explicit learning or other expectation-formation frictions count too.) It's easy to puff about people aren't rational, and looking out the window lots of people do dumb things. But if we take that view, then the whole project of monetary policy on the proposition that people are fundamentally unable to learn patterns in the economy, that a benevolent Federal Reserve can trick the poor little souls into a better outcome. And somehow the Fed is the lone super-rational actor who can avoid all those pesky behavioral biases. We are looking for the minimum necessary ingredients to describe the basic signs and function of monetary policy. A bit of irrational or complex expectation formation as icing on the cake, a possible sufficient ingredient to produce quantitatively realistic dynamics, isn't awful. But it would be sad if irrational expectations or other behavior is a necessary ingredient to get the most basic sign and story of monetary policy right. If persistent irrationality is a central necessary ingredient for the basic sign and operation of monetary policy -- if higher interest rates will raise inflation the minute people smarten up; if there is no simple supply and demand, MV=PY sensible economics underlying the basic operation of monetary policy; if it's all a conjuring trick -- that should really weaken our faith in the whole monetary policy project. Facts help, and we don't have to get religious about it. During the long zero bound, the same commentators and central bankers kept warning about a deflation spiral, clearly predicted by this model. It never happened. Interest rates below inflation from 2021 to 2023 should have led to an upward inflation spiral. It never happened -- inflation eased all on its own with interest rates below inflation.Getting the desired response to interest rates by making the model unstable isn't tenable whether or not you like the ingredient. Inflation also surged in the 1970s faster than adaptive expectations came close to predicting, and fell faster in the 1980s. The ends of many inflations come with credible changes in regime. There is a lot of work now desperately trying to fix new-Keynesian models by making them more old-Keynesian, putting lagged inflation in the Phillips curve, current income in the IS equation, and so forth. Complex learning and expectation formation stories replace the simplistic adaptive expectations here. As far as I can tell, to the extent they work they largely do so in the same way, by reversing the basic stability of the model. Modifying the new-Keynesian modelThe alternative is to add ingredients to the basic new-Keynesian model, maintaining its insistence on real "micro-founded" economics and forward-looking behavior, and describing explicit dynamics as the evolution of equilibrium quantities. Christiano Eichenbaum and Evans (2005) is one of the most famous examples. Recall these same authors created the first most influential VAR that gave the "right" answer to the effects of monetary policy shocks. This paper modifies the standard new-Keynesian model with a specific eye to matching impulse response functions. The want to match all impulse-responses, with a special focus on output. When I started asking my young macro colleagues for a standard model which produces the desired response shape, they still cite CEE first, though it's 20 years later. That's quite an accomplishment. I'll look at it in detail, as the general picture is the same as many other models that achieve the desired result. Here's their bottom line response to a monetary policy shock: (Figure from the 2018 Christiano Eichenbaum and Trabandt Journal of Economic Perspectives summary paper.) The solid line is the VAR point estimate and gray shading is the 95% confidence band. The solid blue line is the main model. The dashed line is the model with only price stickiness, to emphasize the importance of wage stickiness. The shock happens at time 0. Notice the funds rate line that jumps down at that date. That the other lines do not move at time 0 is a result. I graphed the response to a time 1 shock above. That's the answer, now what's the question? What ingredients did they add above the textbook model to reverse the basic sign and jump problem and to produce these pretty pictures? Here is a partial list: Habit formation. The utility function is \(log(c_t - bc_{t-1})\). A capital stock with adjustment costs in investment. Adjustment costs are proportional to investment growth, \([1-S(i_t/i_{t-1})]i_t\), rather than the usual formulation in which adjustment costs are proportional to the investment to capital ratio \(S(i_t/k_t)i_t\). Variable capital utilization. Capital services \(k_t\) are related to the capital stock \(\bar{k}t\) by \(k_t = u_t \bar{k}_t\). The utilization rate \(u_t\) is set by households facing an upward sloping cost \(a(u_t)\bar{k}_t\).Calvo pricing with indexation: Firms randomly get to reset prices, but firms that aren't allowed to reset prices do automatically raise prices at the rate of inflation.Prices are also fixed for a quarter. Technically, firms must post prices before they see the period's shocks.Sticky wages, also with indexation. Households are monopoly suppliers of labor, and set wages Calvo-style like firms. (Later papers put all households into a union which does the wage setting.) Wages are also indexed; Households that don't get to reoptimize their wage still raise wages following inflation. Firms must borrow working capital to finance their wage bill a quarter in advance, and thus pay a interest on the wage bill. Money in the utility function, and money supply control. Monetary policy is a change in the money growth rate, not a pure interest rate target. Whew! But which of these ingredients are necessary, and which are just sufficient? Knowing the authors, I strongly suspect that they are all necessary to get the suite of results. They don't add ingredients for show. But they want to match all of the impulse response functions, not just the inflation response. Perhaps a simpler set of ingredients could generate the inflation response while missing some of the others. Let's understand what each of these ingredients is doing, which will help us to see (if) they are necessary and essential to getting the desired result. I see a common theme in habit formation, adjustment costs that scale by investment growth, and indexation. These ingredients each add a derivative; they take a standard relationship between levels of economic variables and change it to one in growth rates. Each of consumption, investment, and inflation is a "jump variable" in standard economics, like stock prices. Consumption (roughly) jumps to the present value of future income. The level of investment is proportional to the stock price in the standard q theory, and jumps when there is new information. Iterating forward the new-Keynesian Phillips curve \(\pi_t = \beta E_t \pi_{t+1} + \kappa x_t\), inflation jumps to the discounted sum of future output gaps, \(\pi_t = E_t \sum_{j=0}^\infty \beta^jx_{t+j}.\) To produce responses in which output, consumption and investment as well as inflation rise slowly after a shock, we don't want levels of consumption, investment, and inflation to jump this way. Instead we want growth rates to do so. With standard utility, the consumer's linearized first order condition equates expected consumption growth to the interest rate, \( E_t (c_{t+1}/c_t) = \delta + r_t \) Habit, with \(b=1\) gives \( E_t [(c_{t+1}-c_t)/(c_t-c_{t-1})] = \delta + r_t \). (I left out the strategic terms.) Mixing logs and levels a bit, you can see we put a growth rate in place of a level. (The paper has \(b=0.65\) .) An investment adjustment cost function with \(S(i_t/i_{t-1})\) rather than the standard \(S(i_t/k_t)\) puts a derivative in place of a level. Normally we tell a story that if you want a house painted, doubling the number of painters doesn't get the job done twice as fast because they get in each other's way. But you can double the number of painters overnight if you want to do so. Here the cost is on the increase in number of painters each day. Indexation results in a Phillips curve with a lagged inflation term, and that gives "sticky inflation." The Phillips curve of the model (32) and (33) is \[\pi_t = \frac{1}{1+\beta}\pi_{t-1} + \frac{\beta}{1+\beta}E_{t-1}\pi_{t+1} + (\text{constants}) E_{t-1}s_t\]where \(s_t\) are marginal costs (more later). The \(E_{t-1}\) come from the assumption that prices can't react to time \(t\) information. Iterate that forward to (33)\[\pi_t - \pi_{t-1} = (\text{constants}) E_{t-1}\sum_{j=0}^\infty \beta^j s_{t+j}.\] We have successfully put the change in inflation in place of the level of inflation. The Phillips curve is anchored by real marginal costs, and they are not proportional to output in this model as they are in the textbook model above. That's important too. Instead,\[s_t = (\text{constants}) (r^k_t)^\alpha \left(\frac{W_t}{P_t}R_t\right)^{1-\alpha}\] where \(r^k\) is the return to capital \(W/P\) is the real wage and \(R\) is the nominal interest rate. The latter term crops up from the assumption that firms must borrow the wage bill one period in advance. This is an interesting ingredient. There is a lot of talk that higher interest rates raise costs for firms, and they are reducing output as a result. That might get us around some of the IS curve problems. But that's not how it works here. Here's how I think it works. Higher interest rates raise marginal costs, and thus push up current inflation relative to expected future inflation. The equilibrium-selection rules and the rule against instant price changes (coming up next) tie down current inflation, so the higher interest rates have to push down expected future inflation. CEE disagree (p. 28). Writing of an interest rate decline, so all the signs are opposite of my stories, ... the interest rate appears in firms' marginal cost. Since the interest rate drops after an expansionary monetary policy shock, the model embeds a force that pushes marginal costs down for a period of time. Indeed, in the estimated benchmark model the effect is strong enough to induce a transient fall in inflation.But pushing marginal costs down lowers current inflation relative to future inflation -- they're looking at the same Phillips curve just above. It looks to me like they're confusing current with expected future inflation. Intuition is hard. There are plenty of Fisherian forces in this model that want lower interest rates to lower inflation. More deeply, we see here a foundational trouble of the Phillips curve. It was originally a statistical relation between wage inflation and unemployment. It became a (weaker) statistical relation between price inflation and unemployment or the output gap. The new-Keynesian theory wants naturally to describe a relation between marginal costs and price changes, and it takes contortions to make output equal to marginal costs. Phillips curves fit the data terribly. So authors estimating Phillips curves (An early favorite by Tim Cogley and Argia Sbordone) go back, and separate marginal cost from output or employment. As CET write later, they "build features into the model which ensure that firms' marginal costs are nearly acyclical." That helps the fit, but it divorces the Phillips curve shifter variable from the business cycle! Standard doctrine says that for the Fed to lower inflation it must soften the economy and risk unemployment. Doves say don't do it, live with inflation to avoid that cost. Well, if the Phillips curve shifter is "acyclical" you have to throw all that out the window. This shift also points to the central conundrum of the Phillips curve. Here it describes the adjustment of prices to wages or "costs" more generally. It fundamentally describes a relative price, not a price level. OK, but the phenomenon we want to explain is the common component, how all prices and wage tie together or equivalently the decline in the value of the currency, stripped of relative price movements. The central puzzle of macroeconomics is why the common component, a rise or fall of all prices and wages together, has anything to do with output, and for us how it is controlled by the Fed. Christiano Eichenbaum and Evans write (p.3) that "it is crucial to allow for variable capital utilization." I'll try explain why in my own words. Without capital adjustment costs, any change in the real return leads to a big investment jump. \(r=f'(k)\) must jump and that takes a lot of extra \(k\). We add adjustment costs to tamp down the investment response. But now when there is any shock, capital can't adjust enough and there is a big rate of return response. So we need something that acts like a big jump in the capital stock to tamp down \(r=f'(k)\) variability, but not a big investment jump. Variable capital utilization acts like the big investment jump without us seeing a big investment jump. And all this is going to be important for inflation too. Remember the Phillips curve; if output jumps then inflation jumps too. Sticky wages are crucial, and indeed CEE report that they can dispense with sticky prices. One reason is that otherwise profits are countercyclical. In a boom, prices go up faster than wages so profits go up. With sticky prices and flexible wages you get the opposite sign. It's interesting that the "textbook" model has not moved this way. Again, we don't often enough write textbooks. Fixing prices and wages during the period of the shock by assuming price setters can't see the shock for a quarter has a direct effect: It stops any price or wage jumps during the quarter of the shock, as in my first graph. That's almost cheating. Note the VAR also has absolutely zero instantaneous inflation response. This too is by assumption. They "orthogonalize" the variables so that all the contemporaneous correlation between monetary policy shocks and inflation or output is considered part of the Fed's "rule" and none of it reflects within-quarter reaction of prices or quantities to the Fed's actions. Step back and admire. Given the project "find elaborations