What’s Wrong With Modern Macro? Part 1 Before Modern Macro - Keynesian Economics

Part 1 in a series of posts on modern macroeconomics. This post focuses on Keynesian economics in order to set the stage for my explanation of modern macro, which will begin in part 2. 


John Maynard Keynes – Wikimedia Commons

If you’ve never taken a macroeconomics class, you almost certainly have no idea what macroeconomists do. Even if you have an undergraduate degree in economics, your odds of understanding modern macro probably don’t improve much (they didn’t for me at least. I had no idea what I was getting into when I entered grad school). The gap between what is taught in undergraduate macroeconomics classes and the research that is actually done by professional macroeconomists is perhaps larger than in any other field. Therefore, for those of you who made the excellent choice not to subject yourself to the horrors of a first year graduate macroeconomics sequence, I will attempt to explain in plain English (as much as possible), what modern macro is and why I think it could be better.

But before getting to modern macro itself, it is important to understand what came before. Keep in mind throughout these posts that the pretense of knowledge is quite strong here. For a much better exposition that is still somewhat readable for anyone with a basic economic background, Michael De Vroey has a comprehensive book on the history of macroeconomics. I’m working through it now and it’s very good. I highly recommend it to anyone who is interested in what I say in this series of posts.

Keynesian Economics

Although Keynes was not the first to think about business cycles, unemployment, and other macroeconomic topics, it wouldn’t be too much of an exaggeration to say that macroeconomics as a field didn’t truly appear until Keynes published his General Theory in 1936. I admit I have not read the original book (but it’s on my list). My summary here will therefore be based on my undergraduate macro courses, which I think capture the spirit (but probably not the nuance) of Keynes.

Keynesian economics begins by breaking aggregate spending (GDP) into four pieces. Private spending consists of consumption (spending by households on goods and services) and investment (spending by firms on capital). Government spending on goods and services makes up the rest of domestic spending. Finally, net exports (exports minus imports) is added to account for foreign expenditures. In a Keynesian equilibrium, spending is equal to income. Consumption is assumed to be a fraction of total income, which means that any increase in spending (like an increase in government spending) will cause an increase in consumption as well.

An important implication of this setup is that increases in spending increase total income by more than the initial increase (called the multiplier effect). Assume that the government decides to build a new road that costs $1 million. This increase in expenditure immediately increases GDP by $1 million, but it also adds $1 million to the income of the people involved in building the road. Let’s say that all of these people spend 3/4 of their income and save the rest. Then consumption also increases by $750,000, which then becomes other people’s incomes, adding another $562,500, and the process continues. Some algebra shows that the initial increase of $1 million leads to an increase in GDP of $4 million. Similar results occur if the initial change came from investment or changes in taxes.

The multiplier effect also works in the other direction. If businesses start to feel pessimistic about the future, they might cut back on investment. Their beliefs then become self-fulfilling as the reduction in investment causes a reduction in consumption and aggregate spending. Although the productive resources in the economy have not changed, output falls and some of these resources become underutilized. A recession occurs not because of a change in economic fundamentals, but because people’s perceptions changed for some unknown reason – Keynes’s famous “animal spirits.” Through this mechanism, workers may not be able to find a job even if they would be willing to work at the prevailing wage rate, a phenomenon known as involuntary unemployment. In most theories prior to Keynes, involuntary unemployment was impossible because the wage rate would simply adjust to clear the market.

Keynes’s theory also opened the door for government intervention in the economy. If investment falls and causes unemployment, the government can replace the lost spending by increasing its own expenditure. By increasing spending during recessions and decreasing it during booms, the government can theoretically smooth the business cycle.

IS-LM

The above description is Keynes at its most basic. I haven’t said anything about monetary policy or interest rates yet, but both of these were essential to Keynes’s analysis. Unfortunately, although The General Theory was a monumental achievement for its time and probably the most rigorous analysis of the economy that had been written, it is not exactly the most readable or even coherent theory. To capture Keynes’s ideas in a more tractable framework, J.R. Hicks and other economists developed the IS-LM model.

I don’t want to give a full derivation of the IS-LM model here, but the basic idea is to model the relationship between interest rates and income. The IS (Investment-Savings) curve plots all of the points where the goods market is in equilibrium. Here we assume that investment depends negatively on interest rates (if interest rates are high, firms would rather put their money in a bank then invest in new projects). A higher interest rate then lowers investment and decreases total income through the same multiplier effect outlined above. Therefore we end up with a negative relationship between interest rates and income.

