Arnold Kling  

Whose Macro is Bizarre?

Securitization and Credit Defa... Inner Economist Watch...

Thanks to Mark Thoma for keeping the debate going. In a defense of what Paul Krugman would call Dark Age Macroeconomics, David Beckworth unleashes that most medieval of weapons, the dreaded Vector Autoregression. More on that below the fold. Also below the fold, I will discuss Nick Rowe and Josh Hendrickson.

What happened one year ago that caused the economy to tank over the winter?

(a) a credit crunch. Banks would not lend to one another, and they cut back on credit to businesses, which in turn caused the contraction in economic activity.

(b) a recalculation. People found out that their housing wealth was lower, so they spent less. The home construction, real estate brokerage, mortgage lending, and securitization industries found out that their services were in much less demand than they had been, and they cut back. Finally, Ben Bernanke and Henry Paulson shouted "The Great Depression might come back!" in this crowded theater, and everybody ran for the exits. For example, law firms started telling new hires to go do something else for a while.

(c) people woke up to find that the elves and helicopters had left less money lying around.

(d) people woke up to find that the Fed had lowered its de facto inflation target.

The economists I consider to be most sensible are pushing some combination of (a) and (b). I differ from the consensus in that I push (b) exclusively and minimize (a). Lots of folks--defenders of Bernanke in particular--push (a) more than (b). What Scott Sumner and David Beckworth wish to defend is (c) and/or (d). Their advantage is that they are consistent with the way macro was taught (in graduate school, not in undergrad) the past thirty years. Their disadvantage is that this macro is, in fact, completely bizarre.

Nick Rowe argues that money is different because it is a medium of exchange. I would say that it is a medium of exchange because it is a temporary store of value, so that I am willing to lump together the store of value function and the medium of exchange function. Rowe says that because money is the medium of exchange, it is the "hub" of transactions. He offers the metaphor of a hub-and-spoke system in airlines. Remember what always happened to USair--Or Allegheny, as we used to know it--when Pittsburgh got rainy. Where I disagree with his hub-and-spoke story is that in the case of money, I don't think that USair gets messed up because of what happens in Pittsburgh. I think that what happens in Pittsburgh is a symptom of what happens when USair gets messed up. That is, when the economy is Recalculating, money circulates less rapidly.

This issue of causality is a natural segue to the empirical issues raised by Josh Hendrickson. What if we can show that fluctuations in GDP are preceded by fluctuations in money demand or money supply? Would that not be strong evidenced against my monetary theory? Hendrickson points to a long tradition of economists, including Friedman and Schwartz, Allan Meltzer, and others, who claim to have found such evidence. While I recognize that this work is formidable, I retain some influence from the late Franco Modigliani, who conducted the Money Workshop at MIT. Modigliani was so frustrated by the way that monetarists would search for a definition of money that correlated with nominal GDP that Modigliani mockingly referred to M1, M2, and so on as Milton1 and Milton2.

All of the different Miltons lead me to say this: there is no single medium of exchange. Instead, there is a lot of substitutability in media of exchange. Think of all the different ways you have to pay for stuff. The way I see it, there is a lot of substitutability among stores of value, including among temporary stores of value. Because substitutability is not perfect, the Fed can fiddle around in asset markets and change the relative values of some assets. By a little bit. For a little while. But I don't equate this fiddling with being able to hit a precise GDP target.

I think that my theory leads to a view of inflation as a fiscal phenomenon. Certainly, that works for hyperinflations--you cannot have a hyperinflation without an out-of-control government budget. The question is (and I guess we're about to find out) whether you can have an out-of-control government budget without a lot more inflation. The monetarist view would be that if you don't monetize the debt, you don't get more inflation. The view that assets are close substitutes would suggest that whatever liabilities the government issues to pay for its deficits will eventually cause inflation.

Finally, we get to David Beckworth, who writes,

I have posted below some figures from another VAR I did that looks at the effect of unexpected changes or shocks to the monetary base for the period 1960:3 - 2008:2.

VAR is the dreaded vector autoregression. The monetary base is Milton0.

