Arnold Kling  

Work-Safe Readings for Macro

Economists with Pseudo-Knowled... A Pat on the Back for Macro...

In response to my post on the porn that is modern macro, readers naturally asked me for alternatives.

I think there are two difficult issues that puzzle me about macro. First, as much as some people hate the "Wall Street, Main Street" lingo, the question of how financial markets affect the real economy is really important and unsettled. The second question is why labor markets don't adjust to solve problems. Why does a recession show up as unemployment, rather than, say, lower wages at full employment?

I think that the answer to the second question is sociological. But I personally would not spend a whole lot of time on the issue. I may be estranged from my former thesis adviser, Robert Solow, in other ways, but here I agree with him that: (a) you probably need sociology to explain sticky wages and unemployment; but (b) it's not an economist's comparative advantage to pursue it.

To see why it's a sociological issue, think in terms of an example (something Solow also encouraged). Suppose that the job market for third-year law students like my daughter starts to look really grim. Is she going to offer to work for, say, 10 percent less than her competition? Is she going to work as a secretary if she can't find any law-firm jobs? Economic theory suggests she would do either of those things in order to avoid unemployment, but my guess is that neither will happen. I think that the economist with the best feel for this sort of sociology is George Akerlof. But it's not the area I would pursue.

Incidentally, my thesis was an explanation for why nominal prices might be sticky downward. I suggested that if you need to raise your price, you can costlessly drive marginal customers away. But if you lower your price, it costs you advertising money to inform marginal customers of other firms that you are offering a better deal. I mention that because I managed to spend time thinking about what might be an important issue--why are prices sticky, as opposed to solving Euler equations. And look where I am today. Not exactly a tenured professor at an elite university. The moral, in my view, is that it's safer to follow fads. On the other hand, Krugman also ignored the fads to focus on an interesting real-world problem, and he got tenure at Princeton and a Nobel Prize. So you never know.

Anyway, that leaves us with the second issue, of how Wall Street affects Main Street. In my day, a lot of the focus was monetarist, in the sense that people were asking how money could be non-neutral. Keynes had a great story of "animal spirits" of investors and hoarding by savers. But that got jammed into IS-LM, and much was lost.

The Keynesian story is better told in other places. Skidelsky's second volume on Keynes gives a much better flavor of Keynes' views, in my opinion. So that's one book I would recommend. I also think that Charles Kindleberger's ideas in Manias, Panics, and Crashes are worth looking at. I think that Tyler Cowen is channeling Kindleberger when he suggests that one explanation for the recent boom and crash is that new Asian wealth was looking for a place to take risks. That sounds to me like an explanation that Kindleberger might have approved. Finally, George Goodman, aka 'Adam Smith,' does well by Keynes in The Money Game. I'm about to re-read that book, so my opinion could fluctuate.

[update: I re-read the book, and I still recommend it. Don't expect every page to have held up (the book is 40 years old). But it is interesting to compare modern behavioral finance with Goodman's psychological profiles of individual investors and his general focus on the intersection between psychology and finance. The modern practitioners may seem to be more rigorous, but are they? I feel that one learns more reading Goodman than from reading Shiller, not that I am dismissing the latter. My favorite vignette is Goodman's description of a conversatino with Edward Johnson, born at the end of the 19th century and the man who took Fidelity to the top of the mutual fund industry. Johnson comes across as a total airhead. Makes you wonder.]

The bottom line is that the Keynesian view treats financial markets as highly irrational. I think there is much to be said for such a view, even though it presents challenges.

Going in the opposite direction, I think that one should know how modern finance works out the implications of rational markets with objectively known information. You could go back to Modigliani-Miller, to Tobin-Markowitz-Sharpe, and so on.

I think that Fischer Black gives the best description of a pure financial equilibrium, in which I would argue that there is no reason for intermediaries to exist. So Perry Mehrling's biography is essential. Black's own writing ranges from brilliantly clear to hopelessly obscure. On the clear side, I would put, "The Pricing of Commodity Contracts," which explains futures and forward markets. I would also recommend "Bank Funds Management in an Efficient Market," which thinks about what a bank would look like if it understood efficient markets.

Finally, I think that to explain real-world finance one needs asymmetric information. The paper that influenced me was Doug Diamond on delegated monitoring. There are also papers by Stiglitz and Greenwald that are probably important, but they haven't stuck with me as firmly.

The challenge is to weave together these three strands--pure finance, irrationality, and asymmetric information. The pure finance strand is unrealistic, but so is a lot of economics. It still may have value as an "as if" model. For example, index funds outperform most other mutual funds, which is a nice vindication for pure finance (although not necessarily for rationality, if you consider how many people invest in those other mutual funds).

