Please: Lets Agree to Speak the Same Language

Olivier Blanchard finds the drop in the value of American stocks hard to explain in a framework where only fundamentals matter. He concludes that ‘herding’ is to blame.

Can we please agree on terminology? Animal spirits, confidence, sunspots, self-fulfilling prophecies and, sentiments have all been used to mean shifts in markets caused by factors that are non-fundamental. Now Olivier adds herding as one more term. (To be fair, that term too has been used before in the finance literature). Why this smorgasbord of synonyms?


Beatrice Cherrier and Aurélian Saïdi have a nice survey of the history of sunspots. The idea that non fundamental factors can have real effects, was developed at the University of Pennsylvania in the 1980s at about the same time that the Real Business Cycle model took off. According to the RBC school, recessions are times of technological regress caused by shocks to technology. According to the sunspot school, recessions are times when belief shifts move the economy from one equilibrium to another. Initially, both paradigms flourished but the RBC agenda pulled ahead and stayed ahead for thirty years. That is now changing.

Why this divergence in fortunes? According to Cherrier and Saïdi there were three major reasons why the RBC program pulled ahead. 1) there was no single strong individual to promote the sunspot agenda and the three initial leaders, Costas Azariadis, Dave Cass and Karl Shell could not even agree among themselves. Azariadis used the term self-fulfilling prophecies. Cass and Shell used sunspots. 2) The literature on sunspots was technically demanding and the protagonists made no attempt to explain it to a non technical audience. 3) Cass, Shell and Azariadis were not interested in empiricism and they did not make an effort to promote their agenda at central banks or at applied groups such as the National Bureau of Economic Research.

My own work on self-fulfilling prophecies began at Penn in the early 80s and I have made the effort to promote this agenda at central banks and to promote these ideas in a series of books and coauthored papers. My research agenda has been devoted to explaining these ideas to a non technical audience and to providing a link with empirical work. My coauthors on this agenda include Michael Woodford,  Jess Benhabib and Jang-Ting Guo. Why weren’t we more aggressive in promoting the agenda? I can only speak for myself; but I realized early on that, if we accept the idea that business cycles are just autocorrelated disturbances around the natural rate of unemployment, that a sunspot shock is one more disturbance that takes its place alongside productivity shocks, tastes shocks, news shocks and monetary disturbances.

In a survey paper published here, I distinguish between first and second generation models of endogenous business cycles. I use that term to mean models driven by non-fundamentals (yes, I too am guilty of adding one more synonym). In first generation models, sunspots are one more shock that temporarily shifts the economy away from the natural rate of unemployment. In second generation models, movements away from the natural rate are permanent. There is no self-correcting mechanism.

If you are a graduate student or a researcher who is working, or planning to work, in this area, I have a plea. Can we at least agree to add no more words to refer to the same idea? Please: Lets agree to speak the same language and, in so doing, give credit to those who laid the foundations for this agenda.

Why a Bottle of Beaujolais is not the same as a Collateralized Debt Obligation (Updated May 2016)

I have updated this blogpost with a link to the new version of my paper. The new revised paper has the title of "Pricing Assets in an Economy with Two Types of People". 

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Brad DeLong kindly tweeted a link to a working paper (updated to new version May 21st 2016) I wrote last year. Matt Yglesias asks Brad to explain the paper. Let me take a stab at that.

Every graduate student of economics learns, early in her career, that markets work well. The idea that ‘markets work well’ has a well defined meaning: allocating resources by buying and selling goods in free markets does at least as well as any other way of allocating them. Let me be more precise.

A society, to an economist, is a bunch of people and a bunch of goods. A good is something that people want. For example, a ticket to see the latest Star Wars movie is a good. A bottle of Beaujolais is a good: and so is a banana. I could go on. But the basic idea here is that everyone in society has preferences over different bundles of goods. I personally would prefer a bottle of Beaujolais and a banana to a trip to the movies: but you may rank things differently.

We need a way of thinking about abstract ways of allocating goods amongst all of the people in the society that is general enough to include the activity of buying and selling goods in markets as one possible allocation mechanism. Economists think about that idea by introducing an abstract individual that we call the social planner. The social planner is a non-existent benevolent dictator who knows the preferences of every person in society.

