Arnold Kling  

Musings on Macro

Bailouts: When Will They End?... Cognitive Failure or Moral Fai...

Russ Roberts interviews Ed Leamer. If you are not already familiar with Leamer's views on econometrics, then you should listen.

Leamer has a notion of macro that I think needs more elaboration. He says that in a normal economy, when someone loses a job it does not affect anyone else. However, in a weak economy, one person's job loss causes other people to lose jobs. This is similar to Leijonhuvfud's corridor idea. The problem, for those of us who believe that something like this is true, is to explain the relationship between the good economy and the bad economy.

If we think that the economy makes smooth transitions from one state to the other, then the challenge is to tell the difference between the two. If we think that there is an abrupt difference, then the challenge is to explain the discontinuity between the two.

One abrupt-transition story is between a high-confidence state and a low-confidence state. When people have high confidence that, say, house prices will rise or the government of Greece will repay its debt, then borrowers and lenders both think they are well off and can consume a lot both today and in the future. In a low-confidence state, borrowers lose the ability to borrow and lenders take losses. This makes them realize they are not as rich as they thought they were (a Tyler Cowen point), and they suddenly shift down their consumption to reflect this new information.

Leamer suggests briefly that the economy can recover on its own from this sort of change in state. However, government needs to reduce uncertainty, rather than exacerbate it.

I think this is more on track than crude Keynesianism. However, there is much that needs to be filled in.

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CATEGORIES: Macroeconomics

COMMENTS (8 to date)
Ironman writes:

Suppose however that government, or more accurately, those running it, have an incentive to increase uncertainty in that situation.

For example, if a government is embarking on many new, large spending initiatives that will be primarily supported by deficit spending, it is to their advantage to borrow the money it will take to support that spending at the lowest interest rates possible. After all, money that they don't have to pay back in interest is money they can then spend on other things, so being able to borrow at low rates is very desirable.

If these government leaders can then promote uncertainty elsewhere in the world, say in a place like Greece, they benefit from the relative flight to quality taken by people seeking to invest in government bonds, as they flee Greece's government bonds in favor of those of other nations. The resulting shift in that demand helps lower the other nations' cost of borrowing the money they wish to spend, since greater demand for government securities pushes down the interest rates that they must pay for the money they borrow.

But then, if the problems elsewhere erupt into crises bad enough to require aggressive corrective action on the part of other nations, those nation' leaders benefit by taking half measures. It's in their own interest to keep the crisis churning so they can continue to drive investments toward their own government's bonds.

So the question is, are the corrective actions being taken by other governments adequate to correct the problems or will they require additional intervention? And is the need to have additional intervention what those other governments really want?

8 writes:

Sounds like socionomics.

Alex J. writes:

An important (to me!) issue is how deflation screws up existing debt relationships. To stay current, debtors must pay their old debts in more-dear money. Lenders face the issue that many more debtors than they expected will find it in their interests to default.

If V drops and M does not increase, with GDP relatively stable, you have deflation. The housing sector would suffer as above, even if the drop in V was not caused by changes in the housing sector.

fundamentalist writes:

"One abrupt-transition story is between a high-confidence state and a low-confidence state."

But what causes the high confidence in the first place, and the change to low confidence? The business cycle! So this approach says basically that the business cycle causes the business cycle.

Hayek has a better approach in "Profit, Interest and Investment." Here is an excerpt. Compare it with unemployment rates in these industries today. They're similar.

Hayek: "If we find that, as appears to be approximately the case, average unemployment
over a whole trade cycle is in the neighbourhood
of 25 per cent in the earlier stages of the capital good industries and somewhere about 10 per cent in the consumers' goods industries2, this would mean that continuous full employment of all the available labour in these industries would increase the, output of capital goods belonging to relatively early stages by one-third
and the total output of consulners' goods by only oneninth. And it seems clear that the consumers' goods industries could absorb such an increase in the output of capital goods only if the labour supply there were considerably increased. But so long as the capacity for producing consumers' goods is not much increased
by a transfer of labour from the capital goods industries to the consumers' goods industries and an increased output of equipment capable of producing consumers' goods as against further increase of capacity for producing capital goods, all attempts to create full employment with the existing distribution of labour
between industries will come up against the difficulty that with full employment people will want a larger share of the total output in the form of consumers' goods than is being produced in that form."

footnote: These figures are given merely as an illustration of a general tendency and make no claim to accuracy, being based on a general
impression rather than a systematic study which this question would well deserve. But they are rather remarkably well borne out by figures of the mean unemployment rate (i.e., the percentage of the insured males unemployed) for the period 1927-1936, which have been kindly supplied by Sir William Beveridge to the author since he used the above figures in an earlier draft of this essay. According to Sir William's calculations the mean unemployment rate during
this period was 25"6 per cent for the six metal manufacture 'ndustries of the Labour Gazette classification, 24' I per cent in the six extractive industries other than coal mining, 24'6 per cent in coal mining, 20 per cent in the eight instrumental industries, and 20'2 per cent in the extractive, instrumental and constructional industries generally, compared with 10' I per cent in the food, clothing
and consumers' service ind ustries."

roversaurus writes:

He says that in a normal economy, when someone loses a job it does not affect anyone else. However, in a weak economy, one person's job loss causes other people to lose jobs.

That is quackery.

The loss of one job ALWAYS affects someone else. Perhaps it is a small impact but it is always in impact.

And the most important impact is the loss of PRODUCTIVITY. Not the loss of consumption.

Doc Merlin writes:

Productivity usually goes up when firings happen. Look at our economy now.... measured productivity is way up.
So either,:
1. we have more legal make-work destroying actual productivity
2. The productivity story is wrong.

Troy Camplin writes:

SOunds like nonlinear dynamics, butterfly effects, and catastrophe theory to me. Network and systems science and the theory of emergence all provide models for exactly these things.

I talk about these things a bit here:

Ray writes:

Abrupt lines between the good economy and the bad are only seen retrospectively which means - in my opinion - that such lines do not in fact exist.

Post hoc narratives, and dooms day financial prophets who see nothing but abrupt lines do not prove the existence of such.

A simple analogy for the explanation of the relatively smooth transition I think would be something along the lines of momentum i.e. success breeds success and failure breeds failure. There's plenty of research that's not foreign to most readers here pointing to the effects of such momentum.

As noted in Arnold's post, when confidence is high, certain things follow, and when confidence is low, certain things follow. This is true in individual lives as well as combat, sports, etc. Napoleon said something to the effect that "the moral versus the physical is 3 to 1" and I tend to agree with this, and believe that life in general supports such a view.

But even in a ball game or combat, the momentum does not actually change as quickly as it seems in retrospect, but there is a straw breaking the proverbial back that allows heretofore unnoticed events to cascade.

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