On the inflation debate - a note of caution

Arguably the most important macroeconomic debate of present times is whether inflation is transitory or persistent. Emerging signals and the commentary around it appear to be making opinion makers gradually veer around to the view that it may be persistent. We are at a critical moment in this debate since it's the time when the opinion flips definitively and actions follow suit. 

In case of something like inflation, where expectations are perhaps more important than even the dynamics of the substantive underlying forces, it's important to not let our guard down and allow the decision to be made purely on momentum. Persistent inflation is now a momentum trade on a strong upswing. In such times, it's important to keep track of the rear-view mirror and transitory inflation proponents. 

Consider the following. For inflation to become persistent, the following has to happen

1. The underlying inflationary contributors have to play out
2. These forces have to leave permanent effects
3. The price pressures have to become broad-based enough
4. They have to persist for long-enough
5. Enough opinion makers will have to be convinced of a definitive turn
6. And these opinion makers end up shaping expectations among the public at large

Apart from the first two substantive points, the rest are all subjective assessments. And by nature such assessments are vulnerable to being wrong. This should come as no surprise given the irrational exuberance that has come to characterise financial asset markets in recent years. All it takes is for a self-fulfilling spiral of inflation doomsday prophecies to somehow take root.

There is not one macroeconomic model or theory which can explain with consistency trends like inflation over decades. Every time inflation becomes an issue, supporters come up with a model to explain their argument overlooking the fact that it could not have explained the earlier episodes. Dom White hits the nail on the head

Given the failure of (all?) models, I think it’s important to recognize that any explanation for why inflation has surged over the last year is improvised – it has no track record of being right or wrong. We’re all Bayesians now! But some are more convincing than others.

On whether inflation is transitory or persistent, Adam Tooze makes the case that there is not enough evidence of broad-based and longish enough nature of the inflation trend to argue that it's persistent in either Europe or US. 

There are some important signatures which cannot be ignored. For one, as this graph on the US inflation conveys, almost two-thirds of the deviation in US retail inflation from pre-covid trend is contributed by motor vehicles and energy prices.

Then there is the services sector dog that did not bark. Services, which forms the bulk of CPI weights, remains largely unaffected by any new inflation trend. 

Martin Sandbu parses the latest US inflation data and is not convinced. He has a compelling case.

It's acknowledged that the supply-chain disruptions due to the pandemic have been the most important immediate trigger. The supply-chain disruptions likely became amplified when the pent-up demand got released and boosted aggregate demand at the extensive and intensive margins. The increased disposable incomes and pent-up demand (extensive margin) was coupled with the re-allocation of consumption (intensive margin) away from services to goods due to the pandemic enforced closures and work from homes. How long will these trends last is anybody's guess. 

Adding more uncertainty to the calculations is the future of Covid 19. Is Omicron the end-game for elevated Covid? If it's the case that Omicron is the end-game then several assumptions made by the persistent-camp becomes questionable. 

We need to be cognisant that "this time is no different" explanations may have only limited relevance given the unique nature of the shock - sudden supply and demand shocks, followed by equally sudden release of pent-up demand but very slow release of supply constraints (or even persistence of certain supply constraints), and all of this happening in a world awash with liquidity. 

In conclusion, this is an important observation from Adam Tooze,

All things considered, the main reason to worry about inflation may be precisely that people are talking about it. Whatever its effects in the markets, in the political arena inflation talk is not neutral. Inflation tends to hurt the Democrats... If one takes this argument seriously, then what the Biden administration needs is for the Fed to do the bare minimum necessary to anchor inflation expectations, calm public fears and the markets. Unfortunately, the calm in the markets is now based on pricing in four interest rate hikes. Let us hope that this is not more than the economy can bear.

Update 1 (23.01.2022)

NYT has this good summary of the demand for goods in the US,

Virus outbreaks shut down factories, ports faced backlogs and a dearth of truckers roiled transit routes. Americans still managed to buy more goods than ever before in 2021, and foreign factories sent a record sum of products to U.S. shops and doorsteps. But all that shopping wasn’t enough to satisfy consumer demand. The Port of Los Angeles is a window into the mismatch. The port had its busiest calendar year on record last year, processing 16 percent more containers than in 2020. Even so, it still has a huge backlog of ships waiting to dock, several of which, as of Friday, have been waiting a month or more... 

Giving households more money to buy camping equipment or a new kitchen table widened the gap between what consumers wanted and what companies could actually supply. As goods came into short supply and began to cost more to transport, businesses raised their prices. Government checks haven’t been alone in driving strong U.S. demand. As virus fears prevent consumers from planning a trip to Paris or a fancy restaurant dinner, many have turned to refurbishing the living room instead, making goods an unusually hot commodity. Lockdowns that forced families to abruptly stop spending at the start of the pandemic helped to swell savings stockpiles. And the Federal Reserve’s interest rates are at rock bottom, which has bolstered demand for big purchases made on credit, from houses and cars to business investments like machinery and computers. Families have been taking on more housing and auto debt, data from the Federal Reserve Bank of New York shows, helping to pump up those sectors.

Update 2 (30.01.2021)

Philipe Hildebrand makes the case that the inflation is being driven not by any demand but by supply-side shocks. He points to this BlackRock research paper which highlights the unprecedented nature of the supply disruptions.

It also points to the Covid induced shifts away from services to goods. 

Weekend reading links

1. The Economist has a fascinating survey of the harmful effects of occupational licensing in the US. Sample this,

In 1950 one in 20 employed Americans required a licence to work. By 2017 that had risen to 22%... Most studies find that licensing requirements raise wages in a profession by around 10%, probably by making it harder for competitors to set up shop... Forty-one states license makeup artists, as if wielding concealer requires government oversight. Thirteen license bartending; in nine, those who wish to pull pints must first pass an exam... manicurists are licensed everywhere but Connecticut. Louisiana licenses florists... Such examples... are not representative of the broader harm done by licensing, which affects crowds of more highly educated workers... Among those with only a high-school education, 13% are licensed. The figure for those with postgraduate degrees is 45%. More educated workers reap bigger wage gains from licensing. Writing in the Journal of Regulatory Economics in 2017, Morris Kleiner of the University of Minnesota and Evgeny Vorotnikov of Fannie Mae, a government housing agency, found that licensing was associated with wages only 4-5% higher among the lowest earning 30% of workers. Among the highest 30% of earners, the licensing wage boost was 10-24%. Forthcoming research by Mr Kleiner and Evan Soltas, a graduate student at Oxford University, uses different methods and finds no wage boost at the bottom end of the income spectrum, but a substantial boost for higher earners... In particular, licences are more common in legal and health-care occupations than in any other.

2. In the context of assessments of historical figures and events, Livemint invokes John Rawls to offer a three point Rawlsian test,

The first point Rawls made was that the giants of the past had to be understood in the context of their times rather than ours. Any moment in history should then be seen from their point of view rather than ours. It is fundamentally wrong to pass sweeping judgements, with the benefit of perfect hindsight, on people making complicated choices in real time. The next point Rawls made was that any scholar has to strive to offer the ideas of a historical figure in their strongest form. They have to be assessed in the best light possible... Rawls once quoted John Stuart Mill in this respect: “A doctrine is not judged at all until it is judged in its best form.”... The third lesson from Rawls is that one should approach the great figures in history with modesty. “I always assumed that the writers we were studying were always much smarter than I was…. If I saw a mistake in their arguments, I suppose they saw it too and must have dealt with it, but where? So I looked for their way out, not mine.”