of the standard new-Keynesian model to match VAR impulse response functions" could you have come up with any of this? But back to our task. That's a lot of apparently necessary ingredients. And reading here or CEE's verbal intuition, the logic of this model is nothing like the standard simple intuition, which includes none of the necessary ingredients. Do we really need all of this to produce the basic pattern of monetary policy? As far as we know, we do. And hence, that pattern may not be as robust as it seems. For all of these ingredients are pretty, ... imaginative. Really, we are a long way from the Lucas/Prescott vision that macroeconomic models should be based on well tried and measured microeconomic ingredients that are believably invariant to changes in the policy regime. CEE argue hard for the plausibility of these microeconomic specifications (see especially the later CET Journal of Economic Perspectives article), but they have to try so hard precisely because the standard literature doesn't have any of these ingredients. The "level" rather than "growth rate" foundations of consumption, investment, and pricing decisions pervade microeconomics. Microeconomists worry about labor monopsony, not labor monopoly; firms set wages, households don't. (Christiano Eichenbam and Trabandt (2016) get wage stickiness from a more realistic search and matching model. Curiously, the one big labor union fiction is still the most common, though few private sector workers are unionized.) Firms don't borrow the wage bill a quarter ahead of time. Very few prices and wages are indexed in the US. Like habits, perhaps these ingredients are simple stand ins for something else, but at some point we need to know what that something else is. That is especially true if one wants to do optimal policy or welfare analysis. Just how much economics must we reinvent to match this one response function? How far are we really from the ad-hoc ISLM equations that Sims (1980) destroyed? Sadly, subsequent literature doesn't help much (more below). Subsequent literature has mostly added ingredients, including heterogeneous agents (big these days), borrowing constraints, additional financial frictions (especially after 2008), zero bound constraints, QE, learning and complex expectations dynamics. (See CET 2018 JEP for a good verbal survey.) The rewards in our profession go to those who add a new ingredient. It's very hard to publish papers that strip a model down to its basics. Editors don't count that as "new research," but just "exposition" below the prestige of their journals. Though boiling a model down to essentials is maybe more important in the end than adding more bells and whistles. This is about where we are. Despite the pretty response functions, I still score that we don't have a reliable, simple, economic model that produces the standard view of monetary policy. Mankiw and Reis, sticky expectations Mankiw and Reis (2002) expressed the challenge clearly over 20 years ago. In reference to the "standard" New-Keynesian Phillips curve \(\pi_t = \beta E_t \pi_{t+1} + \kappa x_t\) they write a beautiful and succinct paragraph: Ball [1994a] shows that the model yields the surprising result that announced, credible disinflations cause booms rather than recessions. Fuhrer and Moore [1995] argue that it cannot explain why inflation is so persistent. Mankiw [2001] notes that it has trouble explaining why shocks to monetary policy have a delayed and gradual effect on inflation. These problems appear to arise from the same source: although the price level is sticky in this model, the inflation rate can change quickly. By contrast, empirical analyses of the inflation process (e.g., Gordon [1997]) typically give a large role to "inflation inertia."At the cost of repetition, I emphasize the last sentence because it is so overlooked. Sticky prices are not sticky inflation. Ball already said this in 1994: Taylor (1979, 198) and Blanchard (1983, 1986) show that staggering produces inertia in the price level: prices just slowly to a fall in th money supply. ...Disinflation, however, is a change in the growth rate of money not a one-time shock to the level. In informal discussions, analysts often assume that the inertia result carries over from levels to growth rates -- that inflation adjusts slowly to a fall in money growth. As I see it, Mankiw and Reis generalize the Lucas (1972) Phillips curve. For Lucas, roughly, output is related to unexpected inflation\[\pi_t = E_{t-1}\pi_t + \kappa x_t.\] Firms don't see everyone else's prices in the period. Thus, when a firm sees an unexpected rise in prices, it doesn't know if it is a higher relative price or a higher general price level; the firm expands output based on how much it thinks the event might be a relative price increase. I love this model for many reasons, but one, which seems to have fallen by the wayside, is that it explicitly founds the Phillips curve in firms' confusion about relative prices vs. the price level, and thus faces up to the problem why should a rise in the price level have any real effects. Mankiw and Reis basically suppose that firms find out the general price level with lags, so output depends on inflation relative to a distributed lag of its expectations. It's clearest for the price level (p. 1300)\[p_t = \lambda\sum_{j=0}^\infty (1-\lambda)^j E_{t-j}(p_t + \alpha x_t).\] The inflation expression is \[\pi_t = \frac{\alpha \lambda}{1-\lambda}x_t + \lambda \sum_{j=0}^\infty (1-\lambda)^j E_{t-1-j}(\pi_t + \alpha \Delta x_t).\](Some of the complication is that you want it to be \(\pi_t = \sum_{j=0}^\infty E_{t-1-j}\pi_t + \kappa x_t\), but output doesn't enter that way.) This seems totally natural and sensible to me. What is a "period" anyway? It makes sense that firms learn heterogeneously whether a price increase is relative or price level. And it obviously solves the central persistence problem with the Lucas (1972) model, that it only produces a one-period output movement. Well, what's a period anyway? (Mankiw and Reis don't sell it this way, and actually don't cite Lucas at all. Curious.) It's not immediately obvious that this curve solves the Ball puzzle and the declining inflation puzzle, and indeed one must put it in a full model to do so. Mankiw and Reis (2002) mix it with \(m_t + v = p_t + x_t\) and make some stylized analysis, but don't show how to put the idea in models such as I started with or make a plot. Their less well known follow on paper Sticky Information in General Equilibrium (2007) is much better for this purpose because they do show you how to put the idea in an explicit new-Keynesian model, like the one I started with. They also add a Taylor rule, and an interest rate rather than money supply instrument, along with wage stickiness and a few other ingredients,. They show how to solve the model overcoming the problem that there are many lagged expectations as state variables. But here is the response to the monetary policy shock: Response to a Monetary Policy Shock, Mankiw and Reis (2007). Sadly they don't report how interest rates respond to the shock. I presume interest rates went down temporarily. Look: the inflation and output gap plots are about the same. Except for the slight delay going up, these are exactly the responses of the standard NK model. When output is high, inflation is high and declining. The whole point was to produce a model in which high output level would correspond to rising inflation. Relative to the first graph, the main improvement is just a slight hump shape in both inflation and output responses. Describing the same model in "Pervasive Stickiness" (2006), Mankiw and Reis describe the desideratum well: The Acceleration Phenomenon....inflation tends to rise when the economy is booming and falls when economic activity is depressed. This is the central insight of the empirical literature on the Phillips curve. One simple way to illustrate this fact is to correlate the change in inflation, \(\pi_{t+2}-\pi_{t-2}\) with [the level of] output, \(y_t\), detrended with the HP filter. In U.S. quarterly data from 1954-Q3 to 2005-Q3, the correlation is 0.47. That is, the change in inflation is procyclical.Now look again at the graph. As far as I can see, it's not there. Is this version of sticky inflation a bust, for this purpose? I still think it's a neat idea worth more exploration. But I thought so 20 years ago too. Mankiw and Reis have a lot of citations but nobody followed them. Why not? I suspect it's part of a general pattern that lots of great micro sticky price papers are not used because they don't produce an easy aggregate Phillips curve. If you want cites, make sure people can plug it in to Dynare. Mankiw and Reis' curve is pretty simple, but you still have to keep all past expectations around as a state variable. There may be alternative ways of doing that with modern computational technology, putting it in a Markov environment or cutting off the lags, everyone learns the price level after 5 years. Hank models have even bigger state spaces! Some more modelsWhat about within the Fed? Chung, Kiley, and Laforte 2010, "Documentation of the Estimated, Dynamic, Optimization-based (EDO) Model of the U.S. Economy: 2010 Version" is one such model. (Thanks to Ben Moll, in a lecture slide titled "Effects of interest rate hike in U.S. Fed's own New Keynesian model") They describe it as This paper provides documentation for a large-scale estimated DSGE model of the U.S. economy – the Federal Reserve Board's Estimated, Dynamic, Optimization- based (FRB/EDO) model project. The model can be used to address a wide range of practical policy questions on a routine basis.Here are the central plots for our purpose: The response of interest rates and inflation to a monetary policy shock. No long and variable lags here. Just as in the simple model, inflation jumps down on the day of the shock and then reverts. As with Mankiw and Reis, there is a tiny hump shape, but that's it. This is nothing like the Romer and Romer plot. Smets and Wouters (2007) "Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach" is about as famous as Christiano Eichenbaum and Evans as a standard new-Keynesian model that supposedly matches data well. It "contains many shocks and frictions. It features sticky nominal price and wage settings that allow for backward inflation indexation, habit formation in consumption, and investment adjustment costs that create hump-shaped responses... and variable capital utilization and fixed costs in production"Here is their central graph of the response to a monetary policy shockAgain, there is a little hump-shape, but the overall picture is just like the one we started with. Inflation mostly jumps down immediately and then recovers; the interest rate shock leads to future inflation that is higher, not lower than current inflation. There are no lags from higher interest rates to future inflation declines. The major difference, I think, is that Smets and Wouters do not impose the restriction that inflation cannot jump immediately on either their theory or empirical work, and Christiano, Eichenbaum and Evans impose that restriction in both places. This is important. In a new-Keynesian model some combination of state variables must jump on the day of the shock, as it is only saddle-path stable. If inflation can't move right away, that means something else does. Therefore, I think, CEE also preclude inflation jumping the next period. Comparing otherwise similar ingredients, it looks like this is the key ingredient for producing Romer-Romer like responses consistent with the belief in sticky inflation. But perhaps the original model and Smets-Wouters are right! I do not know what happens if you remove the CEE orthogonalization restriction and allow inflation to jump on the day of the shock in the date. That would rescue the new-Keynesian model, but it would destroy the belief in sticky inflation and long and variable lags. Closing thoughtsI'll reiterate the main point. As far as I can tell, there is no simple economic model that produces the standard belief. Now, maybe belief is right and models just have to catch up. It is interesting that there is so little effort going on to do this. As above, the vast outpouring of new-Keynesian modeling has been to add even more ingredients. In part, again, that's the natural pressures of journal publication. But I think it's also an honest feeling that after Christiano Eichenbaun and Evans, this is a solved problem and adding other ingredients is all there is to do. So part of the point of this post (and "Expectations and the neutrality of interest rates") is to argue that this is not a solved problem, and that removing ingredients to find the simplest economic model that can produce standard beliefs is a really important task. Then, does the model incorporate anything at all of the standard intuition, or is it based on some different mechanism al together? These are first order important and unresolved questions!But for my lay readers, here is as far as I know where we are. If you, like the Fed, hold to standard beliefs that higher interest rates lower future output and inflation with long and variable lags, know there is no simple economic theory behind that belief, and certainly the standard story is not how economic models of the last four decades work. Update:I repeat a response to a comment below, because it is so important. I probably wasn't clear enough that the "problem" of high output with inflation falling rather than rising is a problem of models vs. traditional beliefs, rather than of models vs. facts. The point of the sequence of posts, really, is that the traditional beliefs are likely wrong. Inflation does not fall, following interest rate increases, with dependable, long, and perhaps variable lags. That belief is strong, but neither facts, empirical evidence, or theory supports it. ("Variable" is a great way to scrounge data to make it fit priors.) Indeed many successful disinflations like ends of hyperinflations feature a sigh of relief and output surge on the real side.
