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

Andre Gide


Sunday, May 18, 2014

G and I in Europe and Japan

Izabella Kaminska reports here on a Credit Suisse comparison of Japan and the Euro area (h/t Scott Sumner). Here is an interesting diagram from that report:


According to Kaminska:
As the analysts note, a powerful fiscal stimulus in Japan helped to counter the demand shortfall. That caused personal consumption to continue to grow until 1997 and investment to rebound almost to its previous peak in just six years — something which isn’t slated for Europe any time soon.

Well, the increase in G counteracting an unexplained decline in I is one interpretation. This is the "deficient demand" interpretation that so many like to portray as obvious. But in fact, it's difficult to ascertain the direction of causality from just a picture.

The Japanese data above corresponds to what I posted some time ago here: What's Up with Japan? In response to that post, Mark Sadowski alerted me to the fact that the Japanese investment series plotted above includes both private and government spending. Here's what things look like when we decompose this aggregate (I discuss in more detail here: Another look at the Koizumi boom):


So it seems that there was a boom in private investment during the Koizumi years (something that Krugman gets wrong here, and something I'm not sure he's acknowledged). Moreover, this boom coincided with a slowing or outright contraction in government purchases. And in a liquidity trap era, I might add! What do our conventional "deficient demand" theories have to say about this? Maybe there is something more complicated than a simple IS-LM+liquidity trap story going on? I'm just asking. Humbly yours, DA.

Monday, May 12, 2014

Desperately Seeking Humility

For what it's worth, I think that Paul Krugman and Simon Wren-Lewis come down way too hard on Tony Yates

In a nutshell, Krugman and Wren-Lewis claim that the economics profession knows how to diagnose and treat post-Lehman-like recessions. The diagnosis is self-evident: "deficient demand" (not the same thing as a decline in demand.) The treatment is written down in the most basic Econ 101 IS-LM model: increase G (or, at least, do not decrease it). 

Evidently, we are to have great confidence in the IS-LM prescription because the model correctly predicted that a massive increase in government debt would not lead to soaring interest rates and that a massive increase in the (base) money supply would not be inflationary. 

Well, that's nice. But I don't read Yates as claiming otherwise. I read him as suggesting that there is still a lot we don't know about many things leading up to the financial crisis and the economic forces governing the (slow) recovery dynamic. And because of this state of affairs, politicians were largely free to pursue policies that fit more in line with their political instincts (when do they not do that, I wonder?). Well, I don't know. Sounds plausible. Certainly, I would not have called Yates out for his "self-destructive" attitude. For a similar "self-destructive" attitude, have a look here at what the physicist Freeman Dyson has to say about what people generally don't get about science: 
Q: "How can you tell if someone is a visionary or a crank?"
A: "You can't tell. The whole point of science is that most of it is uncertain. That's why science is exciting--because we don't know. Science is all about things we don't understand. The public, of course, imagines science is just a set of facts. But it's not. Science is a process of exploring, which is always partial. We explore, and we find out things that we understand. We find out things we thought we understood were wrong. That's how it makes progress."
Well, you might say, Wren-Lewis says we know (we know, damn it) that we had a demand deficit because nominal interest rates went to zero just about everywhere (well, except out along the yield curve).  And what about the fact that IS-LM made some correct "counterintuitive" predictions? 
  
Look, I do not think Yates is saying that this interpretation is wrong. He is saying (correctly, in my view) that it is not necessarily correct. That's a big difference, and it's an important one. 

First off, there are many off-the-shelf models that permit zero nominal interest rates without "deficient" demand. So just because we see zero nominal interest rates is not proof of "deficient" demand. Please be more careful! 

Second, yes, the basic IS-LM model correctly predicted no soaring interest rates and no soaring inflation in the face of fiscal and monetary stimulus. But you know what? There are plenty of models out there outside the IS-LM tradition that made the same prediction. The "new monetarist" models that Steve Williamson works with have this property. Even the simple overlapping generations model I used to interpret Japanese economic developments over a decade ago make the same prediction. Moreover, as I remarked in that paper back then, increasing G is not necessarily the right thing to do in a liquidity trap. Again, I'm not saying the contrary opinion is wrong. I'm saying that it's not obvious. 

And it is even less obvious when we stop to consider that all of these models (my own included) basically begin by assuming that everything in the economy is just peachy when suddenly, a bad shock happens. Goodness, even conditional on this obviously wrong approximation, shouldn't we at least be taking some time to figure out the true nature of the shock? Just because demand falls does not mean it is "deficient" in the way "deficient" is usually defined in this class of models. Demand could be falling for all sorts of reasons, and probably many reasons. Maybe demand should be falling, conditional on these other factors changing?

Maybe it's not a good idea to cut G during a severe recession (certainly, I have argued elsewhere that economists might at least agree to increase infrastructure spending with debt finance). But then, maybe it is (who can really know for sure?). Maybe you view my attitude as "destructive." I view it more in line with Freeman Dyson's answer above.