Category: Economics

One request was this:

The role and future of intelligent agent modeling in economics.

Call me a stuck up sticky bit but I don’t see a bright future for this technique.  We already have, and have had, computable general (and partial) equilibrium models for decades.  In those models you try to estimate the parameters from empirical data.  The models rarely impress me but there are plenty of situations, such as estimating the effects of changes in the tax code, where we don’t have anything better.  And so those models survive, and will continue to survive.

What’s the important innovation behind intelligent agent modeling?  To introduce lots of arbitrary assumptions about behavior?  Greater realism?  Complexity?  Considerations of computability?  Learning?  We already have enough "existence theorems" as to what is possible in models, namely just about everything.  The CGE models already have the problem of oversensitivity to the initial assumptions; in part they work because we use our intuition to calibrate the parameters and to throw out implausible results.  We’re going to have to do the same with the intelligent agent models and the fact that those models "sound more real" is not actually a significant benefit.

What can be done will be done and so people will build intelligent models for at least the next twenty years.  But it’s hard for me to see them changing anyone’s mind about any major outstanding issue in economics.  What comes out will be a function of what goes in.  In contrast, regressions and simple models have in many cases changed people’s minds.

Sometimes a theory model tells you there are many many equilibria, as in much of game theory.
I believe that result is to be taken seriously and we should conclude
that many different things can happen in that situation.  I am
suspicious of trying to solve for the correct or most likely
equilibrium by introducing many more specific assumptions.

In my possibly overdogmatic view, economics is most useful when its models are relatively simple and intuitive.  We’ve run out of new models which are simple and intuitive.  So the theory game is over.  The standard, old data sets have been data mined to death.  We’re now on to the "can you build/create your own data set?" game.  That game can and will last for a long time; in some ways it will favor go-getter extroverts just as the theory game favored introverts.

I don’t yet see that there is a new game in town.  My preferred reform of economics involves more history and anthropology, I might add.

Addendum: Bob Murphy asks:

It may be apocryphal for all I know, but I once read that the editor
of the journal to whom Einstein sent his paper on special relativity
put it down and realized that physics would never be the same (or
something like that).

Is something like that even possible in economics?  What would it be like?  Say, the Lucas critique times 10?

The answer is no, in my view this is not possible, for reasons given above.

Paul Krugman writes:

…if you believe that a surge in private spending would raise employment – and even the critics agree on that – it’s very hard to explain why a surge of public spending wouldn’t have the same effect.

Brad DeLong writes:

But surely we believe that if the U.S. government were to follow the Countrywide plan–to send its representatives out onto the streets to have them walk up to people and say: "Here’s $500,000. You can have it if you go buy a house"–then that would drive a recovery, right?

What’s interesting about these statements is not so much whether they are right or wrong (let’s just say that it depends) but that Krugman and DeLong are so immersed in the Keynesian viewpoint that they cannot even see any other way of looking at the issue. Thus "even the critics" and "but surely we believe," as if no other view were conceivable.

Well if the only frame you can see is the "spending increases employment" frame then whether the spending is private or public may seem like a niggle. But many of the critics of mass fiscal stimulus have an alternative frame in mind, namely, that "employment increases spending."

Frame the issue this way and it becomes clear that the choice between private employment and public employment as a driver of spending is crucial.  Moreover, when we remember that employment drives spending we focus attention on the real allocation of labor and capital across sectors of the economy, on internal and external fiscal balance, on investment as well as on consumption and on time paths of development. The "spending drives employment" frame misses all this.

Paul Krugman describes and writes:

Here’s how I see it: the opponents of a strong stimulus plan don’t
really have an alternative to offer. They don’t even have a really
coherent critique; as Brad DeLong points out,
if you believe that a surge in private spending would raise employment
– and even the critics agree on that – it’s very hard to explain why a
surge of public spending wouldn’t have the same effect.

The critics are instead mainly engaged in a series of minor complaints, aka niggles; FDR didn’t do so well, the statistical evidence ain’t so great, you can’t trust government, etc., etc..

My view is the disaggregated one that sometimes private spending can stimulate employment and sometimes it cannot. Private spending has the greatest chance of stimulating employment when a) market psychology is on its side, and b) the financial system is relatively well-functioning.  Neither is the case right now. 

