Conversations with Brad

Tyler Cowen linked to one of my posts and seems to find something in there to like. Brad DeLong does not like it.



Cowen wanted to think of what I do as "neoclassical economics." Some people like to call it "micro-founded macreconomics," and Barro recently called it "regular economics." The people I have learned from, work with, and talk to do economics - they take theory developed by other people, build on it, match the theory to data, and attempt to evaluate macroeconomic policies in a sensible way. Some of those people are sympathetic to Keynesian ideas; some of those people are critical of those ideas.



Here's what Brad has to say:

From my perspective this "neoclassical macroeconomics" is merely Hicks (1937) (or perhaps Wicksell (1898)) "plus", as Rüdi Dornbusch liked to say, "original errors".

This will be a theme. The pristine ideas are apparently in the classics - Hicks, Wicksell - and we have just thrown sand into the gears.



I said something in my piece about how the inefficiency I wanted to isolate was not a Keynesian inefficiency. The Keynesian inefficiency is a too-high safe real rate of interest; my inefficiency was a too-low safe real rate of interest. Here's Brad again:

In the Keynesian-or perhaps it would be better to say Wicksellian--framework, when you say that real rates of return are "too high" you are saying that the market rate of interest is above the interest rate consistent with full employment, and with savings equal to investment at full employment. Wicksell called that interest rate the "natural rate of interest" and it is relative to that natural rate of interest that Wicksellian (and Keynesians) speak of interest rates being "too high" and "too low". Thus Williamson is wrong when he say that what we have now--when the natural rate of interest on relatively safe securities is negative and the market rate of interest is not--is "not a Keynesian [or Wicksellian] inefficiency". It is precisely such an inefficiency. To claim that it is not misinterprets Keynes (and Hicks, and Wicksell), and misleads readers trying to understand what they did and did not say.

I'm taking my cue here from Mike Woodford, for example "Interest and Prices." Woodford certainly thinks that he is channeling Wicksell, though maybe Brad thinks he's not. In a Woodford New Keynesian model, monetary policy is about moving the market nominal interest rate around, and the transmission mechanism for monetary policy works through the real rate. Once you hit the zero lower bound on the nominal rate, the real rate can't go lower. That's the way New Keynesian economists inside the Fed system frame the monetary policy problem in the current circumstances. The real rate is too high, you want it to be lower, but monetary policy can't do that in the conventional manner.



Here's the interesting part. Brad is characterizing the current state of affairs and says "the natural rate of interest on relatively safe securities is negative and the market rate of interest is not." What I think he is saying is that the safe real rate of interest is low, but the relevant "market rate of interest" is in fact high. I don't think you can find that feature in any "Keynesian" framework where you would be able to correct the problem through some kind of policy Brad might want to prescribe in the current circumstances.



But whether you can find it in the General Theory or not, Brad has brought up something very useful. The fact that the safe real rate is low is intimately related to the fact that the "market rate of interest" is high. In fact, you can find this in this paper. The effect is more pronounced in the financial crisis, but I think it persists. The idea is that greater uncertainty and higher costs associated with evaluating collateral and unwinding debt acted to increase interest rate spreads - the spreads between the safe rate of interest and "market rates of interest" - reducing the quantity of privately-produced liquid assets, creating the asset scarcity that lowered the safe real rate of interest. To understand that idea, you don't need to go digging in Wicksell, Hicks, Fisher, or the General Theory. It's elucidated much more precisely in the work of Rob Townsend, Doug Diamond, and other people who worked on modern information theory, contract theory, and the theory of financial intermediation.



Brad goes on:

A second thing I think is wrong is Williamson's claim that while things could be (or perhaps should be) improved by shifting the IS curve out and to the right...

Don't go there Brad. As I said, it's not in Hicks.



The relevant question he asks is this one:

Why does pulling spending forward into the present fail while pushing taxes back into the future works?

In my post, I was arguing that the problem was a shortage of safe assets, monetary policy could not solve the problem, and we could think of an otherwise Ricardian fiscal experiment that would do the trick. I wanted to avoid talking about government expenditures on goods and services, as that would open up a whole set of issues I did not want to get into - redistribution, alternative types of spending and the government's advantages relative to the private sector, political economy, etc.



Then, Brad says:

And yet a third thing I think is wrong is Williamson's claim that "the Fed is powerless" because "swap[s of] reserves for T-bills or reserves for long-maturity Treasuries… essentially amounts to intermediation activities the private sector can accomplish as well, this will have no effect". But such swaps take various forms of duration and default risk onto (or off of) the Fed's and thus taxpayers' balance sheets and off of the private market and thus investors' balance sheets. These are different (but overlapping) groups who perceive risks differently, have different resources, and react to risks differently. The fact that the private market could undo any particular Federal Reserve policy intervention does not mean that it will.

This is a key part of my argument - i.e. under the current circumstances, quantitative easing is irrelevant. In order for asset swaps to have any effect the Fed has to have some advantage in the intermediation activity it is engaging in relative to what the private sector can accomplish. Currently the Fed has no advantage in turning long-maturity Treasury debt into overnight assets, so QE is irrelevant.



Finally,

I would say go back to Hicks, Keynes, Fisher, and Wicksell, and think about them carefully: they were smart. A "neoclassical macro" that does not start from them has little chance of getting much of anywhere.

Yes, Hicks, Keynes, Fisher, and Wicksell were smart, but Keynes did not spend all of his time with his nose in Adam Smith, otherwise he would not have got any work done. Maybe someone got something wrong, and there are nuggets of insight in early work that were not passed on through the economic writings that succeeded it. However, most of what is useful from Hicks, Keynes, Fisher, and Wicksell is baked in the cake. Modern students of macroeconomics are much better off reading Lucas, Woodford, Prescott, Gertler, Gali, Farmer, Rogerson, Kehoe, Wright, Christiao, Kiyotaki, etc. from the older generations, or any number of excellent young macroeconomists. However, here is what I read the other day in Hicks's 1937 paper:

The General Theory of Employment is a useful book; but it is neither the beginning nor the end of Dynamic Economics.

Hicks was smart.