Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Sunday, July 29, 2012

The Microfoundations Windmill

Well done, Don Paul!
I can't help it. I just have to say something about  Paul Krugman's latest complaint (in a series of seemingly never-ending laments) concerning yet another "problem with the economics profession." See here: Making Ourselves Useless.

A well-aimed critique constitutes an important step in helping us understand things better. In this case, however, I think he is largely making things up--methinks our fair knight is chasing windmills.

Krugman begins by quoting Simon Wren-Lewis (who I happen to find quite sensible most of the time, just not in this case) in reference to the profession's alleged obsession with "microfoundations:"
If you think that only ‘modelling what you can microfound’ is so obviously wrong that it cannot possibly be defended, you obviously have never had a referee’s report which rejected your paper because one of your modelling choices had ‘no clear microfoundations’. One of the most depressing conversations I have is with bright young macroeconomists who say they would love to explore some interesting real world phenomenon, but will not do so because its microfoundations are unclear.
Oh, please. Papers are rejected all the time and for all sorts of reasons. That goes even for papers with microfoundations. And as for those "bright" young economists, they sound truly misguided. Not sure who's to blame for that, however. 

It is true that "microfoundations" are valued in the profession (and Wren-Lewis has several excellent pieces explaining why). But just what are these pesky "microfoundations," anyway?
A narrow view of  "microfoundations" is reflected in the idea that the methodology of microeconomic theory (specifying individual preferences, information sets, endowments, constraints, together with an equilibrium concept) can and should be brought to bear on macroeconomic questions. This is in contrast to an earlier methodology that specified and estimated behavioral relations at the aggregate level. (One can legitimately weigh the pros and cons of these (and other) methodologies.)

Not many macro models are "microfounded" in a pure sense. Almost all models make at least some assumptions that may be viewed as ad hoc and provisional (subject to further investigation). I think of an ad hoc assumption as a restriction on behavior that is inconsistent with other aspects of the model, like maximizing behavior.

To give an example, in most "microfounded" models of money there are ad hoc restrictions placed on the set of assets that might serve as exchange media. Consider a model with money and bonds. The modeler typically assumes that money is used to buy things and that bonds are not. While a "cash-in-advance constraint" of this sort may be descriptively accurate, it does not explain why bonds cannot be used to buy things. In short, liquidity is assumed and not derived. It is generally understood that shortcuts of this sort may matter for some questions and not for others. Understanding where and how these assumptions matter for the particular question at hand is part of the skill set that defines a good economist.

Sticky nominal wages is another popular example. Actually, in this case, I think it's rather worse. As I explain here, sticky nominal wages are likely only relevant if one adopts the questionable assumption that the labor market operates as a sequence of  anonymous spot markets.

Anonymity is a very bold assumption. In particular, it rules out the formation of relationships--something that most of us would recognize as being an important element of most labor market transactions. If the labor market works more like a marriage market, then spot wages (whether real or nominal) are inconsequential for resource allocation. What matters is the manner in which surplus is divided. And generally, there are many wages paths (real and nominal) that are equivalent to dividing the surplus in a particular manner. (This is something Barro (1977) pointed out long ago.)

So why do I mention this? Well, let's see what Krugman has to say:
And this [Lucas Critique] is fair enough. But what if you have an observed fact about the world — say, downward wage rigidity — that you can’t easily derive from first principles, but seems to be robust in practice? You might think that the right response is to operate on the provisional assumption that this relationship will continue to hold, rather than simply assume it away because it isn’t properly microfounded — and you’d be right, in my view. But the profession, at least in its academic wing, has largely chosen to take the opposite tack, insisting that if it isn’t microfounded — and with all i’s dotted and t’s crossed, no less — then it’s not publishable or, in the end, thinkable.
Can you spot what's wrong in that passage? No, it's not the first sentence--it's everything that follows.

First, I see a lot of other facts in the labor market that I might like to model, like the coexistence of large gross flows of workers into and out of employment--something, sticky nominal wage models frequently ignore. So maybe I want to ignore sticky nominal wages because I'd rather model worker flows--not because I can't "microfound" the phenomenon.

