J. Bradford DeLong's Blog, page 285

Cosma Shalizi (1998): Deborah Mayo, Error and the Growth ...

Cosma Shalizi (1998): Deborah Mayo, Error and the Growth of Experimental Knowledge: "Mayo's key notion is that of a severe test... the severity of a passing result is the probability that, if the hypothesis is false, our test would have given results which match the hypothesis less well than the ones we actually got do.... If a severe test does not turn up the error it looks for, it's good grounds for thinking that the error is absent...

...By putting our hypotheses through a battery of severe tests, screening them for the members of our "error repertoire," our "canonical models of error," we can come to have considerable confidence that they are not mistaken in those respects. Instead of a method for infallibly or even reliably finding truths, we have a host of methods for reliably finding errors: which turns out to be good enough. Experimental inquiry, for Mayo, consist of breaking down the question at hand into a series of small bits, each of which is relatively easily subjected to severe tests for error.... If we guess that a certain effect (the bending of spoons, let us say) is due to a certain cause (e.g., the psychic powers of Mr. Uri Geller), it is not enough that spoons bend reliably in his presence: we must also rule out other mechanisms which would produce the same effect (Mr. Geller's bending the spoons with his hands while we're not looking, his substituting pre-bent spoons for unbent ones ditto, etc., through material for several lawsuits for libel). But this solves the Quine-Duhem problem.

In fact, it gets better. Recall that methodological underdetermination (which goes by the apt name of MUD in Error) is the worry that no amount or quality of evidence will suffice to pick out one theory as the best, because there are always indefinitely many others which are in equal accord with that evidence, or, to use older language, equally well save the phenomena. But saving the phenomena is not the same as being subjected to a severe test: and, says Mayo, the point is severe testing.

While I'm mostly persuaded by this argument, I'm less sanguine than Mayo is about our ability to always find experimental tests which will let us discriminate between two hypotheses. I'm fully persuaded that this kind of testing really does underwrite our knowledge of phenomena, of (in Nancy Cartwright's phrase) "nature's capacities and their measurement," and Mayo herself insists on the importance of experimental knowledge in just this sense (e.g., the remarks on "asking the wrong question," pp. 188--9). I'm less persuaded that we can usually or even often make justified inferences from this "formal" sort of experimental knowledge, knowledge of the distribution of experimental outcomes, to "substantive" statements about objects, processes and the like (e.g., from the experimental success of quantum mechanics to wave-functions).

As an unreconstructed (undeconstructed?) scientific realist, I make such inferences, and would like them to be justified, but find myself left hanging...

#shouldread #books #cognition

Rodney Brooks: The Seven Deadly Sins of AI Predictions: "...

Rodney Brooks: The Seven Deadly Sins of AI Predictions: "Imagine we had a time machine and we could transport Isaac Newton from the late 17th��century to today, setting him down in a place that would be familiar to him: Trinity College Chapel at the University of Cambridge. Now show Newton an Apple. Pull out an iPhone from your pocket, and turn it on so that the screen is glowing and full of icons, and hand it to him...

...Newton, who revealed how white light is made from components of different-colored light by pulling apart sunlight with a prism and then putting it back together, would no doubt be surprised at such a small object producing such vivid colors in the darkness of the chapel. Now play a movie of an English country scene, and then some church music that he would have heard. And then show him a Web page with the 500-plus pages of his personally annotated copy��of his masterpiece Principia.... Could Newton begin to explain how this small device did all that? Although he invented calculus and explained both optics and gravity, he was never able to sort out chemistry from alchemy. So I think he would be flummoxed, and unable to come up with even the barest coherent outline of what this device was. It would be no different to him from an embodiment of the occult���something that was of great interest to him. It would be indistinguishable from magic. And remember, Newton was a really smart dude.

If something is magic, it is hard to know its limitations.... What else might Newton conjecture that the device could do? Prisms work forever. Would he conjecture that the iPhone would work forever just as it is, neglecting to understand that it needs to be recharged?... If the iPhone can be a source of light without fire, could it perhaps also transmute lead into gold? This is a problem we all have with imagined future technology. If it is far enough away from the technology we have and understand today, then we do not know its limitations. And if it becomes indistinguishable from magic, anything one says about it is no longer falsifiable....

Nothing in the universe is without limit. Watch out for arguments about future technology that is magical. Such an argument can never be refuted. It is a faith-based argument, not a scientific argument.... We have seen a sudden increase in performance of AI systems thanks to the success of deep learning. Many people seem to think that means we will continue to see AI performance increase by equal multiples on a regular basis. But the deep-learning success was 30 years in the making, and it was an isolated event. That does not mean there will not be more isolated events, where work from the backwaters of AI research suddenly fuels a rapid-step increase in the performance of many AI applications. But there is no ���law��� that says how often they will happen....

Many AI researchers and AI pundits, especially those pessimists who indulge in predictions��about AI getting out of control and killing people, are similarly imagination-challenged.... Long before there are evil super-intelligences that want to get rid of us, there will be somewhat less intelligent, less belligerent machines. Before that, there will be really grumpy machines. Before that, quite annoying machines. And before them, arrogant, unpleasant machines. We will change our world along the way, adjusting both the environment for new technologies and the new technologies themselves. I am not saying there may not be challenges. I am saying that they will not be sudden and unexpected, as many people think...

#shouldread #riseoftherobots

Michael Kremer (1993) The O-Ring Theory of Economic Devel...

Michael Kremer (1993) The O-Ring Theory of Economic Development http://www.jstor.org/stable/2118400: "People in business talk about quality all the time.... This paper makes a stab at modeling quality... proposes an O-ring production function in which quantity cannot be substituted for quality.... Under this production function, small differences in worker skill lead to large differences in wages and output...

...If tasks are performed sequentially, high-skill workers will be allocated to later stages of production. Poor countries will therefore have higher shares of primary production in GNP, and workers will be paid more in industries with high value inputs.... Imperfect matching of workers due to imperfect information about worker skill leads to positive spillovers and strategic complementarity in investment in human capital. Thus, subsidies to investment in human capital may be Pareto optimal. Small differences between countries in such subsidies or in exogenous factors such as geography or the quality of the educational system lead to multiplier effects that create large differences in worker skill. If strategic complementarity is sufficiently strong, microeconomically identical nations or groups within nations could settle into equilibria with different levels of human capital...

#shouldread #economicgrowth

Monday Smackdown: What Tobin Harshaw of the New York Times Wants to Be Remembered For: "I Am Not Authorized to Explain Why I Am Not Authorized..."

Monday Smackdown: What Tobin Harshaw of the New York Times claims he wants to be remembered for. From 2007. No quality control at the New York Times whatsoever. Let us take him at his word, and remember him for this:

Hoisted from 2007: As you may recall, last Friday there was a lot of discussion about revisions to the GISS global warming series of estimated average temperatures in the United States���a revision that changed the hottest year to date in the U.S. from 1998 (which in the old data was 1/100 of a degree hotter than 1934) to 1934 (which in the new data is 2/100 of a degree hotter than 1998) https://delong.typepad.com/sdj/2007/08/why-oh-why-ca-1.html. One surprising thing was that the New York Times's Opinionator weblog https://opinionator.blogs.nytimes.com/... went way overboard on the story:

Among global warming Cassandras, the fact that 1998 was the ���hottest year on record��� has always been an article of faith.... James Hansen, the climate scientist who has long accused the Bush administration of trying to ���silence��� him.... [A] Y2K bug played havoc with some of the numbers.... Michael Ashe... explains.... "The changes are truly astounding. The warmest year on record is now 1934. 1998 (long trumpeted by the media as recordbreaking) moves to second place.... [T]he effect on the U.S. global warming propaganda machine could be huge...

