2008

Like many people out there, I am eagerly awaiting the release of the full transcripts of the Fed's monetary policy meetings for 2008. When they come out (and it should be very soon), you will be able to find them here.

I expect that the media will have a field day with these. No doubt a number of Fed officials will have said things that, with the benefit of hindsight, they wish they had not said, or said somewhat differently.

Jim Bullard, president of the St. Louis Fed, recently gave a speech on the subject titled: The Notorious Summer of 2008. The slides associated with that speech are available here.

Bullard makes some very good observations.

First, many people think of the financial crisis as beginning in the fall of 2008, with the collapse of Lehman and AIG. In fact, the crisis had been underway for more than a year at that point (August 2007). The fact that the crisis had gone on for over a year without major turmoil suggested to many that the financial system was in fact relatively stable--it seemed to be absorbing various shocks reasonably well. Throughout this period of time, the Fed reacted with conventional monetary policy tools--lowering the Fed Funds target rate from over 5% to 2% over the course of a year.

So what happened? Essentially, an oil price shock. By June 2008, oil prices had more than doubled over the previous year. The real-time data available to decision-makers turned out to greatly underestimate the negative impact of this shock (and other factors as well). The rapidly slowing economy served to greatly exacerbate financial market conditions.

The Bear Sterns event occurred in March 2008. The firm was purchased by J.P. Morgan with help (bailout, depending on one's perspective) from the Fed. Bullard identifies two problems with that deal. One, it suggested that all financial firms larger than Bear could expect some form of insurance from the Fed. Two, while the deal was successful in calming down markets, it possibly had the effect of lulling them into a false sense of security.

Of course, we then had the infamous Lehman event in the fall of 2008. But as Bullard points out, everyone knew that Lehman's was in trouble for at least a year--surely investors were prepared for this. And in any case, investors would have properly insured themselves, no?

Well, no. The big insurer, of course, turned out to AIG. Evidently, very few people had any idea about the potential problems with AIG at the time (which, by the way, was outside the scope of Fed supervision). And so, it was the Lehman-AIG event that brought all financial firms under heightened suspicion--and it was this event that drove the financial crisis from September 2008 and onwards.

We all know how the Fed reacted at the time, and since then. The interesting question here is what the Fed might have done differently in the time leading up to the start of the crisis in 2007 and beyond? It is important to answer this question, I think, in the context of policy making that is constrained to operate with the use real-time data (that is frequently subject to significant revisions as time unfolds).

In any case, it will be interesting to eavesdrop on the discussions that occurred in 2008.

Are negative interest rates really the solution?

Miles Kimball believes that the zero lower bound (ZLB) constitutes a significant economic problem (he is not alone, of course). His viewpoint is expressed clearly in the title of his post: America's Huge Mistake on Monetary Policy: How Negative Interest Rates Could Have Stopped the Recession in its Tracks.

That's quite the bold claim. But what is the reasoning behind it? Yes, I can see how a price floor can distort allocations and make things worse than they otherwise might have been if prices were flexible. But would interest rate flexibility really have prevented the recession?

Suppose I wanted to teach this idea in my intermediate macro class, using conventional tools. How would I do it? (Maybe it can't be done, but if not, then someone present me with an alternative.) I think I might start with the following standard diagram depicting the aggregate supply and demand for loanable funds (the foundation of the so-called IS curve):

Suppose the economy starts at point A. (I am assuming a closed economy, so aggregate saving equals aggregate investment.) The real interest rate is positive.

Next, suppose that there is a collapse in investment demand. For the purpose of the present argument, the reason for this collapse is immaterial. It might just be psychology. Or it might be the consequence of a rationally pessimistic downward revision over the expected future after-tax return to capital spending. In either case, the economy moves to a point like B, assuming that the interest rate is flexible.

But, suppose that the Fed is credibly committed to a 2% inflation target. Moreover, suppose that the nominal interest rate cannot fall below zero (the ZLB). Then, when the nominal interest rate hits the ZLB, the real rate of interest is -2%.

If this was a small open economy, the gap between desired saving and desired investment at -2% would result in positive trade balance (as domestic savers would divert their saving to more attractive foreign investments, over the dismal domestic investment opportunities). But in a closed economy, saving must equal investment and so, as the story goes, domestic GDP must decline to equilibrate the market for loanable funds. As domestic income falls (and as people become unemployed), desired domestic savings decline (the Desired Saving function moves from the Full Employment position, to the Under Employment position, in the diagram above).