Note that under standard theory neither monetary nor fiscal policy will set right the basic problems from negative real shocks and indeed the U.S. economy is undergoing a series of massive sectoral shifts.  That includes a move out of construction, a move out of finance, a move out of debt-financed consumption, a move out of luxury goods, the collapse of GM, and a move out of industries which cannot compete with the internet (newspapers, Borders, etc.)

I’ve never seen a stimulus proponent deny this point about real shocks but I don’t see them emphasizing it either.  It should be the starting point for any analysis of fiscal policy but so far it is being swept under the proverbial rug.

Maybe a big enough push to aggregate demand could stimulate useful, productive employment (as opposed to merely boosting measured gdp) right now, but since the
U.S. savings rate must rise sooner or later, that would only mean a
steeper decline for aggregate demand some time in the future.  My discount rate isn’t that high.

The alternative to a huge fiscal stimulus is simple: enough pro-active fiscal policy to ensure that cuts in state and local spending do not bring additional contractionary pressure to bear on the economy.  Otherwise bear the costs of the ongoing sectoral shifts and allow consumption to decline as indeed it must sooner or later.  Aggregate demand macroeconomics really does matter, but it is easier to do badly from negative shocks than it is to engineer good results from expansionary shocks. 

Those looking for other policy alternatives might consider Robert Lucas’s recent suggestions for monetary policy or cuts in the payroll tax, although I am myself not quite (yet?) on either bandwagon (though I think they are better plans than massive fiscal stimulus).

By the way, FDR didn’t do so well, the statistical evidence ain’t so great, and you can’t trust government, etc.  But those are only my minor complaints.

The bottom line remains this: we are being asked to spend ???? hundreds of billion dollars when a) the evidence for fiscal policy is inconclusive, and b) when you consider how real shocks fit into aggregate demand analysis, the theory isn’t there either.

Addendum: Here is a post by Krugman on the "hangover theory."  The answer to Krugman’s #1 is a combination of (perceived) wealth effects, downward nominal and real rigidities, and, during the boom workers at least thought they knew what they should be doing but now they do not.  The coordination problem on the upswing is not symmetric with the coordination problem on the downswing.  In any case it is correct that real sectoral shift theories do not explain all facets of a recession or depression; it is incorrect to conclude that therefore, in light of sectoral shocks, fiscal policy will be effective.

Here is my latest NYT column.  It starts as follows:

The financial crisis is a result of many bad decisions, but one of them hasn’t received
enough attention: the 1998 bailout of the Long-Term Capital Management
hedge fund. If regulators had been less concerned with protecting the
fund’s creditors, our current problems might not be quite so bad.

Bear Stearns, Merrill Lynch, and Lehman Brothers were all major creditors of LTCM.  Given that regulation is inevitably imperfect, and cannot foresee or prevent every firestorm in advance, this was one chance to send a very stern message to those creditors.  Perhaps no LTCM bailout would have meant dire consequences at the time, but still:

…Fed inaction might have had graver economic consequences,
especially if a Buffett deal had fallen through. In that case, a rapid
financial deleveraging would have followed, and the economy would have
probably plunged into recession. That sounds bad, but it might have
been better to have experienced a milder version of a downturn in 1998
than the more severe version of 10 years later.  In 1998, there was no collapsed housing bubble, the government’s budget
was in surplus rather than deficit, bank leverage was much lower, and
derivatives markets were smaller and less far-reaching.

I’ve been reading much about LTCM in recent times, and in so many ways it was a micro- dress rehearsal for our later problems.  This column also criticizes the current now-standard practice of "regulation by deal."

Addendum: Matt Yglesias adds: " At the time I think everyone was clear on the idea that if
institutions such as LTCM were “too big to fail” that they had to be
brought into a regulatory umbrella. But as soon as it was clear that
disaster had been averted, a lot of people became complacent about
operationalizing this determination to expand the scope of regulation
and some of the key participants – especially Alan Greenspan – in the
bailout only redoubled their opposition to regulation."

He makes many good points.  Excerpt:

The
evidence is fuzzy, to be sure, but to me it suggests a multiplier
around one, maybe smaller. Even stimulus cheerleader Paul Krugman only
claims 1.1. If that’s the case, the impact of government spending (say
700b over two years) is barely enough to reverse the decline in GDP we
expect to see over the next two quarters.

