Sunday, June 30, 2013

Corporations And The Theory Of The Firm

I think the following are fairly typical aspects of a large corporation:

  • Operation of more than one plant.
  • Production of more than one product.
  • Use of large amounts of capital goods with fixed costs.
  • Production and sales in more than one country.
  • Provision of stock (also known as shares) that are traded on a specified stock exchange.

I suggest the indicated work of the following economists1 are useful to read2 in attempting to understand such organizations:

  • Joe Bain and Paolo Sylos Labini on Industrial Organization3.
  • John Maurice Clark, especially Studies in the Economics of Overhead Costs4.
  • John Kenneth Galbraith, especially his book The New Industrial State
  • Michal Kalecki on mark-up pricing.
  • Robin Marris' on managerial theories of the firm.
  • Gardiner Means and Adolf Berle, especially their book The Modern Corporation and Private Property5
  • Edith Penrose, especially her book The Theory of the Growth of the Firm.
  • Herbert Simon on the theory of administration.
  • Josef Steindl, who, as I understand it, was a follower of Michal Kalecki and did much work in Industrial Organization.

The theory of the firm, as taught to undergraduates, does not cover modern corporations and these economists. I do not claim that the theory cannot be expanded. Important issues include knowledge, organization, and competencies needed to expand into adjacent products and to expand the number of plants.

  1. Some of these authors or their works I only know of through secondary literature.
  2. Bruno Rizzi's 1939 book, La Bureaucratisation du Monde, occasioned an internal debate among followers of Trotsky and supposedly foretold some of the themes in some of the following works.
  3. Franco Modigliani's 1958 paper, "New Developments on the Oligopoly Front", reviews an important book by each member of this pair of authors.
  4. I do not want to claim Piero Sraffa showed how to correctly account for overhead costs; do corporations have sufficient data to set up his equations in their full generality? Do they not commonly adopt heuristics that sometimes, but not always, deviate from his equations?
  5. As I understand it, this book deals with, among other issues, the separation of ownership and control.

The Fed's Communication Problem

Since early May, real and nominal long-term bond yields have risen in the United States. The most stark depiction of this is in the following chart, which shows the 10-year TIPS yield - which has risen by roughly 100 basis points since early May - and the breakeven rate (nominal 10-year yield minus the TIPS yield) - which has fallen by about 50 basis points over the same period.
I think it's fair to say that this was not the Fed's intent. The Fed thinks that "accommodation" is what is appropriate, and the way it sees that working is through low real bond yields and high anticipated inflation. But apparently real bond yields have risen, and anticipated inflation has fallen. Further, I think it's also fair to say that the bond price movements since early May have been driven primarily by the interpretation by financial market participants of public statements by Fed officials - principally Ben Bernanke.

On Thursday, Narayana Kocheralakota was interviewed on CNBC, and tried to make sense of this. Narayana thinks that the key problem was that the markets were (are) misinterpreting statements about QE (quantitative easing) as statements about the future path of the policy rate. That's in the right ballpark, but doesn't quite get at the essence of the problem. While the Fed took some pains to to make public statements about how QE was just normal policy (ease by moving long rates down rather than short rates), they have consistently segmented QE from forward guidance (statements about the future path of the fed funds rate), particularly in the FOMC statement. QE and forward guidance are typically described by the Fed as two different tools - like a hammer and a saw. But it should be clear to anyone - and I think it is - that these two elements of policy are somehow related.

But how are QE and forward guidance related? The Fed tells us that purchases of long-maturity government bonds and mortgage-backed securities by the Fed work to reduce long bond yields, and that this will increase some components of aggregate expenditure. Sounds just like standard Fed talk, right? When things are too hot - in the sense of inflation being "too high," and real economic activity being "too high," then the Fed cools things down by "tightening," i.e. the Fed intervenes in an attempt to increase nominal market interest rates. And the reverse if things are "too cold."