Now, if this is a fair characterization of the situation as Miles sees it (and it may not be--I am sure he will let us know), then I would say sure, I can see how the ZLB can muck things up a bit. The economy is at point C, but it wants to be at point B (conditional on the pessimistic outlook).

But while point B might constitute an improvement over point C, it does not mean an end to the recession. Domestic capital spending is still depressed, and ultimately, the productive capacity of the economy will diminish. I'm not sure I see how a negative interest rate is supposed to prevent a recession, or get the economy out of a recession, if the fundamental problem is the depressed economic outlook to begin with.

If anyone out there has another way of looking at the problem, please send it along.

***

Update:  Here is a reply from Gerhard Illing:

Hello David,

I am not sure if that is what you are asking for, but at least within the standard NKM framework (with negative time preference shocks)  it is fairly straightforward to illustrate that eliminating the ZLB would allow monetary policy to perfectly stabilize the economy at the natural rate. I just finished a sort of “textbook” version (allowing for an explicit analytical solution) of that framework.

In terms of your graph (with the nominal interest rate as adjustment tool to time preference shocks under sticky prices) it looks as follows:

 

Presumably you are not happy with the NKM framework as a realistic description of current issues - but within that logic, these arguments follow naturally, in particular if you are on the “secular stagnation” trip.

And here is a further elaboration, provided by Gerhard:
 

Monitoring Japan



I am as curious as anyone in ascertaining the effects of Japanese Prime Minster Shinzo Abe's QE experiment. Miles Kimball points us here to an early assessment by Marcos Nunes, who writes:

Shinzo Abe was elected in December 2012 on a promise to revive growth and put an end to deflation. How have his promises ‘performed’ one year after taking power? The ‘performance’ will be illustrated by a set of charts.

Nunes focuses on Japanese macroeconomic data beginning roughly with Abe's appointment as PM. But that's only about a year's worth of data. What I want to do here is compare these recent measurements with a longer sample, beginning in the year 2000 (the shaded region in my diagrams correspond to the Koizumi era, which I have written about before here).

First up is Japanese inflation (headline and core):

The evidence unfolding here really does seem to suggest that QE matters for inflation. My coauthor Li Li and I have recently remarked on this here.  Next, let's look at NGDP and RGDP growth:

Well, you know...this does not look so great, does it? While it is true that both NGDP and RGDP are growing, similar growth experiences are evident even in the earlier deflationary periods. Sure, it's nice to see RGDP growth rising recently, but it's still far too early to tell whether it will be sustained. And in any case, note the relatively robust period of growth during the "Koizumi boom" period--an era of deflation and fiscal austerity.

The exchange rate and the stock market:



 
So the stock market was booming late in the Koizumi era, the exchange rate stable, and core inflation negative. What about trade patterns? Take a look here:

 
I'll let you make up your own mind. Now for some comparisons with the Eurozone. First, a comparison of broad money growth:

Next, a comparison of inflation rates:

 And finally, a comparison of RGDP growth rates:

So sure, the Eurozone is underperforming as of late, and prospects in Japan are looking relatively good. How good in Japan relative to the Koizuma era, I'm not sure. And how much of the recent Japanese performance can be attributed to QE, one can only speculate. All that I conclude from this data is that QE may be influencing the inflation rate and the exchange rate. But whether it is having a quantitatively significant impact on the real economy is far less certain.

Addendum:

A comment by Noah Smith below suggests that Japanese CPI and GDP deflator are behaving quite differently. This indeed appears to be the case.

So, since about the time of the Asian financial crisis, the relative prices of non-consumer goods and services has declined steadily.

A bit more on the economics of Bitcoin

I'm still trying to understand the details of how cryptocurrencies like Bitcoin work. But the general principles involved seem clear enough, so let me start by explaining (what I think) these are. I'll let the experts out there fill in the gaps (and correct any errors I may have made). So what follows is basically an introductory lecture I would deliver to a class on the subject.

This is about the payment system: the way we pay and get paid for things. Any payment system has to solve the following two problems:

    [1] How to transfer credits across accounts in an honest, secure, and reliable manner;
     and
    [2] How to manage the total supply of credits over time.