Die Inhalte der verlinkten Blogs und Blog Beiträge unterliegen in vielen Fällen keiner redaktionellen Kontrolle.
Warnung zur Verfügbarkeit
Eine dauerhafte Verfügbarkeit ist nicht garantiert und liegt vollumfänglich in den Händen der Blogbetreiber:innen. Bitte erstellen Sie sich selbständig eine Kopie falls Sie einen Blog Beitrag zitieren möchten.
There are a lot of moving parts to the MMT program. I want to focus on one of these parts today: the relation between monetary and fiscal policy. One thing I find appealing about MMT scholars is their attention to monetary history and institutional details. I've learned a lot from them in this regard. But as is often the case with details, one has to worry about whether they help shed light on a specific question of interest, or whether they sometimes let us not see the forest for the trees. And in terms of the broader picture, since I grew up in that branch of macroeconomics that tries to take money, banking, and debt seriously (i.e., not standard NK theory), I sometimes have a hard time understanding what all the fuss is about. Much of standard monetary theory (SMT) seems perfectly consistent with some of the ideas I seen discussed in MMT proponents; see, for example, The Failure to Inflate Japan.
This post is devoted to better understanding a contribution by Eric Tymoigne. Eric is one of the people I go to whenever I want to learn more about MMT (if you're interested in MMT, you should follow him on Twitter @tymoignee). In this post, I discuss his article "Modern Monetary Theory, and Interrelations Between the Treasury and Central Bank: The Case of the United States." (JEI 2014). Passages quoted from his paper are highlighted in blue. The working paper version of the paper can be found here. Eric has kindly agreed to respond to my comments and let me post our conversation. We had to some editing, hopefully this did not disrupt the flow too much. In any case, I hope you find it interesting. And, as always, feel free to join in on the conversation in the comments section below. -- DA
One of the main contributions of modern money theory (MMT) has been to explain why monetarily sovereign governments have a very flexible policy space. Not only can they issue their own currency to spend and to service their public debt denominated in their own unit of account, but also any self-imposed constraint on budgetary operations can be easily bypassed.
I'm curious to know what the contribution is here relative to standard monetary theory (SMT). In SMT, the government can also issue its own currency to spend and to service the public debt denominated in its own unit of account. So this degree of "flexibility" is already accounted for. As for "self-imposed constraints on budgetary operations," SMT takes several approaches to this issue, depending on the purpose of the analysis. One approach is to take these constraints as given and then to study their implications. But it is also common to consolidate the central bank, treasury and government into a single authority, which implies no self-imposed constraints on budgetary operations.
Perhaps what is meant is that MMT shows how existing self-imposed constraints on budgetary operations can be (or are) bypassed in reality. This leads us to question, however, concerning what those self-imposed constraints are doing there in the first place. Are they there by design and, if so, why? Or are they there by accident (and, if so, how in the world did this happen)?
ET: Yes consolidation is not unique to MMT as we have said repeatedly. Not only is it used quite commonly in the economic literature, but also it is a common rhetorical tool in economic talks, discourse, etc.
DA: Right, so everyone understands this (at least, they should)--it's perfectly consistent with standard monetary theory. So far, so good.
ET: Most economists, politicians and the public don't understand this or its implications. They will interpret the above as saying that it is obvious that the government can create money but it is not a normal way to proceed and it is inflationary. MMT just pushes consolidation to its logical conclusions and shows that institutional details do back those conclusions. In a consolidated framework, the federal government can only implement spending by creating money, this is not abnormal and it is not inflationary by itself. There is no other way to find the necessary dollars to spend. Here is what consolidation means in terms of balance sheets:
For the federal government, taxes destroy currency (L1 falls) and claims on non-fed sectors falls (A1 falls) (an alternative offsetting operation is net worth of government rises). When US spends, it credits accounts (L1 rises). Similarly, bond issuance does not lead to a gain of any asset for the government; all it does is replace a non-interest earning government liability (monetary base) with an interest-earning government liability (Treasury securities).
DA: I am not going to argue against your accounting. As for bond-issuance, in SMT, an open-market operation is modeled as a swap of zero-interest reserves for interest-bearing treasuries. The interest on treasuries is explained by their relative illiquidity (another self-imposed constraint). The economic consequences of such a swap depends on a host of factors, which I'm sure you're familiar with.
ET: Sure, in addition, self-imposed financial constraints (e.g. debt ceiling, no direct financing by the Fed, no monetary power for treasury) have been put in place at various times with the argument that they impose discipline in public finances. MMT argues, these financial constraints are not necessary and are bypassed routinely through Treasury-Central Bank coordination.
DA: Sure, the standard view is that these self-imposed constraints are designed to impose discipline in public finance. The proposition that these financial constraints are or are not necessary, however, must be based on a set of assumptions that may or may not be satisfied in reality. (The fact that these constraints may be bypassed through Treasury-Central Bank coordination does not seem relevant to me -- the conflict emphasized by SMT is between an "independent" central bank and the legislative authority (e.g., the Fed and Congress, not the Fed and Treasury). I'm not sure why a new theory is needed here. We know, for example, that if the legislative branch of government fully trusts itself (and future elected representatives) to behave in a fiscally responsible manner, the notion of an "independent" central bank (and other self-imposed constraints) makes little sense.
ET: Remember that MMT emphasizes the irrelevance of financial/nominal constraints for monetarily sovereign governments (bond vigilantes, risk of insolvency of social security, etc.). One can do that by using the consolidated government (taxes don't finance, bonds don't finance, government spends by crediting accounts, etc.) or by using the unconsolidated government (the central bank helps the Treasury, the Treasury helps the central bank). The second method conforms to actual federal government operations but it is much less easy to use rhetorically and it waters down the core point: government finances are never a financial issue as long as monetary sovereignty applies.
Given that point, as you note, financial constraints are not only irrelevant, but also disruptive and used for political games. MMT wants to make government financial operations as smooth and flexible as possible. Once society has decided how, and to what degree, government should be involved in solving socioeconomic problems, finding the money should not be an issue when monetary sovereignty prevails. That means demystifying and eliminating financial barriers to government operations so the political debate can focus on solving real issues (environment issues, socio-economic issues, etc.). Fearmongering about the public debt and fiscal deficits makes for poor political debates and policy prescriptions.
There is a view, expressed by Paul Samuelson, that if we tell policymakers and the public that there are no financial limits to government spending, policymakers will spend like mad; therefore, economists need to lie to policymakers and the public (and themselves). This is nonsense. We ought to discuss policy choices not on the basis of Noble Lies but rather on the basis of sound and informed premises. Economists needs to make sure that policymakers focus on resource constraints.
In addition, political constraints on government should be geared toward improving the transparency and participatory aspects of government (e.g. limit role of big money in elections, limit wastes, etc.). We already have a government that passes a budget (it needs to do so for transparency and accountability purposes), we already have an auditing process, and we already have some (limited) democratic process, so aim at improving these aspects. MMT proponents are not naive, we know that some politicians are self-interested, we know that policy implementation may lead to mistakes, we know people may try to game the system ("free riders"); however we trust that a transparent and democratic government can (and does) get through these issues. MMT does not see financial constraints as helping in any ways, rather they inhibit the democratic process.
Of course, MMT proponents also have a policy agenda (Job guarantee, financial regulation based on Minsky, etc.) because we do not see market mechanisms as self-promoting full employment, price stability and financial stability. As such, as you said, MMT proponents favor alternative means to achieve these goals through direct government intervention. We don't see the central bank as an effective means to promote price stability. The central bank should focus on financial stability through interest-rate stabilization and financial regulation (an area where the Fed has not performed well).
Finally, yes independence of the central bank is seen as a big deal but MMT disagrees for two reasons. First, MMT emphasizes the lack of effectiveness of monetary policy in managing the business cycle and, second, and probably more importantly, MMT notes that central-bank independence in terms of interest-rate setting and goal settings does not mean independence from the financial needs of the Treasury.
DA: I think it's fair to say most people want to see government operations run smoothly, and would welcome a sober debate over the issues at hand without the fear-mongering that some like to promote. The broad objective seems the same--the debate is more over implementation--how monetary and fiscal policy is to be coordinated--given human frailties.
