A New Macroeconomics Paradigm

Joseph Stiglitz calls for a paradigm shift in macroeconomics:

The blame game continues over who is responsible for the worst recession since the Great Depression – the financiers who did such a bad job of managing risk or the regulators who failed to stop them. But the economics profession bears more than a little culpability. It provided the models that gave comfort to regulators that markets could be self-regulated; that they were efficient and self-correcting. The efficient markets hypothesis – the notion that market prices fully revealed all the relevant information – ruled the day. Today, not only is our economy in a shambles but so too is the economic paradigm that predominated in the years before the crisis – or at least it should be.

There follows the typical litany of complaints against modern macroeconomics: equilibrium assumptions, representative agent models, no room for finance. Some of these points make some sense, but there is no alternative approach that shows the way to go. Stiglitz talks about success in economic theory that has not gotten into macroeconomics.

Fortunately, while much of the mainstream focused on these flawed models, numerous researchers were engaged in developing alternative approaches. Economic theory had already shown that many of the central conclusions of the standard model were not robust – that is, small changes in assumptions led to large changes in conclusions. Even small information asymmetries, or imperfections in risk markets, meant that markets were not efficient.

The problem is not to recognize that a model is just a model, but how to incorporate frictions into usable models. This is really hard. The most likely reason it has not been done yet is that nobody has figured it out, not that economists are ostriches.

Stiglitz also takes the typical potshot at market efficiency. Economists assumed markets were efficient so nobody stopped people from taking too much risk. I just don't get this argument. If people thought markets were efficient they would not have believed that extra return could arise with extra risk. The problem is that too many in the financial world, including regulators, did not really believe in efficient markets. Otherwise, they would have known that risks were being seriously piled up.

Fiscal Stimulus

An interesting piece by Jim Manzi in the New Republic argues that uncertainty about the impact of fiscal stimulus is inevitable because of the difficulties of doing counterfactual exercises. Of course to do a credible counterfactual you have to specify a model and you need agreement about which is the correct model. This is complicated especially with a topic like fiscal stimulus.

But I wonder if there is also another problem. What if the relationship between fiscal stimulus and growth is non-linear? Is it implausible that a credible fiscal retrenchment might lead to an investment boom? There is considerable evidence that fiscal consolidation can be expansionary, according to Albert Alesina. It may also be the case that conventional Keynesian remedies can work, especially in countries that do not have too much government debt already.

But if both fiscal stimulus and fiscal consolidation are expansionary it may be hard to isolate the effect in standard econometric exercises. It may also explain why each side in the debate can point to evidence that supports their view.

The Bankers and the Producers

Over at Vox-Eu, Thorvaldur Gylafson compares banking scandals with plot of Mel Brooks' The Producers. Like modern day Biayalstock and Blooms the bankers make bad loans and hope to loot the bank before anybody notices how much they have earned:

Not all the CEOs running the fraudulent savings and loans (S&Ls) in California and Texas in the 1980s and 1990s saw The Producers, but all of them could have played Max’s role convincingly. They shared Mr. Brooks’ insight into why the massive frauds use accounting as their “weapon of choice”, structure their efforts to fail, and recruit an accountant as their most valuable fraud ally. The fraudulent CEOs and their accounting allies were the real-life Bialystocks and Blooms. They bankrupted the S&Ls, enriching themselves and their friends along the way, at the expense of stockholders, creditors, and taxpayers.

This explanation is then applied to the recent financial crisis.

During the ongoing subprime mortgage loan crisis, the rating agencies and the top tier audit firms played the real life role equivalent to the critic that Max pretended to try to bribe to make sure that Springtime for Hitler received a terrible review. Unlike the critics, who Max realised he could not succeed in bribing, the rating agencies and the top tier audit firms gave rave reviews to toxic subprime mortgage paper. The rating agencies claimed the toxic waste was pristine “AAA” – the safest of the safe. The elites that we count on to advise us on quality in the real world are more corruptible than the elites in the fictional world that Max and Leo inhabited.

