My Blog Has Moved

I have consolidated my blog and my website on squarespace. If all goes according to plan: you will be able to find new and existing blog posts HERE as well as a link to my updated shiny new website. Fingers crossed: this should be up and running in the next 72 hours if all goes according to plan. 😎

Would Robinson Crusoe Please Leave the Stage?

I have just completed a new working paper, ”Asset Prices in an Economy with Two Types of People”. You can find it as an NBER 
working paper here, as a CEPR discussion paper here, or directly from my website here. The paper shows how asset price volatility may be driven by non-fundamental shocks.

The paper constructs a formal mathematical model to capture the idea that free trade in capital markets does not lead to optimal outcomes.[1] We would all be better off if national governments were to regulate the capital markets through counter cyclical trades of debt for equity. 

In a second new working paper, "The Theory of Unconventional Monetary Policy" coauthored with Pawel Zabczyk of the Bank of England, we show how those regulations would work in a simple two-period general equilibrium model.  As Ben Bernanke said in the aftermath of the Great Recession; "Quantitative Easing works in practice but not in theory". We show in this paper why it works in theory. The paper is available from the NBER here, CEPR here and from my website here.

Prosperity for All: Coming Soon to a Bookstore Near You

This is my first post for a while: so, sorry if you missed me. I've been busy writing books and papers. I received the final galley proofs this week for my new book, Prosperity for All: How to Prevent Financial Crises. You can pre-order it from OUP or Amazon and it will ship on September 1st.

I also finished three new working papers that I will say more about in future posts.

I've been consistent in my criticisms on this blog of attempts by Paul Krugman to revive the IS-LM framework. That's not because I'm opposed to IS-LM as it appeared in its earliest incarnations; the papers by John Hicks and Alvin Hansen. It's because of the bastardization of the Keynesian agenda by what my friend and teacher David Laidler referred to as North American Keynesianism. In my view, articulated in Prosperity for All, macroeconomics went off the rails in 1955 when Samuelson introduced the neoclassical synthesis in the third edition of his textbook, Economics: An Introductory Analysis. (See Pearce and Hoover for a great discussion of the influence of Samuelson's text and my book How the Economy Works).

Idiopathic Tardus Augmenti

There are religious nonconformists. There are climate change deniers. And there is now a new class of political agnostic: the secular stagnation skeptic. According to a piece in Time magazine this week, Barry Eichengreen finds the issue of secular stagnation so divisive amongst academic economists that he has coined a new term to help us sort ourselves into believers and non believers: the 

Steam Boat off Harbour's Mouth: J.M. Turner

 secular stagnation Rorschach Test. I like that term. And as I look at the ink blot of incoherent theory and misinterpreted facts that is presented to us for interpretation I find myself peering at a late Turner painting. I am straining to see the ship in the blizzard.

The Time piece is supposed to explain, to the layperson, what economists mean by secular stagnation. It serves only to spread the confusion that was laid by Larry Summer’s original article in which he resuscitated the term ‘secular stagnation’, originally coined by the American economist Alvin Hansen.

Why the Fed Should Raise Rates and Purchase More Assets

Here is a link to my Bloomberg TV segment today on "What'd You Miss" with Scarlett Fu, Alix Steel and Joe Weisenthal:  In which I

argue that the Phillips Curve is like the Planet Vulcan. Although observed by eminent astronomers in the early twentieth century: it was never actually there. 

The Phillips curve seemed remarkably stable in a century of UK labor market data. But as soon as Phillips published his eponymous article, it vanished.  That didn't stop economists from seizing on the Phillips curve as a building block of macro theory to prop up the neoclassical synthesis; Samuelson's attempt to connect Keynesian economics with classical ideas.

Why is this relevant? Because central bankers think that by lowering interest raters even further they will create inflation. This is a bad mistake. We need to raise rates now and support the value of risky assets by trading an ETF in the stock market.

Much more to come in my forthcoming book "Prosperity for All", coming in September from Oxford University Press.

So you believe the stock market can directly affect the economy?