This surprised me: "effect... huge," "havoc," the scare quotes around "silence," "data meltdown," et cetera seemed very out of place for a three-one-hundredths of a degree shift--either complete mendacity or total innumeracy, or both.... The Opinionato... Tobin Harshaw, wh... [had] also served as an enthusiastic stenographer for last Friday's Stupidest Man Alive nominee, Tom Nugent of National Review, who slipped a decimal points and wrote a totally off-the-rails piece... overestimating how much money such a tax might raise by a factor of ten. It seemed that Harshaw had failed to do the slightest amount of quantitative due diligence on either story before he committed fingers to keyboard and thus electrons to the n��osphere.... So I called Toby Harshaw.... It seems to me that he and the New York Times have much bigger problems than simple innumeracy:

Brad DeLong: Good afternoon. I'm Brad DeLong, an economics professor calling from UC Berkeley. I read your Cassandra post about global warming data revisions, and had a couple of questions. Can you help me out?

Tobin Harshaw: Certainly.

Brad DeLong: Did you eyeball the data--either in a graph or a table--before you wrote your "Cassandra" post about GISS global warming data revisions?

Tobin Harshaw: Are you writing something about this?

Brad DeLong: I will be, yes.

Tobin Harshaw: Then no, I cannot speak to you. You will have to speak to our public relations department.

Brad DeLong: Why won't you talk to me?

Tobin Harshaw: Because I am not authorized to speak to the press.

Brad DeLong: Because?

Tobin Harshaw: Because that is our policy. Our policy is that editorial staff are not allowed to speak to the press.

Brad DeLong: Seriously? Why is that your policy?

Tobin Harshaw: I am not authorized.

Brad DeLong: So you cannot even explain why your policy is that you cannot explain what you write?

Tobin Harshaw: I will have to transfer you to the operator.

Brad DeLong: But surely you can at least give a reason for the policy that keeps you from explaining...

Tobin Harshaw: I've spoken to you clearly.

Brad DeLong: You have not.

?Tobin Harshaw: I've explained to you that our policy is that I am not authorized to speak to the press.

Brad DeLong: Why aren't you authorized to explain and elaborate on what you wrote?

Tobin Harshaw: I am not authorized to say why I am not authorized. It is our policy...t authorized to speak. You will have to speak to our public relations department.

Brad DeLong: You are sure?...

Tobin Harshaw: Goodbye Mr. DeLong.

I thought about calling public editor Clark Hoyt, but he picks up his voice mail about once a week.

Why oh why can't we have a better press corps?

#journamalism
#hoistedfromthearchives
#globalwarming
#orangehairedbaboons
#mondaysmackdown

Self-Fulfilling Financial Crises: No Longer Fresh at Project Syndicate

As Published: Self-Fulfilling Financial Crises: Many mistaken assumptions about the 2008 financial crisis remain in circulation. As long as policymakers believe the crisis was rooted in the housing bubble rather than human psychology, another crisis will be inevitable. | My Earlier Draft: The 2008 financial crisis and subsequent recession left the Global North 10% poorer than it otherwise would have been, based on 2005 forecasts. For those hoping to understand this episode better, for a while now I have been recommending four very good books on and about the financial crisis of 2008 and what has followed���the catastrophes that have left the Global North 10% poorer now than we confidently forecasted back in 2005 that we would be today. They are:

Kindleberger's Manias, Panics, and Crashes https://books.google.com/books?isbn=0230365353,
Reinhart and Rogoff's This Time It's Different https://books.google.com/books?isbn=0691152640,
Martin Wolf's The Shifts and the Shocks https://books.google.com/books?isbn=1101608447, and
Barry Eichengreen's Hall of Mirrors https://books.google.com/books?isbn=0190621079.

Now I want to add on a fifth book: Nicola Gennaioli and Andrei Shleifer's A Crisis of Beliefs: Investor Psychology and Financial Fragility https://books.google.com/books?isbn=0691184925. (Full disclosure: Shleifer was my roommate in college and graduate school; to this day, I credit him more than anybody else with whatever positive skills or reputation as an economist I may have.)

A Crisis of Beliefs is important for three reasons. First, it offers a welcome rejoinder to those who argue that the past decade was an unavoidable result of the housing bubble in the United States. Many experts still claim that the bubble���s deflation triggered the financial crisis. Only last month former Federal Reserve chair Ben Bernanke pointed to the deflation of the housing bubble as what had ���triggered the financial crisis��� of 2008. But the deflation of the housing bubble did not do so. The housing bubble had already deflated substantially before the financial crisis.But the fact is that the bubble had already deflated substantially before the crisis erupted.

Recall that by mid-2008, home prices had returned to, or even fallen below, levels supported by their underlying fundamentals, and employment and production in the residential construction industry had declined to levels far ar below trend. The work of rebalancing asset valuations and reallocating economic resources across sectors had already been accomplished.

To be sure, there were still about 750 billion dollars worth of financial-asset losses to be assigned to somebody���that is the likely level of access subprime and home equity defaults that would have occurred in the absence of a big recession. But 750 billion dollars of total losses is one-quarter of what global equity markets saw on the single day of October 20, 2018���not something that should take down a global financial system with sophisticated risk-bearing institutions.

Ben Bernanke himself and his Federal Reserve appeared highly confident in the summer of 2008 that the deflation of the housing bubble had not triggered any unmanageable financial crisis: he and his were focused more on the dangers of rising inflation.

It is true that some welcomed financial stress and the prospect of a recession because they thought it would assist in needed rebalancing. In November 2008 there were people like John Cochrane of Stanford���s Hoover Institution claiming that the economy ���needed��� a recession ���because people pounding nails in Nevada need to find something else to do���. But people of that ilk were simply not reality based: clueless about what the numbers were.

And yet the bottom fell out, even though the structural work of expenditure- and resource-switching had been accomplished, even though there was no air left between risky asset prices and fundamentals in a bubble to be popped, even though the magnitude of unallocated losses was small relative to the risk-bearing capacity of the global economy.

This is why Gennaioli and Shleifer are most worth reading. They understand why: the bottom fell out because beliefs changed in a way correlated with but not rationally motivated by changing fundamentals. The freezing-up of the interbank market, the housing finance failures, the collapse of Bear Stearns, the Treasury's move to take advantage of the embarrassment of FHLMC and FNMA to bring them under its control and curb their exorbitant privileges, and most of all the unmanaged failure of Lehman led investors to diagnose that financial markets were suffering from greatly elevated risk. Hence the sudden run on the shadow and then the non-shadow banking system, as a desperate scramble to buy assets that would still be perceived as safe no matter what and to dump others caused the increase in risk that they had diagnosed. Think of investors as triage nurses in an emergency room, taking a hasty look at the most salient features of the case presented and then running with their immediate diagnosis as if it were the only way things could be.

And yet nothing about the fallout from the crisis was inevitable. All this was contingent: Had the Federal Reserve had possessed contingency plans for putting all too-big-to-fail institutions into receivership and becoming the risk-bearer of last resort, whether or not such plans were ultra vires the technicalities of the Federal Reserve Bank of New York's corporate charter, we would with high likelihood live in a very different world today. Gennaioli and Shleifer recognize this contingency in a way that many who now construct retrospective narratives of inevitability stemming from the existence of the housing bubble did not. This is why they are most worth reading.

