The objective facts are far easier to handle in the models than the shifting, subjective expectations of people trying to deal with radically uncertain futures. This is what may get reflected in financial markets. Attempting to understand all of this requires conceding that some knowledge will be imprecise and will lie outside of the box (model). The model is simply a toy that can be thrown out when it no longer suits. This means that it is indeed possible to have valuable knowledge outside of hyper-models (although, of course, all thinking proceeds in terms of assumptions and simplifications).

But this will give the "scientists" among us headaches. As John Maynard Keynes famously said about the econometrician Jan Tinbergen, "[H]e is much more interested in getting on with the job than in spending time in deciding whether the job is worth getting on with."

As long as this is the dominant attitude, macroeconomics will remain "other-wordly." Instead, the way to greater realism is through more attention to the methodology of science and to whether "the job is worth getting on with." Paradoxically, greater philosophical sophistication would put economists is closer touch with the real world. (Or so I hope.)

Lean, mean DSGE machines?

Reading the recent characterizations of Ph.D. education in our top departments, one would conclude that all one ever learned in a program is how to write out and calibrate dynamic stochastic general equilibrium (DSGE) models, or for the older among us, calibrate a real business cycle model. I have to say that this all seems a little like an all too convenient caricature (and, as I have said repeatedly in the past, these types of models have led to important insights for issues besides crises [4]).

I won't deny that in the past 20 years, I haven't seen more than a few models that struck me as pretty irrelevant for analysis of real world issues. But I think that some mathematical training, and the use of models, is essential to economic analysis. After all, one can think of completely irrelevant frameworks for looking at the world even without a model, just as one can with a model.

Furthermore, perhaps my experience in a Ph.D. program is atypical but I don't remember being forced into a particular mode of analysis in writing my dissertation (University of California, Berkeley, 1985-1991). In macro/international/econometrics, my teachers included Roger Craine, George Akerlof, Jeffrey Frankel, Andy Rose, and Richard Meese. We studied Euler equations as well as the market for lemons. We knew what Arrow-Debreu markets were, but we also learned about the Great Depression (from Bernanke's paper as well as Friedman and Schwartz). The time series econometrics taught did not presuppose optimizing behavior. We even studied models with sticky prices (gasp!). Doesn't sound too doctrinaire to me.

So what was a common theme in the curriculum? For me, the defining feature in thinking about what model to use was whether the analysis answered the question posed, and whether the question posed was of interest. Now, whenever I read a dissertation prospectus, the key question I ask the student is: "What is the question being asked?", not what is the methodology. (Admittedly, the subdisciplines have different "characters", as alluded to by Paul Krugman; my focus was open economy macroeconomics, rather than macroeconomics/monetary economics.).

How monolithic?

I wonder if indeed the macroeconomic mainstream is as monolithic as conveyed by various observers. For instance, one certainly perceives a certain homogeneity amongst Ph.D.'s trained at certain universities. And there's a certain similarity in the mode of analysis preferred by economists in financial firms. Since the financial press tends to focus on Wall Street economists, one gets a misleading impression regarding the degree of uniformity of views.

To make this more concrete, let's consider whether academic economists differ in their views regarding the economy, as compared to those in the financial sector. I have some indirect evidence, pulled from Dilbert's survey of economists in the American Economics Association (see also [5]). Scott Adams, with the assistance of Joshua Libresco of the OSR Group, was kind enough to have the stats pulled. Last summer, academic economists believed that a President Obama administration would promise more progress on the economy than a McCain administration, by a 2 to 1 margin (n=314); in contrast financial sector economists were equally split. The sample in the latter case is quite small (n=29) (I dropped the undecided/no difference responses). Nonetheless, a difference in means test (recalling the variance of a binomial is (1/4)/n) rejects the null hypothesis of equality at 6%, using a two tailed test.

