Knowing and Making

[ Apologies to X-Factor fans: this article is about "one direction" towards a new model of macroeconomics, not about the band. But do feel free to stick around and join in the discussion. ] If you read nothing but Rajiv Sethi 's and Interfluidity 's blogs, and developed all the consequences of what they said, you'd get a spectacular career in economic research out of it. Fortunately, Mark Thoma reads them - as well as hundreds of others - and has a good commentary on a recent post of Rajiv's . I won't quote the whole thing, but here is the key message. Without the assumption of a representative agent - the idea that everyone in the economy behaves identically - current macroeconomic models can't work. But this assumption misses some of the key dynamics in the economy - the fact that some people borrow and others save; the fact that different people have different beliefs and preferences - which are fundamental to both why and how economic activity...

Turns out quantitative easing is  deflationary - at least the Federal Reserve thinks so. Today the Fed announced that the interest and capital repayments from the bonds it bought last year will not be retired from the system (which would reduce the money supply). Instead, they will use them to buy new Treasury bonds. Via Mark Thoma: ...the Fed will keep “securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities” Now I hate to say I told you so, but I told you so ... There is, however, a point more important than my self-satisfaction: whether this policy will work. Unfortunately this policy adjustment appears to reveal a basic uncertainty in the Fed's goals. By making ad hoc adjustments like this, the Fed keeps the rest of us off balance - we don't know what it will do next because its signals are too vague. In some cases this kind of policy is desirable - regulators and...

Notes and some videos on what sounds like a brilliant course at Edge last year on behavioural economics, with Thaler, Kahneman and Mullainathan as speakers - and just look at the attendees! Thoughts from Felix Salmon (also click through to the more detailed Wine Economics article he references) about one of my favourite subjects: how cognitive biases influence our willingness-to-pay for wine. Useful comments from Charles Goodhart in the FT about the money multiplier - I suggest you read this as preparation for an article I'm writing on self-fulfilling expectations and the money supply. Mark Thoma's link  to  Paul de Grauwe's paper , " Top-down versus bottom-up macroeconomics " [PDF] which says some powerful things about limitations on knowledge and the consequences for rational expectations theory. And Steve Randy Waldman's Interfluidity blog has moved - updated link in the right-hand column and here .

A commenter on Robert Peston's latest article asks: why can't we just treat banks and building societies like normal businesses? And Mark Thoma also links to a similar question from Joseph Stiglitz: are the banks too big to restructure ? First an answer to Robert's commenter: The most obvious difference between a bank or building society and a normal business is that the government guarantees the deposits of a bank. If this didn't happen, the depositors would be creditors like any other. But the other distinction, which I'll come to in a few paragraphs, is that banks are much more closely embedded in the operation of the rest of the economy than most other companies. If they were to be treated as a normal business, then the liquidators would come in and start to sell off their mortgage book (probably at a discount) and the creditors (bondholders, depositors and suppliers) would have to queue up to get back whatever they could from the proceeds. If there was anythin...

Mark Thoma reports Robert Shiller's article on the psychology of the asset bubble and bust , and asks " how to implement this forecasting technique - one based upon a theory of the mind ". I have been working in this area for some time and can suggest the following as a possible framework. I don't know if Shiller has something like this in mind - I suspect not - but I do think it will be a step in the direction that he calls for. Note that this is not yet a fully developed model, but a proposal for how such a model might look. While standard economic theory deals with a set of goods , I propose instead that there are a set of concepts  in the world. We can imagine some of these as corresponding directly to traditional goods - for example the concept of a loaf of bread  or an economics PhD . These concepts are mental constructs and not physical ones; they represent the relationship of a person in this model to the ideas  of bread or PhDs. Next, let us define concepts w...

I don't often do link lists but they seem to be quite the thing for bloggers. Here's one: Tim Harford's article in Forbes about what credit does to our brains . A clear and simple model showing one way to think about toxic bank assets from Mark Thoma The US is following the UK again: the administration has a plan to improve small business access to credit, just like Alistair Darling; a guest post on Econbrowser  has some interesting microeconomic analysis of the rationale. Nick Rowe is always good value: here is a discussion of how liquidity can be factored into the value of a financial (or other) asset. A very nice summary (PDF) from Tyler Cowen of different definitions of rationality used in economics (somewhat technical, so you'll need a bit of economics vocabulary, but not much mathematics) That will do for now. Given the results of this week's zeitgeist, perhaps I should include something about AIG. But I find it difficult to care.

I've had an article published today in VoxEU: Models of bounded rationality and the credit environment : Responses to the recession should not be based on unrealistic expectations of rational behaviour. We now know enough about real, flawed human psychology to be able to take some account of it in policy setting. Mark Thoma has linked to it and there are some interesting responses in the comments to his posting.

Greg Mankiw is not in favour of a "Buy American" clause in the expected US fiscal stimulus package. I don't like protectionist rules myself, and normally you wouldn't find many economists arguing for them. But I have a feeling now that we might see support among some economists for variations of this "Buy American" rule. For example, a condition that spending can go only to countries that have also passed a major fiscal stimulus package. This might just come from people feeling peeved at Germany. It might come from instinctive protectionists finding a respectable way to get their point across. It might come from strong Keynesians who are worried about the damage to the fiscal multiplier from propensity-to-import. It may be unfair to him, but I predict that Paul Krugman may be a flagbearer for this argument. He has just won a Nobel Prize for his New Trade Theory work, which argued (among other things) that some protectionist policies might be justified if th...

If you have time, try reading not only this post from Mark Thoma at Economist's View , but all the comments below it. It's rare for a blog to have so many comments and of such consistent high quality. They genuinely add a major contribution to the discussion, and hardly any of them are sniping at each other.