The second reason that I see Gennaioli and Shleifer's book as important is that they see such "crises of beliefs" like 2008-9 as so deeply rooted in human psychology that we will not be able to institutionally outgrow or route ourselves around them. Prudential policy before and crisis-management policy during such episodes cannot regard them as one-off exceptions, but rather as chronic conditions that must be managed.

This means, most particularly, that central banks and fiscal authorities cannot take the end of a crisis as an excuse to stand back. Beliefs have been permanently shifted, and so the configuration of policies that supported full employment, low inflation, and balanced growth before the crisis can no longer do so. Moreover, the seeds of the next Kindlebergian episode of displacement-optimism-feedback-enthusiasm-crash-panic-revulsion-descredit are already being sown by the policies needed in the aftermath of a depression to rebalance the fundamentals of the real economy and employ resources.

And there is a third reason���a more technical reason for economists to pay attention to Gennaioli and Shleifer's diagnostic expectations. Economists have long recognized that requiring one's representative agents to hold rational expectations of the future leasd to models that are in many ways profoundly unapplicable to the real world. But no alternative has yet gained traction. Their modeling strategy of seeing investors as triage nurses overfocusing on the most immediately salient features of the patient right now has great promise as an alternative horse to bring on to the model-building track.

For a decade now, people have been looking for a silver lining to the disasters of 2008-2018, hoping that this period will bring about a more productive integration of finance, behavioral economics, and macroeconomic orthodoxy. So far, they have been searching in vain. But with the publication of A Crisis of Beliefs, there is hope yet.

#projectsyndicate
#economicsgoneright
#monetaryeconomics
#behavioral
#finance

I am keenly aware that since, say, 1997 one disagrees wit...

I am keenly aware that since, say, 1997 one disagrees with Paul Krugman at one's grave intellectual peril. But I am not as confident as Paul Krugman is that "the past decade has been a huge validation for textbook macroeconomics". A large component of what Krugman calls "good old-fashioned macro" was that expectations were, if not rational, adaptive. Keynes's "speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done..." had no place in "old-fashioned macro". And it is not as though this was a flaw and could be quickly, coherently, and satisfactorily patched. The integration of behavioral finance and macro is still not done���which is why I am such a booster of Nicola Gennaioli and Andrei Shleifer (2018): A Crisis of Beliefs: Investor Psychology and Financial Fragility https://books.google.com/books?isbn=0691184925. (That, and Andrei is my friend.) They are at least looking in the right direction: Paul Krugman: What Do We Actually Know About the Economy?: "Among macroeconomists, the self-criticism seems to me to be mainly too narrow: people berate themselves for, say, not giving financial markets a bigger role in their models, but few have done what they should, which is to question the whole direction macroeconomics has gone these past four decades or so...

...Among economists more generally, a lot of the criticism seems to amount to the view that macroeconomics is bunk, and that we should stick to microeconomics.... [But] in an important sense the past decade has been a huge validation for textbook macroeconomics; meanwhile, the exaltation of micro as the only ���real��� economics both gives microeconomics too much credit and is largely responsible for the ways macroeconomic theory has gone wrong.... So let me talk about... the unsung success of macroeconomics, the excessive prestige of microeconomics, [and] the limits of empiricism, vital though it is....

IS-LM... is the simplest model you can write down of how interest rates and output are jointly determined, and is how most practicing macroeconomists actually think about short-run economic fluctuations.... The overall story... is one of overwhelming predictive success. Basic, old-fashioned macroeconomics didn���t fail in the crisis���it worked extremely well. In fact, it���s hard to think of any other example of economic models working this well���making predictions that most non-economists (and some economists) refused to believe, indeed found implausible, but which came true. Where, for example, can you find any comparable successes in microeconomics?

But, you say, we didn���t see the Great Recession coming.... What happened was that economists refused to believe that home prices could be that out of touch with reality. That���s... a problem with financial economics... the general unwillingness of human beings... to believe that so many people can be so wrong about something so big. The bottom line: the past decade has been a vindication, not a refutation, of good old-fashioned macro....

Trade people tended to consider international macro people semi-charlatans, doing ad hoc stuff devoid of rigor. International macro people considered trade people boring, obsessed with proving theorems and offering little of real-world use. Both sides were, of course, right.... Does microeconomics really deserve its reputation of moral and intellectual superiority? No. Even before the rise of behavioral economics, any halfway self-aware economist realized that utility maximization���indeed, the very concept of utility���wasn���t a fact about the world; it was more of a thought experiment, whose conclusions should always have been stated in the subjunctive.... Here���s my question: where are the examples of microeconomic theory providing strong, counterintuitive, successful predictions on the same order as the success of IS-LM macroeconomics after 2008? Maybe there are some, but I can���t come up with any. Just to be clear: there���s plenty of excellent micro work, both theory and empirical. What I���m talking about, however, is the kind of mind-altering, the-world-doesn���t-work-the-way-you-think-it-does stuff macro has achieved. When I look at the American Economic Review���s list of its top 20 papers, I think I may see one micro paper like that ��� Kenneth Arrow on health care. Other candidates?...

Meanwhile, the demand that macro become ever more rigorous in the narrow, misguided sense that it look like micro led to useful approaches being locked up in Schwinger���s back room, and in all too many cases forgotten. When the crisis struck, it was amazing how many successful academics turned out not to know things every economist would have known in 1970, and indeed resurrected 1930-vintage fallacies in the belief that they were profound insights....

Economists do turn out to know quite a lot: they do have some extremely useful models, usually pretty simple ones, that have stood up well in the face of evidence and events. And they definitely shouldn���t defer to important and/or rich people on policy: compare Janet Yellen���s macroeconomic track record with that of the multiple billionaires who warned that Bernanke would debase the dollar. Or take my favorite Business Week headline from 2010: ���Krugman or [John] Paulson: Who You Gonna Bet On?��� Um. The important thing is to be aware of what we do know, and why...

#shouldread
#economicsgonewrong
#monetaryeconomics
#finance
#economicsgoneright

Tweed Jackets and Natural Disasters: No Longer Fresh at Project Syndicate

No Longer Fresh at Project Syndicate: For Whom the Climate Bell Tolls: As I began my first lecture this fall here at the University of California at Berkeley, I immediately realized that I was too hot: I desperately wanted to take off my professorial tweed jacket.

A tweed jacket is, in many ways, a wonderful albeit peculiar costume. For one thing, it is the closest thing you can get to Gore-Tex if all you have for raw material is a sheep. Thus it is perfect for a cloudy climate with frequent fog and drizzle. For another, it is surprisingly warming���wet or dry���for its weight. Hence in the world as it was before central heating, it���and the rest of what we today think of male formal and semi-formal attire���were effective and comfortable garb in the Oxfords and Cambridges, in the Edinburghs and Londons, in the Bristols and Norwiches where they were originally devised.

Blame the British Empire for the spread of these garments around the globe.

That spread was a decidedly mixed blessing. Indeed, these garments have long been cursed by those living closer to the equator, or further from the clouds and fog, or in regions of greater temperature variation than the island of Great Britain. And with the coming of central heating these garments became uncomfortable indoors, at least for those of us who do not sit sessie at desks, in most of even those parts of the world where they were comfortable outdoors���save for those Global North offices and shopping malls where they would really crank up the air conditioning to make jacket-and-tie or suit-and-tie feel comfortable.

