Knowing and Making

I may have more to say about this in the next few weeks, but this New York Times article about industrial policy reminds me of a question I asked on twitter the other day: ...hedge funds and venture capitalists are geared toward investing in financial instruments and software companies. In such endeavors, even modest investments can yield extraordinarily quick and large returns. Financing brick-and-mortar factories, by contrast, is expensive and painstaking and offers far less potential for speedy returns. This might not just be a change in investors' preferences. (Although if they have decided they prefer fast returns over slow ones, I don't know that I'd criticise them for that.) What if something deeper has happened. In the late 1940s and early 50s, macroeconomic trends were fairly clear: Europe was on the verge of a major recovery, and American growth was likely to continue. In conjunction with this, we could predict with some confidence what people would want to ...

Another day, another LSE lecture . This one features David Miles from the Bank of England and is chaired by Charles Goodhart. It's on monetary policy and banking fragility. There are two aspects of this problem that are particularly important. The first is transmission mechanisms – an important aspect of monetary macroeconomics. Simple monetary models highlight that there is a relationship between the amount of money in the economy and the amount of economic output (consumption, investment or both). From this we can infer that printing money may increase GDP. Slightly more sophisticated theories give a causal explanation of how this can happen. The central bank prints money and uses it to buy bonds. More money (and fewer bonds) mean that the price of bonds rises – this is simple supply and demand. The price of bonds is the inverse of the interest rate (that is, if a bond pays £50 per year interest and it costs £1000, interest is 5%. If the bond price goes up to £2000, it sti...

This evening Paul Mason leads a debate for LSE , the Adam Smith Institute  [ Update : I made this assumption based on the debate being listed on the ASI's "Events" page. A BBC editor has kindly emailed me to correct my mistake. Thanks!] and Radio 4 on Keynes versus Hayek. It’s a good day to talk about it, with UK growth figures coming in at a disappointing 0.2% and a lot of uncertainty about whether public sector austerity is slowing economic growth, or conversely enabling more private investment which will improve things in the long term. [ Update 3 August 2011 : The programme will be broadcast this evening at 8pm UK time, and will be available after that from this address ] On Hayek’s side, Jamie Whyte and George Selgin are speaking; for Keynes, Duncan Weldon and Lord Skidelsky. Do come along if you can, though the event is likely to be full so arrive early (5.30 is suggested). If you don’t get in, come to the Old Bank of England pub on Fleet Street afterwards for d...

[ 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...

Paul Krugman in " Bourbon Economics " (and his commenter Peter von zur Muehlen ) complain that we've had new ideas for decades in macroeconomics, but they don't take hold. By 1988, it was already obvious that equilibrium business cycle theory had failed. Shiller had already circulated his devastating demonstration that asset prices were much too volatile to be explained by fundamentals...nothing happened. Real business cycle theory continued to prosper, developing an increasing stranglehold over the professional journals. Behavioral finance stayed on the margins. The equilibrium guys had learned nothing and forgotten nothing... Our problem, in short, isn’t lack of nifty new ideas; it’s the refusal of too many economists to face up to the fact that some of their preferred theories don’t work I sympathise - as an adherent and practitioner of behavioural finance, I could hardly not. But it's too easy to blame this on the establishment for not listening. And really, ...

Rising German bond yields over the week since the Irish bailout have been interpreted ( here  and here ) as an increase in default risk to the German government. But surely there is another "risk" much more likely to explain this increase. And that is the simple risk of inflation. The Irish bailout must make inflation more likely - through one of two routes. One : ECB liquidity support, i.e. lending to Irish and other banks, might not be repaid - which will result in an effective increase in money supply unless the ECB then tightens monetary policy to reduce it, which would be politically quite difficult. The ECB lending is secured on bank assets, but we know that those assets might not be worth 100% of their nominal value. So in the case of a bank default, the ECB has printed a billion euros to buy an asset which repays less than a billion euros of principal. Two : monetary policy may be deliberately loosened, either to help reduce the pressure on sovereign borrower...

Two articles this evening lead me to ask the question: how do we predict GDP growth? Before reading on, why not ask yourself this question: what do you expect next quarter's GDP growth figures to be? How about the next 12 months? And why? I'd be interested to see some of your answers in the comments to this post - please also say which particular GDP figures you're predicting (personally I'm most familiar with the UK and US figures, but would be interested in comments from the eurozone and other regions too)*. I'm not going to test you on the accuracy of your forecasts: I'm more interested in the prediction itself, and your reasoning, than whether it turns out to be right. My prompts for thinking about this are: a paper Roger Farmer sent me this evening, introducing the concept of a belief function  describing what people expect next year's growth and inflation figures to be David Smith's blog excerpt of his Sunday Times column today , in which h...