Second, and more important, it is clear that he is just making things up here. Why do I say this? Well, just take a look at one of the dominant paradigms in macroeconomic theory--the New Keynesian framework. As anyone who is familiar with the paradigm knows, it is built around models that embed ad hoc assumptions reflecting the alleged costs associated with nominal wage and price adjustments in auction-like settings. It seems to me, on the basis of this (and plenty other) evidence, that the profession cannot be obsessed with microfoundations in the way that Krugman suggests. On the whole, the profession is much more pragmatic than he makes it out to be.

By the way, I like to take a broader view of "microfoundations;" or, rather, the search for microfoundations. Microfoundations does not, in my mind, mean stopping at preferences and technology, or anywhere else, for that matter. It simply means seeking a deeper understanding. (My colleague, Arthur Robson, for example, is exploring the "microfoundations" of preference formation.) I certainly hope that this search for deeper understanding is not the "obsession" that Paul Krugman is concerned with.

What I find puzzling is that I'm pretty sure that the K-man knows all this. But if so, then what motivates his insatiable desire to tar-and-feather the profession as a whole in this manner? I find the following passage illuminating:
Now we’re having a crisis that makes perfect sense if you’re willing to accept some real-world behavior that doesn’t arise from intertemporal maximization, but none at all if you aren’t — and to a large extent the academic macroeconomics profession has absented itself from useful discussion.
Well, maybe not that illuminating. I mean, he can't literally believe this given that he has a paper with Gauti Eggertsson that makes use of use of intertemporal maximization that purports to explain recent events.

At root, I think the source of the man's bitterness toward the profession is that in his view, we are doing this stuff called "research" into questions for which we already know the answers (the answer is to increase G, something I partially agree with here). We are fiddling like Nero while the economy burns.

I would like to ask Krugman whether he believes there is anything left to learn about how an economy functions in the aftermath of a financial crisis. Is the profession wrong in devoting a good part of its time searching for a deeper understanding ("microfoundations") of how monetary and fiscal policies work using its best available tools? How would he rather we spend our professional time?

Or is the science now settled?


  1. I took my three-credits in macro long enough ago that I missed the whole Lucas revolution. That gives me a different perspective than everyone else on the planet, apparently. But it seems to me that Keynes' main point was you have to look at the big picture. And it seems to me that "microfoundations" takes the big picture, cuts it into a jigsaw puzzle, throws some pieces away, repaints the rest, and says "There, that's better."

    I get agitated when economists start talking about "individual preferences" and "behavior". My preferences and behavior is nobody's business.

    1. It is agitating, but true nonetheless, that human behaviour is predictable in certain circumstances to a high probability. Our preferences are less autonomous, unpredictable, non-causal, than many want to admit, and it makes perfect sense for a psychologist, sociologist, or economist to make models for individual preference.

      I agree with your (awesome!) analogy, but would amend your last statement to being agitated not when they model my preferences but when they do so dogmatically - a simple set of post hoc assumptions turned into the axiomatic truths underlying models that, at least over the last 3 years, have little to do with our world.

  2. Whenever I hear 'microfoundations' I hear 'taking human action seriously.' Economic laws simply do not operate at any level higher than bilateral human interaction. GDP isn't mystical or exogenous to humans, like gravity is. Deriving economic laws that ignore human behavior may accidentally lead to correct conclusions, but likely as not it will lead to incorrect ones.

    Let us not forget the Lucas critique ("hey, um... your models ignore human behavior") came up due to wide failure of macro models of the time to account for observed data.

    If economics is anything, it is the explanation and elucidation of human action. With a proper understanding of human action, economists can (and should) explain the consequences of state policies that interfere with the market order. Or, if differences exist between observed reality and model implications, the economist's job is to explain those differences. And that explanation isn't to say "the market is f'd up because it doesn't conform to my model!"

    Even the Keynesian reasoning behind state stimulus (a big increase in G) is microfounded (although not explicitly). The Keynesian reasoning behind recessions is (most often) a collapse of confidence among business men, which leads to a collapse in investment. Stimulus is supposed to restore that confidence. As much as this argument misses, at the least it is addressing human action. It is not just saying "G goes up, so GDP goes up, and we're done."

    Economics that is not based on a sound understanding of human action is not economics; it's statistics. Now, we can have many fruitful discussions regarding human action & decision making, and I'm not trying to say economists model human action perfectly or even correctly. But that's a different argument for a different time.