The LM (Liquidity Preference-Money) curve plots all of the points where the money market is in equilibrium. Here we assume that the money supply is fixed. Money demand depends negatively on interest rates (since a higher interest rate means you would rather keep money in the bank than in your wallet) and positively on income (more cash is needed to buy stuff). Together these imply that a higher level of income results in a lower interest rate required to clear the money market. An equilibrium in the IS-LM model comes when both the money market and the goods market are in equilibrium (the point where the two lines cross).

The above probably doesn’t make much sense if you haven’t seen it before. All you really need to know is that an increase in government spending or investment shifts the IS curve right, which increases both income and interest rates. If the central bank increases the money supply, the LM curve shifts right, increasing income and decreasing interest rates. Policymakers then have two powerful options to combat economic downturns.

In the decades following Keynes and Hicks, the IS-LM model grew to include hundreds or thousands of equations that economists attempted to estimate econometrically, but the basic features remained in place. However, in the 1970s, the Keynesian model came under attack due to both empirical and theoretical failures. Part 2 will deal with these failures and the attempts to solve them.

Links 8-7-2016

Scott Sumner is Feeling the Johnson,

Vox says Republicans should be too,

But Bob Murphy’s Not Convinced.

Maybe Denmark isn’t so Great After All

“when it comes to government support of grants from the National Science Foundation (NSF) for economic research, our sense is that many economists avoid critical questions, skimp on analysis, and move straight to advocacy.”

About that Productivity Gap

In my post yesterday, I put up this graph, which has been used by many as evidence of major economic problems.

The graph shows a growing gap between the production of an average worker and the compensation they receive for that production. The Economic Policy Institute (which is the source of the graph above), claims that this gap represents a failure of wealth to “trickle down” to workers. The economy is growing, but workers don’t see any of the benefits. I agree that this story, if true, would be deeply concerning. But I’m not so sure it’s true.

First, I wanted to make sure I could recreate the gap on my own. I used FRED to plot real compensation per hour against real gross value added divided by total hours (to proxy for productivity). I’m not sure if these are exactly the series used by EPI above, but the pictures look pretty close.

compensation_productivity_gap

Notice, however, that in order to get these data into real values, I deflated by two different price indexes – CPI for compensation and an implicit price deflator for productivity (if you aren’t sure what the difference is, here’s the BLS explanation). FRED also provides real values for each of these variables and they also use different inflation measures for each. I assume other people that have made this graph have done the same. Although it might make sense to deflate these series using different measures of inflation in some situations, it does not allow for an easy direct comparison between them. Looking at the difference between the two measures over time reveals a familiar looking gap.

inflation_gap

So what happens if instead of trying to look at real values using different (and imperfect) measures of inflation, we just put everything in nominal terms? Bye-bye productivity gap:

compensation_productivity_gap_2

Now, maybe there’s still something to be concerned about here. The CPI is supposed to measure the goods actually purchased by consumers. If the prices of these goods are growing faster than average, then the value of a worker’s compensation is lower. I’m not sure I have enough faith in either measure to even grant that point, but at the very least can we start calling it an inflation gap rather than a productivity gap?

2016: The Best Year Yet

In the last few weeks I’ve seen multiple people on Facebook claiming 2016 is the worst year in history. After I checked to make sure I wasn’t in an alternate timeline where events like the Black Death, the French Revolution, and World War II (among many others) never happened, I concluded they were probably exaggerating. Still, it seems like many people have started to believe the idea that overall welfare in the world is on a downward trend. Luckily, they couldn’t be more wrong.

Let’s take a look at some of the main complaints about the world in 2016. Our World in Data is a great source to visualize these long run trends and is where I got most of the graphs below. Check it out if you’re interested in topics I didn’t cover here.

Violent Crime

If you listen to the media, you might be a little bit scared to go outside. Mass shootings, terrorist attacks, and police brutality seem to be perpetual components of the nightly news. I of course do not want to trivialize any of these problems. Any level of unnecessary violence above zero is something we should try to eliminate. But violence has always been a part of this world. Has it been getting worse? No.

Homicide rates in the US, for example, are around their 50 year low and other countries show similar trends

You might think that restricting the focus to gun homicides would show a different trend. As Mark Perry explains, gun violence has actually fallen even as the number of guns has steadily increased.

gun_violence

We still have a long way to go, but it looks like we’re on the right track.