3. In the context of the debate surrounding whether macroeconomic theory needs revision or not, Srinivas Thiruvadanthai makes a very valid point that perhaps we need to go back and construct certain stylised facts from real world data. He suggests some which are all contrary to the orthodoxy - demand shortfalls have persistent effects; fiscal policy is effective in recessions; private debt matters enough to cause recessions and worse, whereas public debt matters less so; investments are not very sensitive to interest rate changes, both reductions and increases.

I can add a few more - capital grows faster than national incomes; technology markets converge to monopoly; financial markets cause misallocation of capital and human resources; higher marginal tax rates do not appear to reduce effort or investment decisions etc.

4. This story highlighted the bruising work culture among white collar employees in Amazon. It does appear that the story is even worse with blue-collar workers.

Highlighting the fact that jobs do not translate into higher incomes as well as the features of jobs in the logistics industry, City Lab illustrates with the example of San Bernardino, 60 miles east of Los Angeles, where since establishing base in 2012, Amazon has come to employ more than 15000 full-time workers in 8 fulfilment centres (where goods are stored and packed for shipment) and one sortation centre (where packages are organised by delivery area).

In San Bernardino, the unemployment rate that was as high as 15 percent in 2012 is now 5 percent... Yet in many ways, Amazon has not been a “rare and wonderful” opportunity for San Bernardino. Workers say the warehouse jobs are grueling and high-stress, and that few people are able to stay in them long enough to reap the offered benefits, many of which don’t become available until people have been with the company a year or more. Some of the jobs Amazon creates are seasonal or temporary, thrusting workers into a precarious situation in which they don’t know how many hours they’ll work a week or what their schedule will be... the experience of San Bernardino shows, Amazon can exacerbate the economic problems city leaders had hoped it would solve. The share of people living in poverty in San Bernardino was at 28.1 percent in 2016, the most recent year for which census data is available, compared to 23.4 in 2011, the year before Amazon arrived. The median household income in 2016, at $38,456, is 4 percent lower than it was in 2011... according to a report by the left-leaning group Policy Matters Ohio, one in 10 Amazon employees in Ohio are on food stamps.

This contrast between the labour markets of two eras is striking,  

In 2012, Amazon seemed like a lifesaver. San Bernardino’s unemployment rate was at 15 percent, home values had fallen 57 percent since 2007, and the city, facing a $45 million budget shortfall, would file for bankruptcy in August of that year... The jobs that used to dominate San Bernardino were unionized ones with good benefits, at the Kaiser steel mill, the Santa Fe railroad maintenance yard, and the Norton Air Force Base. Now, jobs like the ones Amazon creates pay less and aren’t unionized, and require multiple members of a household to work, often more than one job.

In terms of the Amazon effect, this is illuminating,

According to available data from the Bureau of Labour Statistics (BLS), warehouse workers in counties where Amazon operates a fulfilment centre earn about $41,000 per year, compared with $45,000 per year in the rest of the country, a difference of nearly 10% (see chart 2). The BLS data also show that in the ten quarters before the opening of a new Amazon centre, local warehouse wages increase by an average of 8%. In the ten quarters after its arrival, they fall by 3%.

The one thing that comes to mind is that this fabulous wealth of the world's richest man has been effectively built on what should arguably constitute "slave labour" in the world's richest country!

5. After having overtaken the US in exports and manufacturing, the final frontier for the Chinese economic march may be the technology sector. 

In some of the cutting-edge areas of technology like artificial intelligence, facial and speech recognition, the Chinese are breathing down the Americans on most parameters.

6. Finally, the graphic below puts the Chinese debt orgy in perspective - in 2009-17 its official and shadow bank lending was more than $20 trillion during 2009-17, whereas US Fed, BoJ, ECB, and BoE together added just $13 trillion in their respective fastest ever balance sheet expansions!

This is truly scary. The only thing that would be of some comfort is the Chinese government's commitment to address the problem and its credibility in terms of translating talk into actions. As a measure of that consider two data points - the crackdown on capital outflows led to it collapsing from $640 bn in 2016 to just $60 bn in 2017; shadow bank lending in January 2018 was the lowest January level since 2009 at just $25 bn, 90% lower than in January 2017. Not too many governments anywhere can pull off such feats. 

The more things change, more they remain the same - macroeconomic policy edition

The breakdown of the Philips curve relationship between inflation and unemployment has been among the major casualties of recent macroeconomic tumult. It has led to demands that central banks replace the current New Keynesian (NK) models involving a demand equation, a policy rule and a Phillips curve to calculate interest rates.

Over the past few years, Roger Farmer and co-authors have shown that an alternative, the Farmer Monetary (FM) Model, which replaces the Phillips curve with a new equation, the belief function, outperforms the NK model by a large margin when used to forecast the US data for the period from 1954-2007. He writes,

The belief function captures the idea that psychology, aka animal spirits, drive aggregate demand. It is a fundamental equation with the same methodological status as preferences and technology. To operationalise the belief function, we assumed that people make forecasts of future nominal income growth based on observations of current nominal income growth... Conventional dynamical systems have a stable steady state that acts as an attractor. The economy will converge to that steady state, no matter where it starts. The FM model does not share that property. Although the economy follows a unique path from any initial condition, the FM model has a continuum of possible steady states and which one the economy ends up at depends on initial conditions. The FM model explains the data better than the NK model because the unemployment rate in US data does not return to any single point... 

The unemployment rate, the inflation rate and the interest rate are so persistent in US data that they are better explained as co-integrated random walks than as mean-reverting processes. The FM model captures that fact. The NK model does not. What does it mean for two series to be co-integrated? I have explained that idea elsewhere by offering the metaphor of two drunks walking down the street, tied together with a rope. The drunks can end up anywhere, but they will never end up too far apart. The same is true of the inflation rate, the unemployment rate and the interest rate in the US data... the NK model is wrong and there has been no stable Phillips curve in the data of any country I am aware ever since Phillips wrote his eponymous article in 1958.

If the recent Peterson Institute conference on Rethinking Macroeconomic Policy is any indication, Farmer and Co may have more work to do. As Matthew Klein writes in FT, the conference co-Chair, Olivier Blanchard, reaffirmed his faith in the Phillips Curve,

I have absolutely no doubt that if you keep interest rates very low for long enough the unemployment rate will go to 3.5, then 3, then 2.5, and I promise you at some point that you will have the rate of inflation that you want.

Translation - keep the monetary accommodation on and unemployment rates will keep going down till they stoke off inflationary pressures "at some point"! Coming as it does from someone who was till recently the Chief Economist of IMF, this is a staggering level of obduracy. And he was leading a conference on "Rethinking Macroeconomic Policy"!

Klein decomposes the Blanchard view in terms of four propositions - jobless rate influences wage bargaining; workers bargain over nominal and not real incomes; workers spend extra money on consumer products, driving up prices; and businesses in the aggregate can raise pay or hike prices. The last three, especially the last, stand on tenuous foundations and limited empirical evidence.

Thankfully, the rest of the conference appears to have been more receptive to change. The most useful reminder for macroeconomists came, as usual, from Dani Rodrik,

The ratio of redistribution to efficiency gains is not only very large, it rises to ridiculous heights as the tax/policy distortion that is removed gets smaller.

He shows that redistribution per dollar of aggregate gain (in favour of the well-off or entrenched) increases sharply as the tax and tariff rates get ever smaller.