So what could the problem be? As economists, we know that things are actually more complicated than that. We disagree about what "too hot" and "too cold" mean, whether the Fed can actually heat and cool in particular circumstances, and whether the heating/cooling/thermostat analogy makes any sense. Sometimes it makes me cringe, and medical analogies are even worse ("the patient is bleeding," "the appendix needs to come out," etc.) But, in terms of what can be understood by the average person on the street, or even by the average bond trader, this may be the best the Fed can do in terms of communication. There are two directions: up and down. And the Fed can communicate whether they are going up or down, and the likelihood of going up and down in the future.

So, the Fed seems to have communicated QE in its usual up/down hot/cold language, but the message isn't getting across. Why?

1. QE is an experiment. As with all experiments, ideas about how to run the experiment have changed as the experiment proceeds. Sometimes the Fed swaps reserves for long Treasuries (QE2 and QE3), sometimes it swaps short Treasuries for long Treasuries (operation twist), and sometimes it swaps reserves for mortgage-backed securities. Why has the Fed done this in different ways? Does it now think that one type of intervention is preferable to another, or that there were different circumstances along the path we have followed since the financial crisis that warrant different approaches? None of that is clear from Fed communications. The only explanation we have is that these are different tools, and that when you have a lot of tools and you're in a predicament, you should use them all. Maybe there's little difference among the effects (if any) of these different tools. If so, the Fed is needlessly confusing us.

2. QE2 and operation twist were announced as asset purchases of specific assets at a specific rate, for a specific period of time (with some provision to change the plans in unusual circumstances). QE3 started that way, but then changed to a contingent plan (move the rate of purchases up or down depending on new information). What's confusing about this is that we have no idea where some of the numbers are coming from. Why does the Fed think that $85 billion per month in asset purchases is the appropriate number to move long bond yields by the amount the Fed wants to move them? If the Fed can't tell us, we have to be suspicious that they don't know. Why doesn't the Fed just announce a target for, say, the 10-year nominal Treasury yield? The fact that they do not makes us suspicious that the Fed thinks it may not be able to move Treasury yields in the way it confidently tells us it can. So, if the Fed is confident on the surface, but we're suspicious that it is actually mired in ignorance and doubt, how are we to think about what the FOMC will be doing at the next meeting, or next year?

3. The Fed has taken pains to be more specific over time about when the date of "liftoff" will occur - the date at which the policy rate (the interest rate on reserves under current conditions) increases above 0.25%. Liftoff will occur after the unemployment rate passes the 6.5% threshold. But, until recently, the Fed was not specific about "tapering" in asset purchases. Whenever the forward guidance language changed, it was clear that this was intended as a change in policy (up/down; heating/cooling) toward more accommodation. So, when Ben Bernanke gives more information about how the tapering will occur, how else should anyone interpret that but as "tightening," even though that was clearly not the Fed's intention?

One last point. Most Fed officials who speak in public argue that, even if we don't understand how QE works, that the empirical evidence demonstrates that it does. That empirical evidence is based on announcement effects - the Fed says something, and asset prices move. For example, the Fed announces some upcoming asset purchases, and bond yields move down. I hope that recent movements in asset prices will call that logic into question. In this case bond yields have moved up in response to something the Fed said when, in terms of how the Fed thinks about policy, either nothing has happened on the policy front, or the news should be interpreted as more accommodation rather than less.

Wednesday, June 26, 2013

In Defense of Greg Mankiw

I don't think anyone is surprised at the reaction to Mankiw's forthcoming JEP article. Discussions about the distribution of income get people excited. I read Mankiw's piece, and thought it was a decent summary of what economists have to say about the distribution of income and wealth. Mankiw's own views certainly enter into it, but he makes it clear when he's relying on serious research, and when his argument is based only on casual empiricism.

There are two main points. First, Mankiw argues that the increase in dispersion in the income distribution in the United States is due mainly to two factors: technological change driving an increase in the relative demand for highly-skilled labor, and a scarcity of high-skilled laborers. He could add international trade as a third factor - the idea that wages of low-skilled are lower than they would otherwise be because of lower barriers to trade and a plentiful supply of low-skilled labor abroad. But the point is that most of the change in dispersion is due to factors that have little to do with government activity (except perhaps trade policy), i.e. with tax policy and regulation. I think those conclusions are not particularly controversial among economists who have worked in this area.

