How the Economy Works

The first paperback English language edition of my book How the Economy Works has just been published by Oxford University Press.  I hope this edition finds a new audience that will take the time to consider the ideas I present.  The book provides, not only a history of contemporary economic thought, but also some fresh ideas for dealing with financial crises and for the design of a new financial architecture to prevent them from reoccurring.

Here are a few excerpts from the new Preface.

How the Economy Works, (HTEW) first appeared in 2010. By the time of its publication, the world was in the throes of the worst recession since the 1930s. Thirty-seven months after the NBER called the recession over, in June of 2009, the U.S. economy is still a long way from regaining all of the jobs lost during the crisis. I wrote this book to help you understand why this happened and to offer some new ideas to prevent similar financial crises from reoccurring in the future.

Teaching Economics

Students at the University of Manchester in England are unhappy with the way they are being taught and they are not alone. In a widely publicized, and highly articulate report, the Post-Crash Economics Society, a group of Manchester Univesity students, is highly critical of "business as usual" in the economics curriculum in the wake of the crisis.

There is much to agree with in their arguments.

Expectations Employment and Prices

I am teaching two graduate classes this quarter, and that gives me the opportunity to publicize some ideas that I'm teaching in my classes, and that I have been working on for some time. I plan to put up a series of posts explaining the ideas in my 2010 book, Expectations Employment and Prices. I will also talk about extensions of the book that I have subsequently published in peer reviewed journals.

Here is how I characterized the project in the preface to EEP.

I have long believed that modern interpreters of Keynes missed the main point of The General Theory; high unemployment is an equilibrium phenomenon that can persist for a very long time if nothing is done by a government to correct the problem. This was the point of my 1984 paper, which argued that the natural rate hypothesis is false. In the intervening years, I had time to refine this idea. Expectations Employment and Prices is the result.

Regime Switching at the Lower Bound: A Research Topic for Students

I just returned from a conference at the San Franciso Fed on Monetary Policy and Financial Markets HERE where I discussed a paper by Fumio Hayashi and Junko Koeda. They use a novel way of identifying the effects of policy during periods of Quantitative Easing which recognizes that policy is different when interest rates are at the lower bound. An interesting take away from their paper is that QE is effective at reducing the output gap.

The Hayashi-Koeda paper suggests the following research topic for Ph.D. Students. H-K use an SVAR, i.e. a vector autoregression that is identified by making assumptions about the covariances of the variables. See Stock and Watson here for a summary of what that means.

The novelty in Hayashi Koeda is to allow for different coefficients of the VAR when the interest rate is at the lower bound. The pitfall here, is that although SVAR stands for "structural vector autoregression", there really isn't anything structural about it. An SVAR is just the reduced form of a DSGE model. And that means that the coefficients of the equations cannot be relied upon to remain constant if the policy rule changes.

Nothing new there -- we've known that for a long time. I was asked to discuss the paper because I've worked here (with Dan Waggoner and Tao Zha) on DSGE models where the parameters switch occasionally from one regime to another. Here is the interesting research topic. How are Regime switching SVARs of the kind estimated by Hayashi and Koeda, related to the Markov switching DSGE models that I studied with Dan and Tao?

Labor Markets Don't Clear: Let's Stop Pretending They Do

Beginning with the work of  Robert Lucas and Leonard Rapping in 1969, macroeconomists have modeled the labor market as if the wage always adjusts to equate the demand and supply of labor.

I don't think thats a very good approach. It's time to drop the assumption that the demand equals the supply of labor. 

Why would you want to delete the labor market clearing equation from an otherwise standard model?  Because setting the demand equal to the supply of labor is a terrible way of understanding business cycles.

Thought for the Day

"In economics, the majority is always wrong." — John Kenneth Galbraith

Asset Prices in a Lifecycle Economy

I have just completed a new paper on asset prices, "Asset Prices in a Lifecycle Economy".  The paper is available here from the NBER or here from my website.  This is a good time to comment on asset price volatility and the apparently contradictory findings of two of the 2013 Nobel Laureates because my paper sheds light on this issue. 

In 2013, Gene Fama, Lars Hansen and Robert Shiller, shared the Nobel Prize for their empirical analysis of asset prices.1 

Fama won the Nobel Prize for showing that financial markets are efficient. He meant, that it is not possible to make money by trading financial assets because markets already incorporate all available information. 

Shiller won the Nobel Prize for showing that financial markets are inefficient. He meant that the ratio of the price of a stock to the dividends it earns, returns to a long run average value; hence, an investor can profit by holding undervalued stocks for very long periods. 

These apparently contradictory results are consistent  because Fama and Shiller are referring to different concepts of efficiency.

When Fama says that financial markets are efficient, he means informational efficiency. There is a second concept that economists call Pareto efficiency. This means that there is no possible intervention by government that can improve the welfare of one person without making someone else worse off. The fact that markets are informationally efficient does not necessarily mean that they are Pareto efficient and that fact helps to explain why financial markets appear to do such crazy things over short periods of time.