Everything that needs to be said has already been said.
But since no one was listening, everything must be said again.

Andre Gide

Friday, November 25, 2011

A bridge over the macroeconomic divide

No one can deny that Paul Krugman is a gifted expositor of economic ideas. His column today, "Death by Hawkery," constitutes a fine example of this skill in action.

What I found most interesting in this column is something that would have almost surely escaped his average reader. In particular, I noticed that in telling his basic story, he appealed to a mathematically explicit model of credit cycles written by Nobu Kiyotaki and John Moore (JPE 1997).

Why do I find this interesting?

Well, first of all, I notice that at the time, Kiyotaki was affiliated with that great "freshwater macro" department at the University of Minnesota. You will also notice that the arch-devil Ed Prescott is thanked (among others) for his "thoughtful comments and help" on the paper.

I mention this because I think that Krugman has in the past overemphasized the disagreement that exists among the newer cohorts of macroeconomists (one could make the case that disagreement was much greater in the past); see, for example, here: Disagreement Among Economists. On this matter, I side with Steve Williamson, who I think has rightly taken Krugman to task on this issue; see here and here.

Secondly, I find it interesting that the mechanism highlighted by Kiyotaki and Moore in no way relies on nominal or real price rigidities. It is, in fact, a real business cycle model. Yes, you heard me correctly: Paul Krugman is appealing to an RBC model to help him account for recent events. (Granted, it is an RBC model that incorporates limited commitment, a friction that plays a prominent role in all modern macro theory; see my post here: Asset Shortages and Price Bubbles: A New Monetarist Perspective).

I think this constitutes evidence that the great macroeconomic divide is not as great as it is sometimes portrayed. Most of the disagreement I am aware of is of the gentlemanly "let us agree to disagree" type. But there is no fundamental disagreement in basic macroeconomic methodology among most academic macroeconomists. (There are, of course, healthy and welcome challenges from the fringes of the profession.)

Now for some comments on the economic ideas.

As you may have gathered from my previous post, I am generally sympathetic to the idea of expanding the supply of U.S. treasury debt at this time (with a commitment to unwind in the future, if and when economic conditions improve). Of course, a big question is what to do with the funds acquired in this manner. I'm with Krugman in that heck, we may as well use it to build physical capital (public infrastructure). Financing a corporate tax cut to stimulate domestic private capital spending might be a good idea too (not so politically popular though).

These provisional policy recommendations suggest themselves to me by way of a class of "new monetarist" models that I like to use to organize my thinking about things. But I should say, however, that I'm still not sure just how seriously to take these models (at least, their current incarnations). I'm still a little sketchy about how one might plausibly generate negative real rates of interest in these models; that is, models that take seriously the intertemporal production capabilities of actual economies (you will note that Krugman abstracts from physical capital in telling his little story).

I can't help but note that this same class of models might be used instead to support "conservative" policies. In particular, one force that can potentially drive the expected marginal product of capital (real interest rate) lower is the rational (or irrational) expectation of a future regulatory/tax burden paid for by capital accumulators of all types (including human capital).

If (and I emphasize the if) this is the (or a significant part of the) fundamental problem (and how do we really know that it is not?), then it is hard to see how treasury debt expansion and/or inflationary policy is going to solve it. Fixing the problem in this case means providing an environment that rewards private investment. Death by Dovery is also a possibility. 


  1. Mr. Andolfatto, you say that Krugman "appealed to a mathematically explicit model of credit cycles written by Nobu Kiyotaki and John Moore (JPE 1997)." This fact is "something would have almost surely escaped his average reader."

    For those average readers out there, could you cite where Krugman appeals to this model? Thanks.

  2. BJH: He mentions them explicitly in his column. You can also take a look at this:

  3. There are at least four ways to generate a lower (negative) real interest rate:
    [i] lower expected growth over the medium-run
    [ii] higher uncertainty
    [iii] higher expected capital taxes
    [iv] larger intermediation wedges between lenders and creditors

    and all seem relevant today.
    I would also be careful to distinguish between the real risk-free interest rate and the return on capital - the difference between the two, the risk premium, is arguably large esp. today.