The asymmetric information strand has trouble getting very far. You tend to tackle one or two information problems at a time, when in the real world there are many. But I think you need it in order to develop any theory in which financial intermediaries provide real benefit to the economy, and in which the failure of a financial intermediary imposes real costs. Without asymmetric information, it seems to me that bankruptcy cannot be an interesting event--just liquidate the assets and move on. If new buyers are at a disadvantage in figuring out how to value assets, then bankruptcies are not such trivial events.

I think that without asymmetric information, all assets are liquid, so liquidity preference makes no sense. With asymmetric information, I think you can get liquidity preference. You can get financial intermediation that matters by transforming assets from illiquid to liquid by creating trust, and so forth.

That is why I have trouble saying that all the answers are in Austrian economics, which seems to say that transforming an illiquid asset into a liquid asset is some sort of original sin. My problem is that if we assume no asymmetric information, then everything is liquid. In that world, yes, anything that an intermediary does to introduce risk can only impose costs without benefits.

Once you have information asymmetry, then you cannot say whether the transformations undertaken by intermediaries are harmful or not. They may very well be beneficial, even though they introduce new risks as well.

Finally, you have irrationality. One might like to believe that financial intermediaries profit by providing efficient information-processing services, and that their institutional structures and contract designs are brilliant solutions to problems of incentives in gathering and revealing information. Instead, my guess is that financial institutions evolve to some extent to take advantage of fools. The desire on the part of Asians for dollar-denominated assets has looked foolish to me and to many other economists for a long time. I may be putting words in Tyler's mouth, but I think he at least implies that mortgage securitization was in part a response to the expanding market in Asian fools. Any way you look at it, somebody has been overconfident. The Asians and the skeptical economists can't both be right.

In addition to the readings above, I recommend Liar's Poker for an accurate street-level description of selling and trading securities. There, you will learn something about cultivating markets for fools.

COMMENTS (16 to date)
Grant writes: guess is that financial institutions evolve to some extent to take advantage of fools.
To me, this suggests that bubbles could be "macro-rational" in the sense that they transfer from wealth from "bigger fools" to lesser fools. It would seem that a "fool's bubble" might be natural and unpreventable, but how to we keep it from harming the rest of the economy? Is this an artifact from out national financial system, and not something which would occur under other systems?

I am probably in the minority by suggesting that mechanisms which punish irrational behavior are good things, given the amount of support for fool-protecting legislation out there. I just don't think the distribution of rationality is fixed. Given the proper incentives, I believe it can expand or contract like any other resource.

Unit writes:

"Suppose that the job market for third-year law students like my daughter starts to look really grim. Is she going to offer to work for, say, 10 percent less than her competition? Is she going to work as a secretary if she can't find any law-firm jobs? Economic theory suggests she would do either of those things in order to avoid unemployment, but my guess is that neither will happen."

But isn't that a problem of regulations? Presumably if foreigners were free to jump in and offer a lower price they would do so. It doesn't necessarily have to be your daughter that cuts back. So with all the talk of Main Street and Wall Street, why are we not talking also of K Street? And the distortions that that creates?

"And look where I am today. Not exactly a tenured professor at an elite university."

Personally, I see you as being in the very select company of "people for whom I have great respect", and the even more select company of "people who taught me to love economics".

It may be safer to follow fads, but I seriously doubt you'd have earned my respect that way. You probably don't value my respect very much (declining my Facebook invite and all! How rude!), but it IS a limited resource in a tightly controlled market.

Arnold Kling writes:

Nothing person on the facebook deal. I'm conservative in terms of trying to stick to people I have met personally. Not 100% strict on that, but pretty close.

Mencius writes:


The word "liquidity," as used in modern finance, is extremely tricky and confusing. I am not quite sure what you mean by "liquid" versus "illiquid," but let me try to untangle it slightly.

The basic problem with "liquidity," which is also the reason I try not to use this term, is that it has two different definitions which are used interchangeably. Let's call them liquidity(a) and liquidity(b).

The original financial meaning of "liquidity" is liquidity(a). Liquidity(b) is a completely different, though equally important, concept which has for some reason been trapped in the same word. It is easy to construct fallacious and/or misleading chains of reasoning by switching inadvertently between (a) and (b). And indeed we see this a lot.

Liquidity(a) is an asymmetrical-information issue. A house, for example, is a classic example of an asset which is illiquid(a). It is hard to convert a house into cash - because houses are not fungible, information is generally asymmetric, etc, etc. A market which is illiquid(a) has slow transactions, high bid-ask spreads, hard-to-estimate prices, etc, etc. A market which is liquid(a) has fast transactions, thin spreads, and so on.

