How to Fix the Banks: Revisited

The bankers are angry. They feel the regulations designed to prevent another meltdown are cramping their style. Their bonuses are down. I agree. Red tape is not the way to save the banking system.

The banks engaged in a freewheeling orgy of unregulated risk taking for two decades. And when the world crashed: they expected, and received, bailouts. But we don't need to bash the banks to save the system.

As a society, we do not have a stake in saving HSBC. We do not have a stake in saving Barclays, or RSBC, or Lehmann Brothers, or Bank of America. But we do have a stake in saving the banking system. Here is a link to a piece I wrote in 2009 on how to do that.

GDP: A Brief But Affectionate Review

For a neo-paleo-Keynesian like me, the first week of an undergraduate macroeconomics lecture is taken up with accounting: Tedious but necessary. What is GDP? How is it different from GNP? National Income? How do we measure it? Does it matter? I've always struggled with outside readings to fill this material out and make it interesting. Now I have one. Diane Coyle has written a timely and very readable little tome about her love affair with national income accounting. It's very short, and you will be able to gobble it down in an afternoon. I did, while whiling away a few hours on a flight.

Why? You say! How could this be interesting? It's interesting because it has a lot to say about the current controversy over productivity. Unemployment is almost back to normal in the UK and the USA. But Real GDP is lagging well behind trend. How could this be?

We have been drinking the index-number cool-aid for so long that we have forgotten how difficult and ambiguous it is to construct a measure of aggregate product in a world where more than 60% of GDP is intangible: as Diane would say, it is weightless.

It is tempting to give up entirely on measuring real GDP and implicitly on economic growth. One might argue that we should be far more concerned about resource utilization than about the number we attach to an increasingly diverse bundle of differentiated commodities. Unemployment matters. What we produce, in a modern market oriented economy, arguably, matters less.

If we are interested primarily in resource utilization, the stuff of business cycles, there is an alternative to standard measures of real GDP. We can divide nominal GDP by a wage index, instead of a price index. Labor has a least a semblance of homogeneity and aggregating the time input of doctors with that of burger flippers is surely easier that adding plum puddings to computer chips. I showed how to do this, in a recent book, by using national income accounting data to estimate the money wage: My wage index data is available here.

I do not want to suggest that we should stop trying to measure growth. Economic progress is an important idea as 1.5 billion Chinese can attest to. If we must be metaphorical bean counters, and there are few alternatives to counting progress, there is no alternative but to bite the bullet and produce the best measures of an aggregate price index that we can. But as Diane reminds us, small revisions to our measurement methods can cause very large revisions of our estimates. Let's not be too concerned when our index numbers temporarily misbehave.

Thought for the Day: Animal Spirits as a New Fundamental

 In IS-LM models there is always something in the background shifting the IS curve.  What is it?  

In my view that 'something' is Keynes' animal spirits that we should add to our models as a new fundamental.

In my work, I close my models by adding an equation that I call a 'belief function'. The belief function is an effective way of operationalizing the Old Keynesian assumption of ‘animal spirits’. It is a forecasting rule that explains how people use current information to predict the future. That rule replaces the classical assumption that the quantity of labor demanded is always equal to the quantity of labor supplied.

Here is a link to the blog I wrote on that topic last year.

Multiple Equilibria and Financial Crises

Models of sunspots and multiple equilibria were developed in the 1980s as an alternative to the dominant Real Business Cycle agenda. For the last couple of decades, these models have taken a backstage role as explanations of the macroeconomy. Now they are back with a vengeance. 

On Thursday and Friday of this week, Jess Benhabib and I are running a conference at the San Francisco Fed that showcases new research on multiple equilibria and financial crises. The papers at this conference trace their roots to an agenda on sunspots, developed at the University of Pennsylvania in the 1980s.

The sunspot agenda began with the seminal paper by David Cass and Karl Shell, Do Sunspots Matter?, the pathbreaking paper on Self-Fulfilling Prophecies by Costas Azariadis and a paper by myself and Michael Woodford in which we developed techniques that form the basis for dynamic models of indeterminacy that are now widely used to understand monetary policy regimes. 