There did, however, remain a few places in the world where tweed jackets and their ilk remained comfortable wear: Scotland, those places of England where it was considered gauche to actually use your central heating���and San Francisco Bay north of Silicon Valley, including the University of California's home here at Berkeley on the east side of San Francisco Bay. I will admit that the idea that professorial-style wear was actually comfortable here was a reason���a small reason���to locate in Berkeley after three years in Washington learning how many pounds of sweat a wool suit can absorb and hold.

But over the past twenty years I have found professorial garb becoming increasing uncomfortable here on the east side of San Francisco Bay. And these days the climate of Berkeley feels to me like the climate of Santa Barbara 200 miles to the south felt back in the days when I was young. Hence now, increasingly, we lecture wearing the short shirt sleeve costume that we saw people in Greater Los Angeles���at CalTech and the Jet Propulsion Lab���wearing half a century ago.

In the United States���for the entire Global North, in fact���global warming is probably not going to be a huge problem over the next century. It essentially means that the climate will march about 3 miles north each year. Probably. There are possible disaster scenarios���disappearance of snowpacks, rapid desertification, wheat belt turns into a corn belt, corn belt turns into rangeland, rangeland turns into desert, and so forth. Dealing with such would be inconvenient. Dealing with such would be expensive. But dealing wiht such would be doable.

But elsewhere objects that are much worse than inconvenient are much closer in the mirror of the future than they appear to many. We still have two billion who are or whose livelihoods depend on the near-subsistence farmers living in the six great river valleys of Asia, from the Yellow all the way around to the Indus. These farmers do not have a lot of money or non-farming skills. They would have a very hard time moving elsewhere and making a living other than as farmers in the six great valleys of river valleys of Asia���the six that have supported most of human civilization for the past five thousand years. Those rivers rely on there being enough snow on the high plateaus of Asia and that snow melting at the right time in the right volume, neither too little nor too much when the crops need them. We have another billion who depend on the monsoon showing up at the right time in the right place in the right volume. Plus there is the fact that the pattern of typhoons in the Bay of Bengal will change as global warming proceeds: they will grow stronger or weaker as the sea level starts to rise. If they grow stronger, and start roaring north with a storm surge toward the 250, million people living essentially at sea level in the greater Ganges Delta...

We as a globe are not prepared for that. The mainland United States was not prepared for Katrina in New Orleans, Sandy in New York, or Harvey in Houston. Puerto Rico was not prepared for Maria. The four most damaging hurricanes in U.S. history have all occurred in the past fifteen years���and, no, they were not the most damaging because of administrative incompetence or the increased density of coastal settlement. Yet those natural disasters were merely small pinpricks compared to the natural disaster risks we are now running.

Bells. Tolling. John Donne. No man���no ethnic group���no country���is an island.

https://www.icloud.com/keynote/0msteA8O3XcMB1x6n4EvwqWVw

#projectsyndicate
#globalwarming
#highlighted

The Wrong Financial Crisis: Hoisted from the Archives (October 2008)

Hoisted from the Archives (October 2008): The Wrong Financial Crisis: Catastrophic failures of risk management throughout the entire banking sector multiplied a relatively minor collapse in housing prices into a paralysis of the global finance system not seen since the Great Depression. To fix it, governments should embark on a coordinated fiscal and monetary expansion and a coordinated bank recapitalisation:

All of us from Lawrence Summers to John Taylor were expecting a very different financial crisis. We were expecting the ���Balance of Financial Terror��� between Asia and America to collapse and produce chaos. We are not having that financial crisis. Instead we are having a very different financial crisis. Catastrophic failures of risk management throughout the entire banking sector caused a relatively minor collapse in housing prices to freeze up global finance to a degree that has not been seen since the Great Depression.

The first good thing about this situation is that it does not call for different central banks and Treasuries to do different things, but rather for them all to do the same thing in unison without fouling each other���s oars. That should be relatively easy to arrange.

What we need right now are:

Coordinated fiscal expansions across the globe: If the world economy is not now in something close enough to a liquidity trap to make no difference, it soon will be.

Coordinated monetary expansions across the globe: A bank is any organisation that borrows or accepts investments short and lends long; the durations of its assets and liabilities are deliberately mismatched; when the entire banking sector is insolvent at current market prices, anything that reduces interest rates all along the yield curve helps reduce the magnitude of the insolvency.

Coordinated banking sector recapitalisations across the globe: Since at least 1844 there has been broad consensus that the short-term price of safe liquidity is too important to be left to the market; now there is growing consensus that the price of risk is too important to be left to the market as well. For the government to operate on the price of risk through Operations-Twist on a Galactic scale is infeasible. That means that the aggregate degree of capitalisation of the banking system must become the object of policy choice. Call it socialism in one sector.

What we need in the longer term are:

Global rules to make outsized compensation incentive-compatible: The Princes of Midtown Manhattan and Canary Wharf need to know that their fortunes will be lost if their institutions blow up within a decade of their handing over operational control ��� only in this way can you make them truly long in the fortunes of their firms and of the global economy rather than simply long in volatility.

More progressive global tax systems: We wish we could build a better global economic system, but we do not know how to build one that does not contain a solid safety net for plutocrats, and the systems we do know how to build are politically unsustainable unless all voters know and believe that from those who have much will be taken away.

The global market economy continues to evade all our attempts to make it foolproof���in large part because our greater fools are so ingenious.

But there is not yet any requirement that this global economic downturn reach the magnitude of 1982, or even 1975.

#hoistedfromthearchives
#highlighted
#greatrecession
#finance
#behavioral
#monetaryeconomics
#greatrecession
#highlighted

Hoisted from the Archives: ���Unknown Unknowns���: High Public Debt Levels and Other Sources of Risk in Today���s Macroeconomic Environment

Next time I give a "general macro-finance" talk, I should give this one���updated, of course. But how much updating is needed>: ���Unknown Unknowns���: High Public Debt Levels and Other Sources of Risk in Today���s Macroeconomic Environment (NEEDS REVISION) https://www.icloud.com/keynote/0_py01Y-ZrGddLKba8Rl2r9eQ

It's alternative title is: Confusion: High Public Debt Levels and Other Sources of Risk in Today���s Macroeconomic Environment:

The theme is: confusion. Confusion on the theoretical level, confusion on the empirical level, confusion on the policy level. I am confused and astonished that that we are here today facing the global macroeconomic situation we face today. Cast me back seven year, ask me then "what are the chances that we will be this far down in the lower tail of global nominal GDP distributions?" and I will answer you that there is only a 1-in-a-100, only a 1-in-a-1000 chance.

The fact that we are here makes me fear that much of what I thought seven years ago was just completely wrong.

Twelve Seven years ago, when asked, I said that as far as macroeconomic policy was concerned I was a fairly orthodox neoliberal monetarist. I agreed with Robert Lucas that the problem of depression prevention had largely been solved. But I would go on to say that the problem of ensuring that inflation expectations remained anchored had not been solved���hence central banks needed to set and meet firm inflation targets. And fiscal authorities needed to avoid even a whisper of a hint of fiscal dominance. Fiscal dominance���a situation in which the political system will not let the government raise the primary surpluses it needs to amortize the debt at the current price level���is the thing that most easily undermines anchored inflation expectations.