The earliest (and arguably still most important) payment system relies on informal communal record-keeping. In small communities (villages, networks consisting of close friends, or work colleagues, clubs, etc.) a lot of what gets produced and consumed relies on what one might call "social credit" designed to exploit multilateral gains to trade (even when bilateral gains to trade are absent). In small groups, it is relatively easy for many members of the community to keep track of individual contributions to, and individual withdrawals from, the collective good. I may sometimes ask a favor of a team member even if we both know I have no direct way to return the favor personally. At the same time, I may be asked to deliver a favor to a team member even if we both know he/she has no direct way to return the favor personally. We just do these things because it is in our collective self-interest. In such reciprocal "gift-giving" economies, the currency that facilitates exchange consists of individual reputations (credit histories). If credit histories are easily observed by members of the community, then its difficult to misrepresent or distort your credits, or steal credits from others. If you try to do so, and if you are caught, you may be ostracized from the community, or worse. (

I mention this idea of "communal monitoring" because some form of it seems to play a critical role in the practical application of the Bitcoin protocol.

As a practical matter, the "social credit" system described above seems to work well for small groups, but not so well for larger communities. It's tough to keep track of the individual credit histories of thousands or millions of people, let alone ensure that such records remain a true representation of history. In large communities, many individuals become "anonymous" to one another. Anonymity here means that anything they do in a transient bilateral meeting will not be observed and recorded by the community. That's too bad because efficiency may have dictated that a gift be made in such a meeting. The gift might have been made if the gift-giver received (a social) credit for his/her sacrifice. But if no social credit is forthcoming (because nobody can see it), then the trade does not take place, even though it should have (in an ideal world).

One solution to this problem is monetary exchange. That is, imagine that there exists a set of durable, divisible, portable, recognizable physical object that is hard to steal/counterfeit (the way that reputations need to be hard to steal or counterfeit). Then contributors (workers) could build up credit by accumulating this object, and recipients (consumers) could draw down their credit by spending this object. As it circulates in this manner, this object becomes money. According to this interpretation, money is nothing more than a substitute for the missing (excessively costly) communal record-keeping technology (see Ostory 1973, Townsend 1987, and Kocherlakota 1998).

In a monetary economy, there is no explicit communal monitoring going on. If money is difficult to steal/counterfeit, then the only way I could have acquired it is by working for it (or by having someone else who worked for it bequeath it to me as a gift). When I show up at my local Starbucks and ask for a triple grande latte, they won't hand over my drink until I show evidence my contributions to society. The evidence is in the form of the money that I earned from work. As I hand over my money, I debit my wallet and credit the Starbucks wallet. This transfer of credits involves no intermediary--it is a "self-serve" accounting mechanism.

Of course, many exchanges do take place via intermediaries like banks and clearinghouses. A check drawn on my bank account is an instruction to debit my account and credit another account. The accounts sit on the books of a third party--the intermediary. The money in this case need not even take a physical form -- it can exist simply as a book-entry object. Today, these book-entry objects take the form of electronic digits, and these digits are debited and credited across accounts managed by banks with instructions from debit card technology.

O.K., well suppose that you do not trust the government (or central bank) and their paper money. Suppose you want the convenience of electronic money (so no commodity money). And moreover, suppose you do not want to rely on a third party like a bank. Maybe you don't trust them, or you do not like their fees, or the records of your purchases they keep, or the fact that your identity is associated with your account. What is the alternative?

What we want is some way to replicate the cash experience using electronic digits instead of physical currency. Recall that in bilateral cash transactions, the accounting is done on a self-service basis without the help of the community or some other third party. When it comes to digital money transferred over the internet across a large network of users, self-serve accounting is not likely to be practical. The self-serve part will have to be replaced by some communal monitoring service (obviously not a delegated third party, since this is what we are trying to avoid). I'll try to explain why in a moment, but first let me considered an idealized world where the relevant information is costlessly accessible to all members of the community.

Digital cash with communal record-keeping and communal monetary policy

Digital cash consists of information encoded electronically as bits. For concreteness, let's call digital cash "e-coins" and assume that an e-coin takes the form of a unique N-digit serial number.

[A1] Assume that the serial numbers of every e-coin created are recorded in a public data bank for all to see.

There is an initial money supply (50 bitcoins in the case of the Bitcoin protocol) and a publicly known protocol that governs money creation. In a nutshell, money growth can only occur by "communal consent." In the present context, you can think of monetary policy as a rule for money creation (and distribution), where the rule can only be changed by communal consent.

