Arnold Kling  

Macro Beliefs and Reality

Sympathetic Self-Interest Quot... New Richter Podcast...

I am leaning toward a view of macroeconomics in which firms, households, and government face a collision between beliefs and reality.

Beliefs tend to be formed out of habitual observation. If certain types of investments in human and physical capital have paid off in recent years, then keep making those sorts of investments. A problem arises when beliefs tend to be self-fulfilling for a while, but turn out to be unsustainable. The obvious example I have in mind is house prices and mortgage lending in the U.S. before the crisis. As long as everyone believed house prices would continue to rise, lending became easier, more people bought houses, and house prices in fact rose. These beliefs became more and more out of touch with long-term reality, and so the adjustment to reality was harsh.

Probably my favorite Scott Sumner post is the one where he offered what I called a cyclical monetary theory, meaning that monetary theory is itself cyclical. In good times, people are monetarists. They believe that the Fed is all-powerful and can always produce great economic outcomes. When a crash hits, people become Austrians, believing that the previous prosperity was false and that now we must pay the price. When the bad times have been around for a while, people become Keynesians, convinced that government must be able to do something but that monetary policy has been tried and does not work. I would note that this time around, many people are coming around to the view that fiscal policy has been tried and does not work.

I think that my least favorite Sumnerian proposition is that the Fed can affect the economy by announcing a long-term target for a nominal variable. I think that in order for this to work, you have to assume that people are forward-looking and focused on future monetary policy. On the other hand, his mechanism by which monetary policy works is the conventional story in which nominal wages are sticky, so that with higher aggregate demand you get lower real wages and more real output. But for nominal wages to be sticky, workers cannot be forward-looking and focused on monetary policy. So, on the one hand, for targets to matter, people have to be forward-looking. On the other hand, for monetary policy to matter, people cannot be forward-looking. I cannot past what I see as a basic contradiction. For what it's worth, in case you cannot tell already, I do not think that people are forward-looking. I think that they are habit-driven and backward-looking.

Because I believe that people are habit-driven and backward-looking, I think it is possible for real wages to fluctuate. However, I do not think that real wage movements have been very important in post-war economic fluctuations.

I do not think of the prosperity we experienced a few years ago as inherently false. It happened to be false because it relied on unsustainable beliefs. If we had not had a housing bubble, I think it is possible that instead firms and households could have created patterns of specialization and trade that resulted in full employment and affluence that were more sustainable. Ultimately, I think that the Recalculation will result in such new patterns of specialization and trade.

As it is, a lot of people's plans have been disrupted by the collision between prior habits and reality. I do not think that there is much that government can do about it. Extending unemployment benefits, stimulating road construction, or giving money to state governments to maintain high levels of compensation for public employees will not do anything that I can see to establish new patterns of trade and specialization. I do not see open market operations by the central bank as doing anything to establish new patterns of trade and specialization.

The empirical basis for the belief that government can do something about output and employment is quite thin. If you really want to believe that, say, fiscal policy works, you can focus on those examples where it appeared to work (say, military spending in World War II and the Kennedy tax cut in the early 1960's) and try to explain away all the examples where it appeared to fail (which is pretty much every other time and place that it has been tried).

My father used to say that the First Iron Law of social science is, "Sometimes it's this way, and sometimes it's that way." My reading of the record on fiscal and monetary policy is that it follows the First Iron Law. Sometimes, we see economic improvement when fiscal expansions are attempted. Sometimes we don't. The same with monetary policy expansions. I think it is reasonable to read history as saying that economic outcomes are pretty much orthogonal to macroeconomic policy moves, which is a fancy way of saying that the economy does what it does without regard to fiscal and monetary policy.

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The author at  Modeled Behavior in a related article titled Arnold Kling, Complexity Economist writes:
    One of the biggest problems that has plagued economics has been its reliance on a theory that lies at the very core — that of human behavior. As you may surmise, macroeconomic phenomena is the emergent result of micro-interactions between markets... [Tracked on July 15, 2010 8:35 PM]
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Daniel Kuehn writes:

"I think it is reasonable to read history as saying that economic outcomes are pretty much orthogonal to macroeconomic policy moves, which is a fancy way of saying that the economy does what it does without regard to fiscal and monetary policy."

Could you explain why you come to this view rather than, say, the view that fiscal policy works under certain conditions and not under others, and monetary policy works under certain conditions and not under others.

A seeming lack of correlation seems to indicate to possiblities:
1. An actual lack of correlation, or
2. A correlation that is obscured by contingencies you haven't controlled for.