Thus legislators should be prohibited from even thinking about using large debt expansions for any purpose short of total war.

And rebalancing an economy in depression? That should be left to monetary policy.

Central banks were able to do that job, with the unfortunate exception of the 1930s. But, otherwise, central banks had proven themselves very capable of boosting nominal aggregate demand whenever they wished to whatever target they wished. That was the implication I drew then from my belief that the principal macroeconomic stabilization policy problem on the inflation and employment front was that of ensuring that inflation expectations remain anchored.

Twelve Seven years ago, when asked, I would have said that the principal macro-financial economic problem was the fact that equity premiums were so outsized from the perspective of the consumption capital asset pricing model. That told me that finance markets were having a very hard time properly mobilizing society's full risk-bearing capacity. Combine that with the fact the problem of preventing financial regulatory capture had definitely not been solved and you are pushed towards thinking that financial deregulation is a very good thing. To the extent that the regulators aren���t regulating that much, their capture can't do much damage. To the extent that financial markets are not mobilizing society's risk-bearing capacity, deregulation to allow experimentation with different business models and different modes of risk-bearing looked like a big winner: if people are not bearing as much risk as they should, convincing them they should bear additional risks is a good.

Were there risks generated by allowing financial experimentation via deregulation? Yes. But they were relatively small.

History told us that the modern Federal Reserve could build a firewall between whatever financial disorder emerged and the real economy of production and employment. There was the 25% one-day crash of the stock market in 1987. There was the 1991 discovery that the savings and loans of the state of Texas had been building shopping centers and office towers they really shouldn���t have been building���which led, among other things, to a transfer to Texas of an amount of 25% of a year���s GDP without a burp from the United Stated political system. There was the 1998 collapse of LTCM. There was the 2001 collapse of the dot-com Bubble that took $5 trillion of equity wealth down with it. IN all of these cases the Federal Reserve was able to react swiftly and smoothly to keep these large financial shocks from having much of an effect on the real economy of production and employment.

Thus the big problems were:

the risk of unanchored inflation expectations, as shown by the US and Western Europe in the 1970s, which might be triggered by
fiscal dominance resulting from the policies of governments that Rudi Dornbusch labeled "populist",
the perennial failure of financial markets to mobilize society's proper risk bearing capacity, plus
financial market regulatory capture.

Were there other risks? Yes. East Asia in 1997-1998 showed us that there were. That crisis came as a huge surprise. But the lesson I drew from it was that things could only go badly wrong if a central bank failed to ensure that the banks and others it supervised did not borrow in a harder currency than the one it could create at will.

By the time of the Alan Greenspan retirement party in 2005 at Jackson Hole in August, not just me but a lot of people were feeling very confident. Yes, the financial system was subject to different kinds of market failures. Yes, there were lots of business models being tried that were probably not going to work. But central banks were able to stabilize nominal demand. Surely there was great value attached in trying to find ways to accomplish financial deepening and increase markets' risk-bearing capacity through experimentation with products like derivatives. And the more competition for the Morgan Stanleys, the JP Morgans, and the Goldman Sachses provided by the Citigroups and the Banks of America seemed to be a very healthy thing.

Only a small number of voices were saying: ���Wait a minute! We don���t understand what we are getting into���.

Of these still small voices the most prominent, in August 2005 at Jackson Hole at least, was Raghu Rajan, with his declaration that we were building much larger systemic risks that we did not understand than we thought we were. I won't say that it provoked a near-riot from the conference audience. I will say that, as I recall it at least, Alan Blinder was the only person who stood up to even half-defend Raghu, and Alan's defense took the form of musing about the extraordinarily convex compensation schemes of investment bankers and traders. We had gotten away from the partnership structure in which every partner of an investment bank, knowing that they are on the hook personally, jointly, and severally for the liabilities of the entire firm, is a risk manager. We had gotten away from the world in which every 30 year old knows they become rich only if they do a good job and their firm survives for the next 30 years, and hence is a risk manager. But in a world in which people are paid high cash bonuses based on their mark-to-model positions as of the previous December?

But even Alan was cautious in his willingness to back Raghu.

The more canonical reaction was that of the brilliant and rich Arminio Fraga, who knows both how to be a central banker and how to be a portfolio manager. In his view, the system we had in 2005 was far superior to what had come before it, and was getting better all the time.

Then we had the housing bubble.

Then we had the US financial crisis.

Then we found ourselves with an extremely large slowdown in the growth of nominal spending below its pre-2007 path.

Then we found we had a lack of traction on the part of North Atlantic central banks that would have been much happier if their policy tools could have returned the economy to its pre-2007 growth path, but found that they could not do so by normal or even by abnormal policies���at least the abnormal policies they were willing to risk.

And now we have the ongoing catastrophe that is the collapse of subsequent flattening of the employment-to-population ratio throughout the North Atlantic.

The collapse was initially largest in the United States. But now Europe is catching up, and by the end of this year is likely to have surpassed the United States in the magnitude of the employment gap. And there is the major fear that a substantial chunk of those who lost their jobs and dropped out of the labor force over the past five years are not going to be coming back, with its implications for potential output and for the ability of governments to amortize their growing debts.

This last I find very disturbing. I did not think this kind of thing happened. I used to teach my students that the US economy had a very flexible labor market: the way to bet was that 40% of excess unemployed will get jobs in a year. Thus three years after a recession trough your employment gap will be down to 20% of its peak value, and after four years it will be down to 12%. But we are coming up on four years, and we haven���t closed 88% of the employment gap. We���ve closed zero. And we've closed zero, in spite of policies that look extraordinarily simulative among a number of dimensions.

That���s not something that I thought would happen.

Moreover, ten fiufteen years ago I would have said that the debt capacity of even the most credit-worthy sovereigns was likely to be limited. Back in the early 1990s, when I was doing staff work for the Clinton administration-to-be and then the Clinton administration, I would have put the U.S.'s debt capacity at 50% of a year's GDP. Throughout the 1980s, whenever there was bad news about the size of the US deficit the dollar appreciated���people said: ���Aha, this means that interest rates are going to be higher, here is a nice opportunity to reach for yield, so let���s buy dollars���. When a country nears its debt capacity that flips, and people say instead: "Bad news about the deficit means that this is a potentially unstable place that we we don���t want to invest in", and the vale of he dollar would drop. It seemed in the early 1990s that the United States government was on nearing this tipping point���thus the urgency the Clinton administration and the Greenspan Federal Reserve felt was at stake in getting the debt-to-annual-GDP ratio on a declining trajectory.

Back then, people said that the U.S. couldn't be approaching its debt capacity because the debt-to-annual GDP ratio had been much higher immediately after World War II. Our answer back then was that debt capacity had been artificially boosted by financial repression���Regulation Q, a Federal Reserve that in pre-Accord days viewed its task as keeping interest rates low, a world of narrow banking, etc. That world, we said then, wasn't the world that we were in, and was not a world we wanted to return to. The 1970s, we said, had made people aware of the risks of lending to the U.S. government in nominal terms. And the memory of the 1930s had ebbed. Both of these had reduced the U.S.'s debt capacity substantially.

Yet the past five ten years have taught us that US and German and British and Japanese government bonds are regarded by the market as extraordinarily safe places to put your money. This demand for them seems to outstrip any possible limit that 10 years ago I would have confidently placed on maximum demand for these securities.