I've had a go at Allister Heath in this blog before. Looking back , I realise that it was on the same subject as today's post: quantitative easing. As I read his column in City AM today, I wondered: when I disagree with someone this much, and yet he is so sure of himself, should I question my beliefs? So I questioned them, and read the column again, and realised: no, 90% of macroeconomists are right, and Allister Heath is wrong. Heath argues with conviction that the Federal Reserve's "hubris" will cause inflation without helping the economic recovery. It's a version of the Austrian story: the economy must undergo a necessary recalculation, restructuring, reallocation of resources, before a recovery can happen. Stimulus will just paper over the cracks and maintain the distortions in the economy. There are reasonable arguments that this may be true of fiscal stimulus (though on balance, I don't agree with them). But monetary stimulus (including QE) can h...

The 2010 Nobel Prize in Economics has been awarded to Peter Diamond (MIT), Dale Mortensen (NWU) and Christopher Pissarides (LSE). Tyler Cowen has written a good concise summary of each prizewinner's work and contribution (linked above). I promised on twitter earlier today to write a post about the application of their research to the 2008-2010 recession. First I'll mention Diamond's book on behavioural economics , which is one of the respected texts in the field and which I've been meaning to order for a while. Today I finally got around to it. The introduction, available here , gives a very clear and perceptive abstraction of the key contributions of behavioural economics as currently practised. It can be summarised in three departures from the standard model: bounded rationality, bounded willpower and bounded self-interest. He (and co-author Hannu Vartainen) also reference the psychological process of decision-making as an important part of behavioural analys...

From Mario Rizzo's comment on Coordination Problem (an Austrian blog): Keynes...does turn certain virtues (like saving) into vices -- from an economic or consequentialist perspective. What is particularly disturbing is that from a long-run perspective surely saving is a "virtue." But surely it's not. Investment  is a virtue; and saving, usually, is what enables investment. Saving in itself is a neutral act, because one person's savings are another person's debt. In the Keynesian model, attempts to increase saving while investment is falling simply lead to a spiral of shrinking income. It's investment that creates future wealth. According to the savings identity , total savings does equal investment, but that statement is misleading for two reasons: one, because this definition of investment includes inventory (which may be built up involuntarily, and is not especially "virtuous"); and two, because it hides the effects of savings in one peri...

Whenever I see some huge figure for an institution's "losses" I am suspicious. Ireland has now supposedly spent about 55% of its GDP , or €100 billion, to bail out its banks and buy toxic property assets from them. But they haven't created  anything with this money - it hasn't been spent on goods or services. In fact, it's just a transfer. So where is the money now, and has anything of economic value actually been lost? Partly the story is similar to that in the UK - lots of people who had a property and sold it in 2007 have made a ton of money. Many of the people who bought the properties have now handed the properties - and the debt - over to the government. But at average Irish house prices, that €100 billion is about 500,000 houses - and surely that number of people did not exit the housing market (in a population of 4.4 million). Even if they had, the government has certainly not foreclosed on (or acquired) 100% of the relevant mortgages. Beneficiar...

The French MEP and ex-justice minister Rachida Dati has entertained legions of Youtube viewers  with a slip of the tongue - intending to state that "inflation" was close to zero, but instead claiming "fellatio" was close to zero. Fortunately, we hear, the European Central Bank is responding in a timely manner to this problem, with a "moral easing" or ME policy. In contrast to its attitude to inflation, the ECB board - especially its French and Dutch members - are quite concerned about a shortage of fellatio in the economy. They are willing to print as many euros as it takes - and distribute them wherever necessary - to return fellatio to its trend rate. As precedent they have cited Oval Office policy during the Clinton administration. Some economists have claimed that fellatio targeting is not the appropriate measure, and instead the overall level of orgasms in the economy (also known as NGDP, or Number of Groans Derived from Poking) should be the con...

Thank goodness we have economics blogs to explain Ben Bernanke to us. On Wednesday, I read at Scott Sumner's blog that: ...there are lots of simple answers (massive QE...etc.) But...for some reason our monetary authorities don’t see it this way. They view all these ideas as exceedingly risky.... Scott is outraged that the Fed refuses to do more monetary stimulus to reduce unemployment because they are worried about inflation. But it seems that other people live in a different world. On Thursday, I read at FT Alphaville that: The current wisdom appears to be that more quantitative easing (QE) would be a good thing...Bernanke only has one playbook, which he has so far followed almost religiously. The final solution in that playbook involves helicopters and money. So, no, he will not stop printing - it's the only idea he possesses. Alphaville is concerned that the Fed is increasing monetary stimulus to reduce unemployment, and thinks they should worry about inflation. ...

Nick Rowe has come up recently with a couple of nice analogies for monetary policy: the pole balancer and the farmboy . And for those of you not reading the other economics blogs, there's a bit of an uproar right now about Narayana Kocherlakota, president of the Minnesota Federal Reserve, and his claim that long-term  low  interest rates will lead to deflation , when surely every schoolboy knows low rates lead to inflation . I've been trying to work out why Kocherlakota's argument is so intuitively wrong and yet theoretically consistent with standard monetary models. I think I've got it, with a bit of inspiration from Nick, Karl Smith , Andy Harless and Scott Sumner . So here's my contribution to the monetary analogy industry: You're driving a truck, one of those big articulated lorries with a trailer full of goods and services. There are three main variables which determine the truck's acceleration: how much you push the gas pedal (let's call...