You seem to be opting for (1.) over (2.). Why is that?

8 writes:

What about socionomics? It has an answer to your question.

david writes:

So... does this mean that Kling supports industrial policy on a national scale as is commonly practiced in East Asia and elsewhere? It isn't part of any mainstream economist's fiscal toolbox any more; only development economists (if that). But it is still possible.

I mean, he clearly doesn't buy into the usual intellectual framework that justifies why the new pattern of trade and specialization that would arise in the absence of intervention is necessarily the unique optimum.

Philo writes:

"I think that my least favorite Sumnerian proposition is that the Fed can affect the economy by announcing a long-term target for a nominal variable." No, it's not just *announcing* the target--it's *credibly* announcing the target, which (to sustain credibility) requires *actually hitting* the target consistently over time.

Are you complaining that *the Fed can't hit its target*, which would imply that it can't credibly announce that it will hit the target? If so, you would really be agreeing with Sumner. He says "If P then Q," and you would be holding P to be *impossible*; by elementary logic that would make the whole conditional proposition *necessarily true*.

But that isn't quite what you say; you do not directly reject the claim that the Fed *can* hit a target (for NGDP 12 or 18 months into the future). Well, if you allow that the Fed can do that, how can you deny that it can "affect the economy"?

We can call this the "Psycho Minsky Model"

Alex J. writes:

The fed doesn't have to convince "people" that it will hit its target. It has to convince just the right people -- the very smart people with money on the line on this very issue, the people most likely to predict the actual outcome correctly. The fed doesn't even have to convince all of the relevant traders, just enough to fleece the ones who get it wrong.

I will now address Kling's "Define Money" conundrum. Everyone knows that a central bank can generate hyperinflation if it wants to: just print lots of money and use it to buy lots of stuff (aka Quantitative Easing). Everyone knows a central bank can preside over deflation: it just has to do nothing in certain circumstances. On the face of it, it would be odd if a central bank could hit both extremes, but not points in the middle.

But what does putting money in circulation do if the central bank uses it to buy money-like bonds? (Tyler Cowen brought this up in his Econ Talk podcast on macro.) It doesn't do anything directly, it's like changing dimes for nickels. I believe that it is largely a signal of the central banks willingness to engage in quantitative easing in the future. If central bankers say "we're out of ammunition" while rates are still positive, that's a very strong signal that they are not going to engage in significant QE.

Under normal circumstances, GDP and inflation putter along, V stays more or less the same and M putters along. The central banks change change rates up or down but it doesn't make much difference, it doesn't have to. Imagine a sailboat before a steady wind. The captain holds the wheel with a few tweaks and trims or loosens the various sails a bit. Compared to the force of the wind, his actions are a trivial component of the boat's actions. Even so, you'd be worried if the captain tied the wheel down and went below for a nap.

Now the wind changes (aka V drops, or we discover we aren't as rich (GDP) as we thought we were). If the captain takes no action, the sails won't catch the wind and the ship will stall, or worse, capsize. The captain needs to sail close hauled instead of before the wind. If the central bank doesn't compensate for changes in V with changes in M, due to sticky wages and prices, disruption of price information via deflation, changes in solvency of debtors and lenders etc, the real economy will suffer.

[OK, here the nautical analogy is getting streched.] The difference between the captain of a sailboat and the central bank is that instead of dealing with wind and water, the central bank is dealing with people who can anticipate the future (even if most of them don't do it very well). Therefore, if (the right) people believe the fed will act appropriately, V won't drop as much and the fed won't have to actually do much. Of course, since the people who have the most on the line will have the best idea of what the fed will do, the best way for the fed to convince them that it would be willing to engage in QE is to actually be willing to engage in QE.

I think that the longer the fed goes without serious action, and especially if said action in the past led to bad inflation, the less plausible will be the idea that against deflation, the fed will close the barn doors before the cows get out: cyclical monetary theory. (Bringing back the sailing analogy, the captain gets used to making minor adjustments and doesn't tack when it's called for.)

Gregor writes:

"But for nominal wages to be sticky, workers cannot be forward-looking and focused on monetary policy."

I don't think so. There are several models in which the public has forward looking rational expectations and yet nominal rigidities still exist. This could occur if wage contacts are staggered – if some fraction of the workforce has signed two, three or four year contacts downward adjustment will be slow. It will also be slow if some fraction of the workforce (such as the unionized public sector workers) is never forced to accept a nominal wage reduction.