Members of the community possess "computer wallets" where e-coins are stored in an encrypted file and managed by a computer app (you can download these programs for free). Computer wallets have a public address, like a P.O. box (the identity of the wallet is not known, and a person may own several wallets). So people can send money to your wallet, but only you can extract money from your wallet (only you possess a private digital key for this purpose).

[A2] The e-coin content of every wallet is part of the public database.

So here's how things might work. Suppose a buyer wants to send an e-coin to a seller. Essentially, the buyer sends a message to the community: I wish to send e-coin SN01234 to [seller's wallet address]. A digital signature ensures that this message could only have originated from the buyer's wallet.

[A3] All messages are publicly observable.

 (The italicized sentences above emphasize the assumed information structure. For Bitcoin, there is even more information than this: the entire transaction history of every wallet is part of the public database.)

Now, if every member can costlessly scan and verify every element of the public database, the transaction process should be straightforward. First, the seller can see that the buyer does indeed own e-coin SN01234. Second, by comparing SN01234 to the public database of serial numbers outstanding, the seller can see that SN01234 is unique and was not counterfeited by the buyer. Third, the seller can see that the buyer is not trying to "double spend" SN01234 (e.g., by simultaneously offering it to another merchant's wallet).

The practical problem with this protocol is not that information assumptions [A1]-[A3] are violated. The information is available. There's just so much of it that not everyone can be expected to absorb it all instantaneously. It is time lag that opens the door for scammers. The task of legitimizing, recording, and updating the database has to be delegated in some manner. In the Bitcoin protocol, the task is not delegated to any single third party, rather it is delegated to members of the community who wish to "volunteer" their monitoring services.

Now, the precise details of how this public monitoring and record-keeping is done presently escapes me. The basic idea is that the monitoring activity must be made costly, because otherwise there is an incentive for scammers to announce that their scam deals (e.g., attempts to double spend) are legitimate. In Bitcoin, the monitors (miners) are required to solve a complicated mathematical problem (consumes energy and CPU time), the answer to which is easily verifiable. I think that (somehow) the verification of this answer also verifies the legitimacy of the transaction (someone help me out here).

But if it is costly for miners to verify transactions, what motivates them to do it? There is a reward, of course. In Bitcoin, the reward comes in two forms: newly minted bitcoin and/or service fees. So in the Bitcoin protocol, the verification costs are partly financed via seigniorage. I do not understand the exact mechanics of this process, in particular, the cryptographic techniques involved, and how the parameters are varied over time (for example, to ensure that the supply of bitcoins never exceeds 21 million). Maybe some smart person can explain it to me in plain language. (Here is a good attempt).

Before I leave this part of the discussion, I want to make a remark about the "mining" activity in Bitcoin. A lot of people, including Paul Krugman, appear confused about it. I initially shared in this confusion. Mining actual gold for the purpose of increasing the money supply is indeed socially wasteful. That's because an existing supply of gold can be stretched into an arbitrarily large supply of real money balances via an appropriate deflation. But the mining activity in Bitcoin is not a social waste--it is the cost associated with operating a payment system of this particular form when people have an incentive to cheat. The analog here is the cost associated with opening and maintaining your checking account at a bank.

Is Bitcoin a good money?

One could argue that the USD is at least partially backed by its ability to discharge real tax obligations. But bitcoins truly are purely fiat in nature (they have no intrinsic use in either consumption or production). Does this mean that the value of bitcoins must eventually crash to zero (their fundamental value)? No.

Bitcoins are information -- record-keeping devices. You can't eat my credit history either, but some companies would value (and pay for) this information nevertheless. So as long as Bitcoin conveys accurate information, its value can persist indefinitely. (There is, of course, the threat of entry, though Bitcoin appears to have a substantial early-mover advantage.)

One problem with Bitcoin as a currency is that its purchasing power sometimes fluctuates violently and at high frequency. As I have argued before, a desirable property of a monetary instrument is that it possess a relatively stable short-run rate of return. (A stable long-run rate of return is nice, but not essential, since other assets than money can be utilized as long-term stores of wealth.). Let's take a look at the USD price of bitcoin:

Holy cow. (Wish I had bought in at 5 cents!)

What accounts for this price volatility? (By comparison, the real rate of return on USD over the same period of time was a relatively stable -1% p.a.). Well, it might have something to do with the thinness of the USD/BTC market (can anyone point me to some evidence?). Or it might have something to do with the fact that bitcoin is not a unit of account (even if it is a medium of exchange, prices are usually denominated in USD). Both of these problems might diminish over time as the popularity of the instrument grows.

