Month: October 2009

Is Real Business Cycle Theory Dead?

No. Real business cycle theory is alive and kicking.  If we write Y=a*F(K,L) and call “a” technology then an RBC theory is mostly about how fluctuations in “a” change output.  Amusingly, Brad DeLong calls this the great forgetting theory of recessions and indeed it is hard to see how we could forget about technology, thus reducing output in some periods.  But this view takes the term technology too literally.

I am in my office every day (L=1), my computer is here every day (K=1) but my output and thus my productivity fluctuates.  Why?  It’s not that I forget how to use STATA.  Some days, however, a reporter calls and distracts, another day I need to tidy my office, on other days creativity just doesn’t strike.  In short, everyone recognizes that at a micro-economic level productivity fluctuates a lot so why should macro productivity follow a smooth process?

In fact, there is a standard answer to that question which is the law of large numbers–spread idiosyncratic productivity shocks across many firms and in the aggregate volatility will be low.  In an important paper, The Granular Origins of Aggregate Fluctuations, Xavier Gabaix takes on this answer with a simple but important point: large firms matter.

In the United States, for example, sales of the top 100 firms account for about 30% of GDP.  (The share is even larger in most other developed economies.)  In fact, we know from my GMU colleague, Robert Axtell, that firm size follows Zipf’s law.  As a result, large firms get larger in larger economies so that firm-level productivity shocks do not disappear in the aggregate even in large economies.

Gabaix shows theoretically that combining idiosyncratic shocks and Zipf’s law for firm size can produce significant fluctuations in GDP.  Empirically the difficulty is to distinguish aggregate shocks from firm-specific or sectoral shocks.  Using one plausible, but no doubt debatable decomposition, Gabaix shows that idiosyncratic shocks to the top 100 firms can explain about one-third of aggregate volatility.

The bottom line is that Gabaix has opened the way for a much richer real business cycle theory in which real shocks can be identified and tied to specific firms and through transmission mechanisms these real shocks can affect the aggregate economy.

*The Invention of Lying*

I didn't think it was possible to make a movie this Hansonian and no they never waver.  The basic premise is "a comedy set in a world where no one has ever lied."  People speak the truth to each other in unbiased fashion and every channel on TV is some version of The History Channel.  You then see, step by step, why this is not a Nash equilibrium and you observe, as the title indicates, "the invention of lying," including under conditions of altruism.  Along the way, you see a theory of the origins of religion, a portrait of how the world would look if no one signaled, a redo of Geoffrey Miller on The Mating Mind, and hints at the idea of ESS.  It's a "remarkably radical comedy" (Ebert) and the gushy parts have hidden venom. 

Criticisms of the recalculation argument

1. Sectoral shock theories of unemployment have a long lineage, including search theory, David Lilien (1982), Fischer Black, work by Steve Davis and John Haltiwanger, Mortensen and Pissarides, plus some recent writing by Michael Mandel and much earlier Franklin Fisher's work on disequilibrium adjustment.  Avent and Yglesias suggest that Kling is making up his own macro but the innovation is simply to call the adjustment process "recalculation," to give it a more Austrian gloss.  Mortensen and Pissarides are sometimes mentioned in the context of future Nobel Prize winners.

Or try Brainard and Cutler (nowadays both Obama-linked), who note sectoral shifts are especially likely to account for unemployment episodes of long duration.  Here is a list of some of the relevant real shocks.

2. Ryan's summary of the argument involves several strawmen.  Various polemic phrases are used throughout his post, including "makes no sense" and "nuts."  When you read language like that, it often indicates the writer has not worked hard enough to imagine a sensible version of the idea he is criticizing.

3. Here are a few claims I do believe and in most cases I am on the record:

a. The AD shock today is very real, albeit overemphasized by many relative to sectoral shocks.

b. There is an optimum delay on the recalculation process.  An economy can't always do all the recalculation all at once and that is one way of thinking about why some bailouts have been necessary, plus automatic stabilizers.

c. Reemployment does not in general proceed in accordance with an optimum, especially during major shocks.  This follows from many (not all) of the models cited above.

d. The new, on-its-way optimum may well involve new government expenditures in various areas on a permanent basis; pick port security if you want one non-controversial example.

You can believe all those propositions, as I do, and still think that the recalculation argument means that, in absolute terms, significant parts of the current stimulus won't be very effective.  As James Hamilton has pointed out, a big chunk of the problem is something other than insufficient aggregate demand and so more stimulus doesn't translate necessarily into better outcomes.  In other words, we're spending lots of money for smaller "bang" than was advertised.