What the VAR says is this. Suppose that Joe the Plumber is influenced by surprise changes in Milton0. We pretend that in 1975 Joe had access to all the data from 1960 in the third quarter until 2008 in the second quarter, and that he used state of the (future) art in time series econometrics to come up with a statistical model to predict Milton0. We use forecasting errors of this model as indicators of the surprises that Joe experienced from the elves and helicopters. We then correlate these surprises with inflation and/or real output.

Seriously. And I wonder how well this model does out of sample. In late 2008 and early 2009, Milton0 goes through the roof, and the economy goes through the floor.

Sumner would point out that the relationship between Milton0 and Milton1 changed drastically during the crisis, because the Fed started paying interest on reserves. That is an important point. I would add that, as best as I can recall, the relationship between Milton0 and Milton1 also changed quite a bit in another important monetary episode, the Nixon re-election monetary expansion of 1972. I may be wrong, but I have a recollection that the Fed made some technical change that affected reserve requirements that year.

Anyway, my view of how Joe the Plumber figures out that the monetary regime has changed is that he gradually notices that prices are going up at a different rate than they were before. Because of this, it takes a really long time for changes in the rate of printing money (or rate of running government deficits) to show up as changes in the rate of inflation.

Comments and Sharing

COMMENTS (14 to date)
liberty writes:

Someone has been thinking too hard and has forgotten the uselessness of his basic assumptions.

By someone I mean most macroeconomists.

As my favorite quote, from an old Soviet economics journal, goes:

"The mathematical economist has 30 pages of equations, and at the end there emerge the assumptions he put in at the beginning."

winterspeak writes:

ARNOLD: What do you mean by an "out of control" Federal deficit? Big enough to cause inflation?

Suppose that all that money being injected in the private sector by the "out of control" Federal deficit is saved? Does money being saved cause inflation?

Finally, is Japan's budget deficit out of control? (It's about 200% of GDP, IIRC.)

wm13 writes:

Hmm, well, I say "A recalculation. There was a dramatic increase in people's risk aversion. (In the financial world, we call this widening spreads. In the CAPM world, you could think of it as a shift in the shape of the efficient frontier.) This increase caused the price of risky assets to fall, so that their expected future return would satisfy purchasers' new risk preferences. The need to recalculate the price of every investment asset caused considerable economic dislocation. In particular, it caused an old-fashioned 'panic' in the shadow banking sector."
What caused the increase in risk aversion? I'm still working on that.

Robert Speirs writes:

It didn't help that many consumers started saying to themselves, "If I buy anything or go anywhere or have any fun, I'll kill the polar bears." When a new Calvinism starts taking hold in an economy dependent on personal deficit spending, Keynes' multipliers start deflating like pricked balloons.

Gary Chartier writes:

Winterspeak: I’m puzzled. You ask, “Suppose that all that money being injected in the private sector by the ‘out of control’ Federal deficit is saved? Does money being saved cause inflation?”

Perhaps not if it’s simply stored under mattresses. Then, it would have no influence on price levels. But surely that would defeat the point of its “being injected into the private sector.” To be sure, if it’s not spent on consumption, but invested directly, or even deposited in bank accounts, its arrival on the scene will not have the same effects as if it were used to buy consumer goods. But why isn’t inflation also affected by rising prices of capital goods and real property, which surely would result from the “saving” of the newly injected money? Ignore the poor production decisions likely to be made in response to the inaccurate signals about demand and capacity being sent by the injection of this new money; just consider the quantity for now. How could this increase in quantity not have inflationary consequences?

Joey Donuts writes:

I have followed this discussion closely and have yet to see anyone take the crude oil market into account.

My rough calculations (based on a base price of $65 per barrel) yield the result that from Nov of 2007 to March of 2009 the difference in crude oil price from the base price took $280 billion in spending out of the US economy. Foreign producers didn't increase their purchases by the windfall. Domestic producers didn't either at least in that time frame. Another great recalculation took effect along with a "Macro" increase in the demand for money.
You can do your own caculation from data found here:

TomB writes:

I see no reason why reasons (a)-(d) all could not have contributed to the economic situation. I think that the recalculation is what will slow things from returning to normal quickly. Were the problem merely some combination of (a), (c), and (d), fixing that problem would fix the economy. However, the recalculation that must also occur cannot be sped up, and we must be patient while that happens.

