Some notes on macro modelling

             This post is prompted by this post by Robert Waldmann, and this by Noah Smith, commenting on an earlier post by Wieland and Wolters. 

1) Forecasting and policy analysis

Noah repeats what is a standard line, which is that microfounded models are for policy analysis and not forecasting, and for forecasting “we don't need the structural [microfounded] models, and might as well toss them out”. The reason he gives is policy invariance: microfounded models address the Lucas critique.

While the Lucas critique is important, it is not in my view the reason we have microfounded models. The need for internal consistency drives the microfoundations project. Often internal consistency and addressing the Lucas critique go together, but not always. The clearest example is Woodford’s derivation of a quadratic social welfare function from agents’ utility. This is not needed to address the Lucas critique, but it is required for an internally consistent analysis of what a benevolent policy maker should do.

Why is internal consistency important? Because we think that agents in the real world are internally consistent, so models that are not can make mistakes. They can make mistakes in forecasting as well as policy analysis.

However, in an effort to achieve internal consistency, we may well ignore important features of the real world. ‘Ad hoc’ models that capture these features may be better models, and give better policy advice, even though they are potentially internally inconsistent.

So microfounded models could be better at forecasting, and ‘ad hoc’ models could give better policy advice. In that sense I think Noah is repeating a common misperception.

2) On a pedantic point, there is a long tradition of comparing different macromodels, both for forecasting and policy analysis, so Wieland and Wolters is hardly a first step. In the UK for 16 years we had an excellent research centre that did just that, run by Ken Wallis. There is a wealth of expertise there, which anyone doing this kind of comparative analysis needs to tap.

3)  Just in case anyone reading Robert’s post gets the wrong impression, the idea of the core/periphery structure for the Bank of England’s model came from economists at the Bank (strongly influenced by the antecedents from other central banks that I mentioned in my post), and not me. My role was mainly to give advice on theoretical aspects of the model to a very competent team who needed little of it. However Robert and Noah are wrong to suggest that because the Bank uses the core/periphery structure for forecasting, there is no point in having the microfounded core. For example, you can do policy analysis with both the complete model and just the core.

4) This final comment is just for those who read Robert’s post, and is very pedantic. Robert starts off by saying “As far as I can tell, Simon Wren-Lewis has been convinced by Paul Krugman”. The first point is that all my posts on this issue have come from a consistent view. I think microfoundations modelling is an important thing to do, but I do not think it is the only valid way of modelling the economy and doing policy analysis. I think Paul Krugman and I are on absolutely the same page here, and always have been. Robert is however right that my aim has been to convince those doing microfounded modelling of this point.

I’ve disagreed with Paul Krugman (and Robert) on the empirical success of the microfoundations approach, and I still disagree. But given that we agree that analysing microfounded models is useful, I don’t think this is terribly important. I picked up on the ‘mistaking beauty for truth’ phrase, because – taken literally – I don’t think that this is a problematic force behind the way the microfoundations project progresses. All scientists like simplicity, and they also get complicated when they need to, and DSGE models do the same. What I think is problematic is the weak role played by external consistency that I illustrated here, and the role of ideology. On the latter I think I’m once again on the same page as Paul Krugman. 

Microfoundations and Evidence (1): the street light problem

                One way or reading the microfoundations debate is as a clash between ‘high theory’ and ‘practical policy’. Greg Mankiw in a well known paper talks about scientists and engineers. Thomas Mayer in his book Truth versus Precision in Economics (1993) distinguishes between ‘formalist’ and ‘empirical science’. Similar ideas are perhaps behind my discussion of microfoundations and central bank models, and Mark Thoma’s discussion here.

                In these accounts, ‘high theory’ is potentially autonomous. The problem focused on is that this theory has not yet produced the goods as far as policy is concerned, and asks what economists who advise policy makers should do in the meantime. But the presumption is generally that theory will get there as soon as it can. But will it do so of its own accord? Is it the case that academics are quite good at selecting what the important puzzles are, or do they need others more connected to the data to help them?