I think the strongly evidence suggests that:

1) wages adjust downward relatively slowly
2) monetary policy has real effects in the short run
3) (unexpected changes to)monetary policy affects asset markets immediately
4) asset markets incorporate and reflect changes in expectations of growth and inflation

And I think these facts strongly support the Friedman/Sumner view of the macro economy.

steve writes:

I think you have lot right here. I think of fiscal policy as just providing a bridge until new patterns of trade and specialization emerge. As we go through cycles of creation and destruction, they are more tolerable if we minimize the negative effects.


robbl writes:


Based on your belief in the need for "new specializations" shouldn't the government step in with tax subsidies and loan guarantees to nudge workers in the proper direction? Or is your position that the "new specializations" are unknown in their character? If so, what is known? Clearly not much about economics.

Nathan Smith writes:

Why the stimulus didn't work this time:
1. Fiscal stimulus can't work if Ricardian equivalence holds.
2. Of course Ricardian equivalence doesn't hold because some people are myopic and/or credit-constrained.
3. But because the types of spending the government engaged in this time around tended to be the kind that is hard to repeal (giveaways) to various lobbies, because there was no "exit strategy," so to speak, the stimulus created expectations of future taxes that were EVEN MORE than the volume of current spending.

In short, the stimulus was incompetently executed, much worse than, say, the Iraq War.

The lesson I draw from this is that James Buchanan and Richard Wagner, in *Democracy in Deficit,* were right. Keynesian macroeconomic management might actually be a good idea, but since politicians will never do it even close to right, it's better for them not to try. The one exception is WARS. But you don't need Keynes to explain why wars stimulate the economy. Wars are purely destructive, so they make people poorer, and work harder.

Rebecca Burlingame writes:

Why the stimulus didn't work this time:
Finally, a tipping point in which too many individual economic freedoms and possibilities were circumvented or otherwise destroyed by the actions of countless organizations and associations, and also some large corporations.

Lord writes:

I think there isn't just one kind of people. Some, leaders, are forward looking. Others, followers, are backward looking. The former respond to policy changes, the latter to market changes. The former act and in doing so persuade the latter to follow. The former are quick and the latter slow, so turnarounds can be slow but once the latter have built up momentum, difficult to reverse. The Fed hasn't persuaded the former it has done enough yet.

Pete writes:
But for nominal wages to be sticky, workers cannot be forward-looking and focused on monetary policy.

I feel like I am missing something here: are we overlooking the effects of unemployment? It appears that we are only taking psychological effects into account, but workers can be forward-looking, expect inflation, but as long as AD stalls (and disinflation takes hold) and employment is still in the dumps, and nominal wages stay put.

Am I straying from the mark?

Jfox writes:

I agree completely, albiet with a few twists. Arnold, if you're reading this I'd suggest spending a bit of time on this subject in your text. Actually, I'd recommend that you write several texts....maybe 3. I don't think one can really do justice to the entire subject of econ/finance in 1 book.

With that said, I have 3 comments.

1. I think monetary policy was probably more effective in the past when the "banking" sector (i.e., excluding securities mkts and shadow banking) constituted a larger piece of the money/debt markets. The Fed wielded a bigger monetary hammer.

2. Monetary policy seemed simpler in "old days". Now, I think fiscal policy is interferring with monetary policy. Each dollar in debt raised increases the deficit, which increases the quantity of gov't securities outstanding. Many of these are "money like" which has the unintended consequence of interferring with monetary policy.

3. You say Fed policy doesn't matter much because workers are backward looking. I think that is true. But....many investors are forward looking, and for them real interest rates (and nominal interest rates to an extent) matter. To the extent that the Fed can manipulate real interest rates, I think that a piece of GDP is correlated with interest rates.

Arnold Kling writes:

interesting comments.

The Doubtbook drafts that I am posting now pertain to the hypothetical first chapter, which is supposed to introduce the main characters in the drama. Once that is done, my thinking is to try to tell a chronological story, so that we see how economic ideas evolve from events as well as from new theoretical developments.

Clearly, the increased complexity of financial markets is a major factor here. I cannot imagine someone in 1850 coming up with the same model of the interaction between finance and macro as someone in 2010.

malcolm writes:

Saying that people think fiscal policy didn't work is not the same thing as fiscal policy not working. Joshua Aizenman, in voxeu, argued that state contactionary budgets offset the federal fiscal stimulus almost one for one. It's not that
fiscal policy didn't work; it's that fiscal policy was too small to be effective.

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