TVHE

Interesting.  Both a Fed economist and Stephen Williamson (the author of one of my undergrad macro books) have been saying that persistently low interest rates “cause” deflation in the long run (ht Economist’s view) [Lots of others, WCI *, Money blog, Angry Bear, Paul Krugman, Money Illusion].  This seems a little counter-intuitive, but this doesn’t mean anything is wrong – I’m going to write down a few of my thoughts to see if I can figure out what is going on.

I mean, I agree that the Fisher equation must hold, and I agree that the long-run real interest rate will be exogenous.  But this ain’t enough to tell me that having the Fed keep rates at 0.25% forever “causes” deflation.

Why?  The average Fed rate and inflation expectations are both endogenously determined – they seem to be treating the Fed’s choice as exogenous, when they follow a decision rule. Yes it is true that the cash rate at a point in time is a choice variable – but the average cash rate in the long-run should effectively be determined by the real interest rate and long-run inflation target. [Update Think of it this way, I'm really assuming the central bank follows a Taylor rule and that determines the nominal rate given the inflation target.  The big kicker for any argument like this will be the way inflation expectations are formed].

As a result, we could just as easily interpret rates staying at 0.25% forever as an indicator that inflation expectations are -1.75% -> in other words we observe a low nominal interest rate BECAUSE there is deflation.  Fundamentally, this tells us nothing – as the Fisher relationship is an equilibrium statement, not a casual relationship.

In fact, if there is indeed a forecast of rates staying at 0.25% forever there is a STRONG argument for making policy more stimulatory now – is that what the guy is trying to say?

If we want to discuss a causal relationship we need a causal model of our endogenous variables right – the Fisher equation is not this.

Update: I see where they are coming from now.  However, I believe the key issue is with regards to current policy – fundamentally the mentioning of deflation was taken in context of the CURRENT disinflation going on in the USA, and it seemed like a statement that was pushing for an increase in rates to avoid deflation.

I’m also nervous about the use of the word “cause” when any observed relationship in the data will not necessarily be clear – but I’m always nervous about causation so oww well.  Namely, if I see an average cash rate of 0.25% and average -1.75% inflation I wouldn’t say “aha, having the cash rate at that level caused that” – I would want more information on how inflation expectations got there in the first place …

Over at Econlog, Arnold Kling stated that “persistence” in employment implied that the New Keynesian story was off (ht Marginal Revolution)

This sounded a bit funny to me – New Keynesianism is a framework for models, one where I had seen the persistence in unemployment, and employment (which is a well known stylized fact) before.  So I went to google:

Awesome google search.

And it immediately came up with a working paper from two of the big boys – Blanchard and Gali.  Conclusion being:

The extent of real wage rigidities determines the amplitude of unemployment fuctuations under the optimal policy. Furthermore, unemployment displays intrinsic persistence, i.e. persistence beyond that inherited from productivity. The degree of persistence is decreasing in the job finding rate. Hence, the more sclerotic is the labor market the more persistence is unemployment.

In the paper there is discussion of models with hiring costs, labour market frictions, rigidities in the real wage, and in nominal prices.  They don’t discuss some other things I’ve seen from New Keynesians, such as employment/investment/production decisions made off the back of a lagged state variable, but those sorts of concepts are rolling around as well.

In essence, the New Keynesian framework is grappling with a large number of issues, and trying to analyse them in a consistent way.  I just find it a little strange that we would say “and so the New Keynesian story is wrong” just because some of the current models can’t pick some things – it is like saying “microeconomics is wrong, because it doesn’t perfectly describe all human behaviour”.  Yes, it is a discipline that needs investment and time – but as a framework for putting models inside, it is pretty useful right.

I’m not saying things are perfect now, but I am saying that all the hating on the New Keynesian framework seems a touch out of place – given that all it is doing is providing a transparent and internally consistent method where people can build their own model of the economy by introducing what they believe are realistic “core” assumptions.

