Not too simple: Just wrong

Simon Wren-Lewis has a nice post discussing Paul Romer’s critique of macro.

In Simon's words:

"It is hard to get academic macroeconomists trained since the 1980s to address [large scale Keynesian models] , because they have been taught that these models and techniques are fatally flawed because of the Lucas critique and identification problems."

"But DSGE models as a guide for policy are also fatally flawed because they are too simple. The unique property that DSGE models have is internal consistency."

"Take a DSGE model, and alter a few equations so that they fit the data much better, and you have what could be called a structural econometric model. It is internally inconsistent, but because it fits the data better it may be a better guide for policy."

Nope! Not too simple. Just wrong!

I disagree with Simon. NK models are not too simple. They are simply wrong. There are no ‘frictions’. There is no Calvo Fairy. There are simply persistent nominal beliefs.

Period.

The Next Great Depression

The financial markets are in turmoil. We are dangerously close to the next financial crisis.  The FTSE in the UK is down by 13% from its April peak. The Dow in the United States is off by 10%

and the Hong Kong Hang Seng index, the market that  is closest to the epicenter of the crisis, is down by a whopping 21%.

Why worry? Surely this is just a market correction. Traders in the financial markets are, after all, simply making the trades that are in all of our best interests. I don't think so!

Are the financial markets efficient? In one sense yes. In another sense no.

Animal Spirits and the Two Natural Rates

In my last post I pointed out that it is not enough for monetary policy to guide the economy back to the natural rate of interest. Central banks and national treasuries must use financial policy to guide us back to the natural rate of unemployment.

Imagine two economies in parallel universes. I will call them economy A and economy B. Both economies are populated by identical copies of the same people. They have the same endowments of land labor and capital. And each economy has access to identical technologies for producing goods. In economic jargon: they have the same fundamentals.

But although these economies have identical fundamentals, the people in economy A are naturally optimistic. They believe that shares in their stock market are worth PA. And PA is a large number. The people in economy B are pessimists. They believe that their stock market is worth PB. And PB is a small number. Importantly, PB < PA.

A Tale of Two Natural Rates

Narayana Kocherlakota makes the case for more public debt. Paul Krugman and Steve Williamson agree. (I have to keep rereading that sentence before I believe it). What is this argument all about and how does it relate to the soul of Keynesian economics?

Let's start with a key premise in the Kocherlakota speech. There is a theoretical concept called the ‘neutral real interest rate’ and one of the jobs of a central bank is to get us back to that rate of interest as quickly as possible. The ‘neutral rate’ is what Wicksell called the ‘natural rate of interest’ and I'm going to stick with Wicksell’s terminology here.

Somebody at the PBC blinked

In a recent post I made this comment about China’s decision to intervene in its own stock market.

China is holding more than $1.2 trillion dollars of U.S. government debt. If the Bank were to tap those funds to stabilize the Chinese stock market it could not simultaneously maintain an exchange rate peg. If China goes that route, look out for upheaval in the foreign exchange markets.

Chinese policy makers are now learning that lesson. The Peoples Bank of China (PBC) has allowed the Renminbi to tumble by more than 3% in the last few days. The ride may not yet be over.

What’s happening and why? It's my guess that there are investors on the margin who are pulling money out of the Chinese market and moving it into the world capital markets. Those investors are betting against the valuation that the PBC is putting on domestic assets. The outflow of funds  puts downward pressure on the RMB and if the PBC were to maintain its previous parity they would be obliged to sell their holdings of dollar denominated assets to support the currency.

The PBC blinked! But that's a good thing. They’ve chosen a domestic target over an exchange rate target and to make that work, the world needs to keep buying Chinese goods.

I have advocated a policy of Treasury and Central Bank intervention to stabilize domestic asset markets. What we are seeing in the Chinese case is that this policy is inconsistent with a fixed exchange rate.