Cochrane on the state of macro and finance

As was to be expected, Greg Mankiw didn't stop at posting Eichengreen's link (see my previous entry), but found a different and, from some angles, much better one, this one written by John Cochrane. Here is a link to his post, here is a link to Cochrane's essay (NB: it is an MS Word document, .doc format and all), and here is a link to Cochrane's news page, which includes the essay (and where he asks readers to link to as he may edit it and change its location).

Cochrane's article is simply beautiful. It reminded me why I went into econ to start with. For real. If you are interested in understanding where econ stands and have not been exposed to a doctorate in it, but are willing to spend the time trying to get some nuance (as opposed to Krugman's caricatures), read it.

It is much more detailed about the state of macro and finance than Eichengreen's, while lacking the healthy level of mea-culpa in the latter. I see it as follows: the state of econ, including macro and finance, is fine, thank you (Cochrane), but given incentives, some economists were not introspective enough and joined other agents who, given their incentives, contributed to the bubble and the current crisis.

Together, they are what the NYT should have published.

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Barry Eichengreen as counterweight to Paul Krugman's NYT piece?

No, I'm not dead nor have I been spirited away. And no, I didn't give up blogging. Instead, I've been blogging quite frequently about current economic issues in the US (ironically, being a micro econ, mostly about macro... well, it used to be my job a long, long time ago) here. Warning: it is in Spanish... and a tribute to "they all return to their roots" cliche: the blog is hosted by the think tank / consulting group I used to work for in Peru (yes, Peruvians are interested in the economic comings and goings of the US).

'Nough said.

Point of this entry is to have a place to keep handy a link.

You see, I'm sure y'all have heard about the article / shock-piece Paul Krugman recently published on the NYT, a rather lengthy piece of... well, to call things what they are: a rather selective and I dare say inaccurate re-writing of the history of ideas of economics, in line with his agenda to... what? Re-interpret and resurrect Keynesianism? Settle old scores? Gain popularity among the wide, non-econ public, and political points in some camps?

Just like the Bush admin tried to do about everything, just like it is happening now with the causes of the crisis and health care reform, Paul has fallen into the game of finding evildoers to explain away the problems of the world. It is worrisome, coming from such a smart guy.

C'mon people: policy issues are nuanced, the causes (and ways out) of the crisis are nuanced, health-care reform is nuanced... What isn't that is interesting and worth pondering? The infantile effort to reduce everything to a search for evildoers was stoopid then and it is not any smarter today. It does a disservice to our effort to understand how we got somewhere and how to prevent it from happening again.

We will lynch economists or financiers or insurers or pharma researchers or... And, with all the incentives still in the wrong place, it will all happen again.

So the popularity of Paul's piece was rather depressing. And that is why, when I remembered this little piece, I couldn't stop myself from linking to it.

It is old (end of April), but it is well-written and much more accurate (and, yes, nuanced) than Paul's. Rather than looking for bugbears in the dark, it... well, I'll let you read it. It is written by Barry Eichengreen, Professor of Economics and Political Science at the University of California, Berkeley. Here it goes:

The Last Temptation of Risk

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Busy econ day

1. We're waiting for the Fed to say something about interest rates.
2. Commodity traders "realized profits" yesterday (read: "commodity prices fell a little yesterday"), perhaps to do something while they wait for the Fed's decision. Will the "low US interest rates have lead to speculation on commodities" crowd have more or less ammo if prices bounce back up/ the Fed does something different than cutting 25 basis points? (Full disclosure: for whatever it's worth, I'm part of the bubble-crowd. For a brief, but comprehensive discussion of the different explanations for the rise in commodity prices, see here. The bubble crowd tries to distinguish the continuous, fundamentals-led growth of the last few years from the vertiginous phenomenon of the last few months.)
   