(As an aside, this finding further suggests that when the WSJ says most economist oppose a second stimulus, that probably characterizes Wall Street economists better than all AEA economists. Even for Wall Street economists, it's interesting to note that a majority of economists feel the stimulus package has already improved economics prospects, and will have a bigger impact in subsequent months. Hence, opposition to a second stimulus among WSJ-surveyed economists is not necessarily rooted in skepticism about the aggregate demand enhancing effect of the ARRA. (One would need a cross-tabulation of responses to verify that assertion.))

Concluding thoughts

If my conjecture is correct, then the supposed failure of macroeconomics is more the failure of macroeconomics as described in the popular press, rather than of the discipline itself (after all, Joseph Stiglitz is as much of the economics discipline, if not more, than Eugene Fama.) My conclusion: Not quite time to jettison the apparatus of modern macroeconomics.

For a less personal perspective, see Brad Delong and Paul Krugman, as well as my April post on "macroeconomic schisms".

I don't read very many books. At least not during the academic year. But I have read two books recently that are quite germane to thinking about the buildup to the financial crisis, and thinking about how to respond to the current economic downturn. The first is Akerlof and Shiller's Animal Spirits. The second one is actually not yet out -- it's Justin Fox's The Myth of the Rational Market (I got a prepublication copy; here's a hint of it). They are both important books, well worth reading.

As one can guess from the titles of these two books, neither text is a paean to the predictive power of the neoclassical view of the world. I'd expect that most readers trained in this tradition would then skip this blogpost. But before you do, and go back to reading your financial industry newsletter, you might consider where these seemingly neutral phrases such as "risk appetite" come from. Why did "risk" seemingly disappear in 2005-06, only to reappear in 2008? Why did asset prices (including house prices) climb so much? Think about the traditional asset pricing (Gordon Growth equation):

P_t = D_t/(k_e - g)

Where P is the stock price, D is the dividend today, k_e is the equity discount rate, and g is the deterministic growth rate of dividends; and k_e equals the risk free rate plus the equity risk premium.

Where does this equity risk premium come from? Well, it could come from the covariation of real equity returns with the ratio of the marginal utility of consumption. Or it could come from waves of excess optimism and pessimism. Or it could come from both – although one would need to take a stand on the relative weights of the two effects.

I'm sure there are readers out there at this moment saying "But what about the finding that stock prices follow a random walk; this is consistent with the efficient markets hypothesis." But as Fox writes:

Fama had proposed that the way to test the efficient markets hypothesis was to see if stock price movements obeyed the dictates of the capital asset pricing model, but this was only a relative test. It might reveal whether stock price movements made sense in relation to each other and the overall market, but it was no help in showing whether the overall market was correctly price or not. (p. 184)

Digression 1: To place this in technical terms, the maintained hypothesis is the statistical null hypothesis of no predictability. Failure to reject to no-predictability null is consistent with the random walk hypothesis, and hence the weak form efficient markets hypothesis (EMH). However, it is very difficult for most statistical test to differentiate between no predictability and little predictability. Jeffrey Frankel has called this econometric approach "the zen of perfect nothingness".

Digression 2: Larry Summers (J. Finance, 1985) showed how a financial market pervaded by strong and persistent deviations from the fundamentals ("fads") would take five thousand years to have 50% chance of distinguishing it from a truly efficient market, defined in the statistical sense Fama defined it.

To the extent that these waves of optimism and pessimism -- heck why not call them animal spirits -- are a real world force, then this argues that self-regulation of the financial industry is not likely to be sufficient. It's not a prima facie case in support of government regulation (especially if regulation can be captured, a la Simon Johnson's regulatory capture view). But I think we should at least try to regulation and/or other means of slowing down the excess movements (financial taxes could in principle work this way, as in the Tobin tax).

Akerlof and Shiller conclude Chapter 11 thus:

...financial markets require regulation. And sometimes, when these regulations fail, because of all the feedbacks between financial markets and the real economy, there is also room for thoughtful, careful policies of financial insurance. Rededication to protecting the financial consumer must be one of our highest economic priorities.