Jason Furman called for an end to the debate on whether inequality is good or bad for growth and on its impact on the average of incomes, both irrelevant for policy makers. Instead, he proposes more attention on specific policies that increase or decrease inequality and their impact on indicators that reflect more broader social welfare functions than simple averages (like the impact on specific population categories). His suggestion for developed and developing countries,

In advanced economies a lexicographic framework that focuses exclusively on distributional analysis and then only to growth when the distribution of different policies is the same is generally likely to be appropriate under a broad range of social welfare functions. This is because the distributional effects of many policies are orders of magnitudes larger than the growth effects. In developing economies, however, the scope for policy- and institutionally-induced variations in growth rates is much larger and thus the lexicographic approach is unlikely to be as widely appropriate.

Gita Gopinath puts to rest the orthodoxy about the superiority of freely floating exchange rates and argues in favour of managed floats for emerging market (EM) economies. Channeling BIS economists and Helene Rey, who claim the impossibility of monetary policy independence irrespective of the exchange rate regime, once capital flows are allowed, Gopinath points to the recent work of Obstfeld and Co which shows the persistence of an attenuated version of the trilemma. They show that for EM countries the correlation of a bunch of macroeconomic indicators and global investor risk aversion is lowest for those with intermediate exchange rate regimes.

She also points to the work of Falk Brauning and Victoria Ivashina about outsized influence of US monetary policy cycles on EM economies, driven by global banks, as shown by their finding that over a US monetary easing cycle they experience a 32 per cent loan volume increase.

Mathiness and the narrowing of economics

Lars Syll has a nice post with several interesting links on the ongoing debate on the "intellectual regress" in macroeconomics. In particular, the post discusses the problem with the Lucas-Prescott-Kydland-Sargent "calibration" models. 

Calibration modelling involves identifying uncertain parameters and revising the model coefficients using actual historical data with some measure of goodness-of-fit. See Paul Krugman here and here on calibration modelling. 

Stripped off the jargon, the issue at hand is that one school of thought advocates using a model arrived at based on their theory of change whose parameters are refined (or calibrated) by testing it against actual data. But another group critiques this approach arguing that such calibration is barking up the wrong tree if the theory of change and, therefore, the model itself is flawed. They also argue that unlike scientific models which are generally time and path invariant, the dynamics of change in social science are time and path dependent.  

Also Paul Romer's scathing attack on how "mathiness" and excessive deference led macroeconomics astray,

a general failure mode of science that is triggered when respect for highly regarded leaders evolves into a deference to authority that displaces objective fact from its position as the ultimate determinant of scientific truth.

The complement of "mathiness" is the narrowing of the study of man in the ordinary business of life from its older version of "political economy". On a related note, Economist has a nice year-end article on the Cambridge school of political economy founded by Alfred Marshall. The contrast between the multi-disciplinary school of political economy of Alfred Marshall and AC Pigou and the modern "mathy" econometrics-heavy instruction is seen in their respective student instruction and assessments,

The goal can be seen in the exam questions of the time. Students were expected to combine economic principles with a strong grasp of current affairs. In 1927, for example, one paper on public finance asked students to explain the size and reasons for the main areas of British government spending. They were expected to have the skills of an essayist, spending one three-hour exam on a single question such as the future of gold, the rights and duties of shareholders, or alternatives to democracy. Cambridge economics considered itself to be an analytical science but calculation was not of the essence. A module in statistics produced a page-long test for final-year students; all the other papers were bare of mathematical symbols. Compare this with the exams of today. Charlotte Grace, a student in the third year of the economics tripos (as undergraduate degrees are known in Cambridge), says she could have passed all the questions she faced in her first year without reading a newspaper. And though the five-page final-year macroeconomics exam that was set in 2015 asked about some contemporary policy conundrums, like which features of the euro zone may have contributed to its sovereign debt crisis, most of the paper sought to test students’ knowledge of tricky, algebra-heavy models. Three-hour pontifications on a single topic have been ditched in favour of a compulsory dissertation in which original empirical analysis is encouraged.

These tests reflect changes in the discipline. Students must master the technical apparatus of a highly specialised field. The maths they need to know and apply is sufficiently taxing as to barely leave time for history. Evidence-based conclusions are preferred to arms-length analysis; economists should know the limits of their expertise, and shy away from political judgments as they think through the effects of whatever policy tweaks providence might throw at them.

The four macros and the way forward

Noah Smith identifies four different versions of macroeconomics and feels that the formal academic macroeconomics has failed everyone,

The first is what I call “coffee-house macro,” and it’s what you hear in a lot of casual discussions. It often revolves around the ideas of dead sages - Friedrich Hayek, Hyman Minsky and John Maynard Keynes. It doesn’t involve formal models, but it does usually contain a hefty dose of political ideology. The second is finance macro. This consists of private-sector economists and consultants who try to read the tea leaves on interest rates, unemployment, inflation and other indicators in order to predict the future of asset prices (usually bond prices). It mostly uses simple math, though advanced forecasting models are sometimes employed. It always includes a hefty dose of personal guesswork.

The third is academic macro. This traditionally involves professors making toy models of the economy -- since the early ’80s, these have almost exclusively been DSGE models. Though academics soberly insist that the models describe the deep structure of the economy, based on the behavior of individual consumers and businesses... they contain so many unrealistic assumptions that they probably have little chance of capturing reality. Their forecasting performance is abysmal. Some of their core elements are clearly broken. Any rigorous statistical tests tend to reject these models instantly, because they always include a hefty dose of fantasy. The fourth type I call Fed macro. The Federal Reserve uses an eclectic approach, involving both data and models. Sometimes the models are of the DSGE type, sometimes not. Fed macro involves taking data from many different sources, instead of the few familiar numbers like unemployment and inflation, and analyzing the information in a bunch of different ways. And it inevitably contains a hefty dose of judgment, because the Fed is responsible for making policy.

And on the way forward,

the new macroeconomics will focus on empirics and falsification -- in other words, looking at reality instead of making highly imaginative assumptions about it... macro will be fertilized by other disciplines, such as psychology and sociology, and will incorporate elements of behavioral economics... I think the new macroeconomics won’t just be new kinds of models and a more empirical focus; it will redefine what “macroeconomics” even means. As originally conceived, macro is about explaining national-level data series like employment, output and prices. Eventually, economists realized that to explain those things, they would need to understand the smaller pieces of the economy, such as consumer behavior or competition between companies. At first, they just imagined or postulated how these elements worked -- that’s the core of DSGE. Economists now realize that consumers and businesses behave in ways that are much more complicated and difficult to understand. So there has been increased interest in what’s called “macro-focused micro” -- studies of businesses, competition, markets and individual behavior that have relevance for macro even though they weren’t traditionally included in the field. Examples of this would include studies of business dynamism, price adjustment, financial bubbles and differences between workers.

This presentation by Justin Wolfers captures the problems with academic macro. But I am not sure that academic macro-economists are likely to discard their models in a hurry. For a start, it is difficult to shed layers on layers of orthodoxy accumulated over a long career so easily. More importantly, macro-focused-micro, involving disciplines like agent-based modelling, and rigorous empiricism and cross-disciplinary approaches do not lend itself to being neatly and consistently researched, comprehended and disseminated as a unified narrative. 

In this context, I am reminded of a course taught by Dani Rodrik a few years back. After each class, I would hear disappointed course mates complain that there were no clear and actionable takeaways. That's precisely the point.

I feel a clearer way to look at modern macro would be to use these newer lenses to acknowledge the complex nature of the underlying problem, become aware of all the instruments and tool-kits for its examination, select the most appropriate model(s) as the specific situation demands, and finally apply your informed judgement to choose the right course of action. This is very different from algorithmic application of a model to determine policies.