                There is a longstanding worry that some puzzles are selected because they are relatively easy to solve, and not because they are important. Like the proverbial person looking under the street light for their keys that they lost somewhere less well lit. This is the subject of this post. A later post will look at another concern, which is that there may be an ideological element in puzzle selection. In both cases these biases in puzzle selection can persist because the discipline exerted by external consistency is weak.

The example that reminded me about this came from this graph.

US Savings Rate

The role of the savings rate in contributing to the Great Recession in the US and elsewhere has been widely discussed. Some authors have speculated on the role that credit conditions might have played in this e.g. Eggertsson and Krugman here, or Hall here. But what about the steady fall in savings from the early 1980s until the recession?

                Given the importance of consumption in macroeconomics, you would imagine there would be a huge literature, both empirical and theoretical, on this. Whatever this literature concluded, you would also imagine that the key policy making institutions would incorporate the results of this research in their models. Finally you might expect any academic papers that used a consumption model which completely failed to address this trend might be treated with some scepticism. OK, maybe I’m overdoing it a bit, but you get the idea. (There has of course been academic work on trying to explain the chart above: a nice summary by Guidolin and Jeunesse is here. My claim that this literature is not as large as it should be is of course difficult to judge, let alone verify, but I’ll make it nonetheless.)

                It would be particularly ironic if it turned out that credit conditions were responsible for both the downward trend and its reversal in the Great Recession. However that is exactly the claim made in two recent papers, by Carroll et al here and Aron et al (published in Review of Income and Wealth (2011), earlier version here), with the later looking at the UK and Japan as well as the US. Now if you think this is obvious nonsense, and there is an alternative and well understood explanation for these trends, then you can stop reading now. But otherwise, suppose these authors are right, why has it taken so long for this to be discovered, let alone be incorporated into mainstream macromodels?

                Well in the discovery sense it has not. John Muellbauer and Anthony Murphy have been exploring these ideas ever since the UK consumption boom of the late 1980s. As I explained in an earlier post, there was another explanation for this boom besides credit conditions that was more consistent with the standard intertemporal model, but the evidence for this was hardly compelling. The problem might be not so much evidence, as the difficulty in incorporating credit effects of this kind into standard DSGE models. Even writing down a tractable microfounded consumption function that incorporates these effects is difficult, although Carroll et al do present one. Incorporating it into a DSGE model would require endogenising credit conditions by modelling the banking sector, leverage etc . This is something that is now beginning to happen largely as a result of the Great Recession, but before that it was hardly a major area of research.

                So here is my concern. The behaviour of savings in the US, UK and elsewhere has represented a major ‘puzzle’ for at least two decades, but it has not been a major focus of academic research. The key reason for that has been the difficulty of modelling an obvious answer to the puzzle in terms of the microfoundations approach. John Muellbauer makes a similar claim in this paper. To quote: “While DSGE models are useful research tools for developing analytical insights, the highly simplified assumptions needed to obtain tractable general equilibrium solutions often undermine their usefulness. As we have seen, the data violate key assumptions made in these models, and the match to institutional realities, at both micro and macro levels, is often very poor.”

                I do think microfoundations methodology is progressive. The concern is that, as a project, it may tend to progress in directions of least resistance rather than in the areas that really matter – until perhaps a crisis occurs. This is not really mistaking beauty for truth: there are plenty of rather ugly DSGE macro papers out there, one or two of which I have helped write. It is about how puzzles are chosen. When a new PhD student comes to me with an idea, I will of course ask myself is this interesting and important, but my concern will also be whether the student is taking on something where they can get a clear and publishable result in the time available.

When I described the Bank of England’s macromodel BEQM, I talked about the microfounded core, and the periphery equations that helped fit the data better. If all macroeconomists worked for the Bank of England, then that construct contains a mechanism that could overcome this problem. The forecasters and policy analysts would know from their periphery equations where the priority work needed to be done, and this would set the agenda for those working on microfounded theory.

                In the real world the incentive for most academics is to get publications, often within a limited time frame. When the focus of macroeconomic analysis is on internal consistency rather than external consistency, then it is unclear whether this incentive mechanism is socially optimal. If it is not, then one solution is for all macroeconomists to work for central banks! A more realistic alternative might be to reprise within academic macroeconomics a modelling tradition which placed more emphasis on external consistency and less on internal consistency, to work alongside the microfoundations approach. (Justin Fox makes a similar point in relation to financial modelling.)     