(off topic: notice how high US violence is relative to other countries even in the early 1900s. Might there be an explanation that has nothing to do with our gun laws?)

Poverty

In the US, you have probably heard that income inequality is up, middle class incomes have stagnated, and the poverty rate hasn’t fallen in over thirty years. All of these statistics are true on the surface, But as Don Boudreaux likes to point out, being poor today is not the same as it was in the past. In another post, he notes that most Americans today live much better than the absolute richest American a century ago. He asks how much money would be required in order for you to prefer living in 1916 than in 2016 with your current income. I don’t think I’d be willing for any sum of money. While I’m sure being rich in 1916 has its benefits, I’ll take my computer and airplanes any day.

On middle class incomes, this graph is commonly cited

I’ll deal with this apparent gap between labor compensation and productivity soon in a later post, but for now just take my word for it that it’s not exactly what it seems.

Another important point is that anybody born in the US (or any other first world country), has already won life’s most important lottery. Eliminating poverty in developing countries is a much more pressing issue. Here is what has happened to global poverty over the last 200 years. Since 1970, around the time when many would tell you the neoliberal agenda sent the world into a spiral of misery, the number of people living in extreme poverty has fallen from around 2.2 million to 700 thousand.

Healthcare

Democrats will tell you that too many people are uninsured. Republicans that Obamacare is destroying the country. Meanwhile life expectancy has been rising steadily for decades in every region of the world

life_expectancy

 

While child mortality has fallen

child_mortality

These are of course not the only factors that matter. The rise in healthcare spending (both public and private) in the US and other countries is concerning and we will need to figure out ways to deal with this issue, but once again, the trend seems to be going the right way.

You might say that I’ve cherry picked statistics to fit my story. That’s true. There’s a lot of bad things happening in the world right now. But we hear about those all the time. I think it’s important to also appreciate the stuff that is working and I do believe that the vast majority of people are far better off now than they have been at any point in the past.

Quote of the Day 8-3-2016

I had a growing feeling in the later years of my work at the subject that a good mathematical theorem dealing with economic hypothesis was very well unlikely to be good economics: and I went more and more on the rules – (1) Use mathematics as shorthand language, rather than as an engine of inquiry. (2) Keep to them till you have done. (3) Translate into English. (4) Then illustrate by examples that are important in real life (5) Burn the mathematics. (6) If you can’t succeed in 4, burn 3. This last I do often.
Alfred Marshall

Quote of the Day 8-1-2016

The train of logic departs from a picture that economists of a hundred years ago would recognize as familiar – Robinson Crusoe allocating effort between fish and bananas, say –  but barrels along at uncomfortable speed, picking up loads of subscripts on the way, into a fantasy land where the assumptions made about what people are able to know, to forecast and to calculate would leave them utterly bewildered and incredulous.
Axel Leijonhufvud “Episodes in a Century of Macroeconomics”

Blogs I Read

I spend a lot of time reading other economics blogs and I will probably be referring to many of these in future posts. Here are some of the ones I read most.

Blogs I Love

EconLog: Bryan Caplan, David Henderson, and Scott Sumner cover a wide range of economics issues. Sumner tends to write about monetary policy and Caplan focuses on immigration and education, but all three are pretty varied in their choice of topics. Usually at least one post per day and always interesting analysis.

Slate Star Codex: Not an economics blog and posting frequency is a bit lower, but Scott Alexander is a great writer and has some incredible posts. Just read this and you’ll see what I mean.

Blogs I Like

Marginal Revolution: One of the most popular economics blogs. Tyler Cowen and Alex Tabarrok from George Mason University post about a variety of different topics.

Roger Farmer’s Economic Window: Doesn’t post as frequently as some of the other bloggers highlighted here, but the analysis is always top-notch. Good source for some non-standard macroeconomic views. Also has a new book coming out soon, which I have read and highly recommend.

The Money Illusion: Scott Sumner’s personal blog. Again mostly focused on monetary policy and Sumner’s proposals for targeting nominal GDP.

Worthwhile Canadian Initiative: You’ll probably have to read each post about three times before you get the point (at least I do), but Nick Rowe is the master of thought experiments.

Cafe Hayek: If you want to see a bunch of posts arguing against the minimum wage and in favor of free trade this is the place to go.