In an emergency, as a backup, when we do get into a recession, there is a monetary and fiscal policy. But we know that there are limits to such policy and to its effectiveness. It is now time to redesign financial regulations to take account of the animal spirits that often drive the markets, to make the markets work more effectively, and to minimize the extent to which we will need after the fact bailouts to get us out of the hole.

See also the oped in yesterday's WSJ.

By the way, the authors of both books agree that the point is not to dispense with price theory. That point is made on page 2 of Akerlof-Shiller, and in a quote of one of the fathers of behavioral economics, Richard Thaler, regarding the Shanghai apartment market: "Maybe it's just supply and demand" (p. 286). Rather, the point is that we need to augment price theory with a more realistic depiction of human behavior if we are to avoid a repeat of the current situation.

I leave with two figures from Robert Shiller's paper "Do stock prices move to much to be justified by subsequent changes in dividends," American Economic Review 71(3) (June 1981).

(Hint on interpretation: The dashed line should be more variable than the solid line, under the EMH and assumptions regarding stationarity. See Engel (2004) for updated discussion.)

Furthermore, the correlation between scheduled paper titles and actual is, shall we say, fairly loose. In any case, the main messages of the papers are usually discussed in the context of current events.

I'll illustrate this last point by discussing the only complete session I made it to (most of my time was spend interviewing job candidates): "The Capital Flows behind Financial Globalization" (organized by Kristin Forbes). I had to make it since I was presiding. As it turns out, it was a very lively session, and -- despite the title -- quite relevant to ongoing events. (And if you don't think this was timely, take a look at Brad Setser's post today.)

First on the agenda was my former colleague Joshua Aizenman. He actually presented results from two papers. In "Globalization and the Sustainability of Large Current Account Imbalances: Size Matters," [pdf] Aizenman and Yi Sun conjecture how China's current account will evolve over time, in a context where China is a large player. From the abstract:

This paper evaluates the sustainability of large current account imbalances in the era when the Chinese GDP growth rate and current account/GDP exceed 10%. We investigate the size distribution and the durability of current account deficits during 1966-2005, and report the results of a simulation that relies on the adding-up property of global current account balances. Excluding the US, we find that size does matter: the length of current account deficit spells is negatively related to the relative size of the countries' GDP. We conclude that the continuation of the fast growth rate of China, while maintaining its large current account/GPD surpluses, would be constrained by the limited sustainability of the larger current account deficits/GDP of courtiers that grow at a much slower rate. Consequently, short of the emergence of a new "demander of last resort," the Chinese growth path would be challenged by its own success.

In a second paper, Joshua presented results indicating that the United States served as the "demander of last resort", wherein US current account deficits appeared to be a key determinant of LDC current account surpluses, even after accounting for other factors (demographics, etc.). This paper is available on Aizenman's website here. In that paper, Aizenman and Yothin Jinjarek write:

We identify an asymmetric effect of the US as the “demander of last resort:” a 1% increase in the lagged US imports/GDP is associated with 0.3% increase of current account surpluses of countries running surpluses, but with insignificant changes of current account deficits of countries running deficits.

The discussant, Jeffrey Frankel, lauded the paper for its eschewing complicated intertemporally optimizing models of the current account balance, in favor of an approach that could more useful be empircally implemeted. He also observed that perhaps the current crisis dealt a serious blow to the proposition that the reason why capital had flowed to the US was our "deep and sophisticated capital markets" or the credibility of our financial institutions, but something more simple such as profligacy. (Obviously, this is a view I am very sympathetic to [1], [2], [3].) On a more substantive note, he observes that capital account openness should enter into the authors' specification interactively rather than as a levels effect -- that is capital account openness should determine the easy of financial flows, rather than their sign. In the end, he agreed that these papers were useful in thinking about how the imbalances arose, and how they may now be in the process of abrupt shutoff.