The Financial Market as a Vengeful God

                Reading this Jonathan Portes post, I recalled a point in my undergraduate lectures where I have a little fun at the expense of economic pundits from the City. After explaining Uncovered Interest Parity (if you do not know what UIP is, it does not matter), I tell them that they can now immediately comment on how the foreign exchange market reacts to an increase in interest rates, whatever happens to the exchange rate. If the exchange rate appreciates, that is because domestic assets are more attractive. If the exchange rate does not change, that is because the interest rate increase was already discounted. If the exchange rate depreciates, well the markets were expecting a larger increase.

                This is meant to make a serious point about the difficulties in testing UIP, but if I’m feeling mischievous I then point out that city pundits always seem to know with certainty why the markets have moved this way or that. Now in goods markets, firms pay market researchers serious money to find out why consumers are or are not buying their products, but in the financial markets this appears unnecessary. Despite market moves being made by thousands of trades and by thousands of people, the motivation for these trades appears clear. It is as if each trade is accompanied by the trader completing the following sentence: ‘I bought/sold this currency today because ....’. The truth, I reveal to my stunned audience, is that these pundits are just guessing based on no evidence whatsoever.

                Of course city pundits have no reason to be honest. When asked ‘why has the dollar appreciated’, I would like them to reply ‘well no one really knows, but one possible factor might be...’. They never do. If I wanted to be unkind, I might suggest that these pundits want to appear like high priests, with a unique ability to understand the mysterious mind of the market. As high priests have discovered over and over again, if you can convince people that you have a direct line to an otherwise mysterious but powerful deity, you can do rather well for yourself. And sometimes financial markets can appear a bit like vengeful gods, capable of sudden acts of destructive anger that appear to come from nowhere.

                If I wanted to ratchet up the unkindness I could go on as follows. It is in the priest’s interest to tell the faithful that the god is indeed quite fickle in its mood, and while placid at the moment, it could turn nasty at the slightest provocation. Keep those offerings coming, to make sure that the god stays happy (and don’t think about where those offerings go). If you are particularly generous, the priest will promise to give you the heads up if any changes in mood are imminent. If you cannot be a priest yourself, you can always set up as an advisor (HT DeLong), who will tell people which priests have a better line to the financial market god. 

                OK, this is a bit silly, but sometimes listening to policymakers you wonder whether they think this way. (Perhaps because they talk to the wrong people – see Jonathan again here.) For ‘confidence’, read the mood of the financial market god, or even the many gods of the economy as a whole. For offerings and sacrifices, read austerity. Muti and Padoan tell us “the Eurozone is still in a situation in which multiple equilibria can materialise”. They go on “In a situation of multiple equilibria, where confidence plays a crucial role, the distinction between short-term and long-term measures (suggesting the possibility of postponing action) is misleading and could be possibly dangerous. Short-term measures that weaken confidence would push the medium-term dynamics towards a bad equilibrium.”

                I assume this is about austerity. Here the game for many Eurozone countries is to demonstrate that they are not like Greece. I think that in this game there may be an advantage in front-loading austerity to demonstrate the ability and intension to avoid default, although I think Brad DeLong disagrees. However, as my very first post said, this need not be about appeasing a market god but instead the very human ECB. If deficit reduction programmes are reasonable and are implemented (in cyclically adjusted terms, without moving the potential output goalposts every time output falls), the ECB should ensure interest rates on debt are low enough to make those programmes sustainable.

                Having just gone through a recession largely caused by excessive over confidence in the financial markets about the ability to manage risks, it is natural to think everything is down to confidence. (The word appears eight times in Muti and Padoan’s article.) However in most situations I think markets and economies react in straightforward and understandable ways. The importance of confidence can be overdone, as it is often a symptom rather than a prime cause. To treat financial markets or the economy as a whole as always behaving like a vengeful god whose mood and confidence can ebb and flow at the slightest provocation is not the way to make good policy.

                Jonathan’s post also quotes Shakespeare, so how about this from Julius Caesar

Men at some time are masters of their fates;

The fault, dear Brutus, is not in our stars,

But in ourselves, that we are underlings.