IMF questions neo-liberalism

John Maynard Keynes said, "When facts change, I change my views. What do you do sir?" The latest adherent to this appears to be the IMF. In the ferment that followed the sub-prime crisis and which continues till date, the IMF has been the undisputed thought leader in revisiting many fundamental tenets of conventional wisdom in economics.

It has initiated debates on a higher inflation target, bigger fiscal deficit, some form of capital controls to stem flows volatility, and expressed concern at the distributional consequences of competitive policies and free trade.

The latest salvo comes in the form of an article in the latest edition of its F&D magazine which can only be construed as the formal obituary of the neo-liberal order, popularly embodied in the Washington Consensus. The two central tenets of this were competition, achieved through extensive deregulation and globalization, and shrinking the role of the state, through large-scale privatization and fiscal consolidation. The article questions two of the important elements of this policy push - elimination of capital controls (financial openness) and fiscal consolidation. Its findings are three-fold,

One, the benefits in terms of increased growth seem fairly difficult to establish when looking at a broad group of countries.­ Two, the costs in terms of increased inequality are prominent. Such costs epitomize the trade-off between the growth and equity effects of some aspects of the neoliberal agenda.­ Three, increased inequality in turn hurts the level and sustainability of growth. Even if growth is the sole or main purpose of the neoliberal agenda, advocates of that agenda still need to pay attention to the distributional effects.­

The headline finding on unrestricted capital flows is,

Some capital inflows, such as foreign direct investment—which may include a transfer of technology or human capital—do seem to boost long-term growth. But the impact of other flows—such as portfolio investment and banking and especially hot, or speculative, debt inflows—seem neither to boost growth nor allow the country to better share risks with its trading partners... Although growth benefits are uncertain, costs in terms of increased economic volatility and crisis frequency seem more evident. Since 1980, there have been about 150 episodes of surges in capital inflows in more than 50 emerging market economies... about 20 percent of the time, these episodes end in a financial crisis, and many of these crises are associated with large output declines  

And on fiscal consolidation is,

The need for consolidation in some countries does not mean all countries... Markets generally attach very low probabilities of a debt crisis to countries that have a strong record of being fiscally responsible. Such a track record gives them latitude to decide not to raise taxes or cut productive spending when the debt level is high. And for countries with a strong track record, the benefit of debt reduction, in terms of insurance against a future fiscal crisis, turns out to be remarkably small, even at very high levels of debt to GDP... The costs of the tax increases or expenditure cuts required to bring down the debt may be much larger than the reduced crisis risk engendered by the lower debt... Faced with a choice between living with the higher debt—allowing the debt ratio to decline organically through growth—or deliberately running budgetary surpluses to reduce the debt, governments with ample fiscal space will do better by living with the debt.

Austerity policies not only generate substantial welfare costs due to supply-side channels, they also hurt demand—and thus worsen employment and unemployment... in practice, episodes of fiscal consolidation have been followed, on average, by drops rather than by expansions in output. On average, a consolidation of 1 percent of GDP increases the long-term unemployment rate by 0.6 percentage point and raises by 1.5 percent within five years the Gini measure of income inequality.

It is impressive that IMF has been willing to revisit such holy cows, for very long the central tenets of its own policies, and widely and aggressively prescribed by the institution. 

The futile search for quick-fixes

Most often the long-term economic health of nations is about getting several basic things right. But unfortunately, when in trouble, the search is invariably for innovative and big-bang solutions. James Surowiecki sums up this dilemma in the context of the criticism of President Obama's recent speech that laid out the challenges facing the US economy and what needs to be done. He writes,

Obama’s speech was, in a sense, the equivalent of saying that if you want to lose weight, you need to eat better and exercise more. And demanding that he offer up some “big, bold, and new” idea (as Milbank, for instance, did) is like asking for a fad diet—lose thirty pounds in thirty days while eating only muffins! If we’re really serious about the long-run performance of the economy, we need to abandon the quest for short-term fixes and radical solutions, all of which steal from, rather than enhance, the economy’s still-enormous strengths.

I could not agree more. This is also the problem with popular narratives on what needs to be done to get India out of its current economic weakness. There are no quick-fixes nor "big, bold, and new" solutions. It needs to get the boring basics right - sustainable growth happens when the consumption base expands, encouraging investors to lend capital and businesses to invest, thereby creating more jobs and increasing the base further, and this entire process is facilitated by macroeconomic and social stability, an enabling regulatory framework, and good quality human and physical infrastructure.   

Modern Macroeconomics Family Tree

Dylan Matthews (via MR) provides a short history of modern macroeconomics and this nice family tree of the subject.

Confession of the week!

In four years of reflection and rather intense involvement with this financial crisis, not a single aspect of dynamic stochastic general equilibrium has seemed worth even a passing thought.

Lawrence Summers

Examining the failure of economic thinking

Mark Thoma is spot on in this passionate assessment of what ails the modern economic system,

"It's distribution, not production that has failed us over the last 30 or 40 years. We produce far more than we ever have, and we will continue to increase our ability to squeeze more and more out of the resources we have. We have the ability to produce enough stuff. But the distribution of the things we produce has been tilted toward the top. Instead of wages rising with productivity as our textbooks say they should, wages have stagnated and the rewards have gone elsewhere. Thus, while the pessimism of the past was about production not being able to keep up with population - many classical economists looked forward to a long-run outcome of a dismal, stationary state with most people struggling at subsistence wages - the pessimism of the present is driven largely by a failure of distribution. The haves get more and more, and the have nots get less and less even though overall output is rising... Pessimism about breaking through the wealth and power structures that stand in the way of change is understandable, as is the desire of the winners in our increasingly two-tiered society to keep the focus on growth rather than distribution."

The remarkable achievements of the past few decades - rapid advances in information and communication technology, spectacular economic growth in emerging Asia etc - is confirmation of the fact that markets have allocated scarce resources very efficiently. But the growing evidence of failures and sufferings across the world is ample proof that market systems have failed to ensure fairness in allocation of these resources.

Fortunately, many of these market failures are the inevitable consequence of the process of efficient allocation of scarce resources and they can be atleast partially mitigated by appropriate public policy interventions and through formal and informal social and political institutions. Progressive taxation, social safety nets, subsidies and concessions, and institutionalized regulatory restraints are some of the commonplace policy options used to address such failures in distribution or achieve fairness in allocation. Political parties in democracies, social interest groups, trade unions etc have played significant role in creating an environment that promotes fairness in allocation.

Traditionally, governments have intervened, often very aggressively, with such policies to address failures in the fair distribution of resources. The vibrancy of social and political institutions have also played a major role in containing the excesses emerging from the dynamics of untrammelled free market. However, the disruptive socio-economic changes of the past couple of decades have unleashed forces which have considerably undermined the tenuous balance between efficiency and fairness.

As the concentration of economic power and resultant widening of economic inequality has accelerated spectacularly in recent years, many of these traditional checks and balances have either been dismantled wholesale or their strength considerably eroded. Across the world, thanks to the spectacular growth of financial market incomes, the past few years have seen the emergence of a class of uber-rich elite, whose economic power has found reflection in the traditional political institutions. In other words, economic power has spawned political power.

This has had two fold impact. It has loosened the restraints put by social and political institutions. More worryingly, these changes have seriously undermined the resolve of governments at all levels to step in to rectify market failures. A false consciousness has been sought to be created that the big winners are the beneficiaries of a competitive merit race, and the outcome is a reflection of the natural order of things. Such explanations brush under the carpet the ovarian lottery that increasingly defines a major chunk of life's outcomes.