Why is it that central banks have not been able to get traction to return nominal GDP growth to its pre-2007 path through their normal, or even their extraordinary, monetary policy tools? The natural place to start thinking is with the quantity theory of money, written in logs: lower-case price level p plus lower-case output y equals lower-case money stock m plus log velocity v that depends on the interest rate i, with "interest rate" here being broadly construed as including everything that strikes people as an opportunity cost of holding money balances:

p + y = m + v(i)

How is it that in this framework boosting m by an amount dm doesn���t boost nominal GDP? The answer has to be that when you boost the money stock. You are also doing something to interest rates, to the opportunity cost of holding money, and hence to velocity. m goes up. i and v go down. And so nothing happens.

Thus in order to make monetary expansion effective in a low-interest rate environment, you need to do something to keep the side effects of monetary expansion from lowering the opportunity costs of holding money. And the effects of the reductions in this opportunity cost i are truly extraordinary. If, ten years ago, you had told me that the Federal Reserve was going to take the high powered money stock of the United States from 700 billion in mid���2008 on up to 3 trillion by mid-2013 and say that it was going to keep raising it by $1.2 trillion a year as long as it felt like it, what would I have said in response? I would have said: is the Federal Reserve quadrupling the U.S. price level for some reason?

Karl Smith of the University of North Carolina has convinced me that to understand why the opportunity cost of holding money falls so much with monetary expansion these days, and reduces velocity so that monetary expansion has no or next-to-no traction on nominal GDP, we need to go from the money market over to the bond market to see what the bond market has to tell us about the joint determination of interest rates and output levels.

Smith takes a Stiglitzian perspective. Supply-and-demand for bonds are in balance when savings of the citizenry flowing into financial markets on the left hand side are equal to the willingness of financial intermediaries to accept newly-issued debt and other wealth instruments on the right hand side. If financial intermediaries aren���t willing to hold bonds and make loans, then interest rates are going to drop and you are going to find that your monetary expansion isn���t going to have any effects. So what are the determinants of financial intermediaries' willingness to enlarge their portfolios?

S(Y, Y-T) = FI(i, ��i, ��, Q)

They are financial intermediaries' current nominal cost of funds i, beliefs about likely future changes in that cost of funds ��i, expected inflation ��, and the quality of the loans they are making and the bonds they are holding measured relative to financial intermediaries' risk tolerance: call this Q, for loan quality. I was being a naive Hicksian, saying: how can expansionary fiscal policy not boost output Y when interest rates are at their zero lower bound? After all:

S(Y, Y-T) = I(r ) + (G-T).

Karl Smith pointed out to me that the standard Hicksian IS-LM framework assumed that when financial intermediaries bought newly-issued government bonds in amount G-T this did not use up any of their risk tolerance���that issuing more government bonds raised the average quality Q of the bonds and loans financial intermediaries were holding as assets. And, as he pointed out to me, in the case of Greece that was not true. An assumption smuggled into Hicks's 1937 framework���an assumption Hicks probably did not even know that he was making���is that government debt is by necessity debt of high quality, and thus that the government is not going to have any trouble placing its debt. That may well be false: we have seen that it can be false. And the question of whether issuing more government debt will raise average loan and bond quality is a question that is, I think, underthought.

Those of us who think not just that fiscal rebalancing should be postponed but that fiscal unbalancing should be extended for another year or two or three���until the employment-to-population ratio gets higher than it is���need to stop underthinking this question. Clearly at some point issuing additional debt will crack any borrower's status as a provider of safe high-quality assets. Ricardo Caballero will tell you that demand for safe high quality assets is absolutely through the roof, beyond the moon, and will stay so for the next generation bcause in 2007 private-sector investors were holding about 10 trillion of paper they regarded as AAA that had been created by investment banks and guaranteed by rating agencies but that no sane investor will ever regard anything created by an investment bank and rated by Moody���s or S&P as AAA ever again. That left a 10 trillion hole in people���s desired safe-asset portion of their portfolios which can only be filled by credit-worthy government and government guaranteed debt. Ricardo Caballero will say that filling this hold has to be an essential part of full macroeconomic rebalancing. That may be true. I���m inclined to think that probably is true. But that���s a set of considerations that we have to think about.

Behind everything, there are what I call the Stein-George-Feldstein worries. Banks need to make 3% per year nominal on assets or they report losses. For a banker to report a loss is a quick way for a banker to exit from his or her job. Therefore commercial banks are going to reach for yield so they can report operating profits this year. Esther George, Marty Feldstein, and Jeremy Stein say: banks are only able to report profits in this environment because they are somehow selling out-of-the-money puts, and we really do not want asset prices to move in such a way that reveals what puts they have been selling. If you are Marty Feldstein, you think there is a 20% chance of normalization of interest rates in the United States in each year looking forward, that because of large debt outstanding, the normalization of 10-year Treasury rates carries them not to 4% per year nominal but to 6%, which means that should normalization come that���s a 36% capital loss on bank and shadow bank holdings of 10-year Treasuries and other things of equivalent duration. Given underlying political currents it is not at all clear that the political support for a second rescue of the banking system anywhere exists in any North Atlantic democracy. Hence Stein, Feldstein, and George draw the conclusion that it is time to start raising interest rates so banks can get a wedge between the zero cost of funds from depositors and the amount of money they earned by holding safe medium term assets. Otherwise, they fear, we will soon face a financial crisis worse than 2008-9.

For those of us who want to see further fiscal unbalancing over the next several years, we have to explain why it is that we see a non-disastrous future following in the medium- and long-run from additional run ups in national debts. As a first cut, consider three scenarios: fiscal dominance, financial repression, and normalization to something very like the current macroeconomy as the new normal.

Fiscal dominance: Suppose that countries have political systems that will allow them to run primary surpluses as share of GDP of ��, but no more. Suppose that interest rates will normalize to r. Suppose the real growth rate of the economy is g over the long run. Call the nominal debt D, the price level P, and real GDP Y. Then the basic debt amortization equation is:

(r-g)(D/P) = ��Y

That means that the price level is going to be:

P = ((r-g)/��))(D/Y)

If your r-g is relatively large, if your debt-to-annual-GDP D/Y is relatively high, and if your attainable primary surplus share �� is relatively small, then you have ordered a much higher price level and the market will get you there in short order after interest rates normalize, and the financial, fiscal, and economic chaos generated by this arrival of the long run in the form of fiscal dominance may be considerable and unpleasant. This was, in fact, the advice Keynes gave to the French government in the early 1920s when they asked him how they should halt their inflation. His response was: you can't. In such a situation of fiscal dominance, there is no escape from inflation. So that is scenario 1. And it is unpleasant.

Financial repression: It is possible to escape from fiscal dominance if you can find policies that keep the economy's interest rate on Treasury debt r at or less than its growth rate g. Then no primary surpluses are necessary. But how do you find people willing to hold all of the���large���amount of Treasury debt at an interest rate of only r?

Thus financial repression is a second possible post-normalization scenario. However, it is also a place we would wish to avoid. It���s a first order distortion in the financial market. It���s a tax on savers. It's a tax on financial intermediation. It's a tax on financial deepening. And it is likely to be a bad tax���good taxes have broad bases and low rates, while bad taxes have narrow bases and high rates. The only thing good you can say about financial repression is that it may be an effective way of getting around the limits on the politically-attainable explicit primary surplus from taxation to the extent that its forms of seigniorage remain invisible to a political system that lacks financial sophistication. We really should not go there, and I would rather not go there. But Carmen at least thinks that is the way that the North Atlantic is heading, and the higher the debt with which we enter post-normalization financial repression the more painful it will be.