One important element of this crisis was that the big banks kept too much toxic debt on their own books. This is why the banks had such big losses. They did not just sell off the worst debt. They kept it too.

How does this fit with the Biayalstock and Bloom theory? Holding all that toxic waste on the books is kind of like producing a really bad play. But is it credible that Richard Fuld and James Cayne wanted Lehman and Bear Stearns to fail? Did Stanley O'Neal believe he as dooming Merrill Lynch while he earned his big bonuses? This seems unlikely. The CEO's of these companies were more like the old ladies seduced by Max than they were like Max. They did get rich while the play looked like it was a hit, but they were highly compensated because people actually thought they produced hits.

The problem in this crisis was that risks were underpriced. Executives got overly compensated for taking risks because investors believed that markets were inefficient and these guys were brilliant.

Blown Wind

Is Windpower the solution to our energy needs? This article in Slate suggests that is not. Recently when Texas experienced a heat wave very little of its windpower capacity was of any use:

Put another way, only about 5 percent of the state's installed wind capacity was available when Texans needed it most. Texans may brag about the size of their wind sector, but for all of that hot air, the wind business could only provide about 0.8 percent of the state's electricity needs when demand was peaking.

The problem with windpower is not simply reliability (the wind does not always blow), but the relationship between wind and peak loads. When it is very hot the wind is less likely to be blowing and that is when the demand for electricity is at its highest. Windpower adds to non peak capacity, but then you still need coal and nuclear or whatever for peak loads.

I think the only green thing about the green jobs created by windpower is the currency we waste in the process.

Krugman, Maddow Smackdown

Jack Shafer takes down Paul Krugman and Rachel Maddow for their alarmist warnings of the unpaving of American highways. What Krugman and Maddow see as the decline of western civilization may just be a rational response to lack of use and alternative routes:

A strong case can be made that North Dakota and maybe a few other states are now paying the price—or not paying the price, as it were—for having overbuilt their road systems. The most recent federal numbers show that North Dakota has 86,842 miles of road, compared with next-door-neighbor Montana's 73,202 miles. Montana is similarly rural, but it's twice the size of North Dakota and has a 50 percent greater population. If Montana can function with 13,000 fewer miles of road than North Dakota, then North Dakota can unpave or abandon several thousands of miles of road without disintegrating. Montanans even drive more rural miles (PDF) than North Dakotans. South Dakota, which has about 25 percent more people than North Dakota, gets by with just 83,744 miles of road!

Fannie and Freddie

There is renewed discussion about what to do with Fannie and Freddie. In today's NYTimes Andrew Sorkin channels Barney Frank to explain why reform will be difficult.

More important, shutting down Fannie and Freddie and having the private market step in, as politically popular a sound-bite as that may be, is economically unfeasible. For better or worse, Fannie, Freddie and Ginnie Mae were behind 98 percent of all mortgages in this country so far this year, according to the Mortgage Service News. Pulling the rug out from under them would be pulling the rug from under the entire housing market as it continues to struggle.

The GSE's may have repackaged 98 percent of all mortgages in the country, but they did not finance them. That still came from savers. The GSE's, after all, still need funds just to survive. The real question is why the private market cannot package and sell bundles of mortgages in the absence of the GSEs? We know they did this before the financial crisis.

Presumably, the private markets are less willing now to refinance mortgages with very low down payments. They probably have learned from their mistakes. The pressure to keep the GSE's derives from the desire to continue to make risky loans that the private markets won't make.

So the question is who did not learn from the crisis, private markets or the government?

Sachs, Building Booms and Reforms

Jeff Sachs comments on the reforms in Poland and Russia in Scientific American. He writes of the contrast between Warsaw and St. Petersburg.

Warsaw has enjoyed a building boom, with impressive new business towers going up despite the economic slowdown in western Europe. St. Petersburg glories in the architectural treasures of the past but with much less evidence of current dynamism.