    I'll close with this comment: I don't think wages are sticky. Not that they are sticky and it doesn't matter, as David says - but that they aren't sticky in general. I think stickiness appears when wages are presented at too high of an aggregate. No one earns an 'average' salary. If we know anything for the literature David quotes above it is that salaries are largely individualized (unless there is some state interference a la minimum wage). So here is my argument that wages are not empirically sticky:

  3. Edward C. PrescottJuly 30, 2012 at 8:10 AM

    The aggregate production function has proven to be a powerful and useful construct. Solow provides micro foundations based on the work of Houthaker. The aggregate or standin household utility function has proven to be a powerful and useful construct that rationalizes what use to be considered disparate micro and aggregate observations. Non-convexities are important as they give rise to the empirically observed high use of the extensive margin.

    1. "The aggregate production function has proven to be a powerful and useful construct." One of the advantages of the microfoundations approach is its logical consistency. But aggregate production functions aren't logically consistent because, outside of a one-good model, you can't determine the quantity of capital without recourse to an interest rate. I don't know whether there's broad agreement that the aggregate production function has been "a powerful and useful construct," but I do know there was once, and, I think, there still is, broad agreement that it's logically flawed.

    2. I'd be interested in anyone's response to Franklin Fisher's "AGGREGATE PRODUCTION FUNCTIONS – A PERVASIVE, BUT UNPERSUASIVE, FAIRYTALE"

      Does anyone find it curious that Professor Prescott (and many other economists) claim the "aggregate production function has proven to be a powerful and useful construct" in light of Fisher's critique, bearing in mind that Fisher is not a bomb-thrower by any stretch of the imagination?

    3. A thread in response to this comment:

    4. After reading some of the posts on that thread, I rather fear for the future of economics.

    5. I am totally with you, Ed.

  4. "One of the most depressing conversations I have is with bright young macroeconomists who say they would love to explore some interesting real world phenomenon, but will not do so because its microfoundations are unclear."

    This is a bit of hyperbole, no? It has to be hyperbole. Perhaps it is not obvious how to apply microfoundations to a particular problem, but that is part of the research process, is it not? Microfoundations force one to think about the question in a systematic way. In doing so, one can then generate insights about some "interesting world phenomenon." In other words, learning how to apply microfoundations is part of the process of learning about this "interesting world phenomenon."

    And regarding sticky wages/prices, it is far from obvious that this matters in the aggregate. We are often presented with microeconomic evidence that wages and prices adjust slowly, but this does not necessarily imply that the price level is sticky. Burdett and Judd and others have demonstrated this. What the Burdett-Judd model teaches us, in part, is that this is WHY microfoundations are important.

    1. Josh,

      You have a very nice blog. Thoughtful. I like your post about the monetary transmission mechanism. I wonder if you have considered this paper: Friedman, Benjamin and Kenneth Kuttner (2010). “Implementation of Monetary Policy:
      How do Central Banks Set Interest Rates?” NBER working paper w16165.

      Friedman and Kuttner argue that the 'announcement effect' is more important since the 1980s (I think) in setting the fed funds rate. Thus, the way monetary policy is implemented is by the FOMC announcing the target rate, and then banks simply implement that rate. I think the effectiveness of the announcement effect is because of the Fed's credibility in past actions.

      If the Fed has lost credibility because of recent events, then the announcement effect goes out the window (I'm pretty sure).

      At any rate, I think you are absolutely correct the monetary mechanism is super important and gets very short shrift is discussions of optimal monetary policy.


      P.S. Didn't comment at your blog b/c I don't have a Wordpress account.

    2. Thanks.

      In short, I don't know that I buy the argument of Friedman and Kuttner. I have written more about the expectations effect of policy here:

      (Sorry for highjacking the blog, David.)

    3. That's a good post. I'll get a wordpress account and make my inane comments at your blog, where they belong, to avoid driving this truck off the cliff.

  5. microfounded models don't kill economics. Economists kill economics.

  6. Prof J, Wordpress is forgiving. I forget my password all the time and wordpress works it out for me via email.

    Prof, I would like to respond to your first comment above.

    "Economic laws simply do not operate at any level higher than bilateral human interaction."

    Nevertheless, accounts are kept, and creditors have memories. If income shifts or debt accumulates or money drops out of circulation and is replaced by credit, those things not only happen, but are knowable.

    To me... My background is in math, not economics, and long ago besides, but to me it seems that those who focus on microfoundations tend to ignore the accumulations and the imbalances that result from human action. I do not for a moment dismiss the significance of personal freedom and personal preferences, but I think others dismiss the significance of accumulated debt, for just one example.

