Fiscal Multipliers in War and in Peace

It truly is breathtaking how certain some people are of what they know to be true about the way a macroeconomy operates. The Krugmans and DeLongs of this world really make it sound like everything we really need to know has been settled long ago. Yes, the science is "settled" (where have we heard this before?).

I recently came across this piece by Brad DeLong: A Guide for the Perplexed. Consider the following quote:

But when fiscal boost was tried on a large enough scale, it certainly did the job. And it is reasonable to infer (with all the caveats provided by the CBO) that what is true in the very large will be true in the merely large as well. Eugene Fama says that it is theoretically impossible for fiscal stimulus to boost output: World War II proves him wrong. Robert Barro says that the multiplier is zero: World War II proves him wrong. Benn Steil says that Jacques Rueff in 1947 conclusively proved that fiscal policy could not boost employment: World War II proves him wrong.

Implication: a WWII style fiscal stimulus will "do the job" in a peacetime recession. WWII "proves" it. Egad...how does he know this? Why do I not feel as confident that this is the case? Am I truly that dense? (an invite to some rather rude comments, I'm sure!)

In any case, I decided to gather my thoughts on the subject and post them here for public review and criticism. The piece is a bit too long for a blog posting; so if you're interested, please click here. Looking forward to any comments.

And the New Minneapolis Fed President is...

Narayana Kocherlakota; see here.

Hmm...his biography says that he was born in Baltimore. I seem to recall him mentioning that he was born in Winnipeg. Is he Canadian, or isn't he? Someone enlighten me!

In any case, he is an excellent choice. NK is a consummate academic: clear-thinking, articulate, and persuasive. Does he have what it takes to be a successful/influential Fed president? Yes, I believe so. Apart from his academic credentials, he has a very easy manner; not many people are likely to find him a boor. He has the gift of skewering lame-brained ideas to the wall, and then making you feel good that you've learned something useful (at least, this has been my experience).

Congratulations to NK...and good luck!

Kocherlakota on the State of Macro

A very nice piece by NK here. Unfortunately, you won't see something like this published in the NYT. But naturally, we can rely on DeLong to make a comment; see here: Narayana Leaves Me Puzzled. Consider this DeLong quote:

The models thus tell us that downturns are either the result of a great forgetting of technological and organizational knowledge, a great vacation as workers develop a sudden extra taste for leisure, or a great rusting as the speed with which oxygen in the air corrodes speeds up and so reduces the value of large things made out of metal.

This is exactly how I would expect a first-year undergraduate to interpret a model that they've seen for the first time. And DeLong claims that he has a PhD in economics. Let me help the poor lad along.

Some macro models incorporate "news shocks." A news shock is the random arrival of information that leads people to (rationally) revise their forecasts of future events. These forecasts may be made, for example, over future productivity, future riskiness of investments, future policies, etc. These news shocks do not seem like an implausible impulse mechanism; unexpected news arrives every day.

Investment demand today depends on forecasted productivity of investment. These forecasts will change with news; leading to variations in investment that an econometrician might identify as "aggregate demand shocks." As the investment matures and comes online, its actual productivity may be higher or lower than originally forecast; its realization constitutes another "shock."

There is no need to appeal to DeLong's childish "great forgetting" interpretation of a negative technology shock. A negative technology shock occurs when the realized return on investment is lower than expected. The return on an important class of investments may turn out to be terrible (think of all the fibre optic cable planted across the world's oceans in anticipation of a demand that never materialized). And as Fisher Black has stressed, these types of errors are typically correlated across agents. In short, recessions may be explained, in part, by collective mistakes on investments made in the past.

In any case, what DeLong fails to offer us what he might propose instead as the ultimate source of the business cycle? I am guessing that he might say something like "animal spirits." So why did the recession occur? Because people thought that it would. Why did that boom occur? Because people believed that it would.

There may be an element of truth to the animal spirit hypothesis; but then, there do appear to be competing interpretations as well. If DeLong would spend less time writing his blog and more time reading the literature, he might one day be less puzzled with Narayana's observations.