So, a while back a post on housing and production got criticised, but I didn’t notice.  I shall respond now, as I need something to post on. (I would also note that there are 1 million brilliant comments in the initial post – good stuff guys.)

In a strict sense building a house doesn’t increase measured productivity – however, when making my statement that was never my claim.  My claim was that housing was productive – my intent was to show that a house could be seen as investment as it creates a stream of value.

Now, I was obviously far too unclear, and I’ll admit that for sure – so slap me down and take a point off me.

However, I was so loose with my terminology because I’m lazy … but also because I see the “focus on productivity” as inherently silly.  We don’t value the “productivity”, we don’t go around doing things with “productivity” per see – I would love higher productivity, as it means I get more stuff for the same inputs.  But I would love it because I get more stuff, not because I get more productivity statistic.

And this is the essential issue that is missed when looking at housing.

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Anti-Dismal points out the fact that Colin James seems to have run into a little confusion around the GDP statistics.  Now, I can understand this confusion AND I agree that we need to think more sensibly about what income is before we run around making comparisons.  In this sense, all I want to point out is how the confusion came about.

Now it is true, Australia releases production, expenditure, and income measures of GDP.  However, I would note that they set the chain volume measure of these indicators equal with a “statistical discrepancy” figure.

In New Zealand, our statistics department releases production and expenditure GDP, but does not force them to be equal.  They state that they believe the production figure is more reliable overall – and that is why people discuss this figure.

Of course, GDP misses many “non-market” forms of value-added, it is a measure of “production” so misses the fact that a higher terms of trade increases NZ’s implicit income, furtermore it misses “international transfers” which are highly negative for an indebted nation like NZ.

Furthermore, we have to ask why we are looking at the figures.  Is our concern that someone in the same role gets more $$$ in Aussie and so has the incentive to move over there?  If that is the case, why not just compare the PPP adjusted wages for those professions?  Simply looking at GDP misses the fact that our two economies produce different things, and hire different types of labour.

I am not a fan of cross-country comparisons at this type of aggregate level, and I think we should be thinking carefully a little more carefully about what our concerns are regarding the NZ economy directly – rather than focusing on the arbitrary target of our relative living standards compared to other nations.  I realise these relative standards might give us some information on “what we could do” – but unless we are careful when looking at the NZ economy they will lead us towards policy mistakes.

I have seen economists termed “growth fatalists” for the fact that we don’t believe that there is much government can do to change underlying economic fortunes.  Greg Mankiw posted a quote that summed up the position well:

Politicians are in charge of the modern economy in much the same way as a sailor is in charge of a small boat in a storm. The consequences of their losing control completely may be catastrophic (as civil war and hyperinflation in parts of the former Soviet empire have recently reminded us), but even while they keep afloat, their influence over the course of events is tiny in comparison with that of the storm around them. We who are their passengers may focus our hopes and fears upon them, and express profound gratitude toward them if we reach harbor safely, but that is chiefly because it seems pointless to thank the storm.

If I’m honest, I think that the belief that government can create growth magically stems from the fact that people want to feel like they have control of things – economic growth is something that impacts upon our daily lives that we have no control over, but if we can tell ourselves we have control it is easier to live our lives.

In the same way our forefathers would worship the sun, or a “god of the harvest” our modern society worships government policies that “will provide economic growth”.

Discuss

Ok, so there were a couple of comments in the previous post that I think I need to discuss in order to explain why macroforecasters have value.

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Hold up a second here.  My two favourite bloggers have consecutively posted suggesting that macroforecasters are essentially a waste of space (Offsetting Behaviour and Marginal Revolution).  As a macroforecaster I am inherently biased, but I think that such forecasters can add value.  Let me discuss why.

As I have said in the past, if a forecaster thinks his value comes from the accuracy of predicitons, and sells himself as such, he won’t be adding value.  The economic environment is too uncertain, and our forecasting methods too imperfect, to simply rely on forecasting accuracy per see.  But given that we can’t provide a perfect version of the future – we must offer something else.