This is because Poland has had successful reforms and Russia has not:

In Russia, on the other hand, corruption has run rampant during the past 20 years, and the public shows little capacity to rein it in. The institutions of civil society, suppressed by centuries of tsarism and obliterated by Soviet-era state brutality, remain weak. Because the constraints on corruption were so toothless, vast state wealth—especially oil, gas and mineral wealth—was transferred in the mid-1990s into private hands, creating the so-called oligarchs of the new Russia. A few years later powerful bureaucrats wrested back control of many of these assets. The rise and fall of the oligarchs was murky, without the transparency needed for a healthy market economy. Russia, not surprisingly, lands at a dismal 146th on the Transparency International corruption list.

But the comparison is contrived. As anyone who has visited Moscow in the last ten years knows, it has experienced a tremendous building boom. Indeed, all one reads about in Moscow is how building is trampling on its architectural heritage. There are skyscrapers and apartment buildings everywhere. Outside the home of the New Economic School in Moscow we are surrounded by huge apartment blocks, obscuring what used to be great views of southwestern Moscow.

So if Sachs had visited Moscow would he have written that corruption has no effect on economic performance? Of course there are reasons why Moscow benefits more than St. Petersburg, primarily because it is the capital and business wants to be close to officials. Is this also the explanation for Warsaw? I do not know enough to answer. But it is an odd comparison.

Really Bad Idea

Considering really bad ideas, how about regulating food markets. That is the call made by Joachim von Braun in the Financial Times.

The setting of prices at the main international commodity exchanges was significantly influenced by speculation that boosted prices. Not only are food and energy markets linked, but also food and financial markets have become intertwined – in short, the “financialisation” of food trade. There are increasing indications that some financial capital is shifting from speculation on housing and complex derivatives to commodities, including food. While the financial markets have recently been regulated to curb excessive speculation, commodity markets have remained largely untouched and are the open flank of the system attracting speculation.

Most food riots occur because governments suppress food prices and then under the press of shortages are forced to raise them. Most famines occur because governments regulate the transport of food.

What market imperfection requires food regulation?

Rajan on Economic Security

Raguram Rajan has a good post on energy security. His main point is that most policies to ensure security reduce welfare, and that perhaps what really guides such policies is the fear of a total breakdown of markets. So countries do things to insure against tail events.

Illustrated Guide to a PhD

From Chris Blattman, the illustrated guide to a PhD.

Exotic Municipal Finance

The New York Times has an article on the problems of the Denver school system. Needing to plug a $400 million hole in their pension system they turned to JP Morgan.

The bankers said that the school system could raise $750 million in an exotic transaction that would eliminate the pension gap and save tens of millions of dollars annually in debt costs — money that could be plowed back into Denver’s classrooms, starved in recent years for funds...

Rather than issue a plain-vanilla bond with a fixed interest rate, Denver followed its bankers’ suggestions and issued so-called pension certificates with a derivative attached; the debt carried a lower rate but it could also fluctuate if economic conditions changed.

The contract was signed just as the financial crisis was getting underway. So interest rates fell. Now, of course, the contract has turned against them and it is paying much more interest than planned, and to terminate the contract it will cost an additional $81 million.

It will be argued that the problem is derivatives. But the real issue is simpler. Should municipal agencies use exotic finance to cover their expenses. It comes down to two simple questions:

1. Is the agency well-suited to speculating on the course of interest rates? Is it better able to forecast interest rates than those selling the derivatives?
   
2. Is the agency well-suited to coping with the risks associated with such speculation?
   

It is hard to believe a school board could answer yes to either of these questions.

This is another example of where the lack of belief in market efficiency let somebody down. One could argue, in fact, that there is a normative reason to believe in market efficiency. Forget the positive evidence. Just believe markets are efficient, then you won't believe JP Morgan bankers can save you money without increasing your risk. If you do so, you are not going to be suckered into bad bets.