Imagine that we dump all of the goods that exist in a big pile in the middle of a very large imaginary room. Now let the social planner allocate them to people. For example, she might give everyone equal amounts of every good. That might sound like a good idea, but some people might not drink wine. They would prefer an extra loaf of bread to a bottle of Beaujolais. That idea suggests that some ways of allocating goods are better than others. If the social planner finds a way of allocating goods among people that can’t be improved on, without making someone in society worse off, we say that that allocation is Pareto Optimal.

There is not just one Pareto Optimal way of allocating goods. There are many. And some of them are very bad from a moral perspective. For example, if the social planner gives everything to one selfish person: that allocation is Pareto Optimal. Why? Because, in order to give food to starving children we need to take it away from the selfish person. And that, by assumption, makes him worse off. Pareto Optimality is a very weak concept.

But although Pareto Optimality a very weak concept it is an interesting concept because, if an allocation of goods is not Pareto Optimal, it is very bad indeed. Everybody in society, from the very richest to the very poorest person, could agree upon an intervention that would change things for the better.

Graduate students of economics learn, early in their careers, that markets allocations are Pareto Optimal. Markets may not produce outcomes that you or I judge to be morally acceptable. But they do not leave room for any obvious improvements that we could all agree upon. That idea, with a little reflection, seems to me to be obviously wrong. The ‘Global sunspots…’ paper provides one reason why.

Ok. That's the background. To understand my ‘Global sunspots paper…’ I need to go a little further by elaborating on the idea of a ‘good’.

Writing in 1959, the Nobel laureate, Gerard Debreu, suggested that the theory of markets that I just explained, is much more general than it at first seems. Debreu asked us to think of a good in a new way. A loaf of bread is not just a loaf of bread. It is indexed by location, date and state of nature. A loaf of bread in Paris on March 9th 2016 in the rain, is a different good from a loaf of bread in London England on July 20th if the sun is shining.

Financial economists took that idea and they ran with it. They argued that the financial markets provide people with ways of trading goods across space, time and states of nature. And because market allocations are Pareto Optimal, there is no possible intervention in the financial markets that can make us all better off. Government should get out of the way and let the magic of the market do what it does best.

According to financial economists, the financial instruments that are traded on Wall Street are unequivocally good. Equities, bonds, and exotic derivatives like collateralized debt obligations (CDOs)  all provide opportunities that connect people across time and space. To justify their confidence in the magic of the market, financial economists appeal to the mantra that they learn as graduate students: market allocations are Pareto Optimal. What could possibly be wrong with that?

The problem is a simple and obvious one. In order for markets to work well: we must all be able to take part in them. One of the most important functions of the financial markets is the ability to make bets on the future. If I think that the S&P 500 will crash next month, but you don’t, we have an opportunity to trade. And if I face different outcomes if the market crashes, or if it booms, I will try to insure myself by selling the market short in boom states and paying for that trade by buying the market in the crash state. It is my ability to make those trades, which ensures that market movements are not capricious. If a crash occurs, it occurs for a reason. And that reason is connected with the fundamentals of the economy. That, at last, is the theory. That theory is wrong.

That’s where sunspots come in. Writing in 1983, David Cass and Karl Shell picked up on a phrase that had been used much earlier by Stanley Jevons. Jevons thought that sunspots influence the business cycle through their effect on the weather. Cass and Shell meant something very different. They used the term as a spoof to mean capricious movements in market prices, and in the goods that we all consume, that are unrelated to fundamentals.

That leads me to the conclusion of my global sunspots paper. Because we cannot trade in financial markets that open before we are born, most of the movements in financial markets are Pareto inefficient. Financial markets go up. Financial markets go down. If you are lucky enough to enter the labor market in a boom; you will have a happy and prosperous future. If your first job occurs in the wake of a financial crisis: tough luck.

A bottle of Beaujolais is not the same as a Collateralized Debt Obligation. Why? Because trades in CDOs affect the welfare of the unborn: and the unborn are not around to trade in the CDO market. Stay tuned. I have much more to say about this idea in my forthcoming book ‘Prosperity for All’, to be published by Oxford University Press in 2016.