As I have also said in the past, we provide a description of what has happened, a service on the sort of things going on, and a point of view regarding the risks around the economic situation.

I have asked a number of clients what they find useful, and what they want from us, and I generally get told that they like to have information condensed and described in a clear, consistent fashion.  Having someone available who is keeping up with the news, and is willing to discuss it at any point has value – and as economists we can also paint risks around the situation, and indicate what “general economic” issues people should keep an eye out for.

The value stems from this service – a service that most private sector macroeconomists are blatantly honest about.  Essentially we would never say “this IS going to happen” we would always say “given this set of information, we see this set of potential outcomes, and have this set of probabilities on them – as new information is released we will tell you what this indicates about the general economic situation”.  We definitely aren’t there to tell people how to run their business – we are just there to provide information regarding the general environment this business activity is taking place within.

Sure the information may disparately be floating around in places, but we tie it together and use the economic method to interpret it in a clear concise fashion.  It is a service, a service people are willing to pay for, and so I would suggest it must have value.

Over at Greg Mankiw’s blog he links to a comment on DSGE models by the legendary Robert Solow.  Surprisingly, the comment is relatively negative.

If I am honest, I found Solow’s attack on DSGE a little strange, and fairly inconsistent.  Here is why:

Update: (Before saying why I think this, I should say) This initially came from an Arnold Kling post, and the lingo regarding biology has moved into some of Brad’s negative writing about economists he disagrees with (ht Economist View).  My own view is that these authors are attacking a straw man when they attack DSGE’s (the straw man I’m talking about is the 1980′s RBC model, as I discuss later) – instead of attacking the inappropriate assumptions of some of the practitioners they have decided to attack the method.  This disappoints me.

Yes – all models have weaknesses.  But it is about seeing what to use and where.  And contrary to Brad’s language he is being far from objective in his attack on this type of modeling.

Now, back to the post as it was a few days ago

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One thing I have noticed of late is that many people want to talk about tax cuts in terms of “who gets what”.  We see someone with an income of $XXX and say they will get $Y a week from the tax cut.  I find this perplexing as I have never seen tax this way.

The reason why I find this way of looking at tax changes strange is that it ignores how prices change in response to the structure of the tax system.  I fear that, to many people, this seems like a benign (possibly even esoteric) issue – when actually it is one of the most essential issues to keep in mind when thinking about the design of a tax system.

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Kiwiblog blogs about to a good sounding report by the Maxim Institute on tax.  I especially like this line:

We need to design the tax system so that it allows the government to take the money it requires, while doing the least amount of damage to the economy and so too our potential prosperity

However, there is a proviso that needs to be taken into account when we say this.  Any redistribution that we as a society deem is appropriate given our value judgments needs to occur through “the money the government requires”.

The tax system that is solely based on efficiency will not be a tool for redistribution.  Depending on our value judgments, we will want a certain level of redistribution, and this has to occur through the level of government spending.  The higher redistribution is, the higher government spending is, and as a result the higher the tax rate will have to be.

Yet, according to this post, the recommendations of the report switch from the design of optimal tax to the equity-efficiency trade-off associated with redistribution:

A 2001 OECD study found that about one half of a percentage point increase in government consumption (the expenditure to GDP ratio) could cause a 0.6 to 0.7% direct reduction in per capita output.

Yes, there is a trade-off.  However, the level of government spending and redistribution should be premised on this trade-off.  By saying something like “If we can limit spending so that over time it is under 30% of GDP” we are making a value judgment regarding the amount of redistribution that is in societies interest – we aren’t discussing the role of optimal taxation.

My main point here is, there are two separate issues:  Firstly, the design of an optimal tax system GIVEN the level of redistribution.  Secondly, the socially preferred level of redistribution.  The first question is easy, even an economist can answer it.  The second question is incredibly difficult.