Taking steps to fix (a), (c), and (d) should be fine so long as we do not prolong the recalculation part. Unfortunately, most politicians want to do just that.

Greg Ransom writes:

Hayek macro = a + b+ c

winterspeak writes:

Gary Chartier: If the money the Government spends is kept spent on housing or consumer goods or investment, it is not saved (at least not in any normal sense of the term used in account, national and regular). And spending is inflationary.

If the money is kept under the mattress or in a bank account, or used to pay down debt, it is saved. This is not inflationary, by definition.

When the private sector wants to increase savings, aggregate demand falls and you get unemployment. If Government deficits fund this desire to save, it will support aggregate demand and you do not get unemployment.

So, I ask again, if the money is SAVED, how can you get inflation? Imagine this happened through a payroll tax holiday, don't you think some people might spend a little more?

bakho writes:

You left out the oil shock. Here in the Midwest, EVERY oil shock since the 1970s has been accompanied by a downturn in the auto industry. People "recalcuate" their transportation budget. Because more money is going to gas, less money is going to buying new cars. BigAuto made some changes that adversely affected auto sales. The price of vehicles (especially the domestic Big3) increased and the payment periods were extended from 3 years to 5 or even 7 years. This means that many of the vehicles are underwater (more is owed than their trade in value) for an extended period of time. Auto purchases dropped by almost 50% in this recesssion. This affect is more regional, but some of the highest US unemployment is in auto and auto parts manufacturing states.

winterspeak writes:

Bakho: Your oil shock point is excellent. Energy prices can increase CPI in the absence of too much money.

StatsGuy writes:

You are grossly misstating Ssumner, and being too kind (if that is possible) to the VAR model.

Ssumner's argument is about changes to the expected future path of inflation, not to historical or even present inflation. (And I suspect his real argument is about changes to the expected future path of NGDP...) The future path may, or may not, materialize - which is reflected in volatility of rate spreads during the period in question.

Good luck modeling this dynamic in a VAR model...

BTW, I left a more detailed critique of your other responses to Ssumner at his blog in the comments here:

JP Koning writes:

Arnold, you say:

"I would say that it is a medium of exchange because it is a temporary store of value, so that I am willing to lump together the store of value function and the medium of exchange function."


"The way I see it, there is a lot of substitutability among stores of value, including among temporary stores of value."

But in earlier posts you say several times, something to the effect that:

"I do not think that attaching significance to money as a store of value is the right way to pursue macro"

I am having troubles pinning you down on money and its role as a store of value.

rvman writes:


Risk aversion didn't go anywhere, I don't think. What happened was that the level of risk of a class of assets which had previously been perceived as "low risk" suddenly was revealed to be of a much higher risk class. Since investors tend to have a relatively stable level of desired risk/reward combination, everyone suddenly found themselves with a much higher-risk portfolio than they wanted.

This meant everyone wanted to sell that newly believed/known-to-be-risky class, demand for higher-risk instruments crashed, and demand for the remaining low-risk properties rose. Hence, treasury yields went to approximately zero, the mortgage swaps crashed, taking with them the banks which had depended the most on them as a low risk instrument. This was your spread-issue, not some kind of exogenous shock to risk-aversion itself. (Simultaneously, the newly-risky class suddenly lost liquidity, which threw portfolios out of balance on liquidity, on top of the risk imbalance.)

Since everyone was rebalancing back to low risk and liquid, no one wanted to loan money to anything remotely risky, killing the corporate bond market and through that the private investment market. This put the final bullet into a bunch of zombie companies (like GM) who had been 'surviving' on credit, and a cascade of bad investments walking became bad investments dead.

The federal interventions did tamp the liquidity issue down, but they did not (because they could not) entirely restore the status quo ante with regards to the mortgage instruments' risk profile, and so couldn't prevent the collapse - Federal money or no, everyone still needed to get their portfolios rebalanced, completely aside from short-run macroeconomic expectations.

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