The strong opposition, not only in the West but also in many emerging economies, to increasing taxes on even the richest, withdrawing concessions to corporate groups, stronger regulation of financial markets, and expanding the role of government, even if only to provide basic social safety cushions to those most affected by economic shocks, is a reflection of this changing dynamics of social and political power.

Unfortunately, as a profession, economics has failed to either anticipate or do anything meaningful to highlight the implications of this failure. It has been too concerned with studying "efficient allocation of scarce resources" that it appears to have forgotten that the sustainability of this allocation depends on it being fair.

I am inclined to believe that this skewedness in focus among economists is attributable to two factors - limitations of mathematical models and ideological bias. Modern macroeconomic research is heavily dictated by mathematical formalism. However, unlike issues of efficiency (which is essentially a maximization problem, subject to certain constraints), those of fairness in distribution is not easily amenable to mathematical modelling. Fairness involves the exercise of human judgement, in some form or other, to bring about a desired final state of the system.

Then there are the ideological biases of economists, most of whom work in free-market democracies. Unlike the ideal systems of modern economic theories, the real world is full of imperfections, where the ideal world assumptions do not hold. In the circumstances, fairness demands interventions that seek to re-distribute resources and thereby correct the business as usual state of affairs in the system. But such remedial interventions, more often than not, go contrary to the ideological principles that underpin the theoretical foundations of these economists.

Update 1 (2/10/2011)

Mark Thoma argues that there is a need to revisit the socio-economic and political power balance, but is not sure how it will happen. He writes,

"Congress has no interest in doing so, things are quite lucrative as they are. Unions used to have a voice, but they have been all but eliminated as a political force. The press could serve as the gatekeeper, but too many outlets are controlled by the very interests that the press needs to take on and this gives them the ability to cloud most any issue. Presidential leadership could make a difference, and Obama’s election brought hope for change, but this president does not seem inclined to take a strong stand on behalf of the working class...

Another option is that the working class itself will say enough is enough and demand change. There was a time when I would have scoffed at the idea of a mass revolt against entrenched political interests and the incivility that comes with it. We aren’t there yet – there’s still time for change – but the signs of unrest are growing and if we continue along a two-tiered path that ignores the needs of such a large proportion of society, it can no longer be ruled out."

The Great Macroeconomic Policy Debate - How to restore growth?

The biggest macroeconomic challenge now is to manage a recovery from the stubbornly persistent economic slowdown. But a fierce ideological battle is on about what strategy is required to achieve economic recovery.

Everyone agrees that across both US and large parts of Europe, household, bank, and government balance sheets are suffering from huge debt over-hang. As households cut back on consumption and banks refuse to lend, businesses are postponing investments. The high unemployment rates show no signs of coming down and the economies remain stuck at the trough, far longer than the aftermath of previous recessions. Governments, the only other agency capable of engineering a turn-around, are faced with huge sovereign debts and battered fiscal positions. With interest rates at zero bound and even extraordinary quantitative easing measures already having been tried out, monetary policy appears to have limited traction. So what is the way out?

Conservatives are unambiguous in their advocacy of fiscal austerity and placing deficit reduction at the center of the macroeconomic agenda. They fear about the dangers of inflation taking hold and bond-market yields rising. They claim that the fiscal and monetary expansion of the last decade or so has produced several excesses that need to be wrung out before any meaningful economic recovery can begin. To this extent they advocate immediate re-balancing of public finances with policies to cut government expenditures, raise revenues (albeit without raising taxes), and carry out structural reforms.

They admit that while this will generate some short-term pain, it will be for the long-term good. They argue that this will generate "contractionary expansion", restoring market (business, investor, and consumer) confidence and shaping expectations and thereby encouraging business investments. See Robert Barro (academician), Stephen King (Business), and Wolfgang Schauble (politicians) advocating austerity and fiscal consolidation over expansion.

Liberals differ and propose further fiscal and monetary expansion as the only way out of this mess. The argue that the high persistent unemployment rates should be the central focus of policy makers. They point to historical evidence from US in 1930s and recently from Japan, to argue that unless governments undertake aggressive Keynesian stimulus spending and unconventional monetary expansion, the economy risks being stuck at the bottom for a long time.

They also point to the evident inability and reluctance of businesses to invest in such uncertain and weak environments, especially that of the job-creating but credit constrained small businesses. They see government spending as the only source of generating additional aggregate demand. They also argue that the ultra-low interest rates provide an excellent opportunity for governments to invest in infrastructure and other long-term spending so that the platform for longer-term growth is laid at the cheapest cost. They see little evidence of government spending crowding out private borrowing, inflation emerging as a concern anytime soon, or bond-markets catching cold. See Martin Wolf (Journalist), Mark Zandi (Business), Adam Posen (policy maker) and Dani Rodrik (academician) advocating expansionary policies.

There are also some others who have refrained from taking an explicit position, preferring to suggest specific measures. Some like Ken Rogoff have rightly argued in favor of policies that directly address the issue of cleaning up household and bank balance sheets. To this extent they advocate inflating away debts with a slightly higher inflation target, something which Olivier Blanchard, the IMF Chief Economist too had advocated earlier. However, the efficacy of higher inflation targeting has been questioned on credible enough grounds by Raghuram Rajan.

Interestingly, both sides invoke the magisterial historical examination of sovereign debt crisis, induced by various factors including banking collapses, by Carmen Reinhart and Kenneth Rogoff. Conservatives point to their finding that high-levels of growth dampen growth. Liberals point to their findings about the deep nature of recessions that follow banking collapses and argue that government support therefore is essential for expediting recovery.

All these views carry considerable ideological baggage and are evidently constrained by the need to accommodate their respective ideological predilections. Warts and all, the main issue is about which mixture of policies would be most effective in enabling a sustained recovery. An objective assessment reveals inconsistencies or practical difficulties with both sides.

The problem with the conservatives' position is that if all the actors - governments, businesses, financial institutions, and households - are badly constrained, then where would the thrust for recovery come from? Their argument is that debt restructuring and the dynamics that get generated could restore market confidence and thereby pull the economy up the recovery path. But, given the depth of the problems, will it carry the momentum required to pull the economy out? Even traditionally conservative institutions like the IMF have raised serious doubts about fiscal austerity arguing that it could hurt incomes and job prospects. Further, the experience in the current recession with such policies is hardly encouraging.

As several estimates of growth required to bring unemployment in the US to normal levels and also bridge the yawning output gap show, the scale - magnitude and time - of growth required to restore normalcy in the medium term is substantial. In the absence of a strong engine or anchor, what will be the source of this growth? The justifiable fear then is that the recovery process could go on for years.

The fundamental premise of the liberals' argument is that it is necessary to do everything possible to pull the economy out of recession. They fear, based on historical precedent, that in the absence of aggressive expansion, the unemployment problem will assume structural nature and become a socio-economic problem, and a lost decade will be inevitable. I am inclined to believe that this fear too has strong justifications. However, some of the liberals policy measures are not fully supported by fact and appear to based more on hope than objective considerations.

Their hope is that aggressive fiscal and monetary actions will buy enough time for the markets to repair battered balance sheets of all parties and set the stage for a sustainable recovery. But what if it does not? The trillions of dollars so far spent on fiscal and monetary stimulus in the US had not had the expected impact (there could be a counterfactual problem here). What is the certainty that more rounds of stimulus will work? More critically, it is possible that the amount of stimulus required to make any meaningful dent is so large as to make it fiscally and politically impossible. In the circumstances, expansionary policies would be merely throwing money down the drain.