3. Growing business inventories kept the US's GDP from contracting (it grew by 0.6% in the first quarter). While this is obviously better than a falling GDP, could there a less encouraging reason (looking forward) to have avoided the fall?
4. Thanks to Hillary Clinton, the mainstream media is awakening to the idea (ripped from McCain in a deepening of her mind-bogglingly bizarro attempt to contrast herself from Obama in the primaries by looking more and more... Republican?) of the gas-tax holiday. Can there a more idiotic, nonsensical policy proposal this campaign? Even Robert Reich's against it! The founder of the Pigou Club (and no Obama fan himself) says "Score one for Obama."
5. We're still waiting for Ben...
   

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Are we already experiencing slower trend-growth?

What if the expansion of the long-run aggregate supply curve through productivity growth has slowed down already? Not right now, but a few years back, say around 2002. And say that the expansion of expenditure managed to keep on going thanks to a wealth bubble, deficits, and cheap credit; and that inflation managed to stay down thanks to cheap imports of both goods and inputs?

What are the policy implications?

Forget about whether you believe or not in an upward-sloping short-run aggregate supply, whether you're a New Keynesian, an RBC-er, or a microeconomist playing the macro game (like yours truly); if the expansion of the long-run AS curve has slowed down, then we should bite the bullet and accept that those GDP-growth numbers will be slower for a while and be grateful if we avoid inflation catching up and staying with us.

And we should definitely be wary of policy measures, whether monetary or fiscal, attempting to return us to the growth rates of the 1990s: these would instead quickly morph into inflation boosters with little to show for real income (and with the usual redistribution effects).

Oh! But isn't that what we've been seeing since January?

My "evidence" for the trend-productivity slowdown since 2002: A short while ago, I blogged around this graph by Robert Gordon, showing trend productivity dropping since perhaps 2002; EconWeekly has a similar one, together with a lot more analysis on the sources of growth and an explanation on the methodology.

Again, some basic dynamic (and expectations-augmented) ADAS will help here. This is a graphical representation of the expansion of the (static) aggregate demand and aggregate supply curves (represented by their "dotted" counterparts), with inflation in the vertical axis and GDP growth in the horizontal (and all the hand-waving this requires).

In the graph below, we start from point A, the long-run equilibrium. We shock the system so that the dynamic long run aggregate supply growth curve (LRAS) contracts (to LRAS'): point A is no longer a long run equilibrium and long-term growth will have to slow down to that given by LRAS'.

I am arguing we were in a point like A until the very end of 2007, with inflationary and "slow-down" pressures being kept at bay by the factors mentioned above (bubbles, deficits, cheap credit, cheap imports) and perhaps also some of the usual rigidities/inertias. But we cannot stay out of long-run equilibrium in the, well, long-run.

How will the system return to equilibrium if policy cannot magically increase long-term growth to what it was before? Suppose we let the market economy work its impersonal magic:

1. This overheated economy puts pressure on input prices. When this pressure finally gets passed onto input prices, the dotted AS curve contracts and slides along the AD curve, causing inflation to pick up just as the growth rate decreases. This seems like what we've been seeing over the last few months.
2. At the same time, expenditure could contract not just because of price increases for consumption and investment goods (which cause a movement along the AD curve), but because of the decrease in wealth produced by the bursting of the housing-bubble and by the collapse of credit markets.

This is shown in the graph below and the move from point A to point B:

Of course, the curves don't need to contract by the same amount. We might end up with higher or lower inflation in B than in A depending on whether aggregate expenditure/demand or aggregate production/supply contract faster. Keep in mind that growth will be given, in the end, by the position of the dynamic LRAS curve and is the same whether the adjustment happens with any mix of SRAS or AD contraction; the only difference is how high inflation will be.

For example, say that the adjustment happens with NO contraction of the AD curve, but only SRAS slowdown. In that case, the AS curve must contract more and the equilibrium will "slide" up the AD curve until they meet over the LRAS curve; the end result will be the same growth rate with higher inflation and likely a longer adjustment time.

As an aside: should we care about inflation being higher or lower? In this model, not really; but if the LRAS curve has a negative slope because of all the inefficiencies inflation brings on the price system (plus its distributional issues), then higher inflation leads to lower the long-term growth. I will talk a little more about this later.