But my own take on this is that the price volatility reflects the perception that the supply of bitcoins is (relatively) fixed. This, combined with large fluctuations in the demand for bitcoin, naturally results in huge rate of return volatility. We saw the same thing under gold standard monetary regimes (where gold was a unit of account). In principle, an "elastic" supply of currency (even the credible threat of an elastic supply) can be used to offset sudden changes in demand to keep the rate of return (inflation rate) on money relatively stable.

Trust

My colleague, Francois Velde of the Chicago Fed, has a nice primer on Bitcoin. (It delves into the mechanics of the cryptography involved, but I still find many parts of his discussion a little vague.) But in terms of what sort of trust is involved in Bitcoin and similar endeavors, I like what he has to say here:

[B]itcoin protocol is based on open-source software. Bitcoin is what bitcoin users use. The general principles of bitcoin and its early versions are attributed to an otherwise unknown Satoshi Nakamoto; improvements, bug fixes, and repairs have since been carried out by the community of bitcoin users, dominated by a small set of programmers.

Although some of the enthusiasm for bitcoin is driven by a distrust of state-issued currency, it is hard to imagine a world where the main currency is based on an extremely complex code understood by only a few and controlled by even fewer, without accountability, arbitration, or recourse.

 Yes, it's hard to imagine. But maybe it's because we lack imagination? Only time will tell.

U.S. Inflation Expectations: Low, But Rising

There's been a lot of talk lately about the threat of global deflation. According to Christine Lagarde, Managing Director of the IMF:

“With inflation running below many central banks’ targets, we see rising risks of deflation, which could prove disastrous for the recovery.”

And closer to home:

Ms Lagarde’s comments were echoed by Charles Evans, president of the Chicago Fed. “The recent news on inflation has not been good,” he said in a speech on Wednesday. “Inflation is too low and is running well below the FOMC’s 2 per cent target.”

Inflation in the U.S. is indeed running below target, but what about inflation expectations? Here are some market-based measures of U.S. inflation expectations (based on TIPS spreads) for two, five, and ten years out:

According to this data, inflation expectations in the second quarter of 2013 declined significantly at all horizons. The sudden jump down in expectations in the summer corresponds with the sudden rise in Treasury yields associated with the so-called "taper tantrum" following the June 19 FOMC meeting.

But it is interesting to note that immediately after the taper tantrum, inflation expectations recovered and stabilized, albeit at low levels (especially at the two and five year horizons). At the same time, nominal yields rose and remain elevated (with the 10 year hovering at or just below 3%).

What is even more interesting the reaction of inflation expectations after the December 2013 FOMC meeting, where the taper was actually implemented (the timing of which came as a surprise to most market participants). Short-run inflation expectations, in particular, appear to be on an upward trajectory. The effect is less evident at longer horizons.

I'm not going to offer any interpretation of what economic forces are at play here (I'll leave it up to you to offer your take on things in the comments section). One thing I can say though is that this data will provide at least a small measure of comfort to Fed policy makers concerned about the threat of deflation.

What is the OLG model of money good for?

I want to say a few things in response to Brad DeLong's post concerning the usefulness of overlapping generations (OLG) models of money (and on the value of "microfoundations" in general). Let's start with this:

As I say over and over again, forcing your model to have microfoundations when they are the wrong microfoundations is not a progressive but rather a degenerative research program.

Why is he saying this "over and over again" and to whom is he saying it? What if I had said "As I say over and over again, forcing your model to have hand-waving foundations when they are the wrong hand-waving foundations is not a progressive but rather degenerative research program."? That would be silly. And the quoted passage above is just as silly.

A theory usually take the following form: given X, let me explain to you why Y is likely to happen. The "explanation" is something that links X (exogenous variables) to Y (endogenous variables). This link can be represented abstractly as a mapping Y = f(X).

There are many different ways to construct the mapping f. One way is empirical: maybe you have data on X and Y, and you want to estimate f. Another way is to just "wave your hands" and talk informally about the origins and properties of f. Alternatively, you might want to derive f based on a set of assumed behavioral relations. Or, you may want to deduce the properties of f based on a particular algorithm (individual optimization and some equilibrium concept -- the current notion of "microfoundations"). Some brave souls, like my colleague Arthur Robson, try to go even deeper--seeking the biological foundations for preferences, for example.