Why the Growing Level of U.S. Debt May Not be Inflationary

History shows that high levels of government debt are frequently associated with inflation. The reason for this seems clear enough. At some point, maturing debt needs to paid back. At high enough levels of debt, rolling the debt over is no longer feasible. Cutting back government spending and raising taxes is politically difficult. The easy way out is simply to print new money. As the money supply expands, inflation resuts.

The rough logic described above would seem to fit the experience of many smaller economies that find themselves under fiscal pressure. But things may not work so simply for a select few dominant economies. Japan appears to be one example; and the U.S. another.

Let us consider the U.S. Unlike most other economies, there appears to be a huge worldwide demand for U.S. Treasuries and U.S. dollars (which can be thought of as zero-interest Treasuries). A large scale increase in the supply of these government debt instruments need not lead to a depreciate in their value if there is a correspondingly large scale increase in the worldwide demand for these objects. What is the evidence that this may be happening?

Foreigners Snap Up Treasuries Even as US Debt Keeps Rising

But why should this be so? What accounts for what appears to be an insatiable demand for US debt, especially in the wake of the recent financial crisis?

Ricardo Caballero of MIT offers some hints in a very interesting piece entitled: On the Macroeconomics of Asset Shortages. After reading this paper, I started thinking in the following way. Tell me what you think.

There is a high and growing demand for low-risk assets, both as a store of value, and as collateral objects in payment systems (e.g., repo and credit derivatives markets). This growth has exploded over the last 20 years or so; and stems from the demand from emerging economies and innovations in the financial sector. There is a worldwide "shortage" of good quality (low-risk) assets, like U.S. Treasuries (which explains their relatively low yield). Indeed, many of the innovations in the financial sector can be interpreted as the private sector's response to this shortage: the creation of "low-risk" tranches of MBSs allowing these objects to substitute for U.S. Treasuries as collateral in the rapidly expanding repo market.

The recent financial crisis was centered in the repo market. Very suddenly, agents in the repo market were no longer willing to accept MBS as collateral (or if they did, at very large "haircuts"). The demand for U.S. Treasuries exploded (I seem to recall a day when their yields actually went negative). At the same time, there was a worldwide "flight to quality;" which again, manifested itself as large increase in the demand for (relatively safe) U.S. Treasuries.

If this is more or less true, then the implication is this: The massive increase in the supply U.S. Treasury debt may very be "socially optimal" in the sense that the U.S. government is simply supplying the world with an asset that is in very high demand (which, in turn, means that the demanders obvious find some value in the existence of such an asset). To the extent that this "new demand regime" remains stable, the added supply of U.S. Treasuries will impose no financial burden on the U.S. (indeed, they make off like bandits, as the Treasuries are ultimately purchased by exporting goods and services to the U.S.).

The million dollar question, of course, is whether the high world demand for U.S. debt will persist long into the future (and whether the U.S. government will "overissue" debt beyond what is called for by this new high-demand regime). Who knows what will happen. But it appears to me that IF the U.S. government plays its cards right, it may very well enjoy its higher debt levels without the prospect of inflation. U.S. citizens will benefit (from the sales of Treasuries for goods) and the world will be grateful to hold a stable asset.

Well, maybe. But that was a big IF. What could possibly go wrong?

William Poole on Ben Bernanke

For those of you who may not know, I have recently joined the Federal Reserve Bank of St. Louis as a VP in the research division. Will keep you posted on things that I learn (and am allowed to reveal).

We were recently asked to comment on an article written by Bill Poole, former president and CEO of the Fed here in St. Louis. He asks the question: Should President Obama reappoint Fed Chairman Bernanke? See here. His conclusion is "no." (too late, it appears).

So what's his beef? Essentially, that some of the new policies initiated by Bernanke have violated stipulations in the Federal Reserve Act (FRA) and that, in doing so, he has comprised the Fed's political independence. The relevant stipulations are section 13(3) and section 14(b).

Poole grants Bernanke some leeway in terms of the emergency measures adopted in March 2008 (Bear Stearns) and September 2008 (AIG). But he believes that the Fed's Commercial Paper Funding Facility (CPFF) violates section 13(3). He may have a point here; but there is not much a leg for him to stand on as the term "exigent" is not precisely defined.

