Rajan's Reply

Ragu Rajan replies to Krugman and Wells attack on his book Fault Lines. The book is excellent, no time to discuss it now. The reply is devastating and valuable.

Here is a small taste (but important point):

Krugman starts with a diatribe on why so many economists are “asking how we got into this mess rather than telling us how to get out of it.” Krugman apparently believes that his standard response of more stimulus applies regardless of the reasons why we are in the economic downturn. Yet it is precisely because I think the policy response to the last crisis contributed to getting us into this one that it is worthwhile examining how we got into this mess, and to resist the unreflective policies that Krugman advocates.

Read the whole thing.

Historians versus Economists?

Gideon Rachman had a really abominable article in the FT. It is not his call for economists to become less vain that I have trouble with:

The vanity of economists needs to be challenged. Above all, their claim to scientific rigour – buttressed by models and equations – must be treated much more sceptically.

I am not really sure who is so vain. But the use of models and equations is of course misunderstood here. Models and equations are used to make arguments understandable, not to pretend. But this is not the worst. Rachman quotes Stiglitz calling for new paradigms in economics, and then argues:

For somebody educated as a historian, there is an obvious alternative conclusion to draw from Prof Stiglitz’s opening observation. And that is to conclude that the entire attempt to treat economics as a “science ... defined by its ability to forecast the future” is misconceived.

Economics is not about predicting the future. That is a straw man. It shows how little Rachman understands about economics. Fortunately, his FT colleague, Tim Harford has a good column that deals with this. Here is the money shot:

Historians deal in hindsight. It is a wonderful thing. But it is not the only thing. I wonder whether Gideon, intoxicated with a heady brew of Niall Ferguson and Herodotus, has forgotten that.

Tom Sargent Interview

Tom Sargent is interviewed by Art Rolnick on the state of modern macro. Very nice read. But the best part is this exchange:

Rolnick: I’ll come back to that in a second, but you haven’t said anything yet about what is to be gained in terms of understanding financial crises from importing insights of behavioral economics into macroeconomics.

Sargent: No, I haven’t.

Read the whole thing.

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.