You might disagree with those conclusions, combined with propositions a-d, but they're not "nuts."  There's a disconnect between the emotional content of the polemic Avent wants to level and the information content in his post. 

3. Matt suggests that some of the critiques do not apply to most of the stimulus.  He notes that aid to the states is a big chunk of the stimulus, as is tax cuts and increased transfer payments.  On the transfer payments, see my point 2d; you may or may not like them but most analysts conclude, following the Bush experience, that such programs aren't very good stimulus.  So the recalculation idea doesn't much apply there but the stimulus idea doesn't much apply either. 

On aid to the states, the recalculation problem applies very directly (Matt says it doesn't but I don't see where in his post he gives a reason for that view).  You can think that some form of state-level aid is necessary, as I do, and still see the recalculation idea as explaining why a big state-level ouch is coming in about two years' time.  When (if?) the stimulus is not renewed, a painful sectoral reallocation will have to take place and right now we are only postponing that pain.  By the way, it would be nice if state governments played along by having a coherent long-run fiscal plan but right now at least half of them are not doing this, thereby worsening the forthcoming ouch.  Wait until you see what happens with state universities in two years' time.  Ouch, ouch, and triple ouch. 

Overall the recalculation idea does apply to large chunks of the stimulus, albeit not all of it.

4. We should be especially skeptical of gdp measures when: a) governments care about those measures especially much, and b) we face trade-offs between temporary and permanent gains and we are choosing the temporary gains.  Fiscal theories of cyclical movements, as outlined by Rogoff and the like, deserve to make a comeback and I predict they will.  In fact you can add those theories to the list above at #1.

The bottom line is this: if you're trying to use the recalculation idea to explain why the fiscal stimulus should be zero, that in my view will fail.  If you're using the recalculation idea to explain why the stimulus has a lower rate of return than many people think, it hasn't much been dented by the recent criticisms.  After all, if the problem were just insufficient AD, a solution would be ready at hand.  But it isn't and it's not just because Obama isn't "tough enough" to propose a bigger stimulus.  It's a genuinely difficult problem to solve.

I may soon consider Scott Sumner's very good recent posts on real shocks and the business cycle.

Paul Dirac on economics

This was from his 1933 Nobel acceptance speech (!):

I should like to suggest to you that the
cause of all the economic troubles is that we have an economic
system which tries to maintain an equality of value between two
things, which it would be better to recognise from the beginning
as of unequal value. These two things are the receipt of a
certain single payment (say 100 crowns) and the receipt of a
regular income (say 3 crowns a year) through all eternity. The
course of events is continually showing that the second of these
is more highly valued than the first. The shortage of buyers,
which the world is suffering from, is readily understood, not as
due to people not wishing to obtain possession of goods, but as
people being unwilling to part with something which might earn a
regular income in exchange for those goods. May I ask you to
trace out for yourselves how all the obscurities become clear, if
one assumes from the beginning that a regular income is worth
incomparably more, in fact infinitely more, in the mathematical
sense, than any single payment? In doing so I think you would
then get a better insight into the way in which a physical theory
is fitted in with the facts than you could get from studying
popular books on physics.

I thank Eric R. Weinstein (Twitter!) for the pointer.

Of course you can read this paragraph as offering differing (better?) microfoundations for a liquidity trap argument.  The problem is not expectations of unfavorable interest rate changes (no one buys bonds with cash), but rather no one parts with bonds to receive goods and services.  Is it a behavioral argument, namely that no one wants to give up the feeling of "forever" for the feeling of getting something which is only "temporary."  Or is it a maximizing argument, namely that a kind of zero discount rate hyper-rationality takes over the people who won't spend?  Does the argument require that consols are the dominant form of bonds?

*The Fight for Fairfax*

That's a new book by Russ Banham and the subtitle is A Struggle for a Great American County.  It is published by George Mason University Press.  Excerpt:

Among the incorporated towns was Falls Church, which claimed 1,100 citizens and an excellent connection to Washington, D.C., via the Washington, Arlington, and Falls Church Electric Railway.  Electric trolley lines also connected commuters from the towns of Fairfax, Herndon, Vienna, and Clifton to the District.

That was in 1907.  Does anyone know how fast these electric trolleys were?  This source suggests speeds were up to 20 mph.  Is it possible that a mass transit trip from Fairfax or Clifton to DC was quicker in 1907 than today?  With stops, how fast does a bus go at 8:30 a.m.?