What would expansionary policies achieve in this case? In the tamest case, expansionary policies like those given by the Fed and the White House/Congress since January will achieve what was described above as "keeping the AD curve in place", forcing the adjustment to take place solely through the SRAS.

This could be the case if policy makers have accepted that the economy has slowed down so that the discussion hinges only around the speed of adjustment and what tolerable inflation is, not about the growth (and employment) level.

I'm not sure what the advantage of that would be beyond showing voters that the government is "doing something."

What happens if we have not accepted this slowdown and instead try to keep returning to the previous level of long-term growth through expansionary policies? That is when things get scary.

We start again from point A. Rising input prices contract the SRAS curve; however, as it begins to contract, expansionary policies expand the AD curve so that we move to point B: same short-term growth, but with higher inflation.

Point B becomes the new point A for the "next" period! In this "next" period, policy either sends another expansionary boost to the system (to counter the continuing contraction of the SRAS as input prices keep rising), thus moving the economy from B to a point above it; or the contraction finally begins then, the same thing but delayed.

But is it really the same thing? No, it's even worse: the contraction would begin from a higher inflation level. When we finally make it to the long-term equilibrium, we will have the same growth rate as in the previous (pure market adjustment) scenario but with higher inflation.

No, no: it really is even worse! To keep the short-run equilibrium above the long-run equilibrium, policy must be unexpected. The economy is already expecting last period's inflation and that is precisely what will contract the SRAS curve: real prices returning to equilibrium. Policy must surprise contracts, catch them unaware, with an even higher inflation to keep the real price of production inputs (including real wages) below equilibrium levels. That's what makes producing above the long-run equilibrium possible. In other words: inflation must spiral upwards at an accelerating pace to keep us producing above the long-run equilibrium.

(Of course, at this point, we need to tip our hats in Milton Friedman's direction: inflation is a monetary phenomenon. Fiscal policy can result in price shocks, but a process of sustained price increases must feed from the expansion of the money aggregates. Appropriately for this argument, it's the Fed that's doing most of the heavy expansionary lifting these days.)

One might ask: but can't the government simply keep inflating the economy to keep us moving vertically from A to B (to C to D) each period? Of course not: economics would not be called "the dismal science" if that was the case!

What is not captured in this simple model is how the underlying mechanics of the system begin to break down as inflation accelerates (the negative slope of the LRAS referred to above). Eventually, the real side of the economy, production and income, enters free-fall: negotiating contracts (whether for goods, labor, or credit) becomes the art of divining future inflation and how to compensate for it, since the higher the inflation rate, the greater the penalty for failing to adequately account for it. In other words, transaction costs go up and we all end up spending more time trying to figure out how to work our way around inflation than in being productive. And the poor get harder hit as more of their wealth is kept in assets closer to cash: inflation is a tax on money holders.

So eventually, keeping us above long-term growth is unsustainable and we return to the long-run growth at a higher inflation level. Which, when we add detail to the model, actually means lower long-term growth than otherwise.

And once inflationary expectations settle in, they become little nasty self-fulfilling prophecies. To get rid of them, policy makers need to create recessions until they are beaten down like whack-a-moles through slower growth. A government-induced slowdown like in the early 80s: not nice at all.

The morale of the story: If productivity growth is slower, so is long-term growth; accepting this means letting short-term growth slow down and prices adjust; not doing so means entering a losing fight which would only result in higher inflation and, very possibly, even slower future growth.

UPDATE: Gabriel points out that total factor productivity (TFP) is endogenous and thus not policy-independent. Although I completely agree with him (since I dare call myself an institutional economist, I can't do otherwise!), I don't think this affects my argument unless the expansionary policies implemented to fight the slowdown also increase TFP. While I don't have any particular endogenous-growth model in mind, I don't think that what the Fed or the White House/Congress are doing these days would be among the arguments in one. So with that caveat, I'll still stand behind my post... for now.

