Playing Chess with the Devil

I love this quote (with my amendments for economists)  from the NY Times article about Terrence Tao. 

The true work of the mathematician economist is not experienced until the later parts of graduate school, when the student is challenged to create knowledge in the form of a novel proof piece of research. It is common to fill page after page with an attempt, the seasons turning, only to arrive precisely where you began, empty-handed — or to realize that a subtle flaw of logic doomed the whole enterprise from its outset. The steady state of mathematical economic research is to be completely stuck.

It is a process that Charles Fefferman of Princeton, himself a onetime math prodigy turned Fields medalist, likens to ‘‘playing chess with the devil.’’ The rules of the devil’s game are special, though: The devil is vastly superior at chess, but, Fefferman explained, you may take back as many moves as you like, and the devil may not. You play a first game, and, of course, ‘‘he crushes you.’’ So you take back moves and try something different, and he crushes you again, ‘‘in much the same way.’’ If you are sufficiently wily, you will eventually discover a move that forces the devil to shift strategy; you still lose, but — aha! — you have your first clue.

That's pretty much how I feel about research. Another analogy is that research is like solving a Rubik's Cube: You're about to put the last piece in place and you find you have to go back 25 moves and start over.

Why the Belief Function Matters

A debate on the monetary transmission mechanism was recently reignited on the blogs with a post by Noah Smith, posts from Nick Rowe and Brad De-Long and a response to Noah from John Cochrane. This was all triggered by a set of slides prepared by Michael Woodford and Maria Garcia Schmidt for a Riksbank Conference in June 2015. A good starting point is the summary here back in 2014 by John Cochrane. 

The question: If the Fed raises the interest rate will it cause more or less inflation? The answer is complex and the topics that must be dealt with in formulating that answer are at the heart of monetary economics. 

In my own work, I emphasize two central points.

1. Monetary rational expectations models always have multiple equilibria.

2. The right way to deal with this is by explicitly modeling how people form beliefs using a concept that I call the belief function.

Fasten your seat belts; the ride is about to get choppy.

Chinese policy makers are concerned with the dramatic recent falls in the value of the Chinese Stock Market. They are right to be concerned. Although we can, and should, allow financial markets to allocate capital across sectors, the market as a whole is a creature of sentiment. And U.S. experience suggests that market crashes often precede deep recessions.

Today, the Peoples Bank of China was given the authority to purchase shares in the Chinese Stock Market. This is a bold experiment; but it is not unprecedented. In 1998, in the midst of the Asian Financial Crisis, the Hong Kong Monetary Authority engaged in a similar exercise. That intervention was large and successful and was the beginning of the end of the Asian crisis.

Behavioural Economics is Rational After All

There are some deep and interesting issues involved in the debate over behavioural economics. Greg Hill posted a comment on my previous blog where he says:

Now, you really have to ask yourself whether the kind of rationality involved in [Thaler's idea of a nudge], where a minimal change in cost results in a significant change of behavior, is same kind of rationality Lucas and Sargent have in mind.

That led me to explain my views a little further.

The most interesting issue [with behavioural economics] is whether we should continue to accept the neoclassical assumption that preferences are fixed. Let's go with that assumption for a moment.

If preferences are fixed, then we face a second question. What form do they take? For a long time, macroeconomists assumed that people maximize the discounted present value of a time and state separable von Neumann Morgenstern expected utility function. The narrow version of behavioural economics asserts that this assumption is wrong; but people are still utility maximizers.

The Economics of George Orwell

Diane Coyle has a nice review of Richard Thaler's new book, Misbehaving. Diane's review is, for the most part, appropriately laudatory. But she does voice a concern that I share. Here is Diane...

"Behavioural economics is now one of the most popular areas of the subject, ... but the new embrace by economists makes me uneasy. This is not just because of the well-known debate about paternalism (as discussed by Gilles St Paul in The Tyranny of Utility or Julian LeGrand and Bill New in Government Paternalism: Nanny State or helpful Friend?) It is because the sight of economists delighting in a new tool to engineer society is alarming –"

I agree. Here is a quote from my review of Akerlof and Shiller's 2009 book Animal Spirits, another piece that draws on behavioural economics to engage in social engineering. Akerlof and Shiller want to replace rational choice with behavioural economics. And here is what they mean by that...

Multiple Equilibria and Financial Crises

In May of this year, Jess Benhabib and I organized a conference at the Federal Reserve Bank of San Francisco with much help from Kevin Lansing at the Fed. Many thanks Kevin!

Kevin has just sent me a link to a website put together by the Fed with links to all of the papers, including slides of presenters and discussants plus a video of Karl Shell's dinner talk on the history of sunspots. The conference was sponsored by the NBER, UCLA and NYU. Many thanks to all who helped make this possible. 

Running a Surplus in Normal Times is Keynesian

In a recent letter to The Guardian, a coterie of mainly English academics has criticized George Osborne's Mansion House speech in which he proposed to run a budget surplus in normal times. 

Mansion House

According to the letter writers, 

The chancellor’s plans, announced in his Mansion House speech, for permanent budget surpluses [my italics] are nothing more than an attempt to outmanoeuvre his opponents (Report, 10 June). They have no basis in economics. Osborne’s proposals are not fit for the complexity of a modern 21st-century economy and, as such, they risk a liquidity crisis that could also trigger banking problems, a fall in GDP, a crash, or all three.