Assorted Links

  • "Inside the Wayne County morgue in midtown Detroit, 67 bodies are piled up, unclaimed, in the freezing temperatures. Neither the families nor the county can afford to bury the corpses. So they stack up inside the freezer…You can smell the plight of Detroit."
  • A very good video profile of Tyler, who was honored yesterday at GMU for his many contributions to scholarship.

America was built on the idea of premium services (markets in everything)

Chicago cabbies want to be able to charge passengers $50 for throwing up in their taxis, the Tribune reported last week. The request came along with a demand for a 22% rise in overall rates and a number of other new charges.

Here is the full story and I am wondering what you can get for $70. 

I thank Alex Taylor for the pointer.


Lately everyone is blogging multipliers.  It is frequently suggested that the multiplier today is best estimated at 1.5 or 1.6.  My point today is this: if you postulate a potent multiplier you cannot easily also postulate a liquidity trap.  The whole point of the multiplier is that if the government buys cement from my company (say for a road) I as the company owner take those cash receipts and spend them elsewhere.  Maybe so but that means people are willing to spend cash when they receive it.  It means that a helicopter drop (and maybe other forms of monetary policy as well) would stimulate AD quite readily and for free.  You don't need exotic or balance sheet-distorting QE here, a simple injection of cash will do. 

Indeed, the Christiano, Eichenbaum, and Rebelo model of fiscal policy in a liquidity trap, no matter what you think of it (e.g., I am not sure that the derivation of equations 2.19 and 2.20 takes the non-smooth, black hole properties of the liquidity trap assumption seriously enough; also the critical p.13 sentence about how the MU of consumption rises with employment is the kind of Minnesota macro that Krugman justly complains about) both implies and states that monetary policy will work too.  And if that monetary policy is truly a free lunch in terms of gdp, it should be quite credible (if it's not credible in the real world maybe the problem wasn't AD in the first place).

There are other models in which fiscal policy has a potent multiplier yet there is a liquidity trap.  For instance fiscal policy may be a "sunspot" which gets you out of the liquidity trap.  I have at least two objections.  First, these models are question-begging.  (Might not monetary policy be the sunspot?  Why is fiscal policy the sunspot if indeed fiscal policy would otherwise not have much of a multiplier?)  Second, no one much believed these models ex ante, before the current set of policy debates came along.

I am also puzzled by Paul Krugman's point:

…this [Barro's paper] tells us very little about what would happen under current
conditions: during World War II there, um, was a war on: consumption
goods were rationed, construction required special permits, and so on.
The government was, in other words, deliberately suppressing private
spending, through direct controls. So WWII is not a useful data point
for determining what the multiplier is under other conditions.

As I view it, during the war the government suppressed private spending because the government did not in fact believe there was much of a multiplier (at least at those margins).  The suppression of private spending was not an exogenous accident but rather it reflected the very real trade-offs which had to be faced between guns and butter.  At the beginning of the war unemployment was still quite high yet rationing came quickly, not only after full employment was restored, precisely because the trade-offs were faced quickly.  Are we to believe that without rationing U.S. private consumption would have risen during WWII?  Something like the following can be argued: "there is a multiplier for small acts of public investment but at some margin, such as we faced in WWII, that multiplier goes away for sufficiently large acts of public investment."  I don't read Krugman as making that claim, but it would be his best available response to Barro.

The plain vanilla option for financial competition

Now it's dead, everyone else has been blogging it, and a few readers have been asking me what I think.

On one hand, I believe that many complex financial products are a mix of inefficient shrouding and plain, outright trickery or even fraud.  In this regard I find it easy to see the merits of "plain vanilla" regulation.

On the other hand, I see regulatory agencies as about the least "plain vanilla" institutions out there.  Try looking at the information provided by a regulatory agency and deciding which of its programs are not delivering value for the money.  Are they even trying to explain this to Congress or to the public, much less succeeding?  The regulators present their tasks in complex bundles, topped off with lots of rhetoric about how essential the whole thing is.  Regulators will go to great lengths to make transparent the benefits of what they do, but not the failures or the costs.

So if consumers are tricked into purchasing too many shrouded products in mortgage markets, are they not also tricked into favoring too much shrouded regulation in political markets?

The idea of using regulation to enforce "plain vanilla" offerings to me begs the question.  The pattern of regulation itself won't be…plain vanilla.  Maybe there's a way to get there, but the mere insistence that regulation ought to be done properly I don't find very compelling.