Poole also believes that the Fed's buying program for Mortgage Backed Securities (MBS) is not authorized under Section 14(b). I beg to differ. As far as I can tell, the act does allow for purchases of assets that are guaranteed by the U.S. government. The MBS purchased by the Fed are fully insured by the Treasury (and indeed, they are generating a very nice return).

Poole makes some very good points about distancing the Fed from politics as much as possible. But I do not believe that he makes a compelling case against reappointment. Among other things, he does not propose alternative candidates (many of the apparent frontrunners would likely view Bernanke's interventions as too conservative). Bill should be careful what he wishes for.

In any case, it looks like Bernanke will be reappointed (after a good grilling in front of the Senate). Considering the alternatives, I think this was the right choice.

Against Intellectual Property

I have long suspected that there was something fishy about the economic defense for property rights in knowledge. My first attempt at questioning the wisdom of such a policy at a conference at NYU in 1994 was met with harsh criticism (especially from the late great Fisher Black, bless his libetarian soul). I was never able to fully recover from that experience, and so I meekly let that research program die.

But I am now very pleased to see that Michele Boldrin and David Levine have taken up the cause. Levine was kind enough to visit SFU on March 20, 2009 where he delivered a public lecture entitled "Against Intellectual Property." The lecture, if you are interested, is now available online here.

There is much food for thought here. The logic of his argument and the evidence he provides is quite persuasive, in my view. But if you see any holes in his arguments that have escaped me, please let me know.

King Solomon's Dilemma and Behavioral Economics

When the tale of King Solomon's dilemma was first told to me as a kid, I was (like most people, no doubt) left marvelling at Solomon's brilliant solution to a rather difficult predicament.

But then I grew up and made the unfortunate choice of pursuing a graduate degree in economics. My mind was left rotted to the point where I could no longer appreciate what most other people continued to believe was the self-evident wisdom of Solomon.

The problem with Solomon's "solution" is that it adopts what in modern parlance would be labeled a "behavioral approach." In other words, the solution relies heavily on the assumption that people are "irrational" in a particular sense. It turns out to be easy to be a wise philosopher king when one assumes that everyone else is irrational. Perhaps this is why so many aspiring philosopher kings today want to replace conventional economic theory with what they call "behavioral economics."

Let's think about this. The "mechanism" (game) designed by Solomon proposes to split the baby in two (sounds "fair" at least). One women screams out "No! Let the other have the whole baby instead." The other woman coldly agrees to the solution. The real mother is revealed in the obvious manner. What is not so obvious is why the false mother could not have anticipated this outcome; a more clever woman would have simply mimicked the behavior of the true mother. Instead, the false mother fails to make this calculation (and instead adopts a simple "behavioral" strategy; which is just a fancy label for irrational behavior).

Now, perhaps there really are "irrational" people like the false mother. But would you be willing to stake a baby's life on this assumption? Even if this mechanism worked out one time, could we reasonably expect it to work in the future (would people not learn from the outcome and tailor their strategies accordingly?). If you believe that people are fundamentally irrational in this sense, then you will make a fine behavioral economist (and a poor philosopher king).

So what is the solution to Solomon's dilemma?

One approach might be to adopt the Coase theorem, which states that if transaction costs are zero, then an arbitrary assignment of property rights will lead to the efficient solution. That is, Solomon could just have assigned the baby at random to one or the other woman. If it fell into the hands of the false mother, the true mother (who presumably values the baby more) could then purchase the baby (from the one who values it less). In other words, if there are gains to trade (as would obviously exist in this case), then these gains will be realized--if transaction costs are zero.

The problem with this approach is that transaction costs are obviously not zero (these costs could arise, for example, if the true value of the baby by both women is private information). Moreover, this "solution" violates what most people would consider to be a principle of "fairness" (why should the true mother pay for her own baby?). The Coase theorem is a fascinating theorem, but it should not be applied as a solution to the problem at hand; the theorem simply states what one could expect to happen IF transaction costs are zero. In fact, the Coase theorem should be interpreted as explaining precisely why various institutions emerge to handle the problem of resource allocation in a world where transaction costs are not zero.