Here is a link to an LA Times interview by James Peltz that features my work on link between confidence, the stock market and unemployment. Here is an excerpt. 

So you believe the stock market can directly affect the economy?

"Yes: When people lose confidence in the market and when the market stays down for three, six months at a time, people start paying attention."

Paying attention in what way?

"Imagine you're a 65-year-old couple and you have money invested in a 401(k). Now if your 401(k) drops for a week and then it comes back up again, you're probably not going to do very much. But if your 401(k) drops for three months or six months or a year, maybe you're not going to take that cruise you were going to take. Maybe you're not going to put money into your grandchild's college education.
Those decisions impact the economy. When people feel less wealthy they spend less. When they spend less, firms lay off workers and unemployment increases, and the fall in wealth becomes self-fulfilling. I believe when we feel rich we are rich."

Why is confidence so critical?

"If people are not out in the shops buying things, then firms are not going to be hiring people and one of the ways they respond is laying people off. And when people get laid off, profits fall along with demand and the drop in profits validates the original belief that their wealth was worth less. The stock market is a reflection of how wealthy we all think we are."

Multiple Equilibria and Financial Crises

Jess Benhabib and I are running our second annual conference on multiple equilibria and financial crises at NYU over the weekend with the support of the C.V Starr Center.We have a great lineup with a guest dinner talk from Costas Azariadis with "reflections on multiple equilibria". Here is a link to the program.

Does the Economy Ruin the Stock Market or Does the Stock Market Ruin the Economy?

John Carney of the Wall Street Journal has written a well researched thoughtful piece featuring my research on the connection between the stock market and the unemployment rate and he asks? 

Does the Economy Ruin the Stock Market or Does the Stock Market Ruin the Economy?

The ideas he talks about are discussed in much more detail in my new book Prosperity for All: How to Prevent Financial Crises coming this year from Oxford University Press.

Thought for the Day

Words are Powerful: especially if you put them in the right order. Roger Farmer

Graph For the Day: Is QE4 Far Away?

Here is an update of the graphs I used here to point to the link from QE to the stock market.

The market is down 10% since this time last year. If it stays down and falls further, look for a spike in US unemployment. I showed here that the stock market Granger causes the unemployment rate. Surely the Fed is aware of that by now. The question is: do they accept my causal explanation that sees low confidence as a self-fulfilling prophecy.

To the Fed and the Treasury: Can we Please Play Cooperatively?

How should government respond to a situation of high unemployment and low growth? If you are a classical RBC kind of person: the answer is simple. Get out of the way. Let the market perform its magic.

If you are a New Keynesian sticky price kind of person: the answer is also simple. Let the Fed do its magic by lowering the interest rate to stimulate aggregate demand. I have a different answer: replace long dated Treasury bonds in the hands of the public with cash or with short dated Treasury bills. 

Many Keynesian economists, journalists and bloggers have argued that, when at the zero lower bound (ZLB) we must repair our infrastructure. Build roads. Build bridges. Build airports. They argue that, when the overnight rate is zero and the thirty year rate is lower than it has been for a century, public infrastructure should be paid for by borrowing at the long end of the yield curve. Float thirty year bonds. Better still: issue Consols that will never be retired.

While I agree that public expenditure in a depression may be helpful: issuing long bonds is not the right way to do it. I agree with Adair Turner that it is better to finance an expansion by printing money or borrowing in the Treasury bill market. Better still: as I argued in How the Economy Works and as Mark Blyth and Eric Lonergan have argued (here) print money and give it to those who know how to spend it: that would be you and me.

Borrowing at the long end of the yield curve is a bad idea because there are still active private participants in that market. There is not one interest rate: there are many. And although it is not possible to crowd out private expenditure at the short end of the yield curve; it is still possible to crowd out private expenditure at the long end.

The maturity structure of debt in the hands of the public matters. As I argue here, it matters because our children and our grandchildren cannot participate in financial markets that open before they are born.