Liquidity(b) is a maturity-transformation issue, specific to Bagehotian (maturity-transforming) financial systems. A security is liquid(b) if maturity transformation is operating in the market for that asset. It is illiquid(b) if MT has broken down.

A ten-year bond, say issued by a major corporation, may well be perfectly liquid(a) - eg, it may have a ticker symbol and be traded as easily as a stock. But it is illiquid(b) if money from demand depositors (or other maturity transformers) has fled the market for securities in this class.

The superficial resemblance between liquidity(a) and liquidity(b) is the result of the fact that holders of illiquid(b) securities typically do not want to mark them down to an MT-off price. Holders of MT-compromised securities would rather just hang on and wait for the government to find a way to turn MT back on.

The result is that no one sells, the market does not trade, and there is no market - the "frozen" state now familiar to all. If there was a way for Misesian (maturity-matching) banking to emerge spontaneously in a Bagehotian environment, in which bailouts, bank suspensions, and the like, are a normal feature of the political system, it would have happened already. To converge on the MT-off price, the market would need an assurance that Washington's helicopter is never coming back.

MBS are especially evil because they are both illiquid(b) and somewhat illiquid(a). The terms of each security may be different. The mortgages in the basket are certainly different. Nonetheless, the financial industry did not have enormous problems pricing these assets before the credit crunch. The information is not all that asymmetric, anyway - as far as I know, the MBS buyer gets all the information that the MBS packager has. This data, while quite imperfect, is symmetrically imperfect.

Mencius writes:

Also, I definitely wouldn't say the Austrians have "all the answers." They are just the people who have been asking the right questions - since well before yesterday.

Ie: reading the Austrians is not just a matter of self-improvement. It is a matter of scholarly precedence.

For example, one of the tropes I dislike in Professor Caplan's "Why I Am Not An Austrian" essay is his frequent insistence that while in the 1950s, Rothbard and Mises were right about X and everyone else was wrong, the field has since independently arrived at the same insights. Which may well be true, but tough. Scholarship does not proceed from error. If Rothbard was right and Samuelson was a charlatan, Samuelson and his disciples need to be purged and ridiculed, Rothbard and his ushered before the throne. Then if Rothbard et al are wrong about anything else, Professor Caplan or anyone else may feel free to construct corrections.

Pedro P Romero writes:

I think that the sad state of macro. Which nowadays is exemplified by Dynamic Stochastic General Equil models. (look at the AER june volume, the first article after the three nobel lectures of 2007 is a DSGE model). It is due to the movement away from the attention of a great part of economists from the Big questions to ...other areas e.g....choose whatever area you want that does not include money, banking, finance, or growth. Or just pick Hayek and Keynes (to balance) what were the questions they were trying to answer? do you research focus on any of those... deeply..

O writes:


Thanks for the macro reading advice, some interesting overlap with Megan McArdle's recent reading list:

eric falkenstein writes:

I like some of those articles you referenced, but they are basically interesting ideas or observations (eg, delegated monitoring in asymmetric info), yet is impossible--or at least unprecedented after a lot of trying--to generate a testable general model from them. I think the representative agent is a waste of time (that's why I don't do it), but it is testable, so perhaps it can be tweaked.

If you read about BSDs, or anecdotes about when financial prices went way up and then way down, or how asymmetric information screws up the first and second welfare theorem, I think you can draw inferences more misleading than studying an economy where Robinson Crusoe lives on an island deciding how many coconuts to plant, eat, or warehouse.

Leigh Caldwell writes:

Good exploration of some tricky issues.

For me, financial intermediation arises because of some basic problems inherent in the nature of markets. I believe the key ones are:

  • asymmetric information, as you said

  • the trap of local Pareto maxima - meaning that individuals acting rationally and alone may achieve less utility than when they act in concert - let's call it the prisoner's dilemma for short

  • the problem of predictability

(There are two other problems which arise from some of the solutions to the above:

  • the agency problem
  • the paradox of structure

but they are less relevant to the current discussion.)

These three problems are why we can't just sit back and wait for Pareto maximisation to bring about the best possible outcome. Among other things, they are a way to account for transaction costs and (depending on the psychological model you apply to the agents in your system) various forms of apparent irrationality too.

In order to solve these three challenges, many mechanisms have arisen that are not strictly called for by a free market model: governments, contracts, firms, and indeed the banking system.

When the banking system breaks down, it is largely because its solutions to the problem of predictability are no longer working. But because banks are a tool to solve more than one problem, its seizure also reduces our ability to control transaction costs and asymmetric information, and to transcend the prisoner's dilemma through better coordination.