So, if the fears of inaction appear well-justified, and the possible policy alternatives are fraught with deep uncertainty, then are the developed economies set to suffer a long and tortuous period of restructuring, high unemployment and low growth? Is this the inevitable cost of the excesses that got built-up over the past decade or so? Is it desirable to have a medium-term period of de-leveraging that is necessary to wring out the excesses and distortions, rebalance balance sheets, and achieve normalcy? In the meantime, is it appropriate if public policy refrains from anything proactive (either expansionary stimulus or austerity) and confines itself to the provision of a basic minimum social safety to those worst affected by the economic weakness?

Unfortunately this approach too appears untenable. It presupposes a longer period of high unemployment rates and economic weakness. However, there are widespread concerns about its long-term impact on the labour force itself. Longer the people stay unemployed, greater the difficulty to rejoin the workforce. Skills will atrophy and productivity will decline. The socio-economic impact of this will be pernicious. The long-term impact on America's labour force and the economy in general will be damaging. See also this excellent study by Alan Krueger and Andreas Mueller.

Then there is also the danger of Japan. That country ahs been stuck in the trough for nearly two decades now and no end appears in sight. Though there are considerable dis-similarities, there are exists striking similarities - similar asset crashes, huge public debts, aging work-force, and possibly a nominal zero-interest liquidity trap. The magnitude of the downside associated with these risks are so huge that not doing anything proactive appears unwise.

In view of all the aforementioned, and given the extremity risks, inactivity may not be desirable. But there is no clarity on which strategy is most effective in stimulating a recovery. In the circumstances, the only alternative may be to throw everything at the problem and hope that some mixture of policies does enough to put the economy in the recovery path.

The contraction with "expansionary fiscal consolidation"!

The big macroeconomic debate of our times is over whether economies facing the Great Recession should indulge in more fiscal and monetary expansion or should embrace fiscal austerity and monetary contraction.

Advocates of more stimulus point to dismal economic conditions - aggregate demand slump, lack of business confidence, idle capacity, depressed business investments, high unemployment rates etc - and argue that the economy would remain in a deep recession in the absence of expansionary policies. The zero-bound in interest rates, they say, only exacerbates the problems.

The Austerians point to the huge build up of public debts across most developed economies and demand immediate steps to bring them down to sustainable levels. They also see dangers of an inflationary spiral and even asset bubbles unleashed by the extended expansionary monetary policy. They also fret at bond-vigilantes driving up interest rates.

In recent months, they have pointed to the work of Alberto Alesina and Silvia Ardagna (pdf here, earlier version here) who examined episodes of all large fiscal policy stances, both stimuli and adjustments, in OECD countries from 1970-2007. They found,

"Fiscal stimuli based upon tax cuts are more likely to increase growth than those based upon spending increases. As for fiscal adjustments those based upon spending cuts and no tax increases are more likely to reduce deficits and debt over GDP ratios than those based upon tax increases. In addition, adjustments on the spending side rather than on the tax side are less likely to create recessions."

This has repeatedly been invoked to justify "expansionary fiscal contraction" or "expansionary austerity", where fiscal consolidation will result in increased growth. It is argued that fiscal consolidation by way of spending cuts or tax increases today will, by reducing the expectations of the need for a larger and disruptive fiscal adjustment later, raise household and business expectations about their future incomes and thereby stuimulate private consumption and business investments.

They also argue that if current fiscal policy can influence agents' expectations about interest rates by signalling to them about the government's resolve, by way of fiscal stabilization, to rein in public debt, "they can ask for a lower premium on government bonds". Further, aggregate demand components sensitive to real interest rates too get a boost if such credible expectations about fiscal stabilization and lower future interest rates are conveyed. They forecast a possible consumption/investment boom if such expectations can be credibly conveyed. This study has also been used to justify the preference of tax cuts over government spending if stimulus is deployed.

A recent paper by IMF economists Jaime Guajardo, Daniel Leigh, and Andrea Pescatori have examined the dataset used by Alesina and Ardagna and find that their findings may have been compromised by the bias within the examples used. The IMF economists drew a distinction between fiscal consolidations motivated by a desire to reduce budget deficit and those responding to prospective economic conditions. They focussed on the impact of short-term fiscal consolidation arising out of only the former and found

"Using this new dataset, our estimates suggest fiscal consolidation has contractionary effects on private domestic demand and GDP. By contrast, estimates based on conventional measures of the fiscal policy stance used in the literature support the expansionary fiscal contractions hypothesis but appear to be biased toward overstating expansionary effects...

Based on the fiscal actions thus identified, our baseline specification implies that a 1 percent of GDP fiscal consolidation reduces real private consumption by 0.75 percent within two years, while real GDP declines by 0.62 percent... Our main finding that fiscal consolidation is contractionary holds up in cases where one would most expect fiscal consolidation to raise private domestic demand. In particular, even large spending-based fiscal retrenchments are contractionary, as are fiscal consolidations occurring in economies with a high perceived sovereign default risk."

As Paul Krugman writes, the Alesina and Ardagna findings are muddled by reverse causation - they mistake the rise in revenues and/or fall in expenditures that generally follows fiscal consolidation (since safety-net spending falls or government prunes down expenditures) to claim that economic expansion follows all spending cuts and/or tax increases.

Counterfactuals and economic analysis

As the debates on monetary and fiscal policy options during the sub-prime crisis and Great Recession have shown, macroeconomic theories can rarely explain with certainty whether one set of policies are superior to another or are certain to succeed in a given circumstance.

For every example of success with a certain set of policies, opponents are quick to show failures with them. They also point to apparent successes with an alternative set of policies. And in any case, no two situations are the same. Such debates usually end in a stalemate over the relative merits of two opposing theoretical and ideological positions. Further, in such ideological battles, even blatantly untenable views have remarkable persistence. Ideologies are not easily buried.

Since successes or failures with a specific set of policies are rarely cut-and-dry, post-mortems of economic policies too are never non-controversial. For example, despite overwhelming evidence about how TARP and ARRA prevented a complete financial meltdown, created employment and off-set deeper output contraction, sceptics refute the evidence.

Supporters who claim success with a set of policies would face opposition from those arguing that an alternative approach would have yielded better results. Even more, they would argue that conditions would have been better off without those policies - Wall Street would have recovered faster and stronger if there were no bailouts.

Supporters will counter by saying that the recovery would have been more swifter and stronger if their prescriptions were applied in full. For example, economists like Paul Krugman have long argued in favor of much stronger fiscal stimulus measures to mitigate the hardships of the Great Recession. Counter-factuals can only be debated about, never satisfactorily, leave alone conclusively, proven.

The NYT reports of the latest example with such from Europe.

Another missed opportunity for Europe? Over the last year, the European Union and the International Monetary fund have pledged 640 billion euros ($890 billion) to bail out distressed economies on the Continent’s periphery. Yet the interest rates on benchmark bonds in Greece, Ireland and Portugal remain at or near their record highs.

Critics of the bailout will surely see the persistent high interest rates as arising from an inability to convince the confidence fairies and a failure of the policy itself. Supporters would argue that there would have been sovereign defaults from Greece and Ireland in the absence of such bailout backstops.

In simple terms, economic policy are equally handicapped in explaining their policies both ex-ante and ex-post.

Update 1 (28/9/2011)

Paul Krugman has this excellent description of the counterfactual debate on stimulus spending in the US.

Re-thinking macroeconomic policies - a graphical summary

The sub-prime mortgage crisis and the Great Recession have questioned several underlying assumptions of modern macroeconomics. Paul Krugman famously called it the "Dark Age of Macroeconomics" and many standard macroeconomics text books are currently undergoing wholesale revisions in the light to these experiences.

