Sunday, December 28, 2014

The Greek dance with debt

If you thought that the Greek debt crisis was over; think again. Tomorrow, the Greek parliament will try, for the third time, to agree on who will be the next president. If parliamentarians cannot agree (and that now seems likely) we are headed for the first potential rock in the road to recovery for 2015.  There is a real danger that the Greek debt crisis will emerge with a vengeance and, once again, throw world financial markets into turmoil.

Under the rules of the Greek constitution, if no candidate receives an absolute majority, parliament will be dissolved, and there will be a general election, most likely in early February. If that happens, all signs point to a victory by Syriza, a left of center party that proposes to renegotiate the Greek debt.

A Syriza victory would force the core Euro countries to decide either to give up on the project of European integration, or to move to the next stage of full scale fiscal union in which German taxpayers assume responsibility for Greek debt.

If the Euro breaks apart, the fallout will be global. The world economy has been hit by a falling demand for raw materials and oil is trading at less than US$60 a barrel. Some of this is caused by newly discovered proven reserves and that is a good thing. But Jim Hamilton has argued that  falling world demand is a big part of the reason for lower oil prices and that does not bode well for a truly global recovery.

The US economy has been the single flickering light in a dark sky. If the Euro collapses, the knock-on-effect will derail the US recovery and send the entire world economy back into recession.

Is a Greek default and a breakup of the Euro the most likely outcome? Probably not. But it is the first of many building storms that the global economy will need to weather in 2015. All eyes on Greece tomorrow!

Saturday, December 13, 2014

Real business cycle theory and the high school Olympics

I have lost count of the number of times I have heard students and faculty repeat the idea in seminars, that “all models are wrong”. This aphorism, attributed to George Box,  is the battle cry  of the Minnesota calibrator, a breed of macroeconomist, inspired by Ed Prescott, one of the most important and influential economists of the last century.
All models are wrong... all models are wrong...

Of course all models are wrong. That is trivially true: it is the definition of a model. But the cry  has been used for three decades to poke fun at attempts to use serious econometric methods to analyze time series data. Time series methods were inconvenient to the nascent Real Business Cycle Program that Ed pioneered because the models that he favored were, and still are, overwhelmingly rejected by the facts. That is inconvenient.

Ed’s response was pure genius. If the model and the data are in conflict, the data must be wrong. Time series econometrics, according to Ed, was crushing the acorn before it had time to grow into a tree. His response was not only to reformulate the theory, but also to reformulate the way in which that theory was to be judged. In a puff of calibrator’s smoke, the history of time series econometrics was relegated to the dustbin of history to take its place alongside alchemy, the ether, and the theory of phlogiston.

Thursday, December 11, 2014

John, Paul and Say's Law

I've followed, with a great deal of interest, the debate between John Cochrane and Paul Krugman. I have a lot in common with both of them.

I agree with Paul that, for the most part, the IS-LM model provides the right answer to policy questions. I agree with John, that we have learned a lot since 1955, when Paul Samuelson invented the Neo-classical synthesis.

But there were a couple of ideas in the General Theory that have been buried by MIT macro. The first, and most important, is that high unemployment is an equilibrium. Repeat after me. E-Q-U-I-L-I-B-R-I-U-M. The second is that animal spirits are an independent causal factor that determines which equilibrium the private economy will select.

Let me ask a simple question that you should feel free to answer. And do please also try to guess the PK and JC answers. (To answer this question, you will need to arm yourself with a knowledge of the textbook IS-LM model. A good introduction would be Greg Mankiw's textbook or, the book I learned from, the intermediate text by Dornbusch, Fischer and Starz.)
Figure 1

Saturday, December 6, 2014

Risk and Return in the Bond Markets

This is the second post to advertise the work of a UCLA graduate student who is looking for a job this year. My first post introduced Sangyup Choi who is working on uncertainty shocks in emerging markets. This post introduces Chan Mang who is working on the implications of term structure models for the foreign exchange market.

Chan Mang
Chan Mang graduated from UCLA two years ago. In 2012 he was awarded a post doc position at the prestigious National University of Singapore and last year he worked in the private sector.  Chan's research builds on the  widely cited bond pricing model developed by John Cochrane and Monika Piazzesi