Arnold Kling  

Macroeconomic Puzzles

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Paul Krugman writes,


Right now, the Mankiw indicator is -8.5 -- core inflation at about 1, unemployment at 9.5. As you can see, that implies a majorly negative interest rate; what we actually get is zero.

He suggests that the low interest rate on long-term bonds is consistent with the CBO forecast of prolonged low inflation and high unemployment. On the other hand, look at stock prices, about which James Hamilton writes:

Despite the recent correction in stock prices, stocks still cost more today relative to the earnings you're buying than they did over most of the previous century and a half. We'd still need about another 17% decline in stock prices to get back to the historical average valuation multiple.

My guess is that if you were to plug in the CBO forecast, the case that stocks are overvalued would be strengthened. And of course, gold remains high. I still would like to figure out how to bet against gold and bonds simultaneously. I cannot imagine an economic scenario in which gold investors and bond investors both hold their own over the next five years.

Another thing about the CBO forecast: if nothing changes, by 2030 we will have reached a point where a sovereign debt default becomes likely. At some point, that risk will find its way into the interest rate on bonds. Actually, the moment a significant default risk gets built into the price, it becomes a self-fulfilling prophecy--at a high enough interest rate, we will have to default. (I take monetizing the debt as a form of default.)

Finally, I am still pondering Tyler Cowen's post:


Let's say that housing and equity values fall and suddenly people realize they are less wealthy for the foreseeable future. The downward shift of demand will bundle together a few factors: 1. A general decline in spending...2. A disproportionate and permanent demand decline for the more income- and wealth-elastic goods...3. A disproportionate and temporary demand decline for consumer durables, which will largely be reversed

One of the weirdest things about macro is the notion that the economy decides to forego output. In the classic "real business cycle" models, a bunch of folks decide to take time off and enjoy leisure. I've cited Franco Modigliani's retort--was the Great Depression a mass outbreak of laziness?

But the Keynesian story is not much better. Instead of the representative agent deciding not to produce a typical year's output, the representative agent decides not to buy a typical year's output. You get a mass outbreak of abnegation.

I know, I know. People try to save all at once. Paradox of thrift. Liquidity trap. But there are still $20 bills being left on the sidewalk. An entrepreneur could hire an unemployed worker at a low wage and produce something that people would want to hold as wealth. Trying to explain why those $20 bills are left on the sidewalk is what leads one in the direction of Zero Marginal Product and the Recalculation Story.


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COMMENTS (8 to date)
fundamentalist writes:

Reality and logic are hard on most macro theories.

Andy Harless writes:
I still would like to figure out how to bet against gold and bonds simultaneously.

Both gold and bonds have active futures markets. Why can't you just short both of them and keep rolling over your shorts until they pay off? It's likely there will be margin calls to meet along the way, so you have to make sure you allocate enough extra capital, but if you have such confidence in the ultimate result, it should still provide a positive return on that capital.

I'm not sure I buy your argument, though. Either bonds or gold will ultimately fail, but not (necessarily) both. If we have deflation, for example, perhaps gold will collapse and bonds will skyrocket. Without doing the actual math, it's not clear whether or not the joint short is a winner in that case. Similarly, if we have inflation, perhaps bonds will collapse and gold will skyrocket. Again, not clear whether you win.

The simultaneous bull markets in gold and bonds reflect, among other things, an unusually high level of uncertainty. Both are hedge assets that pay off in tail scenarios. If you bet against the hedgers, you're selling insurance. You should expect to be fairly compensated (in terms of expected return) but not to have a safe bet.

Sam writes:
I still would like to figure out how to bet against gold and bonds simultaneously.

Buy too much house that you can't afford, spend more than you earn, and get a government job with a government pension. Then wait for your debts to be forgiven. Done!

Lord writes:

The government frowns on forgery and there isn't anything else people want more. There is a shortage of $20 dollar bills thanks to the Fed.

Vangel writes:
I cannot imagine an economic scenario in which gold investors and bond investors both hold their own over the next five years.

I can't imagine how a fiat currency issued by a bankrupt nation holds its purchasing power. That implies making a bet against bonds and in favour of gold. Given the fundamentals, would you honestly make a bet that gold will be below $1,200 in five years? I am quite happy with a prediction that your lenders will demand more in the way of interest or that the Fed's monetization policies will drive the purchasing power of the USD much higher. In both scenarios bond holders lose big time.

Hyena writes:

I see neither contradiction nor tension here.

The Recalc/ZMP thesis is that there is no current value to what people can produce. The "forgone production" thesis is that people aren't producing because it is not worthwhile to do so.

So I don't really see how we can start with the suggestion that macro is false and then proceed to agree with it.

The idea that people are consuming leisure if they're not working is just bifurcation. There's such a thing as being idle without leisure.

libert writes:

"But there are still $20 bills being left on the sidewalk. An entrepreneur could hire an unemployed worker at a low wage and produce something that people would want to hold as wealth."

What could an entrepreneur produce that is purely an asset? Do you mean to suggest that unemployment could be solved by everyone going to work in gold mines or pumping oil? Of course, commodities are risky bets that most retail investors probably wouldn't want to take, so what kind of asset could people produce?

The only low-risk assets that people are currently clamoring to buy (at least, the only ones that I can think of) are cash and T-bills. Of course, entrepreneurs can't produce those, so maybe the government should?

rhhardin writes:

Monetizing the debt has to happen before the debt becomes unsustainable. Otherwise the monetization just adds to the interest rate and the debt gets more unsustainable in lockstep.

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