Why Death Matters for Central Bank Policy

Noah Smith raises the question: can the Fed influence the interest rate? Although the answer may seem obvious, the question itself reflects a conundrum for neoclassical theory. It is representative of a related but more comprehensive question: does the asset composition of the central bank balance sheet matter?

Let me set aside, for now, the deep question: what is money? I will take for granted the fact that the liabilities of the central bank are special. Perhaps this is due to legal restrictions, as Neil Wallace has suggested, or perhaps it is a matter of social convention. My focus here is not on central bank liabilities; but on their assets.

A Systemic Explanation for The 2008 Financial Crisis

In September of 2013, Francis Breedon organized a Round Table discussion at the Money Macro Finance Conference held at Queen Mary College London. The session included myself, Chris Giles of the Financial Times and David Miles of the Monetary Policy Committee as speakers and Sushil Wadwhani as moderator.  Our topic: the Bank of England's remit.

Chris and David chose to speak about monetary policy and the role of the Monetary Policy Committee.  I chose, instead, to focus on the task that faces the newly formed Bank of England's  Financial Policy Committee.  This post will focus on one of the points I made in my talk, the distinction between what I call institutional and systemic explanations of the 2008 financial crisis.  My complete argument is published in a forthcoming paper "Financial Stability and the Role of the Financial Policy Committee", that will appear in The Manchester School.

Recent events have generated widespread consensus that the financial markets are not working as they should. But there is little agreement as to why. One explanation is that financial frictions can sometimes become more disruptive than usual and these frictions can be corrected by regulating financial institutions. An alternative explanation that I have promoted in my own work, is that financial markets do not allocate capital efficiently.  The failure of financial markets occurs because people who will be born in the future cannot trade in current markets. I call this the absence of prenatal financial markets.

Animal Spirits: an Empirical Test

Christian Zimmerman draws attention to a new paper by Paolo Gelain and Marco Guerrazi, "A demand-driven search model with self-fulfilling expectations: The new ‘Farmerian’ framework under scrutiny" 

Here is the abstract from the paper

In this paper, we implement Bayesian econometric techniques to analyze a theoretical framework built along the lines of Farmer’s micro-foundation of the General Theory. Specifically, we test the ability of a demand-driven search model with self-fulfilling expectations to match the behaviour of the US economy over the last thirty years. The main findings of our empirical investigation are the following. First, all over the period, our model fits data very well. Second, demand shocks are the most relevant in explaining the variability of concerned variables. In addition, our estimates reveal that a large negative demand shock caused the Great Recession via a sudden drop of confidence. Overall, those results are consistent with the main features of the New ‘Farmerian’ Economics as well as to latest demand-side explanations of the finance-induced recession.

In Christian's words...

Roger Farmer’s recent work has been causing quite a stir, especially as it seems to validate some the things that happened during the recent crisis. This paper provides an empirical test of Farmer’s theory and shows that he is indeed onto something.

Christian's website was set up to promote discussion of research on DSGE models and he invites visitors to leave comments on the papers he highlights. Thanks Christian, for drawing attention to this very interesting piece.

New Keynesian Flimflam

Simon Wren-Lewis, seeks a serious debate with our heterodox colleagues, and judging by the excellent comment thread that appears on his post, there are plenty of heterodox economists who are ready and willing to take up the challenge. This is a welcome debate.

Simon defends his view of orthodoxy, by which he means New Keynesian economics. In its simplest form, New Keynesian economics is a three-equation model that explains the behavior of the nominal interest rate, the "output gap" and the inflation rate.

I agree firmly with Simon, that from a policy perspective, we should not care one iota if NK economics has anything to do with what Keynes might or might not have thought. But from the perspective of the history of thought, we should not mislead our students with false labels. The New Keynesian model is neither new nor Keynesian. It is a beautiful formalization of David Hume's verbal argument in his 1742 essay "Of Money"; an early piece on the Quantity Theory of Money  that every macroeconomics student should read at least once.

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.