    "Stimulus is supposed to restore that confidence."

    Oh, no way! Stimulus is supposed to restore spending.

    "Economics that is not based on a sound understanding of human action is not economics; it's statistics."

    Okay. Regardless, it must not be ignored. Excessive accumulations of debt influence human behavior! A long term decline in M1 relative to M2 changes human behavior! If large monetary imbalances are ignored, then economists find themselves caught by surprise when a financial crisis arises from those imbalances.

    1. My replies to your response:

      1) I'm actually not sure what you are getting at here. If it is to say that individual decisions add up across people, then of course. That's indisputable. Although, the next level of that is to be careful not to generalize from the behavior of one or a few people. That is also clear.

      The point of focusing on human action is to understand that it is at the human level that decisions happen. And, I should be clear, that the group that is most focused on human action (the Austrian economists) are the ones that focus on how imbalances cause the business cycle. I don't see how you can see the imbalances without understanding the fundamentals of human action.

      2) Stimulus & Confidence

      I only suggest you to read Keynes. Stimulus restores investment (not consumer) spending by restoring confidence. This is not really controversial.

      3) I can only say that it seems to me you have the causation backwards. A long term decline in M1 relative to M2 is a result of human action. Those actions do affect future actions, but not because we note some statistics are behaving a certain way, but rather because the ratio of one type of money to another type is out of whack, which has resulted from actions taken in the past. That affects actions taken today.

      To take a simple example, I argue that QE and QE2 have caused yields on bonds to decrease, which leads people to discount equities at a lower yield as well. That causes people to view higher-than-before equity prices as reasonable (i.e. commensurate with low bond yields) and so not to think the equity market is overvalued. Others would say (as I would) that the equity market is overvalued because the bond yield is artificially low (below free-market rate).

      I hope that clears up my position.

    2. "Excessive accumulations of debt influence human behavior! A long term decline in M1 relative to M2 changes human behavior!"

      Of course, but the point is that the decline in M1 relative to M2 occurred because a bunch of people chose to make it happen (say, by holding more liquid checking accounts and fewer illiquid MMAs). One cannot simply posit a law that says M1 and M2 must move in the opposite direction, then start from there.

  7. This pair is almost as bad as Krugman:

  8. David, if sticky prices are considered an ad hoc assumption inconsistent with some original underlying model, shouldn't efforts be made to change the underlying model so that sticky prices are no longer ad hoc, but wholly consistent with the model? After all, sticky prices are everywhere.

    1. JP,

      Whether the effort should be made likely depends on the question being asked. For some questions, endogenizing the stickiness may not matter. For other questions, it may (e.g., price changes might occur more frequently in high inflation environments, and this may matter for measuring the cost of inflation).

      In any case, the effort *has* been made.

      Finally, and most important, as I explain above, maybe nominal stickiness *does not matter* in economic relationships. You last comment suggests to me that you did not fully grasp the point I was trying to make here. Sticky prices may be everywhere (I do not believe they are as prevalent as you say), but spot prices are not "allocative" in long-term relationships. Maybe I should write another post on the subject.

    2. How was the effort made to endogenize stickiness? Were microfoundations fiddled with and if so, how? (excuse my poor use of lingo here, I'm a layman). If there is a micro-founded theory of sticky prices (ie. derived from first principles) that goes beyond ad hocness, then why is Krugman complaining about micro-foundations?

    3. JP, well, here are a few examples:

    4. Ok, thank you.

      Can you tell me what microfounds the sticky prices in the Siu paper? My interpretations is that he is introducing a friction whereby firms are monopolistically competitive, and therefore they set prices (rather than take them) and do so in either odd or even periods, ie. staggered pricing decisions. Is that a good interpretation?

    5. JP,

      To hopefully reduce confusion, or potentially add to it, the way to think of 'micro founded' price stickiness is to answer the following: why do people find it useful for prices of things to change slowly?

      You may also look at this post of mine: where I argue that sticky wages per se may be a statistical artifact to a great degree.

    6. Thanks Prof J, I'll check your post out. I am also picking my way through David's old post on sticky prices which seems very clearly written and will probably help answer some of my questions.

