Friday, June 4, 2010

Should policies be model-based or blog-based

Each argues to their own conviction that their arguments are right:

Beginning with Tyler Cowen:

Romer, Geithner, Summers, know all the same economics that Krugman and DeLong and Thoma do. If a bigger AD stimulus would set so many things right, they'd gladly lay tons of political capital on the line to see it through and proclaim triumph at the end of the road.

Except they expect it would bring only a marginal improvement.

From Mark Thoma:

As for Tyler's (and others') call for monetary policy instead of fiscal policy, here's the problem. It relies upon changing expectations of future inflation (which changes the real interest rate). You have to get people to believe that the Fed will actually be willing to create inflation in the future when it comes time to do so. However, it's unlikely that it will be optimal for the Fed to cause inflation when the time comes. Because of that, the best policy is to promise that you'll create inflation, then renege on the promise when it comes time to follow through. Since people know that, and expect the Fed will not actually carry through, it's hard to get them to change their expectations now. All that credibility the Fed has built up and protected concerning their inflation fighting credentials works against them here.

Fiscal policy does not have these problems. Maybe monetary policy would work in spite of the time consistency problems, I'm willing to try and there are creative ways around this problem that might work (see
here for how to credibly commit to irresponsibility). But I'm not willing to put all my faith in this one policy basket, particularly since I think fiscal policy is the superior tool in deep recessions (but not in normal times). Fiscal policy must be part of the mix as well, and since the economy is not expected to return to full employment for several years, there's more than enough time for further fiscal stimulus directed specifically at job creation to work.

Back to Tyler Cowen:

This makes perfect sense in terms of a model, but I don't see inflationary expectations as the relevant factors for the real world.

Did he just say that expecations are not relevant for the real world? I am tempted to adopt the attitude I had as a graduate student and be totally dismissive of these arguments by exclaiming: Where is the model? This is all just hand-waving economics. Yet, I am sympathetic to both views. Expectations matter but not all the time. However, I'd like to see some evidence for Tyler making the claim that inflationary expectations not being relevant to the real world. Modeling expectations have been the foundations of DSGE models and even structural equation models since the Lucas critique. The modeling of expectations can be ad hoc or as most economists have done - assume rational expectations.

Yet it is good to be reminded by Rajiv Sethi:

Rational expectations is not a behavioral hypothesis, it's an equilibrium assumption and therefore much more restrictive than "forward-looking behavior". It might be justified if equilibrium paths were robustly stable under plausible specifications of disequilibrium dynamics, but this needs to be explored explicitly instead of simply being assumed.

The arguments put forth by Mark Thoma and Tyler Cowen also has some bearing on Brad DeLong's response to Kocherlakota's claim that economists did not have a playbook to respond to the crisis:

My reaction to this is the old one: "Huh?!"

For "macroeconomics" did and does have a playbook that offered a systematic plan of attack to deal with fast-evolving circumstances.

The playbook was first drafted back in 1825, during the bursting of Britain's canal bubble.

... The government has the power to tax! And so the government can make AAA assets when nobody else can! ... The first and easiest way for the government to create more safe assets is for the central bank to create them by buying up risky assets for safe ones via open-market operations or lending cash and taking other, riskier assets as its sole security.

... Since the fall of 2007 the central banks and the Treasuries of the world have been following this playbook. They have expanded the supply of safe assets via open-market operations, pumping out cash for the private sector to hold and in return accepting duration and interest-rate risk. They have topped up bank capital. They have guaranteed private-sector loans. They have swapped in risky private-sector debt in exchange for government bonds. They have--via expansionary fiscal policy--printed up huge honking additional tranches of government bonds and used the money raised to pull forward government spending and push back taxes.

... The playbook is old and well-established, and has been put to effective use.

Again, I am not arguing against Brad DeLong. My initial reaction was that the IMF used to have a playbook also when rescuing a country facing a capital account outflow and budget deficits. This was to raise interest rates and slash government spending. Saner heads seem to have prevailed and this playbook has, while not discarded, certainly laid aside. What Delong seems to be arguing is that this playbook always works and I am less convinced about that. The Fed acted very innovatively in this crisis yet could do little except to slow the free-fall of the economy. My interpretation of Kocherlakota's comments is that the playbook should not be brought out to clean up the mess but to prevent the mess in the first place (or at least bring it to a screeching halt by the end of 2007 or the beginning of 2008). Slashing interest rates and flooding the market with liquidity is pretty standard but the playbook needs to say by how much and for this we need models not blog entries and shrillness in blog-dom.

Unfortunately (with apologies to Reinhart and Rogoff), while crises are all the same they are also all different. By this, I mean that the source of the shock to the economy is very different. Who could have forseen that Bear Stearns would have gone bankrupt within 3 days even though it began that fateful weekend with $10 billion and there was almost nothing that DSGE economists could point to that would constitute a "technology shock".

There were no models that economists could turn to that they could use to generate a policy for the Fed or Treasury. Likewise, in the beginnings of a crisis such as the East Asian crisis, the facts on the ground are few and existing models were inadequate to show that high interest rates and cutting government spending would stem the tide of outflows.

Models have always been inadequate. As Kocherlakota says:

During 2007–09, macroeconomists undertook relatively little model-based analysis of policy. Any discussions of policy tended to be based on purely verbal intuitions or crude correlations as opposed to tight modeling.

I would say that in all crisis, the analyses and model building have always been retrospective. Whenever a crisis occurs, almost all economists fall back on AS-AD or IS-LM type models. And it is because of this lack of good policy based models that we have debates between Krugman, Cowen, Sumner, and Thoma about what to do. Each of them are talking through their convictions rather than a common model and parameters in which they can all agree on. Even if they could not agree on parameters but could agree on a model then at least the discussion would be less shril than it is.

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