Arnold Kling  

Greg Mankiw Gets Technical

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Jim Rogers: What He's Saying, ... On Monetarism...

He writes,


The purpose of this picture is to show that deeper-than-average recessions are followed by faster-than-average recoveries. (Similar evidence was compiled in the 2005 Economic Report of the President, Chapter 2.) This evidence might be taken as evidence in favor of the trend-stationary hypothesis over the unit-root hypothesis.

Later, he gives a shout-out to Steve Braun, a great economist and an old friend of mine from when we both worked at the Fed.

[UPDATE: Greg says more here. Apparently, he drew the wrath of Paul Krugman and Brad DeLong, the latter arguing that you can tell a permanent change from a transitory change by looking at the unemployment rate. But the unemployment rate is not trend-stationary either--the "natural rate" tends to wander around. So I am basically on Greg's side on this one. But see my original thoughts, below the fold.]

The conflict between trend-stationary and unit-root is basically about the statistical properties of macro data. Under the unit-root hypothesis, which I thought was well established, I see the attempt to do macroeconometrics as basically hopeless. The way I see it, with a unit root, every change is a structural change. As a result, there is no way to use macroeconomic data from different decades as if they allowed you to conduct a controlled experiment. See my lost history paper.

I am not sure that it is correct to attach economic meaning to the concepts of trend-stationary and unit-root, but it will help a non-technical reader to try to do so. Think of trend-stationary as an economy where the movements in output are driven by transitory factors. Eventually, the economy returns to a path determined by steady growth in capacity.

Think of a unit-root economy as one in which movements in output are driven by permanent factors. The economy does not return to some pre-determined path. Instead, starting from wherever you are, you grow at some average rate.

In terms of the current situation, suppose that the economy is down because people are postponing the purchases of cars and other goods out of fear. That would be a trend-stationary story, because it suggests a nice rebound when people get over their fear. On the other hand, suppose that the economy is down because we accumulated the wrong types of physical capital (houses) and human capital (skills in mortgage securitization). That is a unit-root type problem. Yes, the economy will start growing again at some point, but that misallocation of physical and human capital is a permanent loss. We are not going to make up for it with some above-normal growth.

Put in these terms, the trend-stationary story has a more Keynesian flavor, and the unit-root story has a more Austrian flavor. But Austrians don't typically do econometrics, so they would not be playing this game.

I style myself an Austro-Keynesian. I think that both Austrian and Keynesian factors are at work in the current economy. So, I think there is a potential for some catch-up demand down the road in consumer durables. However, there is also just a lot of lost output due to misallocation. In practical terms, I think that a bit of the pain could be alleviated by macroeconomic policy, but not all of it. My sense is that Tyler Cowen and I are in synch on this one.


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COMMENTS (9 to date)
Greg Ransom writes:

As far as I understand him, Hayek agrees with you one this that "a bit of the pain could be alleviated by macroeconomic policy" -- Hayek talks about using macroeconomic policy to help halt a "secondary depression" with a deflationary downward spiral, using both monetary and fiscal policy.

So in your terms, Hayek is also an "Austro-Keynesian".

You write:

"I style myself an Austro-Keynesian. I think that both Austrian and Keynesian factors are at work in the current economy. So, I think there is a potential for some catch-up demand down the road in consumer durables. However, there is also just a lot of lost output due to misallocation. In practical terms, I think that a bit of the pain could be alleviated by macroeconomic policy, but not all of it."

Greg Ransom writes:

As far as I understand him, Hayek agrees with you on this that "a bit of the pain could be alleviated by macroeconomic policy" -- Hayek talks about using macroeconomic policy to help halt a "secondary depression" with a deflationary downward spiral, using both monetary and fiscal policy.

So in your terms, Hayek is also an "Austro-Keynesian".

fundamentalist writes:

It seems to me that in the areas in which Keynes was right, he was Austrian. As Hazlitt wrote, when Keynes was right he wasn't original, and where he was original he was wrong.

fundamentalist writes:

Arnold: "...suppose that the economy is down because people are postponing the purchases of cars and other goods out of fear...the trend-stationary story has a more Keynesian flavor..."

It also has an Austrian flavor. Austrians have always emphasized the human element in economics as the main reason that we cannot strictly apply the methods of natural sciences to economics and why math models often fail.

Greg Ransom writes:

Hazlitt was quoting Frank Knight -- or stole the words from him.

"As Hazlitt wrote, when Keynes was right he wasn't original, and where he was original he was wrong."

Adam writes:

These are great points about transitory and permanent shocks. They have great clarifying power.

I really don't understand, however, how one can support the transitory view. We've experienced years of misallocation--in the dot.com bubble and a 30 year housing and finance bubble. It seems like a permanent shift downward in trend is all too overdo.

Thanks and best,

Adam

Seerak writes:

Yes, the economy will start growing again at some point, but that misallocation of physical and human capital is a permanent loss.

Not necessarily. The public works projects of the FDR era amounted to "lost" wealth because they were built where there was no demand for what they provided. However, in many cases, demand for the results of that work did eventually manifest itself. Looked at this way, the wealth was not "lost" so much as it was frozen

Hoover Dam is one example; IIRC, the electric capacity was unneeded for many decades. Now, however, the dam is maxed out feeding a big chunk of Los Angeles. That was one less generation source needed as the demand for power ramped up.

In fact, if the misallocations of wealth we are seeing now (i.e. all those excess houses) were all of this type, "thawed" by later demand, the severe pain experienced now because of the wealth freezeup would be matched by an economic boost later in the form of large supply in the face of that demand, keeping prices affordable.

It would be like finding the rent money you thought you'd lost years ago; yesterday's pain becomes today's surplus. It's deficit financing in reverse, a transfer of wealth from the present to the future -- but with a negative interest rate (possible wear and tear).

Unfortunately, that "negative interest rate" means that a lot of those houses (and soon, strip malls and other excess commercial space) will end up decaying beyond repair and bulldozed before the demand returns. That *will* be a permanent loss.

GK writes:

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Tood writes:

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