Having said this, I think you go too far by asserting that "government finances are never an issue as long as monetary sovereignty applies." Of course, technical default on nominal debt is not an issue (we all understand this). But SMT also recognizes the importance of economic default on nominal debt. True, a government can always print money to satisfy its nominal debt obligation, but if money printing dilutes the purchasing power of money, this is a de facto default.
On a related issue, SMT asks "what are the limits to seigniorage?" The fact that a government can print money does not give it the power to command resources without constraint. People can (and do) find substitutes for government money (they may also substitute out of taxed activities into non-taxed activities). SMT treats the limits to seigniorage as a financial constraint. Maybe MMT has a different label for this constraint? Perhaps it is related to what I hear MMT proponents call an "inflation constraint." Maybe one way to reconcile MMT with SMT on this score is by recognizing that SMT usually assumes (sometimes incorrectly) that the inflation constraint is always binding. If this is the case, a monetarily-sovereign government does have a financial constraint, even according to MMT.
ET: Yes, ability to create a currency does not mean ability to command resources because there may not be a demand for the currency. That is where tax liabilities and other dues owed to the government become important (cf. the chartalist theory of money, a component of MMT). That's also why taxes, monetary creation and bond issuance are not conceptualized by MMT as alternative financing means but rather as complementary. The government imposes a tax liability, spends by issuing the currency necessary to pay the tax liability, then taxes and issues bonds. Spending may be inflationary indeed and so there is an inflation constraint; but it is not a financial constraint, it is a resource constraint.
About the "printing" of money by government, inflation and economic default. Regarding the first two, there is no evidence of an automatic relation between money and inflation. In a consolidated view, government always spends by monetary creation but controls the impact on inflation via taxes and the impact on interest rates via bond issuance. In an unconsolidated view, the central bank routinely finances and refinances the Treasury by helping some of the auction bidders and by participating in the auction.
Finally, regarding economic default, governments routinely "default" in that sense with no problems. I don't see that as a relevant concept unless someone can show that economic default raises interest rates or generates rising inflation (it does not); here again, there is no automatic link between inflation and interest rates. That link depends on how the central bank reacts; if it does not then market participants don't either.
DA: Let me return to the manner in which the Fed/Treasury/Congress are consolidated (or not) in SMT and why this matters, in your view. In some SMT treatments, Congress decides spending and taxes, which implies a primary deficit. It's up to the Treasury to finance that deficit, with the Fed playing a supporting role (by determining interest rate and issuing reserves for treasury debt). What's wrong with this approach?
ET: That goes in the right direction with an understanding that the government really has no control over its fiscal position. All this, which relates to the implementation of monetary sovereignty, helps understand why the financial crowding out is not operative, why monetary financing is not by definition inflationary, why i > g is normal. It helps explain why the hysterical rhetoric surrounding the public debt and deficits in nonsense. I recently wrote a piece for Challenge Magazine on that topic. Surpluses are celebrated, governments implement austerity during a recession to "live within our means", Social Security needs to be fixed to avoid bankrupting it, governments need to save more, etc. All of this is incorrect.
DA: I'm not sure why you claim SMT leads to the idea of i > g. The case i < g is perfectly consistent with SMT (see Blanchard's 2019 AEA Presidential address, and also my posts here and here). The correct criticism (I think) is that mainstream economists have assumed i > g as being the empirically relevant case (it is not).
ET: That is what I meant. MMT links that to monetary sovereignty.
DA: I think that's correct. I should like to add that mainstream economists (apart from a small set of monetary theorists) have not appreciated the role of high-grade sovereign debt as an exchange medium in wholesale financial markets and as a global store of value, which in my view likely explains a lot of the "missing inflation." But as for "surpluses being celebrated," you are now talking about individual viewpoints and not SMT per se. There were plenty of calls out there for countercyclical fiscal policy based on standard macroeconomic principles. But I do agree virtually all mainstream economists are (perhaps overly) concerned about "long-run fiscal sustainability." The view is that at the end of the day, stuff has to be paid for -- and that having the ability to print money, while granting an extra degree of flexibility, does not get around this basic fact.
DA: I'd like to ask you about this statement you make:
In (the unconsolidated) case, the Treasury collects taxes and issues securities before it can spend. However, federal taxes and bond offerings also serve another highly important function that is overlooked in standard monetary economics. Specifically, federal taxes and bond offerings result in a drainage of funds from the banking system, and MMT carefully analyzes the implication of this fact. From that analysis, MMT argues that federal taxes and bond offerings are best conceptualized as devices that maintain price and interest-rate stability, respectively (of course, the tax structure also has some important role to play in terms of influencing incentives and income distribution; something not disputed by MMT).
DA: Well, yes, taxes serve both as a revenue device (permitting the government to gain control over resources that would otherwise be in control of the private sector) and as a way to control inflation. I'm not sure about the idea of the Treasury offering bonds for the purpose of achieving interest-rate stability (though this may happen to some extent when the treasury determines which maturity to offer). I don't think this is the way things work in the U.S. today.
ET: Taxes and issuance of treasuries drain reserves and so raise the overnight rate. Hence, on a daily basis, a fiscal surplus raises the overnight rate and a fiscal deficit lowers it. There has been significant Treasury-Fed coordination to smooth the impact of taxes (and treasury spending) on the money market.
DA: Fine, but so what? We all understand "coordination" between Fed and Treasury exists at the operational level.
ET: I think you are too kind to other economists and policymakers. On taxes as price-stabilizing factors, there is indeed some similarities here. On the role of treasuries for interest-rate stability, it does work like this today. It may not be obvious because of the current emphasis on treasuries as Treasury's budgetary tools, but Treasury has issued securities for other purposes than its budgetary needs. In the US, this occurred most recently during the 2008 crisis (SFP bills). In Australia, in the early 2000s, the Treasury issued securities while running surpluses in order to promote financial stability.
DA: But even if this is not the way things actually work (in my view, it's the Fed that stabilizes interest rates, possibly through OMOs involving U.S. Treasuries), I'm not sure what point is being made. I think we can all agree that monetary and fiscal policy can be thought of as being consolidated in some manner. What would be good to know is how a specific MMT consolidation matters (relative to other specifications) for a specific set of questions being addressed. There is nothing in the abstract or introduction of this paper that suggests an answer to this question.
ET: The point being made is that in a consolidated government, tax and bond issuance lose the financial purpose they have for the Treasury but keep their price and interest-stability purposes.
DA: In standard monetary theory, tax and bond issuance keeps its funding purposes for the government and at the same time can be used to influence the price-level (inflation) and interest rates. Is this wrong? I don't think so. At some level, taxes (a vacuum cleaner sucking up money from the private sector) must have some implications for the ability of government to exert command over real resources in the economy. What we label this ability (whether "funding" or ''finance" or whatever, seems inconsequential).
ET: Ok here comes the crucial difference between financial and real sides of the economy. In financial terms, taxes do not increase the capacity of the government to spend, i.e. the government does not earn any money from taxing; taxes destroy the currency. In financial terms, there is no reason to fear a fiscal deficit; deficits are the norm, are sustainable and help other sectors grow their financial net wealth. As such, it is not because a government wants to spend more that it must tax more or lower spending somewhere else. That is the PAYGO mentality. This mentality makes policymakers think of spending and taxing in terms of how they impact the fiscal balance instead of their impact on employment, inflation, incentives, etc. While deficits may have negative consequences, they are not automatic. If one takes a look at the evidence, deficits have no automatic negative impacts on interest rates, tax rates, public-debt sustainability, or inflation.
In real terms, the necessity to increase tax rates to prevent inflation, and so move more resources to the government, depends on the state of the economy and the permanency of the increase in government spending relative to the size of the economy. In an underemployed economy, the government can spend more without raising tax rates. In a fully employed economy, shifting resources to the government without generating inflation does require raising tax rate and/or putting in place other measures such as rationing, price controls, and delayed private-income payment. Here Keynes's "How to Pay for the War" provides the roadmap. Standard economics is full-employment economics so opportunity costs are always present. MMT follows Kalecki, Keynes and the work of their followers (have a look at Lavoie's "Foundations of Post Keynesian Economic Analysis") and note that capitalist economies are usually underemployment and economic growth is demand driven. Put in a picture, the economy is usually at point a.
Put succinctly, the real constraint is conditionally relevant, the financial constraint is irrelevant if monetary sovereignty prevails. That is the proper way to frame the policy debates and to advise policymakers; don't worry about the money, worry about how spending impacts the economy.
ET: Moving to another topic, consolidation of the government brings to the forefront forces that are operating in the current system but that are buried under institutional complications. Namely that a fiscal deficit lowers interest rates and treasuries issuance brings them back up, that spending must come before taxing and treasuries issuance, that monetary financing of the government is not intrinsically unsound and does not mean that tax and treasuries issuance don't have to be implemented.
DA: The statement that "deficit lower interest rates" needs considerable qualification. Among other things, it depends on the monetary policy reaction function. As for the claim that spending *must* come before taxes, this is not a universally valid statement (even if it may be true in some circumstances. But even more importantly, who cares? Mainstream theory does not suggest that monetary financing is intrinsically unsound (seigniorage is fine, if it respects inflation ceiling). As for money, taxes and bonds not being alternative "funding" sources, I worry that this semantics. You can call X a "funding" source or not -- it's just a label. The real question is: what are the macroeconomic implications of X?
ET: Let me emphasize where I agree. Yes, evidence shows the central role of monetary policy for the direction of interest rates, fiscal policy is at best a very small driver. And yes, one ought to focus on the real implications of government spending and we ought to forget about the financial implications. A fiscal deficit is not unsustainable nor abnormal; deficits are the stylized fact of government finances and are financially sustainable if monetary sovereignty is present. So don't try to frame the policy debate and set policy in terms of household finances, bankruptcy, fixing the deficit, etc.
To conclude I see three reasons why the "taxes/bonds don't finance the government" rhetoric is helpful:
1- It is strictly true for the federal government (i.e. consolidation).
2- it brings to the forefront some lesser-known aspects of taxes and treasuries issuance: impacts on money market, role of central bank in fiscal policy, role of treasury in monetary policy.
3- It changes the narrative in terms of policy and political economy: government does not rely on the rich to finance itself, taxes should be set to remove the "bads" not to finance the government (e.g. one should not set tax rates on pollution with the goal of balancing the budget but with the goal of curbing pollution to whatever is considered appropriate, that may lead to much higher tax rates than what is needed to balance the budget), PAYGO is insane, one should focus on the real outcomes of government policies not the budgetary outcomes.