The new normal: The third scenario is that we escape both fiscal dominance and financial repression because the normalization of interest rates never comes���that Treasury rates stay low, lower than the growth rate of the economy, without requiring any great imposition of implicit-taxes-through-regulation on the financial market.

It was Philippe Weil who used to say that the equity-premium puzzle is really or is also a risk-free rate puzzle���that a high spread between stock and bond returns produces both high stock and low bond returns.

Since the end, in 1896 with the discovery of how to extract South Africa's gold, of the late-nineteenth century deflation, we have had a high equity premium. We used to attribute the high equity return premium to money illusion���that too-many investors did not understand that there was going to be inflation and that bond returns were nominal and stock returns were real. Then we attributed the equity premium to an unwarranted fear on the part of the investors that we would repeat the Great Depression. Then we attributed it to a shortage of patient capital. But, we thought, the memory of the Great Depression was ebbing and with it the extraordinary aversion to short-run stock market fluctuations it had generated, and financial deepening was broadening the ability to mobilize society's risk-bearing capacity, and the memory of the 1970s had disabused investors of the illusion that bonds were truly safe, and so the equity premium was ebbing. Olivier Blanchard wrote a very nice paper to that effect���was it 15 years ago? Very nice paper. From today���s perspective completely wrong.

The SN&500 is now yielding 7% per year real, at a time when short and medium treasuries are in minus 2%. That���s a 9% point annual return gap. I don���t know what people in the United States think that the labor share is going to rise and the profit share shrink with unemployment still above 7%. There does seem to be every sign that the big equity premium is back, and if anything bigger than ever. Perhaps we are in an r < g world.

That would put the credit-worthy reserve-currency-providing sovereigns of the North Atlantic in much the position of the medieval Medici bank. You don���t put your money in the Medici bank in order to earn interest. You put it there for it to be safe. So that in case the pope excommunicates you and you have to flee from Florence to Paris you���ll be able to get your money from the Medici bank there. Issuing debt then becomes a profit center for the government, rather than a drain. These thoughts lead to hopes that maybe we don't have to worry about a big conflict between our short-run goal of boosting employment and production and our long-run fears of somehow triggering fiscal dominance.

Maybe we can summon the confidence fairy: maybe cutting the deficit is the real expansionary policy because putting government finances on a clearly-sustainable track will raise banking sector perception of loan quality, both public and private. But that would seem to require that we see some action on long-term interest rates when we do cut the deficit, and we don't. You���d expect anything that discouraged private investments would reduce the valuation of old capital as well. But equity values seem to be recovering very well from their panic lows.

There is Greg Mankiw's hope that we really don���t have to worry about too-rapid a pace of fiscal consolidation because monetary policy pursued with sufficient expansionary and expansionary zeal can do the stabilization-policy job. Maybe we can get the real interest rate down further via monetary policy alone by summoning the inflation-expectations imp. But how does a central bank succeed in producing expectations that inflation will be only a little bit higher? As Ken Rogoff warned back in 1998, when Paul Krugman wrote his first liquidity track paper then about Japan, how do you push an economy and deflation from having inflation expectations of minus 1% up to inflation expectations of 4% without pushing them to expectations of 20% per year?

Paul���s rejoinder then was for Japan to target the value of the yen, but you can���t do that for the world as a whole.

If you are the 2009-vintage IMF, which believes in an open economy multiplier for a typical European country of 0.5, and a closed economy multiplier for the North Atlantic as a whole of 0.8, the risks of expansionary fiscal policy are not worth it even in the current interest rate environment. If you are today���s new model IMF, which says open economy multipliers for your typical European country are 1.5, which means the closed economy multiplier for the North Atlantic as a whole is 2.5, all of a sudden it is. The risks of triggering fiscal dominance have to be very large and immediate indeed to think that you can leave this policy tool on the table.

I���m sufficiently confused I don���t have much confidences in my priors. My priors seven years ago, were that Central Banks could push nominal GDP to whatever path they wanted through normal policy tools, and that the US economy at least would erase 40% of its unemployment gap in any one year.

With the exception of 1980-1985 the United States at least has typically been in the r < g zone, as far as the real cost of amortizing government debt is concerned. The fact is that the people holding US Treasury bonds appear to be risk-averse to an extraordinary degree���perhaps they are the combination of the central banks of the world plus the rich of emerging markets, all of whom are trying to insure themselves against various forms of political risk, who may well play the same role that Japan's inertial postal savers have played in the Japanese economy for the past twenty-five years. But I don���t pretend to understand Japan.

Last, let me refer to the paper that I wrote with Larry Summers last year���the one that tried to upset the entire problematic by saying that in fact the debt to GDP ratio has a denominator as well as a numerator. When you take account of how low interest rates are for credit-worthy sovereigns right now. If they stay credit for the sovereigns and if you take account of what plausible multipliers are. If you take a look back at what���s happening to labor force participation in the United States and elsewhere. It���s pretty difficult to say that what happens to the denominator is less important, than what happens to the numerator of the debt to GDP ratio.

Certainly Britain���s experience over the past now three years is not terribly heartening as to what even aggressive attempt to cut your deficit through policy will do in terms of reducing the anticipated long run burden of the debt. We wish that it had been otherwise. The question is: are there unusual things happening to Britain over the past three years that should keep us from taking Cameron-Osborne-Clegg as a horrible warning that cutting government purchases will in fact make debt burdens worse?

Suppose that interest rates do normalize, governments then take a look at the interest burden of supporting the government debt, and decide on financial repression under the pirate flag of "macroprudential regulation". Suppose they force investment and commercial banks to hold huge numbers of Treasuries, require public and private pension funds to do so as well, and so forth. What are the costs to the economy as a whole of such policies? Reinhart and Rogoff argue that there are significant growth costs to undertaking such financial repression policies even though they keep interest rates and inflation rates low.

The natural argument is then a technocrat one, a cost-benefit one. But we have, unfortunately, not been having that argument over Reinhart and Rogoff.

Here's one road to that argument. Suppose that the multiplier is 2.5. Spend an extra 10% of a year's GDP on a fiscal boost and we then have a short term boost to GDP of 25% of the year���s production now. That's a temporary gain. According to Reinhart and Rogoff there might be a long run permanent cost of 0.6% of a year's GDP, but some of that is due to reverse causation.

We never had that debate.

We had congressmen saying: ���You mean there is a cliff at 90% and we dare not let the debt-to-annual-GDP ratio go that high?" We have people running around saying: "There is an error in their spreadsheet and so we don't have to worry about growth costs of debt burdens!" Neither of those is an intellectually edifying way to deal with the issue.

We do need estimates of what the costs of adopting post-WWII like debt management strategies afar normalization would be, and balancing them against the benefits of postponing fiscal consolidation.

And there is yet another issue. Last month Olivier Blanchard said that the technocratic calculation I am calling on people to make is a red herring because what we really should be worrying about are the "unknown unknowns" of debt accumulation���just as nobody understood the systemic risks produced by subprime. And "unknown unknowns" are, by definition, unknown.