Second, Mankiw argues that, to the extent that there is something "wrong" with the income distribution, there are better ways to do the fixing than by changing the way we tax income. If government regulations serve to protect inefficient monopolies, or allow financial institutions to practice what is essentially theft, then we should change those regulations. If patents promote inefficiency, we should change our patent laws. If opportunities are poor for people living in inner cities, we need to be thinking about how we can promote education in those neighborhoods.

Tax policy is something we have to be careful about. Micro evidence seems to tell us that the incentive effects of income taxation are small. But, for example, work by Manuelli, Seshadri, and Shin tells us that, if we look at the full array of tax and retirement policies, and take account of lifetime decisions about capital accumulation in general equilibrium, then the incentive effects are big-time.

So, for the most part, I agree with Mankiw. I think we also a agree about "enrichment" programs for kids. This actually goes much beyond summer camps. At Washington University in St. Louis, where I work, undergraduate tuition fees for the 2013-14 academic year will be $44,100. What do students (or their parents) get for their money? As Mankiw says, a lot of it looks like consumption rather than investment. Indeed, a walk through campus can remind you of a summer camp. Rich parents certainly want to send their kids here, but there's no guarantee that sending them here will perpetuate family wealth. Apparently, taking economics helps, though.

Monday, June 24, 2013

Two Systems Thinking Models: Mind Your Ps and Qs

Figure 1: A Market Mediated By Quantity
1.0 Introduction

I have been examining John D. Sterman's textbook, Business Dynamics. Sterman is a chaired professor at the Sloan School of Management and director of the System Dynamics Group at the Massachusetts Institute of Technology (MIT). The System Dynamics Group was founded by Jay Forrester, and the group is continuing research in his tradition.

This systems thinking approach provides tools for visualizing the hypothetical causal relationships and structures of dynamical systems. They show models in which hypothetical causal relationships, the distinction between stocks and flows, and temporal lags can be postulated and displayed. Software for specifying model structures provides capabilities for simulating dynamical behavior. These tools are directed towards managers who may not fully understand complex dynamical systems. The diagrams are intended to package and facilitate informal discussions about models, including desired system states. Simulations for the resulting models give some understanding of possible dynamics.

Sterman's diagrams and associated tools are one approach. Researchers in related disciplines have proposed other visual languages, with varying degrees of formalism for the syntax and semantics of the elements of such diagrams. I think of system block diagrams and the Unified Modeling Language (UML), for instance. Likewise, a number of tools exist (for example, Steve Keen's Minsky system, MathWorks' Simulink, Berkeley's Ptolemy system, and tools supporting Model-Driven Architectureand Model-Driven Development) for processing corresponding system specifications for various purposes.

2.0 "Tell Me What the Wires Do"

I might as well explain a bit about selected components of what Sterman calls Causal Loop Diagram (CLD). CLDs contain curved arrows connecting variable names. The arrowheads in CLDs are annotated with either a plus or a minus sign. Arrowheads indicate causal relations. Suppose an arrowhead points from the variable X to the variable Y:

  • Positive Link: If the arrowhead is labeled with a plus sign, Y increases when X increases, all else equal. In other words, ∂Y/∂X > 0.
  • Negative Link: If the arrowhead is labeled with a minus sign, Y decreases when X increases, all else equal. In other words, ∂Y/∂X < 0.

A CLD may contain circles with arrows, where each circle contains either the letter B or R, indicating, respectively, either a negative (balancing) or positive (re-enforcing) loop. The dynamical behavior of a system containing a single balancing loop is to approach an equilibrium point. On the other hand, a system containing a single re-enforcing loop exhibits exponential growth. The dynamical behavior of a system containing a combination of interacting balancing and re-enforcing loops, especially if it is non-linear, is more difficult to predict without simulation.