I don't think we (as a profession) should be religiously wedded to any one methodological approach. Which way to go often depends on the question being asked. Or perhaps a particular method is "forced" because we want to see how far it can be pushed (the outcome is uncertain -- this is the nature of research, after all). And I'm not sure what it means to have the "wrong" microfoundations. (Is it OK to have the wrong "macrofoundations?") Any explanation, whether expressed verbally or mathematically, is based on assumption and abstraction. Something "wrong" can always be found in any approach -- but this is hardly worth saying--let alone saying "over and over again."

Now on to the OLG model of money. Here is DeLong again:

Yes, it seemed to me that handwaving was not good. But saying something precise and false–that we held money because it was the only store of value in a life-cycle context, and intergenerational trade was really important–seemed to me to be vastly inferior to saying something handwavey but true–that holding money allows us to transact not just with those we trust to make good on their vowels but with those whom we do not so trust, and that as a result we can have a very fine-grained and hence very productive division of labor.

Not many people know this, but the OLG model (invented first by Allais, not Samuelson) is just an infinite-horizon version of Wicksell's triangle. The following diagram depicts a dynamic version of the triangle. Adam wants to eat in the morning, but can only produce food at night. Betty wants to eat in the afternoon, but can only produce food in the morning. Charlie wants to eat at night, but can only produce food in the afternoon (assume food is nonstorable).

In the model economy above, there are no bilateral gains to trade (if we were to pair any two individuals, they would not trade). Sometimes this is called a "complete lack of coincidence of wants." There are, however, multilateral gains to trade: everyone would be made better off by producing when they can, and eating when they want to (from each according to their ability, to each according to their need).

Consider an N-period version of the triangle above. Adam still wants bread in period 1, but can only produce bread in period N. Now send N to infinity and interpret Adam as the "initial old" generation (they can only produce bread off into the infinite future). Interpret Betty as the initial young generation (they produce output in period 1, but want to consume in period 2), and so on. Voila: we have the OLG model.

I've always considered Wicksell's triangle a useful starting point for thinking about what might motivate monetary trade (sequential spot market trade involving a swap of goods for an object that circulates widely as an exchange medium). In particular, while there is an absence of coincidence of wants, we can plainly see how this does not matter if people trust each other (a point that DeLong alludes to in the quoted passage above). If trust is lacking--assume, for example, that only Adam is trustworthy--then Adam's IOU (a claim against period N output) can serve as a monetary instrument, permitting intertemporal trade even when trust is in short supply.

An exchange medium is valued in an OLG model for precisely the same reason it is in the Wicksell model or, for that matter, any other model that features a limited commitment friction. So if anyone tries to tell you that the OLG model of money relies on money being the only store of value to facilitate intergenerational trade, you now know they are wrong. The overlapping generation language is metaphorical.

In any case, as it turns out, the foundation of monetary exchange relies on something more than just a lack of trust. A lack of trust is necessary, but not sufficient. As Narayana Kocherlakota has shown (building on the work of Joe Ostroy and Robert Townsend) a lack of record-keeping is also necessary to motivate monetary exchange (since otherwise, credit histories with the threat of punishment for default can support credit exchange even when people do not trust each other).

Also, as I explain here, a lack of coincidence of wants seems neither necessary or sufficient to explain monetary exchange. (Yes, I construct a model where money is necessary even when there are bilateral gains to trade.)

Are any of these results interesting or useful? Well, I find them interesting. And I think the foundations upon which these results are based may prove useful in a variety of contexts. We very often find that policy prescriptions depend on the details. On the other hand, I have nothing against models that simply assume a demand for money. These are models that are designed to address a different set of questions. Sometimes the answers to these questions are sensitive to the assumed microstructure and sometimes they are not. We can't really know beforehand. That's why it's called research.

Finally, is a "rigorous microfoundation" like an OLG (Wicksell) model really necessary to deduce and understand the points made above? I suppose that the answer is no. But then, it's also true that motor vehicles are not necessary for transport. It's just that using them let's you get there a lot faster and more reliably.