Once one recognizes that the way that public expenditure is financed matters: it is a short step to recognizing that it is all that matters. If the Treasury increases the stock of thirty year bonds in the hands of the public, it will drive up long yields and crowd out private expenditure. If the Treasury reduces the stock of thirty year bonds held by the public, it will lower long yields and crowd in private expenditure. That leads to the argument for Qualitative Easing. A policy that removes long bonds (or other long dated risky securities) from the hands of the public and replaces them with cash or with Treasury bills, will crowd in private expenditure and increase aggregate demand.

Critics of QE have argued that QE3 was less effective than QE2 and QE1. That is true. But Fed intervention in the asset markets was undone by the Treasury that was simultaneously changing the yield composition of its debt to take advantage of low long-term interest rates. My message to the Fed and the Treasury is simple: can we please play cooperatively?  Much more coming soon on this topic in a forthcoming book.

Please: Lets Agree to Speak the Same Language

Olivier Blanchard finds the drop in the value of American stocks hard to explain in a framework where only fundamentals matter. He concludes that ‘herding’ is to blame.

Can we please agree on terminology? Animal spirits, confidence, sunspots, self-fulfilling prophecies and, sentiments have all been used to mean shifts in markets caused by factors that are non-fundamental. Now Olivier adds herding as one more term. (To be fair, that term too has been used before in the finance literature). Why this smorgasbord of synonyms?

Why a Bottle of Beaujolais is not the same as a Collateralized Debt Obligation (Updated May 2016)

I have updated this blogpost with a link to the new version of my paper. The new revised paper has the title of "Pricing Assets in an Economy with Two Types of People". 

-----------------------------------------

Brad DeLong kindly tweeted a link to a working paper (updated to new version May 21st 2016) I wrote last year. Matt Yglesias asks Brad to explain the paper. Let me take a stab at that.

Every graduate student of economics learns, early in her career, that markets work well. The idea that ‘markets work well’ has a well defined meaning: allocating resources by buying and selling goods in free markets does at least as well as any other way of allocating them. Let me be more precise.

A society, to an economist, is a bunch of people and a bunch of goods. A good is something that people want. For example, a ticket to see the latest Star Wars movie is a good. A bottle of Beaujolais is a good: and so is a banana. I could go on. But the basic idea here is that everyone in society has preferences over different bundles of goods. I personally would prefer a bottle of Beaujolais and a banana to a trip to the movies: but you may rank things differently.

Scott Sumner and Musical Chairs

Since 2009, Scott Sumner has been a big proponent of nominal GDP targeting. He sees nominal wages as slow to adjust and he has sketched a simple model, the musical chairs model, to explain why his policy should be adopted.

I am a new convert to these arguments. That is my loss. I had assumed, incorrectly, that Scott was proposing that central banks should simply adjust the coefficients on their interest rate policies, so called Taylor Rules, to raise the nominal interest rate when nominal GDP growth is above target and to lower it when nominal GDP growth is below target.I will refer to that variant of NGDP targeting, as growth rate targeting. An alternative, NGDP level targeting, would make these interest rate adjustments in response to deviations of nominal GDP from a target growth path. For an elaboration of that view, see, for example, the article by Evan Koenig, Vice President of the Dallas Fed.

Demand Creates its Own Supply

I have been teaching basic Keynesian economics this week to my undergraduate class and I have just completed a new book manuscript with the working title of Prosperity for All, that will be coming soon to a book

store near you. I am thus highly attuned to the debate over the connection between savings and investment. That debate resurfaced with a vengeance this morning on Twitter when Noah Smith and Jo Michell, among others, engaged in a sometimes testy exchange on the role of the State in promoting investment. Since that debate is at the core of Keynesian economics, and since my class is prepping for Monday’s midterm, this seems like a great opportunity to enlighten readers of all varieties on what Jo and Noah were on about.

A Bridge Too Far?

There is much current angst on the difficult problem of how to escape a liquidity trap. Paul Krugman points out that in Japan, the ratio of debt to GDP is growing, leaving little room for a further tame fiscal expansion. He favors something more aggressive.