      You point out that in order to think about microfounded price stickiness, I need to ask why people find it useful for the prices of things to change slowly. Just to make sure I'm getting this, take the Siu paper as an example. Siu seems to be saying that people find it useful for prices to change slowly because they operate in a world characterized by monopolistic competition. He imposes a two period pricing decision on them, so that individuals are not choosing to set prices monopolistically but are forced to by the environment they are in. Is that how he "microfinds" sticky prices? Perhaps I have it all wrong.

      The only reason I am asking this ridiculously detailed question is because I'm interested in the techniques being used behind the curtains, so to say.

    7. JP,

      I absolutely agree with your motivations. I'm very much against imposing empirical regularities without knowing why they happen - the 'behind the curtains' techniques as you aptly put it.

      I didn't read the Siu paper, and I'm afraid I haven't the time to read it in detail necessary. I can give one example of why stickiness in prices may be desirable.

      Consider gasoline prices. Aside from the prices of daily-traded assets, like commodities & stocks, gasoline prices probably change the most often. But the percentage changes are usually small, though frequent. Gasoline retailers are trying to push through some of the input price variation to the final consumer. We are apparently fine with the variation, and know how to deal with it. Some people hoard gas when the price drops, others 'smooth' consumption by purchasing a fixed dollar amount every week. And the behavior of some is not affected by the price changes. Gasoline retailing is as close to 'perfect competition' as any industry really gets, I think. Completely undifferentiated products that compete purely on price.

      Now, take orange juice. I have noticed the price of orange juice is very infrequent. It changes by a large percentage when it does change, though. The price changes I've observed for, say, Simply Orange, are usually around 10%. Usually up, but I have seen it come down once. When the price went up, I did substitute to a different OJ that was also not from concentrate. Tasted about as good, too. So Simply Orange is this kind of monopolistically competitive firm and when they hold prices down it's because they know that some people will switch to other products of their competitors. So, without having read the paper, I would say yes, that is Siu's microfoundation for his sticky price argument.

      Let me close with a few words about wages, since it is often idle labour people are concerned about. We can probably safely assume both employers and employees like to know, within a range at least, what the costs and benefits are going to be of the the employment contract for the coming time period (month, year, whatever). People smooth consumption, and employers smooth costs as well. Smart employers never expand too fast or shrink too fast, for example. So from a household management perspective, because we don't want our lifestyle to change much from week to week, we prefer a lower but less variable wage to a higher but more variable wage. Although some people like the opposite (commissioned sales people, for example).

      What I fail to see is, when employers shrink the employee roles either voluntarily or due to bankruptcy, why employees wouldn't be offered and wouldn't be willing to take lower wages. In my view, it is much more likely to be: (a) no employees are needed at any price; (b) employees can get better compensation in a different industry. Then, there can be other explanations as to why separated labor can't get a new job, like deep skill mismatch (David's had some posts on that too).

      So, in my view, sticky prices are a shoddy excuse for shallow thinking about the structural problems leading to low rates of employment. My response is long and so I will stop here.

    8. Proj J, thanks for your response. Very interesting. I feel as if one could go on ad infinitum asking about microfoundations. If monopolistic competition is used as a microfoundation for sticky prices, then what micrfounds monopolistic competion, and in turn, what microfounds what microfounds what microfounds sticky prices? etc etc.

      I also finished David's post ( which was well written and helpful.

      I have many more questions but perhaps I'll gather my thoughts first and wait for you two to write more posts on the topic down the road before I hop in.

  9. David

    What are the micro foundations underlying your claims and those of Williamson and Cochrane that inflation lurks in the large reserves now on the balance sheets of commercial banks?

    You seem to think that bank lending is about to explode. Why? Or is there some new micro foundation, different from a commercial loan?

    1. JP,

      Please point me to where I have made this claim. I would like to put your question in context.


    2. Whoops, I'm sorry -- the reply above was directed to "anonymous" and not JP.

      Anonymous, I cannot recall ever saying that bank lending was about to explode. Please provide references the next time you pose a question. Thanks.

  10. David,

    I can not recall your writing such expressly but it is tacit and implicit in everything you write, fromm the topics selected to your attacks on Krugman (what justifies any attack on Krugman unless there is a micro foundation for bank reserves to be converted into cash in the hands of consumers?) (I assume you agree that anyone who thinks that business investment will raise all boats is inflicted with mad cow disease).

    In sum, we continue to be, for all practical purposes, in a depression for 98%+ of the American pubic and no amount of credit easing by the Fed will make a damn bit of difference. But it cannot hurt in any way, either for there is no micro foundation for the any increase in bank reserves to get $$$ into the hands of consumers.