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Slowing productivity growth: the AS curve again

This is, admittedly, "old stuff" (a month old when the numbers came out), but I just came across it, bouncing around the blogosphere. And if it truly measures the trend it claims to be measuring, then a month does not make much a difference.

The ultimate source is Robert Gordon, the Northwestern University productivity econ head, but I got it from Michael Mandel's "Economics Unbound", in turn via Mark Thoma's "Economist's View", where I stumbled back after a while after reading something in Megan McArdle's "Asymmetrical Information". (I told you I was bouncing around... sometimes my guilt-prone self makes me think I'm single-handedly responsible for the drop in productivity shown above. Oh, well.)

Slowing productivity slows down the expansion of the aggregate supply curve which, given an aggregate demand now expanding faster in relative terms, leads to price increases and slower GDP growth.

This is just the kind of evidence I was looking for in my earlier post (and, to a lesser degree, this one). The message remains the same: if what lies behind slowing growth (and rising prices) is a slowdown of the AS curve because of slower productivity growth and higher input prices (including credit), then policies aimed at expanding the aggregate demand will soon be fueling inflationary expectations while at best providing temporary GDP-growth relieve.

And if that happens, we will end up with resilient inflation slowing down growth in the longer term and a Fed in need of recessing the economy to lower those pesky expectations.

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Decoupling, The Economist version

You can say you read it here first, almost point by point (you did, didn't you?)... But my, oh my, The Economist says it so much more nicely (and with all those numbers and pretty graphs). In a nutshell: decoupling is not only alive and compatible with globalisation, but is, in fact, an offshoot of globalisation, of its effects on domestic consumption and investment in developing economies, and on the new trade relationships this growth in domestic demand allows between these economies. The part I missed was the one about increasing domestic productivity. Oh, well, thankfully I kept my day job.

It's not just me, now: it's The Economist. I feel in good company!

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More on the tired Aggregate Supply curve

As a total n00b in the blogosphere, it's nice when one finds that the big shots and little-oneself are aligned. A little under a week ago, I typed my thoughts on the slowing of the AS curve, as opposed to AD-based slowdown or even stagflation, and the policy implications of seeing things this way. And today... Samuelson himself writes on The Specter of Stagflation! OMG, I feel like a groupie watching the concert from the backstage.

p.s. Thanks to Greg Mankiw for the pointer!

p.s.2. But seriously, the one point where I'd disagree with Samuelson, at least in emphasis: it seems to me that the current situation is one of an AS curve expanding more slowly than the AD curve. Inflation is not, right now, not yet, strictly speaking a monetary phenomenon, but one driven by rising input costs (directly and via imported goods). We may, in fact, still be in the arena of price shocks rather than inflation itself. It's might seem like picking at straws, but there it is: not all periods of increasing prices are really inflation, but when rising prices get entrenched in expectations, it's inflation alright. So it's from here on when the Fed's policy (specially when combined with an expansionary fiscal policy) can drive these rising prices into inflationary expectations or not. And then it would be a monetary issue, and be stagflationary, and be another case of "the more something changes..."

p.s.3. How do y'all think Bernanke is evolving on this issue? Answer's here. Some interesting (and scary) back-of-the-envelope results by Larry White.

UPDATE (a few hours later): As usual, James Hamilton illuminates the issue... and did so six days ago (he's the one who makes me wish I had studied more time-series metrics). Need more time to keep up with'em blogs!

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Decoupled or Decoupling?

The global impact of the U.S. slowdown indicates that the U.S. economy still exerts influence over the rest of the world, despite predictions that other countries are "decoupling," Johnson said. [Simon Johnson, economic counselor and director of the research department at the IMF.]

All the talk in the recent weeks about decoupling along the lines of "now that decoupling has been proven dead..." is making me think I've missed something. The argument seems to be: markets in the rest of the world are reacting to negative news in the US, so the rest of the world is not immune to US jitters, so there's no decoupling.

Wait: if decoupling meant literally complete detachment, well, then, yes, it's a concept in line with other embarrassments of recent history like "real estate prices can never go down" and "the dot come revolution has changed the laws of (asset pricing) nature." Only true autarky from the US economy would achieve this.