3.0 Two of Three Models

Since Sterman's textbook is directed towards business managers, he provides some examples from economics. In Section 5.5, he presents three models of a single market:

  • Demand and supply responding to price (Figure 5-26 in Sterman (2000), Figure 2 below)
  • Orders and production respond to queues (Half of Figure 5-27 in Sterman(2000), Figure 1 above)
  • Customer base and service quality interact (Other half of Figure 5-27 in Sterman (2000), not shown here)
Figure 2: A Market Mediated By Price

I think Sterman's model of demand and supply mediated by price mixes classical and neoclassical ideas. One should read "demand" and "supply" in Figure 2 as, by an abuse of language, actually referring to the quantity demanded and the quantity supplied. We see that this model postulates that firms increase the quantity supplied for industries in which profits are high, that is, when the price increases more above the cost of production. This is a classical idea, to be found in Adam Smith. The model also postulates that an increase in the quantity demanded puts upward pressure on price. I think how demand is conceptualized in this model, including the role of substitution in consumption, is close to how demand functions are presented in neoclassical textbooks.

Figure 1 shows a model in which firms respond more to increased demand by changes in the level of production, not by changes in price. If price were to be inserted into this model, price would be appropriately modeled by theories of administered, full-cost, or mark-up pricing.

I am not sure I agree with all of Sterman's economic examples. But the above picture of markets fits a Post Keynesian view, articulated by Michal Kalecki, that different microeconomic theories are needed to describe the prices and quantities for markets for raw materials, industrially-produced goods, and services. Do business schools provide a somewhat greater opening for non-neoclassical economics than supposedly leading economics departments?

  • John D. Sterman (2000). Business Dynamics: Systems Thinking and Modeling for a Complex World, Irwin McGraw-Hill

The Performance of a Lifetime


An excerpt from a new poetry collection on economics:

An Economist

Economists study how society produces and distributes its scarce resources.

An economist pretends to know
Why things are made and how they flow.
He studies men’s biggest woe,
He wants it all, what to forego.

Like a machine with unseen gears
Through greed a solution appears.
By making what men hold most dear
Profits are earned by serving peers.

To boost theirs and the common's gain
Become experts in their domains.
To make one thing well they attain,
Through trade the rest they obtain.

But their profits diverge by much.
Those with great tools earn a whole bunch.
Tools like machines, schooling and such
Boost production so very much.

Focus on Bank Liabilities, Not Bank Assets

John Cochrane has a great column in today's Wall Street Journal on how to create a better banking system.  He says that we should focus on the nature of bank liabilities (demand deposits, in particular) rather than on the riskiness of bank assets.

Back in 1993, in my discussant's comments on an Akerlof-Romer article on the savings and loan crisis, I made a similar argument.  Here is an excerpt of what I then wrote:

Traditional banks are peculiar institutions. Traditional banks have depositors who want short-term, liquid, riskless assets. Yet these deposits are backed by long-term, illiquid, risky loans. This incongruity is fundamental. As we have seen, it cannot be easily fixed by a government policy such as deposit insurance.

There is, however, a simple, market-based solution: mutual funds. Individuals who want truly riskless assets can invest in mutual funds that hold only Treasury bills. Those who are willing to undertake greater risk can invest in mutual funds that hold privately issued CDs, bonds, or equities. Long-term, illiquid loans could be made by finance companies, which would raise funds by issuing equity and bonds. In the world I am describing, all household assets would be perfectly liquid. Preventing bank runs---he original motivation for deposit insurance--would be unnecessary, because changes in demand for various assets would be reflected in market prices.

In essence, the system we have now is one in which finance companies are themselves financed with demand deposits. Yet these finance companies hold assets--long-term bank loans--that are risky and illiquid, much in the same way that fixed capital is risky and liquid. Imagine that the auto industry financed itself with demand deposits. Undoubtedly, self-fulfilling "runs" on GM and Ford would be common, and the auto industry would be highly unstable. Indeed, the auto industry would probably be a major source of macroeconomic instability. The best solution, of course, would not be deposit insurance and regulation of the auto industry, but a change in the way the industry financed itself.

Sunday, June 23, 2013

More on the One Percent

If you enjoyed reading my forthcoming JEP paper, you might also enjoy It’s the Market: The Broad-Based Rise in the Return to Top Talent by Steven N. Kaplan and Joshua Rauh, which emphasizes complementary themes. An excerpt:
We believe that the U.S. evidence on income and wealth shares for the top 1 percent is most consistent with a “superstar”-style explanation rooted in the importance of scale and skill-biased technological change. In particular, we interpret the fact that the top 1 percent is spread broadly across a variety of occupations as most consistent with an important role for skill-biased technological change and increased scale. These facts are less consistent with an argument that the gains to the top 1 percent are rooted in greater managerial power or changes in social norms about what managers should earn.