On successful fiscal consolidations

In a recent Vox piece, Alesina and Giavazzi argue that “adjustments achieved through spending cuts are less recessionary than those achieved through tax increases”. At first sight this seems to contradict basic macroeconomics. As I and others have pointed out on many occasions, the impact of cuts in government spending on goods and services are passed straight through to demand, while the income effect of temporary increases in tax will be smoothed by consumers. That is why balanced budget but temporary cuts in government spending are deflationary.

However, what we may have here is just another example of failing to condition on monetary policy. One of the most comprehensive studies of this issue, discussed by Alesina and Giavazzi, is contained in an IMF report, which uses a ‘narrative’ approach to identifying episodes of fiscal consolidation. (This approach was applied to monetary policy by Romer and Romer here: the detailed catalogue of fiscal events is in this IMF working paper. See Jeremie Cohen-Setton (Bruegel) for more on this.) As Alesina and Giavazzi are a little unfair in the way they characterise this report, I will quote extracts from its first four conclusions.

1)    “Fiscal consolidation typically has a contractionary effect on output. A fiscal consolidation equal to 1 percent of GDP typically reduces GDP by about 0.5 percent within two years and raises the unemployment rate by about 0.3 percentage point.”

2)    “Reductions in interest rates usually support output during episodes of fiscal consolidation”

3)    “A decline in the real value of the domestic currency typically plays an important cushioning role by spurring net exports and is usually due to nominal depreciation or currency devaluation.”

4)    “Fiscal contraction that relies on spending cuts tends to have smaller contractionary effects than tax-based adjustments. This is partly because central banks usually provide substantially more stimulus following a spending-based contraction than following a tax-based contraction. Monetary stimulus is particularly weak following indirect tax hikes (such as the value-added tax, VAT) that raise prices.”

The reaction of monetary policy is crucial here. As the report makes clear, if interest rates cannot fall to offset the impact of fiscal consolidation, or if currencies cannot depreciate because everyone is implementing austerity, the deflationary impact will be much greater.

            To quote Alesina and Giavazzi, the report’s authors “agree that spending-based adjustments are indeed those that work – but not because of their composition, rather because almost ‘by chance’ spending-based adjustments are accompanied by reductions in long-term interest rates, or a stabilisation of the exchange rate, the stock market, or all of the above.” That is unfair. As the quotes above show, and any reasonable reading of the whole report confirms, the impact of consolidation is directly linked to the way monetary policy works. Perhaps the crime committed by the IMF report is that it didn’t stress enough the effects of taxes on the confidence of entrepreneurs that Alesina and Giavazzi seem to think is central.

            Point (4) does indeed imply that cutting spending is less contractionary than raising taxes, but again the reaction of monetary policy is crucial. If, as is suggested, monetary policy does not reduce interest rates following tax increases because of the impact of taxes on prices, then it is monetary policy that is leading to the difference in the impact of spending and taxes.

            There is another interesting, if tentative, result from this analysis. Government spending here includes transfers as well as consumption and investment. The report finds that cutting transfers is mildly expansionary, while the costs of cutting consumption or investment are greater, although they do caution about small sample sizes. As cuts in transfers can be smoothed, this fits with basic theory. Alternatively, it may be that cutting transfers is signalling some kind of intent, which may in turn encourage the monetary authority to ease monetary policy more.

            The reason for stressing the role of monetary policy in all these findings should be obvious. At the zero lower bound, monetary policy cannot compensate in the normal way for the deflationary impact of fiscal consolidation. We cannot use evidence from the past when monetary policy was not so constrained to tell us what will happen today. This is well known for austerity in general, but it applies equally to the composition of fiscal consolidation.

           

Framing fiscal stimulus arguments

                It struck me reading DeLong and Summers that Keynesians like myself often inadvertently provoke opposition. When we discuss temporary increases in government spending, we typically assume it is debt financed. Furthermore, as the interest on higher debt has to be paid for, we generally assume taxes increase to do that. So even though our increase in government spending is temporary, both taxes and debt end up being permanently higher. At a rather basic and non-intellectual level, I think this puts many people off from the start.