Tony Yates argues instead for a helicopter drop. Print money and give it to Japanese citizens. The benefit of that approach is that it does not leave the government with an increase in interest bearing debt. Simon Wren Lewis looks more closely at the technical aspects of this idea.

Give me a One Armed Economist

I'm glad to see that Olivier Blanchard and Yanis Varoufakis have come out in favor of my plan for People's QE.

The following passage is from How the Economy Works, (HTEW) page 151.

Economists are famous for hedging their bets. A typical response to the question of how to run fiscal policy might be: “On the one hand we should raise taxes but on the other we should balance the budget”. President Harry Truman who instituted the Council of Economic Advisors famously quipped; “give me a one-armed economist.”

Here's what I said about fiscal stimulus in HTEW. 

A large fiscal stimulus may or may not be an important component of a recovery plan. My own view is that there is a better alternative to fiscal policy that I explain in [How the Economy Works, Chaper 11]. But if a fiscal policy is used it should take the form of a transfer payment to every domestic resident; not an increase in government expenditure.

Well ok, I didn't call it peoples QE. "Peoples QE", was coined by a speech writer for Jeremy Corbyn, the new leader of the Labour Party in the UK and its one of the less crazy parts of the Corbyn platform.  Why do I believe that? Because I also believe something that may seem contradictory. Its time to get interest rates into positive territory. SOON. Quoting again from an impeccable source (HTEW page 152).

Here are my views on monetary policy. Short term interest rates should be increased as soon as feasible, because a positive interest rate is needed if a national central bank is effectively to control inflation. In future, central banks should use the interest rate for this purpose and not to prevent recessions.

Why do I favor a fiscal transfer, rather than currently popular bandwagon of infrastructure expenditure? Two reasons.

• Because the work of Christina and David Romer suggests that tax multipliers (and by implication, transfer multipliers) are big. 

• Because I trust markets to decide how to allocate a fiscal stimulus more than I trust the government.

So: Raising interest rates is necessary to eventually raise inflation. I'm with the "neo-Fisherians" here. But an interest rate hike must be offset by some other expansionary policy to prevent the normalization of rates from creating a new recession. Here's what I said about that in HTEW.

But if a central bank raises the domestic interest rate without independently managing confidence, the result will be a drop in the value of the national stock market and a further deterioration in the real economy. To prevent this from happening, central banks need a second instrument.

So: Janet, Mark, Mario: yes: raise rates. Please. But give us QE too.

Beliefs are Fundamental: Whatever your Religion

A couple of weeks ago, I had the pleasure of attending a very interesting conference at the Federal Reserve Bank of Saint Louis. The topic

of the conference was the relationship between income inequality and monetary policy, but the papers, more broadly, were all trying to cope with the intellectual problem of rebuilding monetary economics to incorporate the lessons of the Great Recession.

I discussed a fascinating paper, presented by Jim Bullard, joint with Costas Azariadis, Aarti Singh and Jacek Suda (ABSS). ABSS Built a 241 period overlapping generations model in which the people who inhabit the model are permitted to trade one period nominal bonds: but nothing else. They focused on one particular equilibrium of their model and they showed that, conditional on this equilibrium, a central bank can help the economy to function efficiently. Here is a link to the paper and here is a link to my discussion.

Washington: We have a problem

John Cochrane makes the case in the WSJ that everything is back to normal. Hunky Dory, rosy tinted, don’t panic, keep-calm-and-carry-on normal. He points out that inflation is under control. We have not entered a deflationary death-spiral and unemployment is back in reasonable territory.

Here is what John learned from the Great Recession.

The [QE] experiment was huge, and the lessons are clear. The economy is stable, not subject to Keynesian “spirals” requiring constant Fed intervention. And when reserves pay the same rate as bonds, banks do not care which one they hold. So even massive bond purchases do not cause inflation. Quantitative easing is like trading a $20 bill for $10 and $5 bills. How would that make anyone spend more money?

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.