The most obvious source of cyclical asymmetry is not a nominal rigidity

I've long been interested in the apparent cyclical asymmetry in business fluctuations. So it's nice to see Paul Krugman publicize the issue here: On the Asymmetry of Booms and Slumps. His post, in turn, was motivated this one, by Antonio Fatas: Four Missing Ingredients in Macroeconomic Models. Fatas writes:

1. The business cycle is not symmetric. Most macroeconomic models start with the idea that fluctuations are caused by a succession of events that are both positive and negative (on average they are equal to zero). Not only this is a wrong representation of economic shocks but it also leads to the perception that stabilization policy cannot do much. Interestingly, it was Milton Friedman who put forward the "plucking" model of business cycles as an alternative to the notion that fluctuations are symmetric. In Friedman's model output can only be below potential or maximum. If we were to rely on asymmetric models of the business cycle, our views on potential output and the natural rate of unemployment would be radically different. We would not be rewriting history to claim that in 2007 GDP was above potential in most OECD economies and we would not be arguing that the natural unemployment rate in Souther Europe is very close to its actual.

Let me dissect the passage above.

1. "The business cycle is not symmetric." Agreed.
2. "Most macro models assume a symmetric impulse mechanism." Agreed.
3. "Not only is this a wrong representations of economic shocks..."

Not sure what to make of this claim. I think it's alright to assume that the shocks are symmetric (unless there is compelling evidence to suggest otherwise). The asymmetry in question is more likely to be the byproduct of human interaction -- the economy's propagation mechanism.

4. "...but it also leads to the perception that stabilization policy cannot do much."

I'm also not sure what to make of this statement. We probably can't infer much about the desirability of policy interventions solely on the basis of the statistical properties of time-series data. And in any case, there are plenty of symmetric models suggesting beneficial policy interventions.

5. "If we were to rely on asymmetric models of the business cycle, our views on potential output and the NRU would be radically different."

Presumably, he means that our views would be more in line with Milton Friedman's plucking model. 

6. "We would not be rewriting history to claim that in 2007 GDP was above potential..."

I often hear people make this claim. Sometimes, they are the same people who claim that the last recession was caused by a bursting asset-price bubble -- of an overheated real estate sector -- of a booming construction (and related) sectors--and over-accumulated debt. According to Larry Summers, this was all needed to get the economy to potential (in this era of secular stagnation). 

In any case, on to Krugman's pet idea that asymmetry is explained by DNWR (downward nominal wage rigidity). Maybe there's something to this idea, but my own view is that any such effect is not likely to be very important. Why is this?

I've explained why before here, but let me summarize the argument here. I claim that economists who rely on sticky wage theories are unwitting slaves of Marshall's scissors--static supply and demand curves. If unemployment exists, it must be because reality does not correspond with scissor-intersection: markets do not clear.

But Marshall's scissors are meant to describe what happens in an anonymous spot market for goods like wheat or oil. The labor market is a market for relationships. Relationships are durable. Relationships are a form of capital. We have to move away from Marshall's scissors to understand these relationships (search theory is one way to do this). The economic surplus generated by a productive relationship is divided through a bilateral or multilateral bargaining process that specifies (among other things) how wages are to evolve through time over the life of the relationship. The spot wage (the wage that an econometrician might observe in a data set) plays no allocative role in the relationship. Stickiness in the spot wage does not matter.

That's the theory, anyway. But then, there is also some evidence: Evaluating the Economic Significance of Downward Nominal Wage Rigidity (Michael Elsby) and here: The Effect of Implicit Contracts on the Movement of Wages over the Business Cycle (Beaudry and DiNardo).

Well then, if not a nominal rigidity, what might account for the asymmetry in the unemployment rate?

As it turns out, the sharp rise in unemployment followed by a slow decline follows as a natural property of labor market search models, something that I showed here (the example I alluded to above).

The basic idea is very simple. As I explained above, the labor market is a market for productive relationships. It takes time to build up relationship capital. It takes no time at all to destroy relationship capital. (It takes time to build a nice sandcastle, but an instant for some jerk to kick it down.)

We see the same sort of phenomenon in population dynamics--the so-called "heat wave effect." That is, mortality rates spike up during a spell of bad weather, causing a sudden decline in the population. There is no corresponding spike up in the population during a spell of good weather for obvious reasons (unless you believe in zombies returning suddenly to life).

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PS. Some related papers where a shock destroys (reshuffles) match capital and takes time to recover: Adaptive Capital, Information Depreciation, and Schumpeterian Growth (Jones and Newman) and Distributional Dynamics Following a Technological Revolution (Andolfatto and Smith).