Read the whole thing.

Brad thinks I am too pessimistic about the prospects for a fiscal-led recovery:

But surely we believe that if the U.S. government were to follow the
Countrywide plan–to send its representatives out onto the streets to
have them walk up to people and say: "Here’s $500,000. You can have it
if you go buy a house"–then that would drive a recovery, right? I mean
it drove a recovery in 2003-2006, didn’t it?

Even the Austrians believe that spending–in their case, driven by
credit-expansion created by the malefactors of fractional-reserve
banking–works. So why can’t the government do what fractional-reserve
bankers can?

Here is the link.

Martin Feldstein argues that military spending should be part of the stimulus
package

Jacob Hacker argues that health care reform should be part of the stimulus
package

Zoo and Aquariums Look for Slice of Stimulus Pie

Keep in mind that no matter what your view of health care reform, the goal of our next round of health care policy changes should not be to spend as much money on labor costs as quickly as possible.

This is an object lesson — in progress — of how bad decisions end up getting made. 

There will be no slice of stimulus pie for me this Christmas, though perhaps we will manage tamales de elote.

Money market funds, an increasingly popular place to park cash, will
need to raise fees or close to new money to remain profitable as yields
hover at near-zero, according to industry managers…

Jim McDonald, who runs taxable money market funds for T Rowe Price,
said: “You can’t make money in this situation. If short-term interest
rates stay where they are, it’s virtually impossible to run a
government [bond] fund and make any money. You can close the fund,
that’s one option.”

Vanguard last week closed two of its money market funds to institutional investors, while Credit Suisse said it would quit managing money market funds in the US and liquidate $8bn in assets across its three funds.

Here is more.  Here is my earlier post on the Tsiang equilibrium.  That’s, sadly, my mantra for the coming year: the Tsiang equilibrium.  Some call it the liquidity trap, but in fact they have different microfoundations and different solutions.  The Tsiang equilibrium is in principle easy enough to spring out of, at least if the government stops guaranteeing everything, but no one knows how to get from here to there.

I was intrigued by this passage, from Interfluidity:

Interest rates are, for the moment, excruciatingly low. But a subsidy
to the banking system, once put into place, will be quite hard to
dislodge. So, let’s imagine that the Fed will pay interest on bank
reserves in perpetuity, that it will pay such interest at or near the
risk-free short-term interest rate, and that the expansion of the Fed’s
balance sheet is more or less permanent. How large a subsidy to the
banking system do the interest payments on reserves represent? Some
problems are arithmetically challenging, but not this one. The present
value of a perpetual stream of market-rate interest payments is
precisely the amount of the principal. Therefore, the present value of
the Fed’s de facto commitment to pay interest to banks on $800B
of freshly created reserves is $800B. We fought and wailed and gnashed
our teeth over potentially overpaying for TARP assets. Meanwhile, we
are quietly allowing the Fed give away, as a direct, literal subsidy,
more than the entire $700B that Paulson was allowed to play with. Note
there is no question about this being an "investment": The interest
payments that the Fed is now making to banks on its suddenly expanded
balance sheet are not loans. The banks owe taxpayers absolutely nothing
in return for this windfall.

I take that calculation to be a very rough one, and possibly an overstatement, but the point remains of interest.  It also can be argued that interest on reserves is a bad signal for at least two reasons:

1. It signals the Fed fears being left holding the intra-day Fedwire bag if a major bank goes under, and

2. It signals the Fed thinks major banks need such a subsidy.

The cited post is interesting throughout.

Anyway, it’s striking that the worst of the crisis is hitting states that largely didn’t experience a housing bubble.

Here is more, from Paul Krugman.  That is another reason why I think that aid to homeowners will not hit the target and why I think markets are failing to solve an economic calculation problem.  The economy needs some new things to do but another bubble will not work, much of finance is frozen or contracting, and economic and political uncertainty is encouraging a scramble for liquidity and decisions to wait.  We can see the information — about what to do next, economically — disintegrating before our eyes.