Scott Sumner and Musical Chairs

Since 2009, Scott Sumner has been a big proponent of nominal GDP targeting. He sees nominal wages as slow to adjust and he has sketched a simple model, the musical chairs model, to explain why his policy should be adopted.

I am a new convert to these arguments. That is my loss. I had assumed, incorrectly, that Scott was proposing that central banks should simply adjust the coefficients on their interest rate policies, so called Taylor Rules, to raise the nominal interest rate when nominal GDP growth is above target and to lower it when nominal GDP growth is below target. I will refer to that variant of NGDP targeting, as growth rate targeting. An alternative, NGDP level targeting, would make these interest rate adjustments in response to deviations of nominal GDP from a target growth path.

Viewed in this light; NGDP targeting, of either variety, is not a particularly new idea. Nor does it represent a departure from the body of New Keynesian economics that grew up in the decades since 1983, when Ed Prescott sought to banish money from macroeconomic models. Scott is saying much much more than that.

The novel aspect of Scott’s proposal, and one that I endorse wholeheartedly, is the means that he advocates to achieve his goal. Scott proposes that central banks and/or national treasuries should set up markets for nominal GDP futures. Robert Shiller has made a similar suggestion. He proposes that national treasuries finance their borrowing by issuing securities that pay off a dividend that is proportional to nominal GDP. He calls these ‘Trills’; where a Trill is a claim to one trillionth of GDP in perpetuity.

In my own work, I have drawn attention to the remarkable stable connection between the real value of the stock market, and the unemployment rate. I interpret that connection through the lens of a causal theory in which expectations drive asset values, and asset values drive aggregate demand. I have suggested that central banks trade an exchange traded fund to stabilize real economic activity. Hold that thought as the word ‘real’ represents a significant point where Scott and I differ.

Trading Trills, trading GDP futures and trading an ETF, are all methods of targeting nominal wealth. I do not want to quibble over the exact method: and I readily concede that Trills or GDP futures have advantages over ETFs.

The important insight here, is that wealth, or permanent income, drives aggregate demand and that expectations cause inefficient fluctuations in aggregate demand that can be stabilized through relatively straightforward interventions.

In the simplest macroeconomic models, GDP measured in wage units, is proportional to employment:

PY/W = bL

where P is ‘the’ price level, Y is real output, W is the money wage, L is employment and b is the inverse of labor’s share of income. Scott points out that money wages move slowly and that, as a consequence, stabilizing PY will stabilize employment, and eventually, wages and prices. Scott  bases his ideas on Samuelson’s neoclassical synthesis (see Pearce and Hoover). According to this idea, the economy is Keynesian in the short run, when prices and wages are sticky, and classical in the long-run. 

In Scott’s world, the economy homes in on the natural rate of unemployment just as surely as a heat-seeking missile converges to its target. Scott’s intellectual heritage is firmly monetarist. If Milton Friedman were alive today, one might imagine that Scott would find a supporter for his ideas.

My own heritage is different. I have sought to wed post-Keynesian insights with new-classical ideas by resuscitating the idea that the economy is not self-stabilizing. There are many equilibrium unemployment rates and any one of them may be an equilibrium. 

I wholeheartedly endorse Scott’s proposal for open market trades in GDP futures. And, like Robert Shiller, I would like to see the creation of a market for Trills. Unlike Scott, I do not endorse the proposal to stabilize either the level or the growth rate of nominal GDP. Trades in GDP futures should aim to stabilize the unemployment rate. And here is my biggest difference from Scott: trades in GDP futures should be seen as a complement to inflation targeting: not as a substitute.

As I explained in my 2013 book,  How the Economy Works, the economy is not a rocking horse, always returning to the same rest point, a metaphor that originates with Wicksell. It is a boat on the ocean with a broken rudder that requires active political interventions to steer it to a safe harbor.

Policy interventions have two dimensions: not one. Central banks should continue to set the overnight interest rate in an effort to target the inflation rate. They should adopt a second instrument, the purchase and sale of GDP futures, to target real economic activity. For more on this idea, stay tuned. I have forthcoming book in 2016  with 

Oxford Univesity Press with the working title: Prosperity for All. It will be available in mid 2016.

