The first half of this
post is meant for non-economists, but it ends with a couple of points on OLG
modelling
I recently wrote a post on the Eggertsson and Mehrotra paper on secular stagnation, because I thought the
paper was interesting. A much more critical post from Unlearning Economics (UE) has just
appeared in Pieria. UE says it “helps to illustrate the
troubles faced by contemporary macroeconomics”. One of UE’s complaints seems to
reflect a misunderstanding, often shared by non-economists, about what much
academic macromodelling is designed to do.
UE objects to the fact that the model assumes that the amount
the young can borrow (the degree of leverage) is exogenous, which means that
there is no attempt to explain where this constraint on the borrowing of the
young comes from. UE also complains that the model contains no banks, and no
investment in physical capital. In other words, the model is much too simple.
It is a natural enough idea: to explain what might be currently going on, you
need a more complex model that includes everything that could be important.
There is certainly a place for this kind of more elaborate
model. Christiano,
Eichenbaum and Trabandt in
this
paper want to argue that a model based on New Keynesian theory can
track what has happened over the last ten years. Their model has 40 equations.
If I was trying to do a similar exercise, I would want to augment the standard
New Keynesian framework with at least the following: nominal wage stickiness as
well as price stickiness, a financial sector that endogenised both the cost and
rationing of credit, a model of consumption which allowed for credit constraints and precautionary
saving, a housing market, a model of the labour market that combined matching with rationing (as here), and something that allowed recessions
to have long lasting (hysteretic) impacts on labour supply and technical
progress. However large models like this will involve many macroeconomic
‘mechanisms’, and it will generally be unclear which mechanisms are important
at driving particular results or explaining particular facts. We do not want to
treat the elaborate model as a black box, but instead we want to understand its
properties.
To understand complex models, we need much simpler models. (I
once - in this paper - called the process of relating complex
models to simpler models ‘theoretical deconstruction’.) In fact it is often
sensible to start with the simpler model. For example, a particular issue with
secular stagnation is to show how the natural real interest rate can be
negative for decades rather than years (i.e. beyond the Keynesian short term)?
What mechanism can do this? As I explained in my post, neither a standard
representative agent model nor a standard two period overlapping generations
model (OLG model, where the two generations are those
earning and those retired) will give you that result. What Eggertsson and
Mehrotra show is that a very simple three period OLG model (which adds a young
generation that borrows) where borrowing by the young is constrained (they
would like to borrow more but cannot) can provide just that mechanism.
That is a key point of the paper. The paper is not designed to
explain where borrowing constraints come from: there is now a big literature on
that. Thankfully the authors do not feel compelled to microfound these
constraints. Instead the paper simply offers and explores a mechanism whereby
an increase in these borrowing constraints could move the natural interest rate
into negative territory, and for it to stay there. Having established that
result, it is for subsequent work (which the authors intend to do) to see if
that mechanism survives complicating the model, by for example adding
investment.
Suppose the endeavour is successful, and a more complex but
realistic model is able to provide an account of secular stagnation that
includes other important mechanisms and which is based on a realistic set of
parameter values. That would be a success, but those not familiar with all the
work would ask: why does this model allow real interest rates to be negative
when the standard models we know do not. The reply would be that the three
period OLG structure was critical, and to see why have a look at the original, simple
model.
Now you might say the authors should wait until they have built
the more realistic model before creating what could turn out to be a research
path that might fail to achieve its goal. That would be quite wrong, because
the more debate there is within the academic community when ideas are at their
early stages the better. I want to give an example of this, but here I will go
into territory that will probably only interest macroeconomists.
It might be the case, for example, that the authors intuition
that their results will survive introducing other assets like physical capital
can be shown to be wrong very quickly. Indeed, Nick Rowe has already made such
a claim, arguing that the presence of land as an asset
ensures a positive real interest rate. If Nick was right this could be enough
to kill the research programme, without any more time being wasted. Whether he
is right is another matter: this paper by Rhee may be relevant in that respect.
Here I just want to add a final thought. Within an OLG
framework, it may not be necessary to establish the existence of a steady state
with negative real interest rates. The typical period in an OLG model lasts two
or more decades. So if the dynamics of such a model involved some overshooting,
it might be possible to generate prolonged periods (in years) of negative
interest rates even if the steady state real interest rate was positive. To be
honest I’m not sure what might give rise to overshooting of this kind, but that
may just reflect my inadequate imagination.