In "Why Do Foreigners Invest in the United States?" [pdf], Kristin Forbes writes:

Why are foreigners willing to invest almost $2 trillion per year in the United States? The answer affects if the existing pattern of global imbalances can persist and if the United States can continue to finance its current account deficit without a major change in asset prices and returns. This paper tests various hypotheses and finds that standard portfolio allocation models and diversification motives are poor predictors of foreign holdings of U.S. liabilities. Instead, foreigners hold greater shares of their investment portfolios in the United States if they have less developed financial markets. The magnitude of this effect decreases with income per capita. Countries with fewer capital controls and greater trade with the United States also invest more in U.S. equity and bond markets, and there is no evidence that foreigners invest in the United States based on diversification motives. The empirical results showing a primary role of financial market development in driving foreign purchases of U.S. portfolio liabilities supports recent theoretical work on global imbalances.

I'll observe that this paper represents an impressive compilation of disparate datasets, so people interested in a thoughtful analysis of the data (as opposed to hyperbole and anecdotes) should consult this paper.

The discussant, Linda Tesar, observed that while the paper did not provide any big surprises, it was interesting to see how the trends evolved over time. In particular, the Gourinchas and Rey (2007) finding of higher returns on US holdings of foreign assets than foreignors earn on their holdings of US assets held true even after the adjustments of Curcuru, Dvorak and Warnock (2008).

More importantly, Tesar took issue with the view that if foreign returns were high (even after risk adjustment) and US returns low, it was a puzzle why foreigners invested in the US. But portfolio theory suggest that just because returns are low, the optimal level of investment in the US is not zero, as long as markets are not perfectly correlated. The question is how much investment, not whether to invest in the US.

The last two papers were closely related in terms of subject matter: measurement.

Pierre Olivier Gourinchas and Helene Rey produced a new version of their tabulation of the US external accounts, in order to generate new estimates of foreigners' returns on US assets versus Americans' returns on foreign assets. Their methodology was basically a more elaborate version of the approach laid out in this paper, discussed briefly in this post.

The discussant, Frank Warnock, wondered whether it made sense for academics to be constructing their own data. In particular, Gourinchas and Rey combine flow and stock data to impute stocks, even though the data were never constructed with this objective in mind (i.e., the data are not compatible). Instead, he argued that maybe it made more sense to utilize the estimates that statisticians in the Federal government were developing, especially to cover holes in the current statistics-gathering system. Some of Warnock's results in this context were discussed in this post, and can be found in his papers found here.

From "Where Did All The Borrowing Go? A Forensic Analysis of the U.S. External Position," [pdf] by Philip Lane and Gian Maria Milesi-Ferretti:

The deterioration in the U.S. net external position in recent years has been much smaller than the extensive net borrowing associated with large current account deficits would have suggested. This paper examines the sources of discrepancies between net borrowing and accumulation of net liabilities for the U.S. economy over the past 25 years. In particular, it highlights and quantifies the role played by net capital gains on the U.S. external portfolio and 'residual adjustments' in explaining this discrepancy. It discusses whether these 'residual adjustments' are likely to be originating from measurement errors in external assets and liabilities, financial flows, or capital gains, and explores the implications of these conjectures for the U.S. financial account and external position

While this paper seems unrelated to the ongoing crisis, during the rejoinder session, Milesi-Ferretti noted that -- using the framework outlined in the paper, and incorporating the fact that foreign equity markets had performed even worse than the US -- it was likely that the US net foreign asset position deteriorated substantially in 2008.

Kenneth Rogoff lauded the attempts by the authors to try to measure the US, and other country, net foreign assets. But he spent most of his time talking about -- how net foreign assets related to the ongoing crisis, relying much on his presentation to the joint AEA/AFA luncheon.

So, returning to the departure point for this post, don't be misled -- discussion of the ongoing crisis (and how global imbalances might have contributed) was everywhere at the AEA's, even if not explicitly in the session and paper titles.

Technorati Tags: American Economic Association, capital+flows, financial globalization, net foreign assets, current account imbalances, net external position, foreign direct investment, and foreign returns.