    Instead of attacking Krugman you ought to be attacking all the very serious people, Williamson, Taylor, Cochrane, WJS, Laffler, the end is really endless, who falsely charge that inflation poses some danger.

    That,and you should admit to "fiddling like Nero while the economy burns."

    Macro economics is wholly irrelvant to the situation were we find ourselves, which is a dilemma much like that faced by the German people so ably discussed by Soros.

    There is only on solution for the country and that is massive private debt forgiveness. However, probably correctly, a majority of the public believes that would be totally unacceptable because they have been responsible with credit and such a program would benefit mostly, and certainly most directly, those who were irresponsible with credit.

    Jealously is the most powerful of emotions; thus, nothing will make people who have been responsible madder than programs that benefit those who have been irresponsible.

    The public sees Krugman as speaking in code. His program suggestions, the public believes, will only benefit the irresponsible. You, SW, Cochrane, etc., likewise speak in code.

    The people most responsible are Obama and Larry Summers who had the votes and, had they used them wisely, could have navigated these political shoals. But we all know there was never any wisdom to Larry Summers, a trait that rubs off on too many people who go near him.

    In sum, I am a part of the great unwashed and mad as H**** and appropriately so.

  11. I think the obsession with wage rigidity comes from the desire to model involuntary unemployment, rather than only voluntary unemployment from search frictions. There were plenty of teenagers during the Great Recession who were looking to work at any wage, or even just do odd jobs for strangers, but found no offers at any wage at all. Combined with the fact that almost all wages are either exempt from or well above the minimum wage (that is, it wasn't a matter of simply hitting the lower bound on wages), this looks a lot like sticky prices rather than search frictions.

    I'm personally not committed to the sticky nominal wage story. I've asked quite a few business managers why they laid off dozens of workers during the recession rather than just cutting their wages to equal what they were worth to the firm, and it is hard to get an answer. Usually, after some light interrogation, I get an efficiency wage story--they don't cut wages because people won't work as efficiently. As a result, I'm a big fan of efficiency wage theory of unemployment--worker productivity is increasing in the differentiated wage (or wage relative to a "reference wage" to stay consistent with the efficiency wage literature), and increasing in the unemployment rate (the "no-shirking" condition needed to make the effect relevant). This in turn can be used to derive a phillips curve relationship as well as equilibrium involuntary unemployment, which strikes me as more believable than the New Keynesian phillips curve arising purely from sticky prices. Moreover, efficiency wages somewhat resemble the "marriage market" model of labor contracts you suggest (just look at some of the "gift exchange" models of efficiency wages).

    1. i wonder why you think there is *one* explanation. I see very wide ranging employment practices in the US. I see lots of managers that get variable comp and still get fired. I also see a lot of managers that use layoffs as an excuse to separate the wheat from the chaff. I know several companies that cut base salaries yet still fired people. When the workload is low, it is very difficult to justify a worker standing around doing nothing, even if you are paying them 1/2 price (when you could be paying them nothing!). labor is not the only input either: if you have an aluminum smelter, a very large portion of your costs are electricity and very likely you have a multi-year fixed price contract for electricity, so even if you cut labor costs there are other inputs costs. and there is also debt, which cannot be cut except through bankruptcy.

      and how do i even know what the right amount to cut is? if industries could coordinate price and wage cuts... but thats illegal.

      seems to me that the micro evidence for involuntary unemployment is consistently inconsistent because, like cancer, there is far more than one gene at play, so its very hard even in an experimental scientific setting to determine the exact set of factors that cause it. the fact that we dont know the exact cause does not stop us from trying various things to cure it though.

    2. You mentioned that firms "separate the wheat from the chaff" during recessions--this is actually an example of efficiency wage theory. It is actually fairly similar to the derivation given in the seminal paper by Shapiro and Stiglitz (1984) in which efficiency wages arise out of heterogeneity among workers.

      The multi-year fixed contract on electricity is really just an example of nominal price rigidity--it is common, even customary to have frictions in input markets (ie capital is determined in advance), but this alone doesn't produce unemployment since there is still a wage an an output price low enough for all markets to clear. If the price is fixed in advance, then we might get unemployment of resources from that.