What should be the role of Central Banks, especially in ensuring financial stability? What are the policies and instruments that can be deployed by central banks? What should be the optimal inflation target? What are the exit routes available for central banks from extraordinary monetary accommodation? Do central banks have a role in stabilizing output, that goes beyond interest rate changes, especially when faced with deep recessions?

What regulations are required to ensure greater stability and improve the crisis-resilience of banks? What can be done to contain the build up of systemic risks and limit the contagion effects of deleveraging and resultant liquidity crisis? How do we mitigate the moral hazard concerns arising from financial bailouts? What type of financial market regulations are required to limit the possibility of asset bubbles?

What are the fiscal policy options for governments faced with an economic recession and zero-bound in interest rates? How should fiscal policy be organized during such recessions? Which policies deliver the greatest bang for the buck? How can we swiftly deploy stimulus measures in the face of political paralyses and gridlocks? Should governments restrain from stimulating the economy, when faced with zero-bound recessions, with short-term fiscal measures for fear of deficits and debts?

What is the role of global macoreconomic imbalances in causing and sustaining asset bubbles? What is required to prevent the build up of such imbalances? How should cross-border financial flows be regulated? What is the optimal capital account policy for emerging economies? What sort of international monetary system is required to satisfactorily resolve cross-national financial crises?

I have tried to consolidate the learnings from events of the last three years and the post-mortems and other research that has gone into more satisfactorily understanding and explaining macroeconomic policy making. The result is this graphic. While I must admit that it is highly simplified (all such beautiful flow-charts are meant to simplify complex policy eco-systems), it only seeks to broadly highlight all the different elements of a post-crisis macoreconomic policy framework.

It is clear that the mandate of central banks have to expand beyond inflation targeting and include financial market stability. And when faced with deep recessions, central banks have a credit policy role, whence it could become a lender, buyer, and insurer of last resort. Fiscal policy becomes critical when monetary policy loses traction and when interest rates are at the zero-bound. Its main instruments are automatic stabilizers and discretionary spending measures. The specific instruments of each policy, as indicated in the chart, are illustrative and is meant to merely guide discussion.



(Please click on the graphic to enlarge)

In fact, the IMF recently brought together some of the world's leading economists to a conference where the Fund and participants urged a wholesale re-examination of macroeconomic policy principles. See also this concise presentation by Olivier Blanchard.

The "Big Questions" in economics?

Food for thought for the new year. Late last year, the US National Science Foundation (NSF) invited social scientists to document the grand challenges facing their discipline in the coming years. The purpose was to channel research interest into these areas for the larger benefit of the society. Many economists responded and here are a few interesting white papers

1. William Nordhaus points to arguably the biggest global political economy challenge - how to get sovereign nation states to act in co-ordinated manner to address global public goods? Global warming, cross-border capital flows, commodity price shocks, over-fishing, terrorism, nuclear proliferation etc are all issues whose effects are global and whose solutions go beyond both markets and individual national governments. He frames the challenge succintly,

"Because nations are deeply attached to their sovereignty, the Westphalian system leads to severe problems for global public goods. The de facto requirement for unanimity or broad consensus is in reality a recipe for inaction. Particularly where there are strong asymmetries in the costs and benefits (as is the case for nuclear non-proliferation or global warming), the requirement of reaching consensus means that it is extremely difficult to reach universal and binding international agreements. Not only does each nation face a powerful incentive to free-ride off the public-good efforts of other nations, but each is likely to perceive the costs and benefits of cooperation through a biased cognitive lens that justifies free-riding...

The grand challenge for economics, political science, international relations, and associated social sciences is to devise mechanisms that overcome the bias toward the status quo and the voluntary nature of current international law in life-threatening issues."

2. Alberto Alesina argued that poverty can be addressed only with greater understanding of why certain countries, (nations, regions) have successfully developed and others are lagging. He advocates greater research at the intersection of economics with political science, sociology, anthropology, psychology, and law. In particular, he draws attention to the role of cultural economics in atleast partially explaining many cross-country differences.

Accordingly, specific cultural traits determine (or play a major role in determining) macroeconomic environments and governance systems - lower geographical mobility is a cause for less flexible labor markets; closer family ties creates less demand for insurance products; deeply entrenched savings habits and aversion to debts comes in the way of development of full-fledged financial markets; less-trust to non-family members dilute compliance with contractual obligations and weakens contract laws; lower civic participation reduces social capital and engenders rigidity in laws, and so on. These correlations or causations are critical to understand various aspects of the economic structure, growth potential and poverty reduction policies.

3. Esther Duflo advocates a massive extension of field experiments to obtain empirical findings that can be used to better understand how poverty shapes individual options and construct more effective development policy actions. She proposes a three stage approach - develop a micro-founded testable theoretical framework, test its empirical relevance and develop theories, and incorporate microeocnomic models into a coherent macroeconomics framework that can be replicated.

She argues in favor of testable frameworks that seek to explore the role of behavioural psychology in keeping people poor. She writes about the challenge of developing a testable theoretical framework with the illustration of how poverty affects individual choices,

"Poverty affects behaviour even if the decision maker is 'neo-classical'. He is more likely to be preventeed from borrowing, for example, because he cannot pledge much collateral. He is also more likely to be risk-averse if he has limited access to insurance, since shocks are particularly painful if one has very little to buffer them. He may thus not be an 'efficient' farmer, because the efficient choice would be too risky. He may also never learn what techniques work the best, because experimenting is risky, and he may want to wait for his neighbour to do it for him."

4. Kenneth Rogoff points to three challenges facing macroeconomics in the light of the sub-prime meltdown and Great Recession,

"The first is to find more realistic, and yet tractable, ways to incorporate financial market frictions into our canonical models for analyzing monetary policy. The second is to rethink the role of countercyclical fiscal policy, particularly in the response to a financial crisis where credit markets seize. A third great challenge is to achieve a better cost‐benefit analysis of financial market regulation."

Conventional theories had assumed that unlike product and labor markets, financial markets did not have any large and meaningfully relevant frictions. Fiscal policy has to grapple issues like relative merits of tax cuts and direct government spending, multipliers on various spending choices, the extent to which economies can run up debts, and so on. The challenge with financial regulation involves managing the micro-level incentives of actors, systemic risk management, pro-cyclical nature of regulation etc.

5. Given the fact that human beings are the central focus of all social, behavioral, and economic sciences, Andrew Lo proposes a search for the final answer - a complete theory of human behaviour. He writes,

"Can we develop a complete theory of human behavior that is predictive in all contexts?... By 'all contexts', I mean all situations in which humans may find themselves, including economic, social, cultural, political, and physical. By 'predictive', I mean an empirically validated and repeatable cause-and-effect relation. And by 'complete theory', I mean a theory that is consistent with all known facts of human behavior, and which is sufficient for making correct predictions of human behavior in novel contexts."

6. Alvin Roth draws attention to the exciting field of 'market design' in complex markets, both to fix them when they are broken and to prevent them from breaking. Market designs can more efficiently capture consumers' differential willingness to pay and the subtle differentiation within the same product. Such complex markets which have been "designed" include auctions of spectrum licenses, organ exchanges, advanced academic positions, school choice systems etc. He writes,

"These markets differ from markets for simple commodities, in which, once prices have been established, everyone can choose whatever they can afford. Most of these markets are matching markets, in which you can’t just choose what you want, you also have to be chosen. One of the scientific challenges is to learn more about the workings of complex matching markets, such as labor markets for professionals, college admissions, and marriage."

Designing effective markets require addressing the issue of efficient market clearing. For example, any market should be thick enough but does not result in congestion.