Will summer camp make my kids rich?

Paul Krugman, commenting on my recent article, thinks it is noteworthy that the rich have increased their spending on child enrichment programs.  To me, that is not a surprise.  The incomes of the rich have risen, and this category of spending, like many others, has a positive income elasticity.

I am a parent of three, and as far as I know, Paul does not have any children.  So I have probably spent a lot more on this category than he has.  And I can report that much of it is consumption, not investment.

A book I probably should have cited in my article is Judith Harris's The Nurture Assumption.  The main thesis of this great book is that, beyond genes, parents matter far less than most people think.  Raising three children has made me appreciate Harris's conclusion.  It is frustrating how little influence we parents have.

I have a friend whose job it is to advise families of extreme wealth.  She is often asked how to raise successful children who know they are going to inherit gobs of money.  It is all too common to see kids raised in this environment becoming ne'er do wells.  Her advice: Make sure they get a summer job.  Rather than spending money on enrichment activities, have them learn what it is like to earn a living.

Friday, June 21, 2013

Bullard Dissent

Jim Bullard has elaborated on his dissent at this week's FOMC meeting. Bullard has three objections:

1. The Fed has interpreted its price-stability mandate as a 2% inflation target. Given that the current 12-month pce inflation rate is well below the target, the FOMC should be addressing that. In Bullard's words:
...the Committee should have more strongly signaled its willingness to defend its inflation target of 2 percent in light of recent low inflation readings. Inflation in the U.S. has surprised on the downside during 2013.

2. Bernanke's elaboration at his press conference yesterday on how asset purchases would be wound down was inappropriately-timed. Apparently parts of Bernanke's statement at the press conference were approved by the FOMC and seem to have been intended as an extension to the formal FOMC statement. Here's the relevant passage from the press conference:
Although the Committee left the pace of purchases unchanged at today’s meeting, it has stated that it may vary the pace of purchases as economic conditions evolve. Any such change would reflect the incoming data and their implications for the outlook, as well as the cumulative progress made toward the Committee’s objectives since the program began in September. Going forward, the economic outcomes that the Committee sees as most likely involve continuing gains in labor markets, supported by moderate growth that picks up over the next several quarters as the near-term restraint from fiscal policy and other headwinds diminishes. We also see inflation moving back toward our 2 percent objective over time. If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year; and if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear. In this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7 percent...
Bullard's point is that Bernanke was emphasizing the wrong thing at the wrong time (or the right thing at the wrong time?).

3. Bullard did not like the language in Bernanke's statement at the press conference (authorized by the FOMC) that referred to calendar dates rather than state contingencies for reductions in asset purchases. The objection seems to be to the parts of Bernanke's statement quoted above where he says "...appropriate to moderate the monthly pace of purchases later this year..." and "...through the first half of next year, ending purchases around midyear."

Bullard is right. The official FOMC statement says:
The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.
But the committee is saying other things inconsistent with that statement. Bad communication is a central banker's worst enemy.

The Left on Just Deserts

I just got an email from the left-leaning Economic Policy Institute regarding their work on inequality.  I was struck by this passage:
Since the 1970s, the United States has become increasingly unequal in terms of income, wages, wealth and opportunity. Today, 1 percent of Americans are taking home nearly 20 percent of the country's total income and own nearly 35 percent of the country's wealth. This means that you (yes, you!) are probably making less money than you deserve to.*
Notice the emphasis on what "you deserve."  They aren't following the logic of the conventional Mirrlees model: they aren't saying we should redistribute more because the marginal utility of the rich is so much less than the marginal utility of the poor and middle class.  Rather, they are talking about what people deserve.

If economists want their models to connect with the political debate, they have to spend less time emphasizing diminishing marginal utility and more time thinking about just deserts.

That does not mean the EPI's conclusion is correct.  But I think they are right about the framing of the issue.