  12. I posted a comment on Macromania some time ago about monetary policy and inequality. As I can't remember which post I commented on, I'm just going to post the link here to an IMF paper on the Fed and inequality:


    1. Thank you for the link to the paper, which confirms common sense. Or said differently, gold bugs like Forbes are idiots, but not fools.

      You challenge Krugman, as to "How would he rather we spend our professional time?" Krugman seems to me to be of the POV that the professions basic assumptions are wrong. Why, for example, should the mission of the Fed be "price stability?"

      We are going to have price increases in food and fuel, do to crop failures. How could it possible make sense under for the Fed to try to control the coming price increases?

      Per Munger, the profession heeds to think in second, third, and fourth order effects

    2. "You challenge Krugman, as to "How would he rather we spend our professional time?" Krugman seems to me to be of the POV that the professions basic assumptions are wrong. Why, for example, should the mission of the Fed be "price stability?" "

      Price stability as a goal is not an assumption, it is the optimal policy in a particular model (cashless NK model with sticky prices). You might consider thinking before you speak, and I suggest some English classes as well.

    3. What does cashless model with sticky prices have to do with real world were the CREAM rule applies (Cash Rules Everything Around Me) and prices are not sticky:

      Oil, up 50 times in 30 years

      College Tuition, up 525% in 15 years

      Prime T-Bone, doubled in one week, following failure of Ill. corn crop.

      Cuban cigars and fine wine: illegal to self-import and priceless.

    4. That's the dumbest reply to a serious post I've seen on the Internet. Those are real relative prices that are moving, you gob, not the nominal price level. Try education first, then speaking.

    5. Why can models be attacked so easily.

      The subject is of interest not only for economists and philosophers of science1 but also for those who suffer –or benefit from- the results of economists’ recommendations.

      Two recent episodes before the U.S. courts are illuminating in this respect.

      In one case, Stanford professor Robert Hall’s opinion was labeled by the St. Louis federal appeals court as “mere speculation.”2

      In 1999, Nobel Prize laureate Robert Lucas testified in a price-fixing case. A Chicago court ruled that his testimony “failed every test of admissibility” because his
      opinions were inconsistent with the evidence.3

    6. "Why can models be attacked so easily."

      Because they're false, you boob. They're designed to illuminate part of reality, not be reality. Lawyers are not scientists, their job is not to figure out whether something is true but rather to convince people that whatever is good for their client is true. Citing lawyers as evidence against economists is absurd to the extreme.

    7. Anon.

      It seems to me that what we need in the economics world are lawyers, lots of them. It would be fascinating to require economists to make statements only under oath, subject to the greatest engine of truth known, cross examination.

      As for bending the trust to "convince people that whatever is good for their client is true," well that is pretty much the entire economics profession, which is fatality infected with incentive caused bias. Look at Taylor, Cochrane, etc., all of whom are angling from job from Romney. Look at all the economists employed to spin a favored POV, especially by the KOCHs, CATO, etc etc etc

      Get over yourself. There is nothing to economics but a collection of greedy, self-centered egos, all trying to gain fortune or fame or both.

      The simple fact is that the big rock hasn't been advanced up the hill since Keynes put down a pen. We are now well past 5 years into the Lesser Depression and we are no nearer an exit than when we started.

    8. John D, your rant isn't fooling anyone. Get over yourself, and go back to lawyering where your lies and mistruths are not only expected, but encouraged.

  13. Economics in Denial

    In an exasperated outburst, just before he left the presidency of the European Central Bank, Jean-Claude Trichet complained that, “as a policymaker during the crisis, I found the available [economic and financial] models of limited help. In fact, I would go further: in the face of the crisis, we felt abandoned by conventional tools.”

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  15. David,

    I am writing to take up my no nearer the exit comment above. The National Bureau of Economic Research has just published, Robert Gordon's s U.S. Economic Growth Over? Faltering Innovation Confronts the Six Headwinds, where Gordon writes:

    Even if innovation were to continue into the future at the rate of the two decades before 2007, the U.S. faces six headwinds that are in the process of dragging long-term growth to half or less of the 1.9 percent annual rate experienced between 1860 and 2007. These include demography, education, inequality, globalization, energy/environment, and the overhang of consumer and government debt. A provocative “exercise in subtraction” suggests that future growth in consumption per capita for the bottom 99 percent of the income distribution could fall below 0.5 percent per year for an extended period of decades.

    Now, you want my opinion whether you are fiddling like Nero while the economy burns?