Another important landmark was the 1994 conference at NYU, published in the Journal of Economic Theory as a symposium on Growth Fluctuations and Sunspots.  Here is a link to a survey paper that explains the history of the sunspot agenda and its connection to endogenous business cycles.

I'm looking forward to the dinner talk on Thursday night by Karl Shell and I'm also looking forward to seeing the tremendous range of papers that are moving this agenda forwards in new and exciting directions. Here is a link to the conference papers. 

The Unit Root of the Matter: Is it Demand or Supply?

John Cochrane responds to my piece on why there is no evidence that the economy is self-correcting with an excellent blog post

on unit roots. John's post raises two issues. The first is descriptive statistics. What is a parsimonious way to describe the time series properties of the unemployment rate? Here we agree. Unemployment is the sum of a persistent component and a transitory component.

The second is economics. How should we interpret the permanent component?

I claim that the permanent component is caused by shifts from one equilibrium to another and that each of these equilibria is associated with a different permanent unemployment rate. I’ll call that the “demand side theory”. (More on the data here and here and my perspective on the theory here and here ).

Modern macroeconomics interprets the permanent component as shifts in the natural rate of unemployment. I’ll call that the “supply side theory”. That theory is widely accepted and, in my view, wrong. As I predicted in the Financial Times back in 2009, "the next [great economic idea] to fall will be the natural rate hypothesis". 

Lets start with the statistics.

In the comments section, (always worth reading beyond the main post) John and I are in complete agreement that unemployment has two components. One is highly persistent, and well approximated by a random walk. The other is stationary.

Here is John

Hi Roger. We’re converging. Yes, there is an interesting low frequency component in unemployment, that might be modeled well in a short sample with a random walk (unit root = random walk plus stationary component). And unit root asymptotics might be a better approximation to finite sample distributions, plus warn of biases like the AR(1) coefficient.

A random walk, as its name suggests, has an equal chance of going up or down. A stationary variable always returns to a constant number. What about a series that is the sum of a random walk and a stationary component? The stationary bit is always pulling the unemployment rate back to something: but that something is not a number, it’s the random walk component. Unemployment is aiming at a moving target.

John has his own unit root tests. In John's words

"Look at the plot" and "think about the units"

I like that. Here is my “look at the plot” diagram seen through the lens of John’s comment that a unit root equals a “random walk plus stationary component”

John's Unit Root Test: 

"Look at the Plot":

The blue line is the unemployment rate since 1949, the grey shaded areas are the eleven post-war NBER recessions, and the red lines are the means of the unemployment rate for each of the eleven post-war expansions. Because unemployment has a “low frequency component”, the number the economy converges to is different after every recession. It is not a single number. It is a moving target.

So much for the statistics: What about the economics? The central question for policy makers and their academic advisors should be: Why is the target moving? My answer is that aggregate demand, driven by animal spirits, is pulling the economy from one inefficient equilibrium to another. My theoretical work  explains how that idea is consistent with the rest of economic theory. 

The orthodox answer, one we have taught to graduate and undergraduate students alike for the past fifty years is that aggregate supply is shifting from one decade to the next, pushed by changing demographics, shifting tax policies and technological change.  

If permanent movements in the unemployment rate are caused by shifts in aggregate demand, as I believe, we can and should be reacting against these shifts by steering the economy back to the socially optimal unemployment rate. If instead, these movements are caused by shifts in aggregate supply, the moving target is  the socially optimal unemployment rate.

John has not yet staked out a position. On this point he says…

I don't have a definite opinion. There is lots of interesting, new, and unexplored economics on that one. I'll read your paper!

Paul Krugman weighed in on this debate and he claims to agree with John about the statistics, although I’m not sure he read the comments section. 

John and I are in complete agreement: there is  a permanent component in the unemployment rate. That component requires an explanation. Is it demand or is it supply? The answer to that question has huge implications for policy. 

Tired old 1950's theory would attribute the permanent component in unemployment to unavoidable natural rate shifts. Shiny new Neo-Paleo-Keynesian theory would attribute the permanent component to avoidable shifts in animal spirits. Which is it Paul: Demand or Supply?