One such solution was offered by Solomon. But I have already highlighted the problem with his proposed institution (or mechanism). Another possible solution was offered by William Vickery: a sealed-bid second-price auction (or a Vickery auction). Assume, as seems reasonable in this case, that only the two mothers know the true value they attach to the baby. A Vickery auction would have both mothers submitting sealed bids for the baby. The woman with the highest bid would then win the auction, but pay the second-highest bid.

This solution is clever because the amount that either woman expects to pay is independent of their actual bid. Accordingly, neither one of them have an incentive to misrepresent how much they really value the baby. If the true mother values the baby more, she will win the auction (it would not be rational for the false mother to bid more than what the baby is worth to her).

Clever indeed. But there is still a problem associated with this solution. In particular, it requires that the true mother actually pay for her baby. Leaving issues of "fairness" aside, a more relevant problem may be that this mother does not have the resources to make the requisite payment. (It is absolutely critical that the payment be forthcoming; if Solomon could not credibly commit to collecting the payment, then rational players will understand this limitation and alter their strategies accordingly).

One solution might be to let the women offer themselves as indentured servants. This sounds feasible and has the desirable property that the true mother gets her baby (she would presumably be happy to offer herself as Solomon's servant, if it means getting her baby). While this solution has its drawbacks, it seems to dominate Solomon's solution--something that risks having the baby split in two.

But is it possible to design a mechanism that "does the right thing" without any cost to the true mother? Several solutions have been proposed in the literature; but each with its own peculiar drawbacks. But I recently came across one proposed solution that seems quite clever; see Bid and Guess: A Nested Solution to King Solomon's Dilemma, by Cheng-Zhong Qin of UC Santa Barbara.

The idea as presented in Qin's paper seems a little more complicated than it needs to be (but I could be wrong). The basic idea, as I see it, is to have the women play a "participation game" just before playing a standard Vickery auction. We could set up the mechanism as follows.

First, Solomon informs the women of the Vickery auction that will be used to allocate the baby. Second, he informs each woman that the price of participating in the Vickery auction will be a half-life of servitude in some miserable occupation. The women are then asked to submit envelopes with ballots that are marked "yes" or "no" (yes, I am willing to participate; no I am not). If both women submit "yes," then the Vickery auction is played. If only one woman submits "yes," then the baby is allocated to her for free (the auction is not played). If neither woman submits "yes," then the baby is disposed of in some manner (perhaps in the King's service).

Now, put yourself in the place of first, the true mother and second, the false mother. How would you play the game? Would you say "yes" or "no?"

Theory suggests that the true mother will say "yes" to the participation game (she knows that she will get the baby if the auction is played; she will pay one half-life of servitude for participation, and the other half-life in payment for the baby). Likewise, the false mother will say "no." Why submit to a half-life of servitude when she knows that she will inevitably lose the subsequent auction? The false mother will rationally bow out of the bidding; she will choose not to participate. And the baby is allocated for free to the true mother.

Of course, this assumes that the people playing this game are "rational" in the sense that they understand the rules of the game and in the sense that they can anticipate how others are likely to play it. One of the great strengths of assuming rationality in this form is that the assumption can be applied as a general condition that prevails in any resource allocation problem. Its weakness is that people may not always possess this assumed degree of rationality.

But the alternative--the "behavioral approach"--suffers from an even greater problem. In particular, the policymaker must be aware of precisely how people are irrational in each and every given circumstance (a great loss in generality). There are an infinite number of ways in which people might be irrational; and the behavioral theorist is forced to choose among an infinite number of "behavioral rules" that he or she believes captures this irrationality in a plausible manner. The only hope that a behavioral theorist has for developing a general theory is in discovering that people are irrational in some systematic manner. But if the theorist can identify this systematic pattern of irrationality, it seems hard to know why people cannot discover it for themselves too. But then, it seems clearly in the interest of aspiring philosopher kings prefer to think of themselves as being systematically more rational than the subjects they study.