Demand Creates its Own Supply

I have been teaching basic Keynesian economics this week to my undergraduate class and I have just completed a new book manuscript with the working title of Prosperity for All, that will be coming soon to a book store near you. I am thus highly attuned to the debate over the connection between savings and investment. That debate resurfaced with a vengeance this morning on Twitter when Noah Smith and Jo Michell, among others, engaged in a sometimes testy exchange on the role of the State in promoting investment. Since that debate is at the core of Keynesian economics, and since my class is prepping for Monday’s midterm, this seems like a great opportunity to enlighten readers of all varieties on what Jo and Noah were on about.

Keynesian economics begins with a basic definition. To sharpen the discussion, I will abstract from the role of government and I will abstract from foreign trade. In an economy with no government, and no foreign trade, we may define all of the goods produced in the economy to be of two types; a consumption good or an investment good. Since all of the income earned by the factors of production is earned from producing either consumption goods or investment goods, it is IDENTICALLY TRUE that:

1) YN = CN + IN

Here, YN is the dollar value of all of the incomes earned by workers, capitalists and landowners in the process of producing consumption goods worth CN dollars and investment goods worth IN dollars. The letter N stands for “nominal”.

In recent discourse, economists have sometimes resorted to the fiction of the one good representative consumer model in which we assume that the economy produces a single good from capital and labor. That IS NOT what I am assuming here. YN IS NOT a single good. It is the dollar value of all final goods produced in a given year.

To move from nominal values, to real values, we need to deflate equation (1) by a nominal index. The Keynes of the General Theory made a very sensible suggestion that has been ignored for the past eighty years and that I resuscitated in my book, Expectations Employment and Prices. He suggested dividing both sides of identity (1) by a measure of the money wage. That is a great way to normalize measurements over time because the money wage grows for two reasons. It grows when there is inflation in the dollar. And it grows when there is real economic progress. Dividing equation (1) by the money wage leads to the following identity where Y, C and I represent GDP, consumption and investment measured in wage units.

2) Y = C + I

Equation (2) is, at this point, still an identity. Now comes the economics. Keynes introduced two simple pieces: A theory of aggregate supply. And a theory of aggregate demand.

The Keynesian theory of aggregate supply asserts that firms will increase or decrease the number of workers they employ in order to produce as many goods as are demanded. The French Economist John Baptiste Say, famously asserted that: Supply creates its own demand. Keynes turned this proposition on its head. In Keynesian economics: Demand creates its own supply.

Keynes argued that the economy is typically producing at less than full employment. And as long as there is any involuntary unemployment: everything that is demanded will be supplied. That central proposition can be represented by a graph in which expenditure appears on the vertical axis, and income appears on the horizontal axis. A line at 45 degrees to the origin, for which income equals expenditure, IS the Keynesian aggregate supply curve.

Keynes did not explain why firms would respond to deficient demand by reducing employment, as opposed to cutting wages. He thought that workers would resist reductions in their wages, but he did not believe that sticky wages were central to his argument. Although Keynes never provided a fully articulated theory that would reconcile his ideas with microeconomics: I have provided such a theory. In my published research, I explain why the forty five degree line is an aggregate supply curve. My work is grounded in the microeconomics theory of search. But I digress. More on aggregate supply in a future post.

Recall that my purpose here, is to explain the debate between Noah and Jo on the equality of savings and investment. In order to move forward with that purpose, let us accept, for now, the Keynesian theory of aggregate supply and move to the Keynesian theory of aggregate demand.

Keynes asked, what determines expenditure on consumption and investment goods? He claimed that aggregate expenditure on consumption goods, by a community of people, will increase when the income of the community increases. But it will increase less than proportionally. He called the constant of proportionality, the marginal propensity to consume. We may represent that idea by equation (3):

3) C = a + bY

Here, ‘a’ is a constant that I will call autonomous consumption expenditure and ‘b’ is the marginal propensity to consume.