*By the way, this was a mass email, not to me personally.  I don't think EPI really thinks I am making less money than I deserve to.

Thursday, June 20, 2013

Monetary Policy Confusion

Here's a quote from today's Wall Street Journal, which I think summarizes public perception of what the Fed is up to.
Fresh signs that the Fed is considering pulling back on efforts to support the U.S. economy rattled markets. The dollar rose, while stocks, emerging-markets currencies and bonds all fell.
So what are these "fresh signs?" The Fed's approach to monetary policy at the zero lower bound is two-pronged:

1. Forward guidance The Fed has effectively tied its hands with respect to the target for its policy rate. The previously-announced policy is that policy rate target will remain where it is (0-0.25% for the fed funds rate) at least until the unemployment rate passes the 6.5% threshold. Bernanke clarified the forward-guidance policy in his press conference following the FOMC meeting.
First, today the Committee reaffirmed its expectation that the current exceptionally low range for the funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, so long as inflation and inflation expectations remain well-behaved (in the senses described in the FOMC’s statement). As I have noted frequently, the phrase “at least as long” in the Committee’s interest rate guidance is important; the economic conditions we have set out as preceding any future rate increase are thresholds, not triggers. For example, assuming that inflation is near our objective at that time, as expected, a decline in the unemployment rate to 6-1/2 percent would not lead automatically to an increase in the federal funds rate target, but rather would indicate only that it was appropriate for the Committee to consider whether the broader economic outlook justified such an increase.

2. Quantitative easing (QE) Recall that the Fed embarked on "operation twist" in September 2012, which evolved into outright asset purchases of $85 billion per month - $40 billion per month in mortgage-backed securities, and $45 billion in long-maturity Treasuries. Since March, the FOMC's stated policy is that these asset purchases should be explicitly contingent on the state of the world, much as policy-rate changes are contingent in "normal" times:
The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes. In determining the size, pace, and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives.
Bernanke added some more detail in his press conference:
If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year; and if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear. In this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7 percent, with solid economic growth supporting further job gains—a substantial improvement from the 8.1 percent unemployment rate that prevailed when the Committee announced this program.

So, given the stated policy rule, how would a rational forecaster have updated his or her forecast given recent information? The key news is that:

1. The measured inflation rate has fallen, as shown in the chart.

2. Anticipated inflation, as measured by breakeven rates (nominal Treasury yield minus TIPS yield for the same maturity) has fallen, as shown in the next chart.

3. In case you missed it, Bernanke's press conference contained a key policy change, related to Fed's "exit strategy."
One difference is worth mentioning: While participants continue to think that, in the long run, the Federal Reserve’s portfolio should consist predominantly of Treasury securities, a strong majority now expects that the Committee will not sell agency mortgage-backed securities (MBS) during the process of normalizing monetary policy, although in the longer run limited sales could be used to reduce or eliminate residual MBS holdings.

The first two pieces of news might make a rational forecaster predict a more accommodative policy, given the announced policy rule. Inflation is lower, and expected to be lower, so we should anticipate, from the forward guidance language, that the policy rate should stay where it is for a longer time beyond the point at which the 6.5% unemployment rate threshold is crossed. But, given the QE language, we would expect that a lower current inflation rate would produce an upward adjustment in the size of asset purchases, and that wasn't in the FOMC statement. Maybe the rational forecaster might be a little confused. Adding to that confusion is this part of the FOMC statement:
... longer-term inflation expectations have remained stable.
Of course the word "stable" is open to interpretation, but it seems that a drop of about a half point in the breakeven rate could not be characterized as stability. A rational forecaster might think that the Fed is misrepresenting information, or not acting in a way consistent with its promises. Thus, more confusion.

The third piece of news (the likelihood that the Fed will never sell any of its MBS portfolio) is important if we buy the Fed argument that QE matters - for quantities and prices - and that monetary policy actions far in the future can make a big difference for current prices. If we accept all of that, policy just became more accommodative.