                Instead we could start with a temporary balanced budget increase in spending. That way neither taxes nor debt are higher in the long run. In addition, for anyone who has done their post graduate training in the last twenty years that is the natural way to start thinking about what is going on. Or if we want to avoid tax increases altogether, why not finance any increase in debt by reducing government spending rather than raising taxes? If raising debt in the long run is a problem (and I think there are good reasons why it might be), then why not use lower government spending after the stimulus not just to pay the interest on debt, but to pay off all the additional debt incurred by the stimulus. When you think about all these possibilities, the standard choice of debt finance paid for by permanently higher taxes is really the least likely to win friends.

                Now you could say that Keynesians do this because this policy choice is the most effective form of stimulus. In that case, why do we nearly always choose an increase in government consumption, rather than public investment? Additional public investment will have some positive impact on the supply of output, which will raise future taxes in much the same way as the hysteresis effects that DeLong and Summers analyse.

                So if I was trying to convince John Cochrane (or less ambitiously Tyler Cowen) of the efficacy of fiscal stimulus, how would I do it? I think I would use a two period model. The first period is Keynesian with interest rates stuck at the zero lower bound, and is the period in which we undertake a debt financed increase in government spending. The second period is classical, but where supply is influenced either by the additional infrastructure investment in period 1, or by hysteresis effects. All debt is paid off by the end of period 2 through lower government spending, but lower government spending does not influence output because this period is classical. (We could add a final third period which is the steady state and is uninfluenced by anything that happens in periods 1 and 2, just to show that we do not believe hysteresis or infrastructure effects last forever.)

                So what is there not to like about this policy? Output is higher in period 1 because demand is higher, and is higher in period 2 because supply is higher on average. There is no long run increase in debt. There is no increase in tax rates at any point. As period 2 is probably longer than period 1, we even have more time in which government spending is reduced rather than increased relative to base. However  because output and therefore tax receipts are higher in both periods, the reduction in government spending required to pay off the debt might not need to be that large: this is how the DeLong and Summers argument would be translated in this set-up. The framework focuses on the essential reason why stimulus works. We shift demand into a period in which it matters - because monetary policy is ineffective at the zero lower bound in period 1 - and out of a period in which it does not - because monetary policy works in period 2.  

The Falklands War: a simple cost benefit analysis

                It is the 30^th anniversary of Argentina’s attack on the Falklands islands. I was against the UK responding with a counter invasion. The key justification for taking the islands back by force was that the people there wanted to live under British rather than Argentinean rule. The population at the time was about 1,800. Nearly 900 soldiers lost their lives in that conflict. The financial cost for the UK was estimated at around $2 billion. 

                My argument at the time was very simple. The order of magnitude of the financial cost was pretty well known in advance.The UK government could have offered each islander $1 million dollars, either as compensation for living under Argentinean rule, or for being relocated in some part of the UK. (The Highlands of Scotland is pretty empty and would be the closest substitute.) The financial cost to the government would be the same, but no lives would be lost.

                There were various counterarguments to this ‘crude’ utilitarian reasoning. One was that, if the UK had not attempted to fight, this would set a precedent which would encourage other dictators to use force in a similar manner. All that was demonstrated, of course, was that the UK was prepared to fight to protect one of its dependencies, against another side it thought it could beat. I do not think the Falklands war has really stopped Spain invading Gibraltar. Another argument was that the UK had a moral duty to protect its citizens. Strangely, this moral duty seemed not to apply to the similar number of residents of Diego Garcia some 10 years earlier, who were removed by the British from their homes to make way for a US airbase.

                Unfortunately I think the actual decision to fight back had little to do with principles. The moment Mrs Thatcher was told she could win, it would have been too humiliating for her government not to go to war. What I find much more depressing is that the war was hugely popular in the UK. National honor was at stake. Just before hostilities began, an opinion poll had only 18% of people saying that the UK government had been too willing to use force. Tellingly, however, only 14% of those polled were prepared to sacrifice more than 100 UK servicemen’s lives to regain the islands. 