Finally, we need a theory of investment. Investment, in the basic version of Keynesian theory, is a highly unstable variable that is driven by the animal spirits of investors. Each year, investors make plans and they enact those plans by placing orders for new machines and factories. I will represent the planned expenditures of investors with the symbol IP. Let me also use the symbol X to represent total expenditure and XP to represent planned expenditure. That leads to the following equations, 

4) X = C + I

5) XP = C + IP

and, using the theory of consumption from (3)

6) X = (a+I) + bY

7) XP = (a+IP) + bY

Equations (6) and (7) distinguish expenditure, X, from planned expenditure, XP. It is identically true that

8) X = Y

But it is only true, in equilibrium, that

9) XP = Y

The difference between I and IP is that goods that are produced, but not sold, are DEFINED to be investment goods. If Toyota builds 100,000 cars, but only 20,000 are sold, the 80,000 unsold cars are defined to be investment expenditure. But they are not defined to be part of planned investment expenditure. An economy in which unplanned inventories increase by the real value of 80,000 cars is not in equilibrium. To restore equilibrium, Keynes argued that Toyota will fire workers, those workers will spend less, and income will fall to the point where saving equals planned investment.

What about the equality of savings and investment? By definition, every dollar not spent, is saved.

10) S = Y – C

Here, S represents savings. A little further algebra establishes that, when Y = XP, it is simultaneously true that

11) S = IP

Here, finally, is the answer to the exchange between Jo and Noah. It is always true, in equilibrium, that savings is equal to investment. In Keynesian theory, it is income and employment that adjust to make this so. In Keynesian economics: Demand creates its own supply.

A Bridge Too Far?

There is much current angst on the difficult problem of how to escape a liquidity trap. Paul Krugman points out that in Japan, the ratio of debt to GDP is growing, leaving little room for a further tame fiscal expansion. He favors something more aggressive.

Tony Yates argues instead for a helicopter drop. Print money and give it to Japanese citizens. The benefit of that approach is that it does not leave the government with an increase in interest bearing debt. Simon Wren Lewis looks more closely at the technical aspects of this idea.

What are the differences between aggressive fiscal expansion financed by debt creation; and printing money and giving it to citizens? There are two.

First, an aggressive fiscal expansion, as envisaged by Keynesians, would be spent on infrastructure. A money financed transfer would be spent by citizens.

Second, an aggressive fiscal expansion, as envisaged by Keynesians, would be financed by issuing long term bonds. A money financed transfer would be financed by printing money.

While infrastructure expenditure is sorely needed, at least in the U.S., I see no reason to give up on sound cost benefit analysis to decide which projects are worth pursuing and which are not. That’s why I favor giving checks to citizens over building a bridge to nowhere.

Once we decide how the fiscal expansion is to be distributed, we face the second question: how should it be financed? Print money? Or issue long term debt. Standard Economic models tells us that it doesn’t matter. At the zero lower bound, money and three month T-bills are perfect substitutes. And financing expenditure by three month T-bills has the same effect as financing it by thirty-year bonds because the composition of the government’s liabilities is supposed to be irrelevant. That of course, is nonsense. The composition of government liabilities matters. And it matters a lot.

Why does the composition of debt matter? Because the asset markets are incomplete. Our children and our grandchildren cannot participate in asset markets that open before they are born. And none of us can sell our human capital or buy the human capital of others. Once you realize that the composition of the governments portfolio matters, it is a short step to recognize that it is all that matters.

Why be wary of building bridges that are financed with 30 year bonds? Because the yield on these bonds is low; but it is not yet zero. A big increase in public sector borrowing, at the long end of the yield curve, will drive up rates and crowd out some private investment. A big increase in public sector borrowing at the short end of the yield curve will not crowd out private sector investment because rates at the short end of the yield curve are currently zero.

That observation suggests a third alternative to building bridges or to a helicopter drop. Buy back long term government debt and refinance it by printing money. That strategy would, one hopes, lower yields at the long end of the yield curve and stimulate private companies to invest in new capital projects.

I prefer private sector investment over government sector investment. But there are also good arguments for more public infrastructure projects. Build a bridge if it is needed; but make sure that it goes somewhere first. More importantly; finance the project by printing money: not by issuing thirty year bonds.