So all the news points to more accommodation, though perhaps in a muddled way. But the public - to the extent it cares - is drawing the opposite conclusion. What gives? There must be a communication problem. I'm guessing that's what Bullard's dissent is about:
Voting against the action was James Bullard, who believed that the Committee should signal more strongly its willingness to defend its inflation goal in light of recent low inflation readings...
Bullard has been worried in past about low inflation (see this paper) and seems to have been a supporter of contingent QE. Maybe he was pushing for an increase in asset purchases in response to the recent news? In any case, Bullard is likely to comment publicly on his dissent soon, so watch for that.

My conclusion is that the monetary policy actions of the Fed, and the public statements of the FOMC and Fed officials, have become too difficult for the average person - or even the most sophisticated financial market participants - to process. Up against the zero lower bound on its policy rate, the Fed embarked on a bold experiment involving forward guidance and (very) large-scale asset purchases. Fed officials are perhaps as confused as everyone else about the effects of those policies. For example, this is an excerpt from an interview with Narayana Kocherlakota. He's discussing what we know about the effects of QE.
The benchmark thinking about QE, actually, was done by Neil Wallace and later by Gauti Eggertsson and Mike Woodford, following up on Neil’s work. And that baseline economic modeling would say these kinds of interventions should have no impact on yields and no impact on the economy at all.

Now, the empirical work that I mentioned has validated that there does seem to be an impact on yields. What that means in terms of the impact on economic activity, I’m still sorting through, to be honest. As of now, I would say that I think quantitative easing works in the right direction, but gauging the actual magnitude of its impact remains challenging.
With regard to the theory behind QE, the Wallace paper Kocherlakota is referring to is this one. Wallace writes down a model and derives conditions under which an open market operation is irrelevant (for prices and quantities). That does not relate specifically to QE - it applies to any open market operation. Presumably a model that would make sense out of QE would also tell us that "normal" monetary policy matters in the way the Fed thinks it does. The Eggertsson/Woodford paper doesn't help us much either. They work with a model where the only friction relates to sticky prices - hardly a good starting point for thinking about the effects of asset swaps by the central bank. So there is not theory to back up what the Fed is doing - and they are doing it in a big way. Kocherlakota seems to put some faith in the empirical evidence, but as he should know we can't interpret data without a theory. Conclusion: The people running the Fed know no more nor less about QE than anyone else. And what we know is: not much.

In Defense of Me

My new paper on the One Percent has generated a fair amount of Internet commentary.  I won't respond to the critics. Time is scarce, and I am busy with other projects. For better or worse, I will leave the paper to speak for itself. (I should note that my paper is part of a forthcoming JEP symposium. I have not seen all the other papers, but from what I have seen, the symposium should offer a good, balanced group of perspectives.)

Regarding all that Internet commentary, I did enjoy this defense from Matt Nolan.  Nolan was apparently a reader of my favorite textbook early in his life.  His defense of me begins as follows:
When it comes to looking at policy, I started life fairly heavily left wing. When I started university at the age of 18, my first textbook was by Greg Mankiw. He was a Republican, while most of my economics reading at the time had been Marxist or a frustrated attempt at reading the General Theory by Keynes. I was immediately certain that I would hate the textbook, and that it had no value – at that point I was even more immature than I am now ;)  
I was utterly and totally wrong – a situation I have become accustomed to. Mankiw’s first year textbook is clear, to the point, and is honest about what the economic method is and what it achieves. He “wears his assumptions on his sleeve” which I have learnt is the distinction of the best type of economist. His textbook, and his papers on macroeconomics and tax, have been insightful for me as a way of not just understanding economic ideas, but of understanding the economic method.
Thanks, Matt!

Wednesday, June 19, 2013

On "Substitutability"

"[The] validity [of the Cambridge Criticism of neoclassical theory] is unquestionable, but its importance is an empirical or an econometric matter that depends upon the amount of substitutability there is in the system. Until the econometricians have the answer for us, placing reliance upon neoclassical economic theory is a matter of faith. I personally have the faith; but at present the best I can do to convince others is to invoke the weight of Samuelson's authority." -- C. E. Ferguson (1969) [as quoted in Carter (2011)].
1.0 Introduction

In this post, I describe two different meanings of "substitutability", as used in the literature and economists' remarks on the Cambridge Capital Controversy1.