DA:
1. I think this is semantics.
2. Not sure how it helps in this regard.
3. I think all of these positions are defensible without the statement "taxes/bonds don't finance the government", so if this is the ultimate goal (and I think it should be), perhaps we should set aside semantic debates and focus on the real issues at hand.
ET: 1 is not semantic. I know you have in mind taxes as a means to leave resources to the government. MMT makes a clear difference between financial (ability to find the money) and resources constraint (ability to get the goods and services) as explained above. The financial constraint is highly relevant for non-monetarily sovereign governments so it should be noted and clearly separated from the real constraint. Too many policy discussions and decisions by policymakers operating under monetary sovereignty are based on an inexistent inability to find money and the imagined dear financial consequences of budgeting fiscal deficits. 2 helps to understand how monetary sovereignty is implemented in practice. On 3, yes focus on the real issues.
DA: We agree on 3! Thank you for an interesting discussion, Eric. There's so much more to talk about, but let's leave that for another day.
Die Inhalte der verlinkten Blogs und Blog Beiträge unterliegen in vielen Fällen keiner redaktionellen Kontrolle.
Warnung zur Verfügbarkeit
Eine dauerhafte Verfügbarkeit ist nicht garantiert und liegt vollumfänglich in den Händen der Blogbetreiber:innen. Bitte erstellen Sie sich selbständig eine Kopie falls Sie einen Blog Beitrag zitieren möchten.
(This post continues part 1 which just looked at the data. Part 3 on theory is here) When the Fed raises interest rates, how does inflation respond? Are there "long and variable lags" to inflation and output? There is a standard story: The Fed raises interest rates; inflation is sticky so real interest rates (interest rate - inflation) rise; higher real interest rates lower output and employment; the softer economy pushes inflation down. Each of these is a lagged effect. But despite 40 years of effort, theory struggles to substantiate that story (next post), it's had to see in the data (last post), and the empirical work is ephemeral -- this post. The vector autoregression and related local projection are today the standard empirical tools to address how monetary policy affects the economy, and have been since Chris Sims' great work in the 1970s. (See Larry Christiano's review.) I am losing faith in the method and results. We need to find new ways to learn about the effects of monetary policy. This post expands on some thoughts on this topic in "Expectations and the Neutrality of Interest Rates," several of my papers from the 1990s* and excellent recent reviews from Valerie Ramey and Emi Nakamura and Jón Steinsson, who eloquently summarize the hard identification and computation troubles of contemporary empirical work.Maybe popular wisdom is right, and economics just has to catch up. Perhaps we will. But a popular belief that does not have solid scientific theory and empirical backing, despite a 40 year effort for models and data that will provide the desired answer, must be a bit less trustworthy than one that does have such foundations. Practical people should consider that the Fed may be less powerful than traditionally thought, and that its interest rate policy has different effects than commonly thought. Whether and under what conditions high interest rates lower inflation, whether they do so with long and variable but nonetheless predictable and exploitable lags, is much less certain than you think. Here is a replication of one of the most famous monetary VARs, Christiano Eichenbaum and Evans 1999, from Valerie Ramey's 2016 review: Fig. 1 Christiano et al. (1999) identification. 1965m1–1995m6 full specification: solid black lines; 1983m1–2007m12 full specification: short dashed blue (dark gray in the print version) lines; 1983m1–2007m12, omits money and reserves: long-dashed red (gray in the print version) lines. Light gray bands are 90% confidence bands. Source: Ramey 2016. Months on x axis. The black lines plot the original specification. The top left panel plots the path of the Federal Funds rate after the Fed unexpectedly raises the interest rate. The funds rate goes up, but only for 6 months or so. Industrial production goes down and unemployment goes up, peaking at month 20. The figure plots the level of the CPI, so inflation is the slope of the lower right hand panel. You see inflation goes the "wrong" way, up, for about 6 months, and then gently declines. Interest rates indeed seem to affect the economy with long lags. This was the broad outline of consensus empirical estimates for many years. It is common to many other studies, and it is consistent with the beliefs of policy makers and analysts. It's pretty much what Friedman (1968) told us to expect. Getting contemporary models to produce something like this is much harder, but that's the next blog post. What's a VAR?I try to keep this blog accessible to nonspecialists, so I'll step back momentarily to explain how we produce graphs like these. Economists who know what a VAR is should skip to the next section heading. How do we measure the effect of monetary policy on other variables? Milton Friedman and Anna Schwartz kicked it off in the Monetary History by pointing to the historical correlation of money growth with inflation and output. They knew as we do that correlation is not causation, so they pointed to the fact that money growth preceeded inflation and output growth. But as James Tobin pointed out, the cock's crow comes before, but does not cause, the sun to rise. So too people may go get out some money ahead of time when they see more future business activity on the horizon. Even correlation with a lead is not causation. What to do? Clive Granger's causality and Chris Sims' VAR, especially "Macroeconomics and Reality" gave today's answer. (And there is a reason that everybody mentioned so far has a Nobel prize.) First, we find a monetary policy "shock," a movement in the interest rate (these days; money, then) that is plausibly not a response to economic events and especially to expected future economic events. We think of the Fed setting interest rates by a response to economic data plus deviations from that response, such as interest rate = (#) output + (#) inflation + (#) other variables + disturbance. We want to isolate the "disturbance," movements in the interest rate not taken in response to economic events. (I use "shock" to mean an unpredictable variable, and "disturbance" to mean deviation from an equation like the above, but one that can persist for a while. A monetary policy "shock" is an unexpected movement in the disturbance.) The "rule" part here can be but need not be the Taylor rule, and can include other variables than output and inflation. It is what the Fed usually does given other variables, and therefore (hopefully) controls for reverse causality from expected future economic events to interest rates. Now, in any individual episode, output and inflation and inflation following a shock will be influenced by subsequent shocks to the economy, monetary and other. But those average out. So, the average value of inflation, output, employment, etc. following a monetary policy shock is a measure of how the shock affects the economy all on its own. That is what has been plotted above. VARs were one of the first big advances in the modern empirical quest to find "exogenous" variation and (somewhat) credibly find causal relationships. Mostly the huge literature varies on how one finds the "shocks." Traditional VARs use regressions of the above equations and the residual is the shock, with a big question just how many and which contemporaneous variables one adds in the regression. Romer and Romer pioneered the "narrative approach," reading the Fed minutes to isolate shocks. Some technical details at the bottom and much more discussion below. The key is finding shocks. One can just regress output and inflation on the shocks to produce the response function, which is a "local projection" not a "VAR," but I'll use "VAR" for both techniques for lack of a better encompassing word. Losing faithShocks, what shocks?What's a "shock" anyway? The concept is that the Fed considers its forecast of inflation, output and other variables it is trying to control, gauges the usual and appropriate response, and then adds 25 or 50 basis points, at random, just for the heck of it. The question VARS try to answer is the same: What happens to the economy if the Fed raises interest rates unexpectedly, for no particular reason at all? But the Fed never does this. Ask them. Read the minutes. The Fed does not roll dice. They always raise or lower interest rates for a reason, that reason is always a response to something going on in the economy, and most of the time how it affects forecasts of inflation and employment. There are no shocks as defined.I speculated here that we might get around this problem: If we knew the Fed was responding to something that had no correlation with future output, then even though that is an endogenous response, then it is a valid movement for estimating the effect of interest rates on output. My example was, what if the Fed "responds" to the weather. Well, though endogenous, it's still valid for estimating the effect on output. The Fed does respond to lots of things, including foreign exchange, financial stability issues, equity, terrorist attacks, and so forth. But I can't think of any of these in which the Fed is not thinking of these events for their effect on output and inflation, which is why I never took the idea far. Maybe you can. Shock isolation also depends on complete controls for the Fed's information. If the Fed uses any information about future output and inflation that is not captured in our regression, then information about future output and inflation remains in the "shock" series. The famous "price puzzle" is a good example. For the first few decades of VARs, interest rate shocks seemed to lead to higher inflation. It took a long specification search to get rid of this undesired result. The story was, that the Fed saw inflation coming in ways not completely controlled for by the regression. The Fed raised interest rates to try to forestall the inflation, but was a bit hesitant about it so did not cure the inflation that was coming. We see higher interest rates followed by higher inflation, though the true causal effect of interest rates goes the other way. This problem was "cured" by adding commodity prices to the interest rate rule, on the idea that fast-moving commodity prices would capture the information the Fed was using to forecast inflation. (Interestingly these days we seem to see core inflation as the best forecaster, and throw out commodity prices!) With those and some careful orthogonalization choices, the "price puzzle" was tamped down to the one year or so delay you see above. (Neo-Fisherians might object that maybe the price puzzle was trying to tell us something all these years!) Nakamura and Steinsson write of this problem: "What is being assumed is that controlling for a few lags of a few variables captures all endogenous variation in policy... This seems highly unlikely to be true in practice. The Fed bases its policy decisions on a huge amount of data. Different considerations (in some cases highly idiosyncratic) affect policy at different times. These include stress in the banking system, sharp changes in commodity prices, a recent stock market crash, a financial crisis in emerging markets, terrorist attacks, temporary investment tax credits, and the Y2K computer glitch. The list goes on and on. Each of these considerations may only affect policy in a meaningful way on a small number of dates, and the number of such influences is so large that it is not feasible to include them all in a regression. But leaving any one of them out will result in a monetary policy "shock" that the researcher views as exogenous but is in fact endogenous." Nakamura and Steinsson offer 9/11 as another example summarizing my "high frequency identification" paper with Monika Piazzesi: The Fed lowered interest rates after the terrorist attack, likely reacting to its consequences for output and inflation. But VARs register the event as an exogenous shock.Romer and Romer suggested that we use Fed Greenbook forecasts of inflation and output as controls, as those should represent the Fed's complete information set. They provide narrative evidence that Fed members trust Greenback forecasts more than you might suspect. This issue is a general Achilles heel of empirical macro and finance: Does your procedure assume agents see no more information than you have included in the model or estimate? If yes, you have a problem. Similarly, "Granger causality" answers the cock's crow-sunrise problem by saying that if unexpected x leads unexpected y then x causes y. But it's only real causality if the "expected" includes all information, as the price puzzle counterexample