So I was under the impression (misunderstanding?) that this was not a binary issue, rather a question of degree: "decoupling" is a process, "decoupled" is a destination, and we're "decoupling," not "decoupled." On a politically-loaded parallel, it's the difference between "drowning" and "drowned," but let's not go there. It means lower, not zero (nor negative!) correlation.

That's why decoupling can coherently co-exist with globalization (and in fact be spawned by it). Decoupling makes a duh-type of sense (as in "is at least plausible") if taken to mean that the relative importance of the US as a source of net demand for other economies' outputs (or as a financial market accessible to them) has fallen, on average, for countries around the world, both because of the emergence of new regional powerhouses AND because of the expansion of their own domestic markets. (And that's an "if": this statement might, of course, be proven wrong by the data by looking at trade and capital flows at different levels of geographic aggregation.)

In fact, the US could be the most important partner for every other country and decoupling still hold: the US just needs to be less important (on average) than before.

I see it as "Globalization, part II": the US' insatiable appetite for consumption (and debt) allowed other economies to grow; as access to the larger US market allowed them to expand and thus exploit competitive advantages and economies of scale, these economies began to link with each other, to produce for their own and their neighbors' rapidly expanding markets; and now that the US is ailing, they will most certainly slow down their expansion since one (still very important) source of demand for their output is weakened, but not so much as they would have slowed if the domestic and non-US foreign drivers of expenditure hadn't increased in importance.

Instead of thinking in terms of the old saying "if the US catches a cold, the rest of the world catches pneumonia," we should switch to "if the US catches a cold, the rest of the world sneezes and feels rather chilly, but still manages to go to work."

UPDATE (Feb 27th): Here's John Authers, Investment Editor at the FT, pointing out, towards the end of this vlog, that decoupling is alive and well.

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AD vs AS

I'm having an issue with the pro-fiscal stimulus talk: it seems to be based on the assumption that there is insufficient aggregate demand. Here's one example from a source I deeply respect:

In particular, when the economy is particularly weak, the key constraint on short-term economic growth is demand for the goods and services that firms could produce with existing resources. (source)

But insufficient demand cannot be the (main) cause for sluggish growth when combined with rising inflation.

Granted that a (dwindling) minority might want to say "if combined with rising inflation", but the non-inflationary scenario is weakening. Here is a view in favor from the Fed via FT; view in favor from the financial markets (a little old by now, relatively speaking); and yet another view in favor, this from the Economist making the argument that commodity prices are not going to be headed down anytime soon. Then we have the jump in wheat prices, with all the linkages that has (geez, thanks misguided subsidies for corn-based fuels). And I will leave it with the falling US$ and rising costs in China, meaning more expensive imports in the US.

On the other hand, here is a good view against.

I am obviously on the side of the inflationary scenario. Let's accept inflation is a problem. Now, to the basics: in an aggregate supply (AS) and demand (AD) model, a drop in AD lowers both price level and output; a drop in the AS lowers output, but increases the price level. Here's the classic graphical representation of the model. In the long-run equilibrium, the AD and the (short run) AS intersect together and with the Long Run AS (LRAS), which is insensitive to the price level (and assumption to be challenged later). We alternatively contract the AD and the AS and see that it's the second case that mimics what we're observing in the economy:

Of course, it's best to rethink these graphs in dynamic terms and, with a lot of hand waving, substitute inflation for the price level and output growth for the output level. In this case, the curves' positions measure their expansion (the "AD dot" and "AS dot"). I know, there's more to it, but bear with me: the point is that, while both curves may be slowing down, the aggregate supply has to be slowing down more if inflation is rising. Rising input and import prices and the cost of credit will do the trick. Also, rising inflationary expectations would increase expenditure today and reduce supply today, specially if nominal input prices remain constant, because of, say, contracts (buy at a lower relative price today, sell at higher relative price tomorrow).