So: My conclusion. I have very serious doubts about my ability to analyze the situation we are in. Whenever I cast myself back in time and think how confident I was ten years ago, and how wrong, my first response is maybe I should give up this business and stop pretending I have knowledge. Because certainly I would not have thought we would be here now.

The failure of Central Banks to have sufficient traction to push nominal GDP to the target paths where we all want it to be suggests that somehow monetary expansion needs to be more effective by some other policies that gain traction for it. Summoning the confidence fairy? Right now I make fun of the people who claim they know how to do so. But it is the case that credible fiscal contraction in the future is expansionary now precisely because it has effects on perceived likely future interest rates and future tax rates. To the extent that you have to do a deficit reduction down-payment now to make fiscal contraction in the future credible fiscal contraction now can be expansionary. That was the basis of Clinton administration economic policy in 1993 and 1994. And that seems to have worked relatively well. Summoning the confidence theory via fiscal contraction is not an obviously silly thing to do.

Another possible road to traction is to summon the inflation expectation imp���people���s expectations of the future price level change and the economy recovers. Neville Chamberlain, according to Nick Crafts, did this quite effectively when he was Chancellor of the Exchequer at the early 1930s. It is, indeed, only due to accidents of history and the unfortunate events in German politics Nevillel Chamberlain now as the person who failed to assemble the anti-Nazi coalition in the late 1930s and rank Churchill far above him. We might be sitting here regarding Neville Chamberlain as the wizard who pulled Britain out of the Great Depression in the early 1930s and scorning Winston Churchill as the person who caused the problem by overvaluing the pound in 1925.

It is unfair for Keynesians to be making fun of the people who call for austerity by saying "confidence fairy" when they are making similar expectational-shift arguments themselves.

There���s the possibility of gaining traction by improving banker perceptions of average loan quality/risk tolerance via expansionary fiscal policy, which succeeds too the extent that the sovereigns issuing the debt remain credit-worthy. But that can also be accomplished via loan guarantee programs. In the United States, the low hanging fruit, of course, is use of the GSEs to rebalance housing finance���but the fact that Tim Geithner did not replace Ed Demarco as head of the FHFA and choose somebody willing to use housing finance as a tool of macroeconomic policy closed that policy option off.

The aim is to try to give traction to expansionary monetary policy without pushing the economy over into the land of unpleasant fiscal dominance. One possibility is to take an end run around this entire problematic by following the DeLong and Summers (2012) line that interest rates are so absurdly low and the debt-to-annual-GDP ratio has a denominator as well as a numerator that there are not benefits and costs to fiscal expansion at the margin but rather benefits and benefits because spending more now produces a lower debt-to-annual-GDP ratio. I believe that many fewer people buy this argument than should. But even I have to admit that DeLong and Summers (2012) is not a consensus position. It is be a bridge too far for many central bankers and economists���although do note that each month that passes with falling US labor force participation and stagnant US employment-to-population ratios increases my confidence at least that DeLong and Summers (2012) is right.

If interest rates were to start to rise, governments are, as Reinhart and Sbrancia have convincingly documented, adept at using "macroprudential regulation" to keep their borrowing costs low. Thus there is a good equilibrium out there, an equilibrium which would support considerably more government debt than we have. In that equilibrium, markets recognize that postponement of fiscal consolidation or even additional fiscal expansion right now does not in fact run large additional risks of fiscal dominance over and above those that are already out there as a result of rising medical costs and the aging of North Atlantic populations. In that equilibrium markets do not blink at additional deficit spending as long as economies remain depressed.

But that markets should recognize this doesn���t mean that markets will recognize this. It doesn't mean that we know that markets won���t get scared of additional deficit spending and tip us over into fiscal dominance.

James Cayne had one billion writing on his belief that he had control over Bear Sterns's derivatives book. You could not have given anybody a larger incentive to gain control over Bear Sterns's derivatives book. The shareholders and directors of Bear Sterns gave James Cayne the right incentives���and look where that ended up.

And let me stop there...

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#finance
#behavioral
#monetarypolicy
#monetaryeconomics
#fiscalpolicy
#highlighted

THE MUST-READ OF MUST-READS on the links between behavior...

THE MUST-READ OF MUST-READS on the links between behavioral finance and macro: John Maynard Keynes (1936): The State of Long-Term Expectation: The General Theory of Employment, Interest and Money: Chapter 12: "If I may be allowed to appropriate the term _speculation for the activity of forecasting the psychology of the market, and the term enterprise for the activity of forecasting the prospective yield of assets over their whole life, it is by no means always the case that speculation predominates over enterprise. As the organisation of investment markets improves, the risk of the predominance of speculation does, however, increase...

...In one of the greatest investment markets in the world, namely, New York, the influence of speculation (in the above sense) is enormous. Even outside the field of finance, Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be; and this national weakness finds its nemesis in the stock market. It is rare, one is told, for an American to invest, as many Englishmen still do, ���for income���; and he will not readily purchase an investment except in the hope of capital appreciation. This is only another way of saying that, when he purchases an investment, the American is attaching his hopes, not so much to its prospective yield, as to a favourable change in the conventional basis of valuation....

Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism���which is not surprising, if I am right in thinking that the best brains of Wall Street have been in fact directed towards a different object.

These tendencies are a scarcely avoidable outcome of our having successfully organised ���liquid��� investment markets. It is usually agreed that casinos should, in the public interest, be inaccessible and expensive. And perhaps the same is true of Stock Exchanges.... The introduction of a substantial Government transfer tax on all transactions might prove the most serviceable reform available, with a view to mitigating the predominance of speculation over enterprise in the United States.... The fact that each individual investor flatters himself that his commitment is ���liquid��� (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk. If individual purchases of investments were rendered illiquid, this might seriously impede new investment.... So long as it is open to the individual to employ his wealth in hoarding or lending money, the alternative of purchasing actual capital assets cannot be rendered sufficiently attractive (especially to the man who does not manage the capital assets and knows very little about them), except by organising markets wherein these assets can be easily realised for money.... The crises of confidence... afflict the economic life of the modern world... [as] the individual... more than usually assailed by doubts... perplexity... [between] consumption and... investment... its being open to him, when thus assailed by doubts, to spend his income neither on the one nor on the other.

Those who have emphasised the social dangers of the hoarding of money have, of course, had something similar to the above in mind. But they have overlooked the possibility that the phenomenon can occur without any change, or at least any commensurate change, in the hoarding of money.

Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits���of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come. Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die;���though fears of loss may have a basis no more reasonable than hopes of profit had before.

It is safe to say that enterprise which depends on hopes stretching into the future benefits the community as a whole. But individual initiative will only be adequate when reasonable calculation is supplemented and supported by animal spirits, so that the thought of ultimate loss which often overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectation of death.

This means, unfortunately, not only that slumps and depressions are exaggerated in degree, but that economic prosperity is excessively dependent on a political and social atmosphere which is congenial to the average business man. If the fear of a Labour Government or a New Deal depresses enterprise, this need not be the result either of a reasonable calculation or of a plot with political intent;���it is the mere consequence of upsetting the delicate balance of spontaneous optimism. In estimating the prospects of investment, we must have regard, therefore, to the nerves and hysteria and even the digestions and reactions to the weather of those upon whose spontaneous activity it largely depends.

We should not conclude from this that everything depends on waves of irrational psychology. On the contrary, the state of long-term expectation is often steady, and, even when it is not, the other factors exert their compensating effects. We are merely reminding ourselves that human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist; and that it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance...

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