shows. Just what properties do we need of a shock in order to measure the response to the question, "what if the Fed raised rates for no reason?" This strikes me as a bit of an unsolved question -- or rather, one that everyone thinks is so obvious that we don't really look at it. My suggestion that the shock only need be orthogonal to the variable whose response we're estimating is informal, and I don't know of formal literature that's picked it up. Must "shocks" be unexpected, i.e. not forecastable from anything in the previous time information set? Must they surprise people? I don't think so -- it is neither necessary nor sufficient for shock to be unforecastable for it to identify the inflation and output responses. Not responding to expected values of the variable whose response you want to measure should be enough. If bond markets found out about a random funds rate rise one day ahead, it would then be an "expected" shock, but clearly just as good for macro. Romer and Romer have been criticized that their shocks are predictable, but this may not matter. The above Nakamura and Steinsson quote says leaving out any information leads to a shock that is not strictly exogenous. But strictly exogenous may not be necessary for estimating, say, the effect of interest rates on inflation. It is enough to rule out reverse causality and third effects. Either I'm missing a well known econometric literature, as is everyone else writing the VARs I've read who don't cite it, or there is a good theory paper to be written.Romer and Romer, thinking deeply about how to read "shocks" from the Fed minutes, define shocks thus to circumvent the "there are no shocks" problem:we look for times when monetary policymakers felt the economy was roughly at potential (or normal) output, but decided that the prevailing rate of inflation was too high. Policymakers then chose to cut money growth and raise interest rates, realizing that there would be (or at least could be) substantial negative consequences for aggregate output and unemployment. These criteria are designed to pick out times when policymakers essentially changed their tastes about the acceptable level of inflation. They weren't just responding to anticipated movements in the real economy and inflation. [My emphasis.] You can see the issue. This is not an "exogenous" movement in the funds rate. It is a response to inflation, and to expected inflation, with a clear eye on expected output as well. It really is a nonlinear rule, ignore inflation for a while until it gets really bad then finally get serious about it. Or, as they say, it is a change in rule, an increase in the sensitivity of the short run interest rate response to inflation, taken in response to inflation seeming to get out of control in a longer run sense. Does this identify the response to an "exogenous" interest rate increase? Not really. But maybe it doesn't matter. Are we even asking an interesting question? The whole question, what would happen if the Fed raised interest rates for no reason, is arguably besides the point. At a minimum, we should be clearer about what question we are asking, and whether the policies we analyze are implementations of that question. The question presumes a stable "rule," (e.g. \(i_t = \rho i_{t-1} + \phi_\pi \pi_t + \phi_x x_t + u_t\)) and asks what happens in response to a deviation \( +u_t \) from the rule. Is that an interesting question? The standard story for 1980-1982 is exactly not such an event. Inflation was not conquered by a big "shock," a big deviation from 1970s practice, while keeping that practice intact. Inflation was conquered (so the story goes) by a change in the rule, by a big increase in $\phi_\pi$. That change raised interest rates, but arguably without any deviation from the new rule \(u_t\) at all. Thinking in terms of the Phillips curve \( \pi_t = E_t \pi_{t+1} + \kappa x_t\), it was not a big negative \(x_t\) that brought down inflation, but the credibility of the new rule that brought down \(E_t \pi_{t+1}\). If the art of reducing inflation is to convince people that a new regime has arrived, then the response to any monetary policy "shock" orthogonal to a stable "rule" completely misses that policy. Romer and Romer are almost talking about a rule-change event. For 2022, they might be looking at the Fed's abandonment of flexible average inflation targeting and its return to a Taylor rule. However, they don't recognize the importance of the distinction, treating changes in rule as equivalent to a residual. Changing the rule changes expectations in quite different ways from a residual of a stable rule. Changes with a bigger commitment should have bigger effects, and one should standardize somehow by the size and permanence of the rule change, not necessarily the size of the interest rate rise. And, having asked "what if the Fed changes rule to be more serious about inflation," we really cannot use the analysis to estimate what happens if the Fed shocks interest rates and does not change the rule. It takes some mighty invariance result from an economic theory that a change in rule has the same effect as a shock to a given rule. There is no right and wrong, really. We just need to be more careful about what question the empirical procedure asks, if we want to ask that question, and if our policy analysis actually asks the same question. Estimating rules, Clarida Galí and Gertler. Clarida, Galí, and Gertler (2000) is a justly famous paper, and in this context for doing something totally different to evaluate monetary policy. They estimate rules, fancy versions of \(i_t = \rho i_{t-1} +\phi_\pi \pi_t + \phi_x x_t + u_t\), and they estimate how the \(\phi\) parameters change over time. They attribute the end of 1970s inflation to a change in the rule, a rise in \(\phi_\pi\) from the 1970s to the 1980s. In their model, a higher \( \phi_\pi\) results in less volatile inflation. They do not estimate any response functions. The rest of us were watching the wrong thing all along. Responses to shocks weren't the interesting quantity. Changes in the rule were the interesting quantity. Yes, I criticized the paper, but for issues that are irrelevant here. (In the new Keynesian model, the parameter that reduces inflation isn't the one they estimate.) The important point here is that they are doing something completely different, and offer us a roadmap for how else we might evaluate monetary policy if not by impulse-response functions to monetary policy shocks. Fiscal theoryThe interesting question for fiscal theory is, "What is the effect of an interest rate rise not accompanied by a change in fiscal policy?" What can the Fed do by itself? By contrast, standard models (both new and old Keynesian) include concurrent fiscal policy changes when interest rates rise. Governments tighten in present value terms, at least to pay higher interest costs on the debt and the windfall to bondholders that flows from unexpected disinflation. Experience and estimates surely include fiscal changes along with monetary tightening. Both fiscal and monetary authorities react to inflation with policy actions and reforms. Growth-oriented microeconomic reforms with fiscal consequences often follow as well -- rampant inflation may have had something to do with Carter era trucking, airline, and telecommunications reform. Yet no current estimate tries to look for a monetary shock orthogonal to fiscal policy change. The estimates we have are at best the effects of monetary policy together with whatever induced or coincident fiscal and microeconomic policy tends to happen at the same time as central banks get serious about fighting inflation. Identifying the component of a monetary policy shock orthogonal to fiscal policy, and measuring its effects is a first order question for fiscal theory of monetary policy. That's why I wrote this blog post. I set out to do it, and then started to confront how VARs are already falling apart in our hands. Just what "no change in fiscal policy" means is an important question that varies by application. (Lots more in "fiscal roots" here, fiscal theory of monetary policy here and in FTPL.) For simple calculations, I just ask what happens if interest rates change with no change in primary surplus. One might also define "no change" as no change in tax rates, automatic stabilizers, or even habitual discretionary stimulus and bailout, no disturbance \(u_t\) in a fiscal rule \(s_t = a + \theta_\pi \pi_t + \theta_x x_t + ... + u_t\). There is no right and wrong here either, there is just making sure you ask an interesting question. Long and variable lags, and persistent interest rate movementsThe first plot shows a mighty long lag between the monitor policy shock and its effect on inflation and output. That does not mean that the economy has long and variable lags. This plot is actually not representative, because in the black lines the interest rate itself quickly reverts to zero. It is common to find a more protracted interest rate response to the shock, as shown in the red and blue lines. That mirrors common sense: When the Fed starts tightening, it sets off a year or so of stair-step further increases, and then a plateau, before similar stair-step reversion. That raises the question, does the long-delayed response of output and inflation represent a delayed response to the initial monetary policy shock, or does it represent a nearly instantaneous response to the higher subsequent interest rates that the shock sets off? Another way of putting the question, is the response of inflation and output invariant to changes in the response of the funds rate itself? Do persistent and transitory funds rate changes have the same responses? If you think of the inflation and output responses as economic responses to the initial shock only, then it does not matter if interest rates revert immediately to zero, or go on a 10 year binge following the initial shock. That seems like a pretty strong assumption. If you think that a more persistent interest rate response would lead to a larger or more persistent output and inflation response, then you think some of what we see in the VARs is a quick structural response to the later higher interest rates, when they come. Back in 1988, I posed this question in "what do the VARs mean?" and showed you can read it either way. The persistent output and inflation response can represent either long economic lags to the initial shock, or much less laggy responses to interest rates when they come. I showed how to deconvolute the response function to the structural effect of interest rates on inflation and output and how persistently interest rates rise. The inflation and output responses might be the same with shorter funds rate responses, or they might be much different. Obviously (though often forgotten), whether the inflation and output responses are invariant to changes in the funds rate response needs a model. If in the economic model only unexpected interest rate movements affect output and inflation, though with lags, then the responses are as conventionally read structural responses and invariant to the interest rate path. There is no such economic model. Lucas (1972) says only unexpected money affects output, but with no lags, and expected money affects inflation. New Keynesian models have very different responses to permanent vs. transitory interest rate shocks. Interestingly, Romer and Romer do not see it this way, and regard their responses as structural long and variable lags, invariant to the interest rate response. They opine that given their reading of a positive shock in 2022, a long and variable lag to inflation reduction is baked in, no matter what the Fed does next. They argue that the Fed should stop raising interest rates. (In fairness, it doesn't look like they thought about the issue much, so this is an implicit rather than explicit assumption.) The alternative view is that effects of a shock on inflation are really effects of the subsequent rate rises on inflation, that the impulse response function to inflation is not invariant to the funds rate response, so stopping the standard tightening cycle would undo the inflation response. Argue either way, but at least recognize the important assumption behind the conclusions. Was the success of inflation reduction in the early 1980s just a long delayed response to the first few shocks? Or was the early 1980s the result of persistent large real interest rates following the initial shock? (Or, something else entirely, a coordinated fiscal-monetary reform... But I'm staying away from that and just discussing conventional narratives, not necessarily the right answer.) If the latter, which is the conventional narrative, then you think it does matter if the funds rate shock is followed by more funds rate rises (or positive deviations from a rule), that the output and inflation response functions do not directly measure long lags from the initial shock. De-convoluting the structural funds rate to inflation response and the persistent funds rate response, you