7. Daron Acemoglu argues for greater research into the fundamental institutional (as opposed to the proximate) causes of development. He asks "why some countries have less human capital, physical capital and technology and make worse use of their factors and opportunities". He answers,

"Institutions have emerged as a potential fundamental cause, contrasting, for example, with geographical differences or cultural factors (even as we recognize that cultural factors are central for understanding the evolution, and the persistence, of institutions). Institutional differences, associated with differences in the organization of society, shape economic and political incentives and affect the nature of economic equilibria via these channels. There is now vibrant theoretical and empirical research documenting the importance of institutions for economic outcomes. But the next stage, which requires an understanding of which specific configurations of institutions are most likely to encourage growth in the decades to come, why institutions differ across countries, and why they change, and why they often fail to change, is more challenging...

We do not know which combinations of property rights, financial institutions, judicial institutions, education and various dimensions of social institutions are most conducive to economic development."

He uses Douglass North's famous definition - "Institutions are the rules of the game in a society or, more formally, are the humanly devised constraints that shape human interaction". He outlines its three important features - it is "humanly devised" (as opposed to factors outside human control like geography and history); they set "constraints" on human behaviour; and they work through incentives. Institution determine the "constraints on and the incentives of the key actors".

More are available here.

The QE 2 debate in perspective

Ben Bernanke's recent speech has set-off heightened speculation about a second round of quantitative easing (QE) being round the corner in the US.

The debate about QE represents the classic economic problem. On the one hand, the supporters point to an economic environment with idling resources - both capital (cash surplus businesses postponing investment decisions) and manpower (unemployed labor) - and weakened animal spirits. In the circumstances, restoration of market confidence can be done only through government interventions, either by way of direct government spending or incentives to encourage businesses to change their investment and consumers their consumption decisions.

On the other hand, such interventions result in increased deficits and debt stock. And this is where opponents draw attention to the danger of stoking inflationary pressures, which in turn puts upward pressure on interest rates. They also point to government borrowing ultimately (and through different channels) crowding out private borrowers and investments. And we know that all this will end up tipping the economy back into recession.

The supporters counter by arguing that all the aforementioned "Treasury View" arguments do not apply when the economy is facing the nominal zero interest rate and resultant liquidity trap. When faced with the zero bound and pervasive gloom, all conventional approaches loose traction, and only governments have the firepower to lift the economy back into a sustainable growth path.

They claim that the danger of doing nothing for fear of inflation and debt spiral is the real possibility of a long-drawn out deflation-induced recession, even a depression. And they highlight the case of Japan and the striking pre- and post-crisis similarities between the US now and Japan of the nineties. They say that Japan's nearly two-decade long troubles underlines the fact that a deflation-induced stagnation is much worse than an inflation induced recession.

Opponents see a slippery slope in this argument. They question the benefits of the earlier round of quantitative easing. They allege that far from saving the economy from any collapse, the TARP doled out tax payer money to bailout greedy bankers and their financial institutions, which they argue should have been allowed to fail. They also point to the fact that even after the $787 bn fiscal stimulus, unemployment rates and output gaps remain at historic highs.

They also argue that any further monetary accommodation and credit expansion will only exacerbate the process of resource mis-allocation in the financial markets, already evident from the rising stock markets. The QE way of stimulating recovery, they caution, carries the considerable risk of inflating another bubble with all its attendant market distortions. It only postpones the inevitable and necessary rebalancing required to wring out the excesses that had got built into the world economy. They therefore not only oppose further QE, but also calls for exiting monetary accommodation.

So who is correct? I am inclined partially to both sides. The fiscalians are correct that there exists the possibility of a long-drawn equilibrium of stagnation, which can be averted only with government intervention. The austerians are correct about the slippery slope and the dangers of a new bubble. The difficulty, even impossibility, of separating cause and effect (like in so many other areas of economic policy making) means that we will never be able to satisfactorily resolve the dispute about whether TARP and ARRA succeeded or failed, leave alone how much they contributed towards the present employment and output conditions.

As Nobel laureate Myron Scholes recently pointed out, a decision to proceed with expansion through policies like the QE has uncertain consequences. Though it lowers the uncertainty associated with government's commitment to keep interest rates low and stimulate the economy, going ahead it also engenders uncertainty about the economy, especially about the problems with exiting from QE and the possibility of inflationary pressures taking hold.

On the policy makers' third-hand, the challenge then is to reconcile these two apparently contradicting yet plausible positions and tailor policies that mitigate dangers without sacrificing the benefits of fiscal and monetary expansion. For a start, they could begin with interventions that deliver the greatest bang for the buck with the least macroeconomic distortions and adverse long-term consequences. Continuation of the automatic stabilizers and interventions like assistance to states are the least controversial of such policies.

The fears about crowding out and inflation taking hold are easily dismissed. Deflation and not inflation looks like the more important concern. The fears about crowding out looks positively out of place in an environment where business expectations are anemic and the credit markets are flush with funds.

Also, the fears of stimulus spending rocketing up deficits and debt stock are not borne out by facts. The stimulus expenditures - even with a large third round of stimulus - a very small proportion of the long-term debt projections. The deficits have exploded due to a stagnating economy and reduced revenues, and even without any spurt in government expenditures.

The more pertinent dangers are with resource mis-allocation. Is it possible to structure expansionary policies which have minimal resource mis-allocation possibilities? Should we raise sectoral capital adequacy ratios and their risk weights so as to disincentivize and limit resource flows into those sectors? Ultimately, debates about macroeconomic balancing reverts back into issues of appropriate regulation of the financial markets.

What should be the policy transmission channels and how should the recovery look like? The ideal outcome would be for the expansionary policies to stimulate aggregate demand without generating financial market distortions. Fiscal policy should employ idling labor resources and government spending should put money in the hands of people who are likely to spend and thereby boost aggregate demand. This in turn should increase business confidence and encourage businesses to go ahead with their investment and hiring decisions.

The unconventional monetary expansion should lower the cost of capital, especially long-term capital, for businesses and governments, and thereby encourage and bring forward business investment decisions and lower the real cost of the public debts run up to finance the fiscal stimuluses. It should also provide the time and opportunity for businesses and households to repair their badly bruised balance sheets. All the while, the aforementioned specific regulations should play their role effectively in preventing the build-up of financial market imbalances.

In other words, instead of debating the relative merits of the respective positions of fiscalians and austerians and fighting fictitious (and ideological) battles against inflation and debts, we ought to be discussing about having in place approppriate regulations to address the possibility of market distortions arising from the expansionary policies.

Update 1 (24/10/2010)
Paul Krugman questions the effectiveness of QE 2, since the net risk remains within the government. He writes that "QE2 amounts to a decision by the US government to shorten the maturity of its outstanding debt, paying off long-term bonds while borrowing short-term".

Taking the Treasury and the Fed as a single entity, any quantitative easing would merely involve redemption of long-term debt (through re-purchases by the Fed) using money generated by expanding the monetary base. sales of new short-term debt instruments. Given the fact that at close to the zero-bound, cash and T-Bills are close substitutes (both pay nearly zero interest rates), it is just as if Treasury sold 3-month T-bills and used the proceeds to buy back 10-year bonds.

Update 2 (17/11/2010)

Mark Thoma has an excellent post on QE II. He describes QE II as, "It is conventional monetary policy that operates at the long end of the yield curve through the buying and selling of long-term financial assets rather than through the more traditional buying and selling of short-term assets. The need to operate at the long end of the yield curve presently is not because the Fed has lost control of long-term rates... it’s because the Fed can no longer move rates at the short-end."