"The data are pretty clear that we are not in a recession," Council of Economic Advisers Chairman Edward Lazear told a meeting of editors and reporters from the Wall Street Journal and Dow Jones Newswires.

...

"I would be very surprised if the NBER, looking back at this period, would date this as a recession," Mr. Lazear said. There are even indications that revised first-quarter estimates would be slightly stronger than 0.6%. "The optimists seem to have been closer to right on that than the pessimists," he said.

Just to reiterate, that quote is from May 2008.

Here's a picture of GDP and gross domestic income (as suggested by Jim in this post, and noted in the BCDC announcement).

I thought at the time Ed Lazear would regret those remarks. But Lazear's views were not unique. Here are some additional quotes of interest, hoisted from the comments sections in Econbrowser:

From March 2008, in response to my worries about 2008H2 growth:

While the financial market turmoil and dysfunctional credit markets are significant wild cards, interest rates are so low (and could be 2.25% this week!) that you have to think that growth later this year and into '09 should be positive, if not strong.

Yet another:

The Macroeconomic Advisers monthly real GDP index rose to a record high in December. It fell in October but rebounded in November and December.

Preliminary indicators suggest it rose again in January.

I get a sense that some academic economists are actually rooting for a recession, a way of punishing the country for having elected Bush.

...

In other words, looking at data too close to the candidate turning point can easily lead to subsequently embarrassing remarks. Nonetheless, the specific dating of the recession to December 2007 has spurred lots of queries about whether it matters, when (i) the recession is so much in evidence, and (ii) whether any greater importance should be accorded to a declaration by the NBER as opposed to any other group or individuals. Here are some thoughts on both questions, augmented with some retrospective views.

First, to the question of whether it matters that there's a declaration. Here, I turn to Jeffrey Frankel, who is on the NBER BCDC, but is speaking on his own behalf:

We sometimes hear the question "Who needs the NBER Committee anyway?" This question most often comes in one of two forms:

(a) Everyone in the real world has known that the economy has been in a recession for some time. In past cycles, media reports have sometimes taken the line "Ivy Tower Eggheads Finally Figure Out What Everybody Else Has Known All Along." The implicit critique is that the committee takes too long after the event -- typically almost a year -- to make its declaration. One short answer is that our job is to be definitive, authoritative, but not fast. We don’t want to have to revise our dating of the peaks and troughs later, in part because it would sow confusion among those who rely on them (from econometric researchers to political speechwriters). GDP and other official statistics are often revised after the fact, for example. We leave it to others -- pundits, forecasters, consulting companies, financial newsletters, and so on -- to try to get there first. We deliberately get there last.

(b) The other form taken by the question "Who needs the NBER committee?" runs as follows: "The rule of thumb is simple: two consecutive negative quarters of GDP growth. Why complicate things?" The Frequently Asked Questions segment of the BCDC announcement answers this in detail. For now, observe simply that questions (a) and (b) are inconsistent with each other. As of December 1, 2008, the US economy has not yet experienced two consecutive negative quarters. So an argument that we should wait for two consecutive quarters (critique b) is the opposite of the critique that we should have acknowledged a recession before now (critique a).

Taking Frankel's points into account, we can then move to the second question, whether it matters that NBER BCDC makes the determination. Think back to the two-quarter rule of thumb. Why is it a "rule of thumb"? Because the data are revised over time -- most importantly GDP -- the two quarter (sometimes defined as a "technical recession") is heavily reliant upon the series that is most subject to revision. I've discussed the importance of revisions numerous times in this context: [1], [2], [3], [4], [5].

Another motivation is to recall that the NBER is a research group, and not a policy group, trying to identify for historical purposes the ebb and flow of activity. In any case, we want to place the responsibility for identifying peaks and troughs in economic activity in the hands of a disinterested group, and not in -- say -- the government. (I'll add that it's an auspicious group: "Robert Hall, Stanford University (chair); Martin Feldstein, Harvard University and NBER President Emeritus; Jeffrey Frankel, Harvard University; Robert Gordon, Northwestern University; James Poterba, MIT and NBER President; David Romer, University of California, Berkeley; and Victor Zarnowitz, the Conference Board. Christina Romer of the University of California, Berkeley, resigned from the committee on November 25, 2008, and did not participate in its deliberations of November 28.")