I have a column in the January 2009 issue of Money magazine (and possibly more columns there to come) on behavioral economics.  The piece covers which psychological mistakes investors are most likely to make in a downturn.  I don’t think it will be on-line anytime soon, but you can pick it up at many newsstands or even subscribe.

Dingel reports:

The US nominal average ad valorem tariff rate for (12 Days of) Christmas this year, which I calculated using the handy Harmonized (Tariff) Christmas schedule, is only 1.9%. I assume that Santa has MFN status.

Drums 4.8%
Pipes 0%
Milking machines 0%
Swans 1.8%
Geese $.02/kg
Golden rings 5.5%
Calling birds 1.8%
French hens $.02/kg
Turtle doves 1.8%
Partridge 1.8%
Pear tree 0%

I thank Alex Thiele, a loyal MR reader.  But I believe the optimal tariff on drums is zero.

In the context of New Zealand, I wrote this back in 1991:

Prudential management is perhaps the area where the current
regime involves the greatest danger. The Basle-based regulations offer too much regulation
in some areas and too little in others, impose inefficient restrictions on banks, and
require ongoing government intervention in the banking industry.

Market participants also express a very strong concern that
Reserve Bank staff do not have sufficient expertise to discern the riskiness of banks. No
criticism of Reserve Bank staff is intended here. The staff are competent when asked to
perform their proper duties, but they do not have the training and expertise necessary to
provide up-to-date evaluations of bank safety. Only experienced bank managers with
detailed on-the-spot knowledge of a bank’s asset portfolio are competent to make these
judgments. The Reserve Bank does collect great masses of information on bank assets, but
the proper digestion and interpretation of this information by an outsider is a nearly
impossible task.

Banks exist as specialized lending institutions precisely because
outsiders do not have the information necessary to evaluate and monitor loans. For the
same reasons that a nationalized banking system would be disastrous, governments are not
able to evaluate bank portfolios effectively.

The Basle capital standards are not sufficiently high to prevent
crises altogether, nor is monitoring frequent and interventionist enough to spot incipient
difficulties on short notice. Current regulations create an illusion of safety and
government sanction of bank solvency at times when real danger may exist.

…Because of differential capital requirements for different types
of loans, regulations effectively alter the net price of making each kind of loan. Some
kinds of loans are subsidised and others are penalised. Not surprisingly, governments have
decided to subsidise loans to public agencies.

In addition, housing loans have also been given favourable
treatment. Banks are now especially eager to make housing loans, because such loans lower
their real, post-regulation cost of capital. In effect, the regulatory environment is
influencing how the banking industry allocates loan capital.

Regulatory attempts to forecast which types of loans are
"safe" are likely to backfire; regulators have no means of ascertaining the true
riskiness of different asset classes. In fact, regulations which artificially encourage
certain classes of loans decrease the safety of these loan classes. Subsidisation of
housing loans, for instance, can lead to overcapacity in the housing sector and falling
home prices. In a non-inflationary environment, housing can be a relatively risky
investment.

Government attempts to influence the composition of bank assets
have had a disastrous history in New Zealand. The older "asset ratio" system was
one of the first and most important targets of deregulation in the 1980s. Under a
different and more subtle guise, the Basle standards are reintroducing this system into
New Zealand.

That also sounds like Arnold Kling.  Here is the whole report, which I have not reread recently, and it is mostly on monetary policy.  It called for capital insurance in lieu of the traditional lender of last resort function; New Zealand banks were mostly foreign-owned and the New Zealand banking system was small relative to global capital markets.  So if capital insurance can work anywhere that should be in New Zealand.

I don’t, by the way, understand what Kiwis spell it "Basle" rather than "Basel," except that they are copying the French.

Robert Waldmann has advice for libertarians:

I’d look into the Lucas critique — when policy makers assume that an
empirical relationship is a natural law and attempt to exploit it, it
disappears. In particular the usefulness to private agents of the
ratings caused regulators to decide to use them too (and destroy them)
via Basel II.

Along related (but contradictory) lines, in The Economist Alan Greenspan calls for higher capital requirements.  The arguments of both Waldmann and Greenspan make perfect sense.  The problem of course is defining "capital" in such a way that is not counterproductive.  You know the old joke:?  "Capital requirements: can’t live with ’em, can’t live without ’em."