I am writing a longer paper on these topics which I'll link here when ready.

bgc writes:

How much is due to having too-long a boom in house prices?

My instinct (for what it is worth) is that we need creative destruction, so that things work better when there are reasonably frequent expansion-contraction cycles.

This is why I blame government for the size of the crisis - because they sustained the expansion when the system would otherwise have contracted, about 4 or 5 years ago.

Politically it is obvious why governments don't want to preside over even a small crash, and why they instead delay the small crash for as long as possible until it is irresistable and much bigger than it could or should have been.

Indeed they are still trying to prevent the necessary crash (yet another 'stimulus' package being mooted).

I think that prolonged and sustained expansion of systems (economic or other) is almost always harmful - for example I think that science has been extraordinarily corrupted by its 60 years of continuous expansion. And the same applies to education.

fundamentalist writes:

Kling: “The challenge is to weave together these three strands--pure finance, irrationality, and asymmetric information.”

I have a masters degree in mainstream econ from a good state school. Later I learned Austrian econ and I think it does what Dr. Kling is looking for. It integrates micro and macro, finance and macro, expectations, sticky wages and prices, and asymmetric information. It doesn’t integrate irrationality because what appears as irrational to mainstream economists does so because of their paucity of theory. What appears to be irrational behavior is actually rational behavior responding to price signals that have been distorted by state intervention in the market. Asymmetric information results from change, which mainstream econ has a very difficult time incorporating into models. Changes in technology and tastes cause prices and other data to change. Entrepreneurs tend to be better than others at absorbing new information. Without asymmetric information no one would make a profit and entrepreneurs would have no incentive to invent new products or organizations.

If you have a background in econ, I highly recommend Roger Garrison’s “Time and Money” because he compares and contrasts Austrian econ with the other schools such as Keynesian and Monetarist econ. Also, Mark Skousen’s “The Structure of Production” is very good.

A trait I have noticed in Austrian economists is that they understand Keynesian, Monetarist and other economic schools as well as anyone, so they can compare. Critics of Austrian econ rarely know much about it and tend to fight straw men of their own making rather than Austrian Econ.

Kling: “That is why I have trouble saying that all the answers are in Austrian economics, which seems to say that transforming an illiquid asset into a liquid asset is some sort of original sin.”

That seems like a gross generalization to me. I have read Mises, Hayek, Rothbard, Garrison, Skousen and many other Austrian economists and have found nothing like that.

fundamentalist writes:

Grant: “I am probably in the minority by suggesting that mechanisms which punish irrational behavior are good things…”

Yes, along with a few others of us, we’re all dinosaurs. But I think the issue is very serious. Mises often wrote to the effect that failure is necessary for civilization. We learn the qualities of self-control, honesty, thrift, hard work, discipline, etc., largely from the suffering we endure when we fail to exercise those qualities. We also learn to be rational by understanding cause and effect. When no one is allowed to fail for any reason, they fail to learn those important traits for success. And civilization falls apart. Someone has said that the difference between the civilized and uncivilized world is the ability to stand in line. If you have ever traveled in the third world you’ll really understand what he meant. Standing in line requires self-discipline.

fundamentalist writes:

Kling: "And look where I am today. Not exactly a tenured professor at an elite university."
I’m not one either, but I suspect the academic world is very much like the corporate world in that who you know and how well you promote yourself are far more important than what you know. I have no respect at all for Krugman, but enormous respect for Dr. Kling.

dWj writes:

I've been reading recently that employers, particularly in recessions, do tend to get offers to work cheap, and they tend to turn them down, in part for adverse selection reasons (who's most likely to offer to work cheap?) but also due to concerns that the new employee, whatever s/he now says, will come to resent it, or even that such an "inequity" in the internal pay scale will cause more general morale problems. This was mostly in factory-type settings, and might apply differently to a professional job.

assman writes:

"What appears to be irrational behavior is actually rational behavior responding to price signals that have been distorted by state intervention in the market."

I disagree. I have read about past speculative crises like tulip mania, the south sea bubble, numerous Ponzi finance schemes and I would have to say that there was no distorted price signal. The schemes where obviously irrational. Anybody could see that. Plus I don't think it can be argued that all the previous bubbles were caused by state intervention. Consider for instance the speculative bubble that occurred in 1825 when England was on the gold standard. What state intervention caused this bubble? There was no state intervention, the government warned speculators they would not be protected and it didn't help. Easy credit came from county banks which were essentially unregulated.

BTW, how does the Austrian school deal with gambling which is obviously irrational.

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