2.0 Joan Robinson's Criticism

Imagine two island capitalist economies, Alpha and Beta, each in a steady state and with access to the same technology. Suppose for some reason, the distribution of income happens to be different in the two islands. Then the capitalists on the islands will, maybe, have adopted different techniques of production and be producing a different mixture of commodities for final output. Consequentially, the structure of capital goods, both in composition and in quantities, will differ between the two islands.

An (illegitimate) thought experiment is to imagine the distribution of income slowly changing from as it is on one island to the distribution on the other. One might mistakenly consider the capital equipment slowly changing through the composition appropriate to imaginary intermediate islands. This claim ignores the reality of what Joan Robinson called historical time. One is treating a process occurring in time as if it occurring in space, ignoring that past bygones are gone, and assuming no difficulties exist in getting into equilibrium.

Neoclassical2 economists frequently ignore the structure of capital equipment and the plans of the entrepreneurs. One meaning of "substitutability" is the assumption that capital goods can be instantaneously taken apart and reassembled to be appropriate for whatever equilibrium is being considered. The tranverse from one equilibrium to another is abstracted from. Robinson satirized this meaning of substitutability by designating the capital good in, say, the Solow-Swan growth model with such names as "ectoplasm", "leets", and "mecanno sets". Post Keynesians, including Sraffians, are generally suspicious of this approach. (Any fans of Austrian school economists want to chime in in the comments?)

3.0 Substitutability and Smooth Microeconomic Production Functions

Another meaning relates to the smoothness of production functions. One might say substitutability exists when derivatives (including, second, third, etc. derivatives) exist for all production functions. That is, substitutability exists in these examples, but not in these ones. (But what would you say about this one, where the cost-minimizing technique varies continuously with the interest rate, and output and each capital good are produced with fixed-coefficients?)

As far as I know, capital-reversing, for example, is consistent with substitutability, in this sense of smooth production functions. I, too, will invoke the weight of Samuelson's authority, even though I reject it in the former case. I would like, however, to see an explicit numeric example.

4.0 Conclusion

I believe C. E. Ferguson was referring to my section 2 meaning of "substitutability". That is, when neoclassical economists claim that Sraffians rely on a lack of substitutability for their critique of neoclassical economics, they should not be objecting to a lack of differentiability of microeconomic production functions.

  1. Other usages are ignored in this post. For example, J. R. Hicks' "elasticity of substitution", as used in his mistaken Theory of Wages (1932), is not treated here.
  2. As far as I am concerned, "neoclassical" is a meaningful and appropriate word in this context.
  • Scott Carter (July 2011). C. E. Ferguson and the Neoclassical Theory of Capital: A Matter of Faith, Review of Political Economy, V. 23, N. 3: pp. 339-356

Monday, June 17, 2013

Elsewhere, On Neoclassical Economics

  • Noah Smith complains about the supposed overuse of the label.
  • Alex Marsh comments.
  • Matias Vernengo responds.
  • Lars Syll responds, including in pictures. Also, see here.
  • I wrote much of the wikipedia article, albeit not the introduction. And some stuff in it I now disagree with. I also wrote much of the Wikipedia article on Classical economics, and the subsection of that article is especially relevant to a Sraffian perspective on neoclassical economics.
  • Daniel Kuehn shares some thoughts.
  • David Ruccio comments.
Update: Added some links.

Saturday, June 15, 2013

Defending the One Percent

Click here to read my new essay "Defending the One Percent," which is forthcoming in the Journal of Economic Perspectives.

Thursday, June 13, 2013

An All-Harvard CEA

With the news that Betsey Stevenson is joining the CEA, the three-member board will now have two Harvard PhDs and a Harvard professor. Just saying....

Update: A friend points out, "Actually, we have had an all-Harvard CEA for some time since Betsey is replacing Katharine Abraham (a Harvard Ph.D.) and Jason is replacing Alan Krueger (a Harvard Ph.D.)."

Monday, June 10, 2013

Saturday, June 1, 2013

A Commencement Address

This morning I gave the commencement address at the Chapel Hill-Chauncy Hall School, from which my older son just graduated.  You can read the speech here.

Update: A video is posted here.