(Of course, the AD might be contracting too because of fears on unemployment, credit constraints, etc. The point is that the AS must be contracting more.)

The issue is not moot. If the AD is the limiting factor, expand it until it can sustain itself (leaving aside the serious issues of timing and overshooting, and of fiscal deficits). But if it's the AS...

An AD-expanding package like the fiscal stimulus will give a temporary boost to the rate of expansion and then take that boost away. Inflation and growth will be higher for a bit than without it. But what happens next will be a return to long term equilibrium growth in output and, very likely, higher equilibrium inflation. How much higher will depend on what happens with the causes behind the slowing expansion of the AS curve and with inflationary expectations.

In the model above, picture the AS curve moving rightwards (say due to a decrease in nominal input prices, with the price level constant), or the AD curve moving also right (an increase in expenditures at all price levels), or both, until the three curves meet again. Along the way, the price level and output (or inflation and growth) adjust accordingly. In the case of the AS, movements along it up and right are due to a fall in the real prince of inputs (their nominal price remains constant, perhaps due to contracts, and the price level as a whole goes up).

How do we return to equilibrium? If the causes of the contraction of the AS go away before higher inflationary expectations settle in (or if other AS-expanding trends, like productivity growth or an increase in the stocks of inputs, speed up and counteract the contraction), then we are in the happy scenario: we could return to essentially the same long term equilibrium we would have had if the AS curve would have adjusted through unemployment's effect on input prices. So start from the long term equilibrium, AS contraction, now the stimulus (AD expansion, say up to an intersection on the LRAS, and now a well synchronized contraction of the AD as the AS expands so that we slide down the LRAS to the original point. If it can be achieved, we could stay at full employment with only a temporary spike in inflation which would settle down to its original level. Tough, but commendable, the job of economic titans and believers in the efficacy of governments.

But what if what caused the AS slowdown does not go away and higher inflationary expectations settle in? Then the AS does not expand and the AD does not contract back. We end up in a higher inflation equilibrium with the same long term growth as before. And before someone jumps up and says "so what if we have higher inflation, as long as full employment is back?": beyond the inefficiencies inflation brings to the price system (more on that later), keep in mind that movements along the AS curve occur because the real price of inputs is falling as inflation rises faster than wages. That is, in the end, workers are in the same position, real wage-wise, as if the return to long-run equilibrium came about because the expansion of the AS curve due to falling nominal input prices, holding the price level constant. And I say "workers" because, with all others input prices rising, it will be real wages falling disproportionately.

I'll hold on a second to say something in favor of the higher inflation scenario: the return to full employment (via lower real wages, one way or another) is usually faster when it's due to rising price inflation (over wage inflation) than when we wait for nominal wages to fall (or, more realistically, for wages to remain constant given a strictly positive rate of inflation).

But unfortunately, inflation does have a long-run cost. In the long run, perhaps a year from now in this case, workers are likely to end up worse off in the higher inflation scenario. As has been convincingly argued and experienced in high inflation and hyperinflationary environments, the long term AS curve could have a negative slope because inflation reduces the efficiency of the price system. Then we'd end up in a long term equilibrium with higher inflation and somewhat lower growth.

Now, for the full picture: it might be the case that the long term aggregate supply is shifting left (say, due to the end of cheap imported inputs). In that case, efforts to go back to the old growth rate would just be inflationary and unsustainable. Do we need to bite that bullet? I, for one, a natural born pessimist, see us moving into the higher input cost / higher inflationary expectations scenario and, possibly, lower long term growth.

Not a bad scenario to tell the truth, there's still robust growth and lowish inflation... just not as good relative to the last decade or two, in which price-less risk (who, what, how, argh!), cheap imports and inputs, and unlimited demand for US$-assets complemented productivity increases. Even with the same productivity increases, risk-pricing should approach something reasonable now (but I'm prepared to be surprised once again by the capacity of capital markets to live in denial), import/inputs will not help keep inflation down as much, and lower demand for US$-denominated assets might lead to higher interest rates.

A most dismal science.

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