(For those wondering why NBER gets to declare the recession dates, one hint is that it was NBER researchers Burns and Mitchell (1946) who developed the lens through which "cycles" experienced in industrial economies were perceived. For the inquisitive, here is a link to the volume which summarized that research: Burns, Arthur F. and Wesley C. Mitchell, Measuring Business Cycles (NBER, 1946).)

This is why I think so much of the commentary, saying that this was all obvious, not only demonstrates a distressing level of ignorance, but also a juvenile approach to discourse (see e.g., here). Yes, it was pretty obvious that we were in a recession, but when it began is something that could have been placed at any number of dates. We will have a similar debate when we starting thinking about dating the trough.

I think it's also of interest to look back at whether we should be so surprised. I'll focus on the debate that occupied our attention months ago: whether the yield spread had predictive power for future economic activity. Well, now we can conclude the answer was yes. The inversion in August 2006 predates the recession's beginning by about 16 months.

Now, what we don't know is how well the prediction holds cross-country. This graph from a March 2007 post suggests it will work for Europe (we'll have to see what CEPR says, although current forecasts seem pretty definitive).

Here's a cross-country snapshot from an October 2007 post.

Australia and the UK seemed to be conforming to the prediction from the yield curve. Canada so far has failed to experience negative growth, and so might be thought to also conform to the prediction of yield curve -- at least so far.

Technorati Tags: yield spread, GDP, gross domestic income, recession, term premium, data revisions, NBER, and Business Cycle Dating Committee.

Today, we're fortunate to have Jeff Frankel, Harpel Professor at Harvard's Kennedy School of Government, as a guest blogger. His blog is here.

The possibility that some Gulf states, particularly the UAE, might abandon their long-time pegs to the dollar is getting increasing attention (from Martin Feldstein and Brad Setser, for instance). It makes sense. The combination of high oil prices, rapid growth, a tightly fixed exchange rate, and the big depreciation of the dollar against other currencies (especially the euro, important for Gulf imports) was always going to be a recipe for strong money inflows and inflation in these countries. The economic dynamism -- most striking in Dubai -- is admirable and fascinating, but also now clearly indicative of overheating. Indeed inflation, as predicted, has risen alarmingly. Among other ill effects, it is producing unrest among immigrant workers. An appreciation of the dirham and riyal is the obvious solution.

Most often discussed as an alternative to the dollar peg is a peg to a basket of major currencies. This would be an improvement. Kuwait, for example, made this switch a couple of years ago.

But a basket peg does not address the fact that when oil prices rise generally (not just against the dollar), as in recent years, monetary policy is constrained to be looser than it should be. Similarly, when oil prices fall generally (not just against the dollar), as in the 1990s, monetary policy is constrained to be tighter than it should be. A floating exchange rate would be the traditional alternative, on the theory that the currency would then automatically appreciate when oil prices rise and depreciate when they fall. But there are serious disadvantages to small open countries floating, such as the loss of a nominal anchor for monetary policy. Today's reigning orthodoxy is to add an inflation target as the new nominal anchor. But this doesn't solve the problem if the price index is the CPI, which gives little weight to oil, the biggest sector in production and exports.

I believe that a better solution would be to include the price of oil in the basket of currencies to which the Gulf currencies would peg. I have laid out the case elsewhere. (I call it PEP, for Peg the Export Price [pdf]) I was pleased to see recently that the Financial Times mentioned this option approvingly ("Dollar-pegged Out," July 7):

"The Gulf needs to peg to something. A first step (after revaluation) would be to peg to a basket of currencies that included the euro and the yen. A bolder step would be to include the price of oil in that basket, so that currencies would appreciate when oil is strong, and depreciate when it is weak."