  4. David,

    Off topic, but being a former Fed guy, I was hoping you could clear up a debate. Zerohedge claims the Fed is secretly propping up banks. Can you opine?



  5. Krugman has to pretend there is a massive divide to make his whole gimmick work. Krugman wants to convince people that there are "good guys" and "bad guys" in economics. Now the bad guys, as Krugman has told us so many times, are these evil economist who believe in RBC models (never mind a New Keynesian model is just an RBC model with a preferred friction, namely nominal rigidities) and what do they want? Well, they want to do nothing and want to see poor people starving and massive unemployment! Once Krugman sets up the stage that anyone who dares to disagree with him is just a bad guy who wants people to starve on the streets, then he can dismiss any argument they make out of hand without engaging them in any serious way. I mean, c'mon, who would listen to someone who advocates children starving in the streets with their unemployed parents?

  6. Why just a regulatory or tax burden story? Here's an alternative: Low consumption propensity households ("savers") lend to high propensity ones ("spenders") via levered shadow banks. The spenders make up for "temporarily" stagnant real wages by borrowing to pull forward consumption. Then both groups discover that wage stagnation might not be temporary. As a result, the savers come to doubt the creditworthiness of the banks and spenders; and the spenders realize the need to save more. This reduces the spending trend, raises uncertainty on returns to capital, and reduces financial intermediation. Now throw in policies that explicitly try to prop up asset prices and zombie banks: this transfers wealth from owners/creditors of new projects to owners/creditors of legacy ones. The result is yet more uncertainty over returns on capital.

  7. David,

    Why is it that you don't consider the existence of an equity risk premium as reconciling a negative risk-free real interest rate with a positive marginal product of physical capital?

  8. David Pearson:

    Your story sounds plausible, as do many others. I guess the trick is in trying to get a sense of the relative importance of various explanations.

    Adam P:

    Short answer is that I haven't gotten around to modeling that force. It is possible to generate MPK > 0 > R without it, and I'm looking into it. (The wedge is driven by depressed asset values, insufficient to serve as collateral for expanded capital investment.) Do you have a nice model that you teach to students about risk premia? Please send it along!

  9. " I am generally sympathetic to the idea of expanding the supply of U.S. treasury debt at this time (with a commitment to unwind in the future, if and when economic conditions improve)."

    isn't that just like a temporary OMO, i.e. should have no impact because of ricardian behavior on the part of taxpayers? and if it is not like a temporary OMO, is that because you think the economy would benefit from fiscal stimulus via a multiplier effect?

  10. Anonymous, I think that limited commitment (borrowing constraints) are important; so no Ricardian equivalence. No multiplier effect either. I have a model written down that I can email to you if you want. (A simple OLG model).

  11. A bit off topic but...

    Did you see that Krugman was pushing for pre-1981 tax rates (70+% ?), at least for high-income brackets?

    PK apparently thinks that the Laffer curve is monotonic.

  12. Nope, Kruggie thinks that higher taxes will force more capital savings to find a investment home ala the post-war economy and boost labors savings surging spending.

    Fact is, the whole "Austrian" philosophy is about lust of capital owners savings and the hatred of labors savings. Anytime a Austrian says "savings" he means capital owners only. Don't fall for that.

  13. I would love to know Krugman's views on the kill-take versus negotiate-exchange decision.

    Is Krugman a partisan ethnic cleanser? Sometimes what you do not say is almost as important as what you say.....

  14. You write, "how do we really know that it is not?" to which Anon. adds, "should have no impact because of ricardian behavior on the part of taxpayers?"

    Of course, we know that both statements are false. All we have here, again, is bias parading as science.

    Why do we know the statements are false.

    Because the taxpayers who are said to be acting on thet basis of ricardian would also know that if people are not employed in fulfilling and productive lives that not only do they risk loss of property, their heads might well end on pikes.

    IOW, force and violence are trump cards in the world of "rational" taxpayer behavior. If these considerations drive behavior (there is no evidence they do) then taxpayers would prefer higher taxes to having their heads on pikes

    So, what have we learned? The crap above, and its is crap, is a bluff. It is an attempt of the surrogates for the rich to preserve their lords riches and power.

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