A response to Niklas Blanchard's post supporting Scott Sumner 's NGDP level targeting proposal (also posted as a comment on that page). My thoughts on this subject are not complete, but I've been thinking recently about how expectations are formed. I wonder about the following scenario: Let's say the Fed does adopt an NGDP level target with a 5% annual increase, and this becomes accepted as the new orthodoxy. How will future wage negotiations proceed? As an employee, I'd say to management: presumably you are good managers, and you expect to achieve growth in the company's revenues, profits and productivity at least in line with the economy as a whole. (I've yet to meet a manager who'd admit that they are not as good as the national average manager). Therefore, you'd expect your top line revenues to increase by at least 5%, given a fixed amount of labour in your company. What's more, now that the Fed has successfully achieved a 5% NGDP in...

Here's  a little something  on fiscal stimulus. It contains a suggestion I've seen from Tyler Cowen and Scott Sumner, among others: ...while the zero bound does not bind, the Fed might nonetheless be reluctant to engage in the appropriate amount of monetary expansion, and that a fiscal boost is therefore required. A potential response to this is that if the Fed has chosen the unemployment rate with which it is satisfied, it will simply offset any fiscal measures to push unemployment below that level. That's only true if the Fed is assumed to be a simple (rational?) agent acting with just one lever: controlling the money supply in order to choose a balance between inflation and unemployment. However, it's very plausible that the Fed is  not  happy about the current unemployment rate, and recognises that it could and perhaps should increase inflation (or NGDP) to fight it. But it is  also  worried about its long-term credibility (as Ben Bernanke indicates i...

In case you were worried, I have not been intimidated by Kartik Athreya's " Economics is Hard " into closing down my blog. I've just been so busy doing stuff and going to things that I haven't had time to write any of it up. Soon, though. Tomorrow, I hope. Meanwhile, a couple of thoughts here and in the next posting: There's an interesting discussion on nominal wage stickiness  between Scott Sumner and Bryan Caplan. Scott, as usual, has some good insights into the question: are sticky wages the primary cause of recessions? To save you reading it all, the answer is yes. This debate exposes a question of economic modelling which I've considered recently. Is the individual transaction the best level to model economic exchange? As a rational agent with no mental processing costs, it is more economically efficient to treat each single exchange as a new decision and re-optimise your choices. But it's not very realistic. Agents who require time to...

Some news has been creeping in which gives us a picture of the British economy that's gradually becoming clearer. First, from the ONS via David Smith : Business investment for the first quarter of 2010 is estimated to be 6.0 per cent higher than the previous quarter. From the same source, some news on public borrowing: ...in December, the Treasury preducted public sector net borrowing for 2009-10 of £178 billion on the definition it uses. The latest figures from the Office for National Statistics show a downward revision to the outturn, taking it to £156 billion...At one time people were predicting figures as high as £220 billion. Recent growth estimates are decent (though not outstanding) too: Gross Domestic Product (GDP) increased 0.2 per cent in the first quarter of 2010, compared with an increase of 0.4 per cent in the previous quarter. There was a concern prior to the release that growth might be negative, due to heavy snow in January and February. So growth of 0.2%, thou...

The Conservatives apparently think a " new economic model " is needed to restore the strength of the British economy. I wonder what they mean. I assume they aren't talking about a model in the way an economist would think of it: a simplified representation of the operations of the economy. Probably they mean "we need to run the economy in a different way". This is how businesses use the word "model" when they talk about choosing a business model, or a revenue model. So maybe he just wants to use a different set of rules for taxes, employment or general economic incentives. This speech  gives some clues - it's tricky to read through the rhetoric to find any common underlying model, but what he seems to want is to set three "priorities" for government economic policy. But taking him literally reveals a more interesting way to think about the question. What if he really does want to change the descriptive model that we use to think abo...

This quite clever proposal from Cavallo and Cottani sounds plausible at first but my immediate reaction is: how can it work? The idea is to eliminate payroll taxes in Greece and instead raise VAT to 25%. This is meant to increase competitiveness while reducing distortions in the economy. It feels like a magic solution - which naturally makes me suspicious. If the economy really needs a devaluation, then how can they miraculously solve the problems without one? But then I realise that magic really can happen . A devaluation is only a nominal change - it simply breaks people's money illusion and affects relative prices. In fact, a devaluation requires no real actions at all, although it does change the pattern of of future real demand. All the benefits of a devaluation can, in principle, be achieved through the coordinated individual choices of all the agents in the economy. Of course such coordinated choices are highly implausible, which is why devaluation is a good short...