would estimate much shorter structural lags. Nakamura and Steinsson are of this view: While the Volcker episode is consistent with a large amount of monetary nonneutrality, it seems less consistent with the commonly held view that monetary policy affects output with "long and variable lags." To the contrary, what makes the Volcker episode potentially compelling is that output fell and rose largely in sync with the actions [interest rates, not shocks] of the Fed. And that's a good thing too. We've done a lot of dynamic economics since Friedman's 1968 address. There is really nothing in dynamic economic theory that produces a structural long-delayed response to shocks, without the continued pressure of high interest rates. (A correspondent objects to "largely in sync" pointing out several clear months long lags between policy actions and results in 1980. It's here for the methodological point, not the historical one.) However, if the output and inflation responses are not invariant to the interest rate response, then the VAR directly measures an incredibly narrow experiment: What happens in response to a surprise interest rate rise, followed by the plotted path of interest rates? And that plotted path is usually pretty temporary, as in the above graph. What would happen if the Fed raised rates and kept them up, a la 1980? The VAR is silent on that question. You need to calibrate some model to the responses we have to infer that answer. VARs and shock responses are often misread as generic theory-free estimates of "the effects of monetary policy." They are not. At best, they tell you the effect of one specific experiment: A random increase in funds rate, on top of a stable rule, followed by the usual following path of funds rate. Any other implication requires a model, explicit or implicit. More specifically, without that clearly false invariance assumption, VARs cannot directly answer a host of important questions. Two on my mind: 1) What happens if the Fed raises interest rates permanently? Does inflation eventually rise? Does it rise in the short run? This is the "Fisherian" and "neo-Fisherian" questions, and the answer "yes" pops unexpectedly out of the standard new-Keynesian model. 2) Is the short-run negative response of inflation to interest rates stronger for more persistent rate rises? The long-term debt fiscal theory mechanism for a short-term inflation decline is tied to the persistence of the shock and the maturity structure of the debt. The responses to short-lived interest rate movements (top left panel) are silent on these questions. Directly is an important qualifier. It is not impossible to answer these questions, but you have to work harder to identify persistent interest rate shocks. For example, Martín Uribe identifies permanent vs. transitory interest rate shocks, and finds a positive response of inflation to permanent interest rate rises. How? You can't just pick out the interest rate rises that turned out to be permanent. You have to find shocks or components of the shock that are ex-ante predictably going to be permanent, based on other forecasting variables and the correlation of the shock with other shocks. For example, a short-term rate shock that also moves long-term rates might be more permanent than one which does not do so. (That requires the expectations hypothesis, which doesn't work, and long term interest rates move too much anyway in response to transitory funds rate shocks. So, this is not directly a suggestion, just an example of the kind of thing one must do. Uribe's model is more complex than I can summarize in a blog.) Given how small and ephemeral the shocks are already, subdividing them into those that are expected to have permanent vs. transitory effects on the federal funds rate is obviously a challenge. But it's not impossible. Monetary policy shocks account for small fractions of inflation, output and funds rate variation. Friedman thought that most recessions and inflations were due to monetary mistakes. The VARs pretty uniformly deny that result. The effects of monetary policy shocks on output and inflation add up to less than 10 percent of the variation of output and inflation. In part the shocks are small, and in part the responses to the shocks are small. Most recessions come from other shocks, not monetary mistakes. Worse, both in data and in models, most inflation variation comes from inflation shocks, most output variation comes from output shocks, etc. The cross-effects of one variable on another are small. And "inflation shock" (or "marginal cost shock"), "output shock" and so forth are just labels for our ignorance -- error terms in regressions, unforecasted movements -- not independently measured quantities. (This and old point, for example in my 1994 paper with the great title "Shocks." Technically, the variance of output is the sum of the squares of the impulse-response functions -- the plots -- times the variance of the shocks. Thus small shocks and small responses mean not much variance explained.)This is a deep point. The exquisite attention put to the effects of monetary policy in new-Keynesian models, while interesting to the Fed, are then largely beside the point if your question is what causes recessions. Comprehensive models work hard to match all of the responses, not just to monetary policy shocks. But it's not clear that the nominal rigidities that are important for the effects of monetary policy are deeply important to other (supply) shocks, and vice versa. This is not a criticism. Economics always works better if we can use small models that focus on one thing -- growth, recessions, distorting effect of taxes, effect of monetary policy -- without having to have a model of everything in which all effects interact. But, be clear we no longer have a model of everything. "Explaining recessions" and "understanding the effects of monetary policy" are somewhat separate questions. Monetary policy shocks also account for small fractions of the movement in the federal funds rate itself. Most of the funds rate movement is in the rule, the reaction to the economy term. Like much empirical economics, the quest for causal identification leads us to look at a tiny causes with tiny effects, that do little to explain much variation in the variable of interest (inflation). Well, cause is cause, and the needle is the sharpest item in the haystack. But one worries about the robustness of such tiny effects, and to what extent they summarize historical experience. To be concrete, here is a typical shock regression, 1960:1-2023:6 monthly data, standard errors in parentheses: ff(t) = a + b ff(t-1) + c[ff(t-1)-ff(t-2)] + d CPI(t) + e unemployment(t) + monetary policy shock, Where "CPI" is the percent change in the CPI (CPIAUCSL) from a year earlier. ff(t-1)ff(t-1)-ff(t-2)CPIUnempR20.970.390.032-0.0170.985(0.009)(0.07)(0.013)(0.009)The funds rate is persistent -- the lag term (0.97) is large. Recent changes matter too: Once the Fed starts a tightening cycle, it's likely to keep raising rates. And the Fed responds to CPI and unemployment. The plot shows the actual federal funds rate (blue), the model or predicted federal funds rate (red), the shock which is the difference between the two (orange) and the Romer and Romer dates (vertical lines). You can't see the difference between actual and predicted funds rate, which is the point. They are very similar and the shocks are small. They are closer horizontally than vertically, so the vertical difference plotted as shock is still visible. The shocks are much smaller than the funds rate, and smaller than the rise and fall in the funds rate in a typical tightening or loosening cycle. The shocks are bunched, with by far the biggest ones in the early 1980s. The shocks have been tiny since the 1980s. (Romer and Romer don't find any shocks!) Now, our estimates of the effect of monetary policy look at the average values of inflation, output, and employment in the 4-5 years after a shock. Really, you say, looking at the graph? That's going to be dominated by the experience of the early 1980s. And with so many positive and negative shocks close together, the average value 4 years later is going to be driven by subtle timing of when the positive or negative shocks line up with later events. Put another way, here is a plot of inflation 30 months after a shock regressed on the shock. Shock on the x axis, subsequent inflation on the y axis. The slope of the line is our estimate of the effect of the shock on inflation 30 months out (source, with details). Hmm. One more graph (I'm having fun here):This is a plot of inflation for the 4 years after each shock, times that shock. The right hand side is the same graph with an expanded y scale. The average of these histories is our impulse response function. (The big lines are the episodes which multiply the big shocks of the early 1980s. They mostly converge because, either multiplied by positive or negative shocks, inflation wend down in the 1980s.) Impulse response functions are just quantitative summaries of the lessons of history. You may be underwhelmed that history is sending a clear story. Again, welcome to causal economics -- tiny average responses to tiny but identified movements is what we estimate, not broad lessons of history. We do not estimate "what is the effect of the sustained high real interest rates of the early 1980s," for example, or "what accounts for the sharp decline of inflation in the early 1980s?" Perhaps we should, though confronting endogeneity of the interest rate responses some other way. That's my main point today. Estimates disappear after 1982Ramey's first variation in the first plot is to use data from 1983 to 2007. Her second variation is to also omit the monetary variables. Christiano Eichenbaum and Evans were still thinking in terms of money supply control, but our Fed does not control money supply. The evidence that higher interest rates lower inflation disappears after 1983, with or without money. This too is a common finding. It might be because there simply aren't any monetary policy shocks. Still, we're driving a car with a yellowed AAA road map dated 1982 on it. Monetary policy shocks still seem to affect output and employment, just not inflation. That poses a deeper problem. If there just aren't any monetary policy shocks, we would just get big standard errors on everything. That only inflation disappears points to the vanishing Phillips curve, which will be the weak point in the theory to come. It is the Phillips curve by which lower output and employment push down inflation. But without the Phillips curve, the whole standard story for interest rates to affect inflation goes away. Computing long-run responsesThe long lags of the above plot are already pretty long horizons, with interesting economics still going on at 48 months. As we get interested in long run neutrality, identification via long run sign restrictions (monetary policy should not permanently affect output), and the effect of persistent interest rate shocks, we are interested in even longer run responses. The "long run risks" literature in asset pricing is similarly crucially interested in long run properties. Intuitively, we should know this will be troublesome. There aren't all that many nonoverlapping 4 year periods after interest rate shocks to measure effects, let alone 10 year periods.VARs estimate long run responses with a parametric structure. Organize the data (output, inflation, interest rate, etc) into a vector \(x_t = [y_t \; \pi_t \; i_t \; ...]'