                The conflict had huge consequences for both countries. It helped keep Mrs Thatcher in power for another decade, but it was fatal for the Argentine junta.  The ‘Falklands factor’ may have encouraged Tony Blair’s military interventionism. This, together with a feeling of gratitude to the US for their intelligence support during the conflict, may have played a part when it came to UK involvement in Iraq. Any ex post cost benefit analysis is hugely complicated and uncertain, but I still think my ex ante crude utilitarian view is compelling.

                The UK declared war three days before my wife and I were due to fly to Peru for a month long holiday. We went as planned, despite knowing that Peru would be very supportive of Argentina. In the first three weeks the Peruvians we talked to regarded the whole thing with bemused curiosity, and there was no ill feeling towards us. The atmosphere changed a bit just before we left after the General Belgrano was sunk. Lives were being lost as two countries attempted to salvage their national pride.                

                 

Happiness and Paternalism

                Although I clearly do not agree with current UK macroeconomic policy, I did note at the end of a recent post that the government had taken the positive step of collecting more data on happiness. (It also deserves considerable credit for setting up the Office for Budget Responsibility, which it predecessor did not have the courage to do.) So I was interested to see a recent broadside from the Institute of Economic Affairs attacking this decision, and the whole happiness project more generally.

                Their collection of essays is slightly schizophrenic. It includes papers that try and show happiness is unrelated to equality, or employment protection legislation, and is negatively related to government consumption. However other papers and the introduction also argue that happiness data is an unreliable guide to wellbeing, and that the government should not use happiness data to promote wellbeing explicitly. What is the underlying problem? Why put so much effort into criticising a few extra questions in a survey?

                This is a question that the New Economics Foundation asks in a refreshingly restrained response to the IEA document. The answer they suggest is that the IEA, and many of its contributors, have a fear that happiness data will be used by governments to do things government thinks will make people happier, rather than allowing individuals themselves to decide what makes them happy. 

                I am sometimes asked by students whether economics as a discipline has an ideological bias. What they often have in mind is the role of markets. My response, which I think is reasonable, is that once you get beyond the welfare theorems in Econ 101, what most economists spend their time doing is analysing market imperfections. So if you want to know what is wrong with markets, ask an economist.

                However I think most economists do share one philosophical characteristic, and that is a deep distrust of paternalism.  This is something I share – by and large, if it does not adversely affect other people, individuals should be allowed to make their own choices. But the by and large here is crucial. Sometimes individuals do make choices which are clearly bad for them.

                This was cogently argued by Richard Thaler and Cass Sunstein in a short paper provocatively entitled ‘Libertarian Paternalism’ (American Economic Review, 2003, Vol. 93, pp. 175-9). A great deal of behavioural economics is all about departures from rationality, and these in turn can lead to people making choices that are not optimal. Thaler and Sunstein point out that sometimes government cannot avoid making decisions that influence choices. An example they give is enrolment in employment based savings plans. Should people be given the choice to opt in or opt out?  What is called ‘status quo bias’ means that which happens will influence people’s choice. Given this, surely it is best for the government to choose the option that makes people better off in its judgement.  The authors have subsequently developed these ideas in their book Nudge. The Economist has a nice summary of this position, and some arguments against it, here. Nudge has been very influential among policymakers, both in the UK and the US.

                Decisions on whether to make savings schemes opt in or opt out, and similar nudges, seem fairly innocuous even if they are important. But what about forcing people to do things they might definitely decide otherwise not to do? Like wearing seat belts. Some economists have difficulties with making the wearing of seat belts compulsory, and regularly cite the possibility that it might encourage drivers to drive more dangerously. This belief seems fairly impervious to contrary evidence, and this post  from philosopher/psychologist J.D.Trout has a justifiable go at economists as a result. The unfortunate truth is that individuals are rather bad at assessing low probability high risk events, and as a result it makes sense – at least in this case – to take away their choice. Can anyone think of a recent similar example with rather more global consequences?!

                So the bad news for the IEA and similar devotees of absolute individual sovereignty is that sometimes people do systematically make bad decisions, and the state is right on those occasions to do something about it. Equally, the state is often too paternalistic, and interferes when it should not. The state can also make bad choices. Given this, the more data we have that allows us to sort out whether government is helping or meddling the better. That is why happiness data is useful, because it can help us do this.