\), then the VAR can be written \(x_{t+1} = Ax_t + u_t\). We start from zero, move \(x_1 = u_1\) in an interesting way, and then the response function just simulates forward, with \(x_j = A^j x_1\). But here an oft-forgotten lesson of 1980s econometrics pops up: It is dangerous to estimate long-run dynamics by fitting a short run model and then finding its long-run implications. Raising matrices to the 48th power \(A^{48}\) can do weird things, the 120th power (10 years) weirder things. OLS and maximum likelihood prize one step ahead \(R^2\), and will happily accept small one step ahead mis specifications that add up to big misspecification 10 years out. (I learned this lesson in the "Random walk in GNP.") Long run implications are driven by the maximum eigenvalue of the \(A\) transition matrix, and its associated eigenvector. \(A^j = Q \Lambda^j Q^{-1}\). This is a benefit and a danger. Specify and estimate the dynamics of the combination of variables with the largest eigenvector right, and lots of details can be wrong. But standard estimates aren't trying hard to get these right. The "local projection" alternative directly estimates long run responses: Run regressions of inflation in 10 years on the shock today. You can see the tradeoff: there aren't many non-overlapping 10 year intervals, so this will be imprecisely estimated. The VAR makes a strong parametric assumption about long-run dynamics. When it's right, you get better estimates. When it's wrong, you get misspecification. My experience running lots of VARs is that monthly VARs raised to large powers often give unreliable responses. Run at least a one-year VAR before you start looking at long run responses. Cointegrating vectors are the most reliable variables to include. They are typically the state variable that most reliably carries long - run responses. But pay attention to getting them right. Imposing integrating and cointegrating structure by just looking at units is a good idea. The regression of long-run returns on dividend yields is a good example. The dividend yield is a cointegrating vector, and is the slow-moving state variable. A one period VAR \[\left[ \begin{array}{c} r_{t+1} \\ dp_{t+1} \end{array} \right] = \left[ \begin{array}{cc} 0 & b_r \\ 0 & \rho \end{array}\right] \left[ \begin{array}{c} r_{t} \\ dp_{t} \end{array}\right]+ \varepsilon_{t+1}\] implies a long horizon regression \(r_{t+j} = b_r \rho^j dp_{t} +\) error. Direct regressions ("local projections") \(r_{t+j} = b_{r,j} dp_t + \) error give about the same answers, though the downward bias in \(\rho\) estimates is a bit of an issue, but with much larger standard errors. The constraint \(b_{r,j} = b_r \rho^j\) isn't bad. But it can easily go wrong. If you don't impose that dividends and price are cointegrated, or with vector other than 1 -1, if you allow a small sample to estimate \(\rho>1\), if you don't put in dividend yields at all and just a lot of short-run forecasters, it can all go badly. Forecasting bond returns was for me a good counterexample. A VAR forecasting one-year bond returns from today's yields gives very different results from taking a monthly VAR, even with several lags, and using \(A^{12}\) to infer the one-year return forecast. Small pricing errors or microstructure dominate the monthly data, which produces junk when raised to the twelfth power. (Climate regressions are having fun with the same issue. Small estimated effects of temperature on growth, raised to the 100th power, can produce nicely calamitous results. But use basic theory to think about units.) Nakamura and Steinsson (appendix) show how sensitive some standard estimates of impulse response functions are to these questions. Weak evidenceFor the current policy question, I hope you get a sense of how weak the evidence is for the "standard view" that higher interest rates reliably lower inflation, though with a long and variable lag, and the Fed has a good deal of control over inflation. Yes, many estimates look the same, but there is a pretty strong prior going in to that. Most people don't publish papers that don't conform to something like the standard view. Look how long it took from Sims (1980) to Christiano Eichenbaum and Evans (1999) to produce a response function that does conform to the standard view, what Friedman told us to expect in (1968). That took a lot of playing with different orthogonalization, variable inclusion, and other specification assumptions. This is not criticism: when you have a strong prior, it makes sense to see if the data can be squeezed in to the prior. Once authors like Ramey and Nakamura and Steinsson started to look with a critical eye, it became clearer just how weak the evidence is. Standard errors are also wide, but the variability in results due to changes in sample and specification are much larger than formal standard errors. That's why I don't stress that statistical aspect. You play with 100 models, try one variable after another to tamp down the price puzzle, and then compute standard errors as if the 100th model were written in stone. This post is already too long, but showing how results change with different specifications would have been a good addition. For example, here are a few more Ramey plots of inflation responses, replicating various previous estimatesTake your pick. What should we do instead? Well, how else should we measure the effects of monetary policy? One natural approach turns to the analysis of historical episodes and changes in regime, with specific models in mind. Romer and Romer pass on thoughts on this approach: ...some macroeconomic behavior may be fundamentally episodic in nature. Financial crises, recessions, disinflations, are all events that seem to play out in an identifiable pattern. There may be long periods where things are basically fine, that are then interrupted by short periods when they are not. If this is true, the best way to understand them may be to focus on episodes—not a cross-section proxy or a tiny sub-period. In addition, it is valuable to know when the episodes were and what happened during them. And, the identification and understanding of episodes may require using sources other than conventional data.A lot of my and others' fiscal theory writing has taken a similar view. The long quiet zero bound is a test of theories: old-Keynesian models predict a delation spiral, new-Keynesian models predicts sunspot volatility, fiscal theory is consistent with stable quiet inflation. The emergence of inflation in 2021 and its easing despite interest rates below inflation likewise validates fiscal vs. standard theories. The fiscal implications of abandoning the gold standard in 1933 plus Roosevelt's "emergency" budget make sense of that episode. The new-Keynesian reaction parameter \(\phi_\pi\) in \(i_t - \phi_\pi \pi_t\), which leads to unstable dynamics for ](\phi_\pi>1\) is not identified by time series data. So use "other sources," like plain statements on the Fed website about how they react to inflation. I already cited Clarida Galí and Gertler, for measuring the rule not the response to the shock, and explaining the implications of that rule for their model. Nakamura and Steinsson likewise summarize Mussa's (1986) classic study of what happens when countries switch from fixed to floating exchange rates: "The switch from a fixed to a flexible exchange rate is a purely monetary action. In a world where monetary policy has no real effects, such a policy change would not affect real variables like the real exchange rate. Figure 3 demonstrates dramatically that the world we live in is not such a world."Also, analysis of particular historical episodes is enlightening. But each episode has other things going on and so invites alternative explanations. 90 years later, we're still fighting about what caused the Great Depression. 1980 is the poster child for monetary disinflation, yet as Nakamura and Steinsson write, Many economists find the narrative account above and the accompanying evidence about output to be compelling evidence of large monetary nonneutrality. However, there are other possible explanations for these movements in output. There were oil shocks both in September 1979 and in February 1981.... Credit controls were instituted between March and July of 1980. Anticipation effects associated with the phased-in tax cuts of the Reagan administration may also have played a role in the 1981–1982 recession ....Studying changes in regime, such as fixed to floating or the zero bound era, help somewhat relative to studying a particular episode, in that they have some of the averaging of other shocks. But the attraction of VARs will remain. None of these produces what VARs seemed to produce, a theory-free qualitative estimate of the effects of monetary policy. Many tell you that prices are sticky, but not how prices are sticky. Are they old-Keynesian backward looking sticky or new-Keynesian rational expectations sticky? What is the dynamic response of relative inflation to a change in a pegged exchange rate? What is the dynamic response of real relative prices to productivity shocks? Observations such as Mussa's graph can help to calibrate models, but does not answer those questions directly. My observations about the zero bound or the recent inflation similarly seem (to me) decisive about one class of model vs. another, at least subject to Occam's razor about epicycles, but likewise do not provide a theory-free impulse response function. Nakamura and Steinsson write at length about other approaches; model-based moment matching and use of micro data in particular. This post is going on too long; read their paper. Of course, as we have seen, VARs only seem to offer a model-free quantitative measurement of "the effects of monetary policy," but it's hard to give up on the appearance of such an answer. VARs and impulse responses also remain very useful ways of summarizing the correlations and cross correlations of data, even without cause and effect interpretation. In the end, many ideas are successful in economics when they tell researchers what to do, when they offer a relatively clear recipe for writing papers. "Look at episodes and think hard is not such recipe." "Run a VAR is." So, as you think about how we can evaluate monetary policy, think about a better recipe as well as a good answer. (Stay tuned. This post is likely to be updated a few times!) VAR technical appendixTechnically, running VARs is very easy, at least until you start trying to smooth out responses with Bayesian and other techniques. Line up the data in a vector, i.e. \(x_t = [i_t \; \pi_t\; y_t]'\). Then run a regression of each variable on lags of the others, \[x_t = Ax_{t-1} + u_t.\] If you want more than one lag of the right hand variables, just make a bigger \(x\) vector, \(x_t = [i_t\; \pi_t \; y_t \; i_{t-1}\; \pi_{t-1} \;y_{t-1}]'.\) The residuals of such regressions \(u_t\) will be correlated, so you have to decide whether, say, the correlation between interest rate and inflation shocks means the Fed responds in the period to inflation, or inflation responds within the period to interest rates, or some combination of the two. That's the "identification" assumption issue. You can write it as a matrix \(C\) so that \(u_t = C \varepsilon_t\) and cov\((\varepsilon_t \varepsilon_t')=I\) or you can include some contemporaneous values into the right hand sides. Now, with \(x_t = Ax_{t-1} + C\varepsilon_t\), you start with \(x_0=0\), choose one series to shock, e.g. \(\varepsilon_{i,1}=1\) leaving the others alone, and just simulate forward. The resulting path of the other variables is the above plot, the "impulse response function." Alternatively you can run a regression \(x_t = \sum_{j=0}^\infty \theta_j \varepsilon_{t-j}\) and the \(\theta_j\) are (different, in sample) estimates of the same thing. That's "local projection". Since the right hand variables are all orthogonal, you can run single or multiple regressions. (See here for equations.) Either way, you have found the moving average representation, \(x_t = \theta(L)\varepsilon_t\), in the first case with \(\theta(L)=(I-AL)^{-1}C\) in the second case directly. Since the right hand variables are all orthogonal, the variance of the series is the sum of its loading on all of the shocks, \(cov(x_t) = \sum_{j=0}^\infty \theta_j \theta_j'\). This "forecast error variance decomposition" is behind my statement that small amounts of inflation variance are due to monetary policy shocks rather than shocks to other variables, and mostly inflation shocks. Update:Luis Garicano has a great tweet thread explaining the ideas with a medical analogy. Kamil Kovar has a nice follow up blog post, with emphasis on Europe. He makes a good point that I should have thought of: A monetary policy "shock" is a deviation from a "rule." So, the Fed's and ECB's failure to respond to inflation as they "usually" do in 2021-2022 counts exactly the same as a 3-5% deliberate lowering of the interest rate. Lowering interest rates for no reason, and leaving interest rates alone when the regression rule says raise rates are the same in this methodology. That "loosening" of policy was quickly followed by inflation easing, so an updated VAR should exhibit a strong "price puzzle" -- a negative shock is followed by less, not more inflation. Of course historians and practical people might object that failure to act as usual has exactly the same effects as acting. * Some Papers: Comment on Romer and Romer What ends recessions? Some "what's a shock?"Comment on Romer and Romer A new measure of monetary policy. The greenbook forecasts, and beginning thoughts that strict exogeneity is not necessary. Shocks monetary shocks explain small fractions of output variance.Comments on Hamilton, more thoughts on what a shock is.What do the VARs mean? cited above, is the response to the shock or to persistent interest rates?The Fed and Interest Rates, with Monika Piazzesi. Daily data and interest rates to identify shocks. Decomposing the yield curve with Monika Piazzesi. Starts with a great example of how small changes in specification lead to big differences in long run forecasts. Time seriesA critique of the application of unit root tests pretesting for unit roots and cointegration is a bad ideaHow big is the random walk in GNP? lessons in not using short run dynamics to infer long run properties. Permanent and transitory components of GNP and stock prices a favorite of cointegration really helps on long run propertiesTime series for macroeconomics and finance notes that never quite became a book. Explains VARs and responses.