Free Advice: Bob Murphy writes mostly about economics from an Austrian school perspective. Spends many posts criticizing Paul Krugman (coined the term Krugman Kontradiction) and Scott Sumner.

Alt-M: An interesting blog focused mostly on exploring free banking, or how a monetary system could work (and has worked) without a central bank.

Coordination Problem: A blog run by Pete Boettke, one of the most prominent modern Austrian school economists.

Noahpinion: A great blog for the analysis of macroeconomic methodology (among other topics). Noah Smith is about as critical of modern macroeconomics as I am (although I think his preferred alternatives are quite different).

The Grumpy Economist: John Cochrane is one of the leading financial economists. Probably not the easiest read if you aren’t familiar with economics and finance.

Blogs I Read, but Don’t Like as Much

The Conscience of a Liberal: Paul Krugman is a great economist, but I find his blogging to be far too partisan and antagonistic.

Wonkblog: Very strong liberal bias. Not so strong economic analysis.

Tom Woods: Still occasionally has some good posts on economics and politics from a libertarian perspective, but has recently shifted towards trying to get you to buy stuff. (Update: Tom points out in the comments that his blog is not really the focus of his website. I should have mentioned he also has a free podcast, which is much better).

Links to these and some other blogs are in the blogroll on the right sidebar.

 

 

 

The Economics of Hayek

hayek_portraitAs I mentioned in my first post, Hayek has had a large influence on the way I think about economics. But despite being one of the most cited authors of all time and winning the 1974 Nobel prize, the bulk of Hayek’s ideas have either been ignored or mischaracterized by modern economic research (see Pete Boettke’s paper on how Hayek is used by modern economics). Looking at the methodology of modern economics (especially macro – more on this in future posts), I doubt there is much of anything that would have appealed to Hayek. Obviously, I think Hayek’s economics deserve a larger role in the theories of modern economists. So what is Hayekian economics? I have broken it into four pieces. If you are not familiar with formal economics, some of the comparisons I make might be a bit confusing, but I hope it is interesting regardless.

The Economic Problem

If we possess all the relevant information, if we can start out from a given system of preferences, and if we command complete knowledge of available means, the problem which remains is purely one of logic…This, however, is emphatically not the economic problem which society faces…It is rather a problem of how to secure the best use of resources known to any of the member of society, for ends whose relative importance only these individuals know
F.A. Hayek, The Use of Knowledge in Society, 1945

Most economics papers begin by doing precisely what Hayek warned against in the quote above. They define a set of preferences for consumers and a production function for firms. They then assume that consumers maximize utility and firms maximize profits and solve for an equilibrium. From Hayek’s perspective, starting from this point assumes away the most interesting questions of economics. The economic problem cannot be solved by taking derivatives of known maximization problems. Instead, it is a question of how resources can be allocated efficiently when this information is not known. It is about the process of discovery, of individuals competing and cooperating attempting to find better ways to achieve their own ends.

The Price System

I am convinced that if it were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind
F.A. Hayek, The Use of Knowledge in Society, 1945

Hayek’s answer to the economic problem he proposed above and the mechanism that allows a decentralized economy to allocate resources is the price system. It is important to note here that Hayek’s prices are not equilibrium prices. They are not set to ensure that all markets clear or that there are no profit opportunities remaining. He is far more interested in the process by which an economy moves toward its equilibrium than he is in the equilibrium itself. Prices, then, are simply guides, providing the information that incentivizes individuals to make decisions that result in goods being allocated efficiently, even though it wasn’t anybody’s direct intention to do so. When a resource becomes relatively scarce, entrepreneurs recognize a profit opportunity, raise the price, and ensure that only those who will make the best use of the resource actually receive it. Through the price system, knowledge that is known only to a few individuals can be communicated indirectly throughout an economy.

The Meaning of Competition

[C]ompetition is by its nature a dynamic process whose essential characteristics are assumed away by the assumptions underlying static analysis
F.A. Hayek, The Meaning of Competition, 1946

The way that prices are formed in Hayek’s theory is through the competitive process. Entrepreneurs, who are usually given little to do in standard economic theory, are central to Hayek’s story. Rather than assume firms to be price takers, aware of their own cost structure and production function, their actions are instead “a voyage of exploration into the unknown, an attempt to discover new ways of doing things better than they have been done before.” In standard economic theories, “perfect competition” is a state where nothing changes as firms decisions are largely made for them. In contrast, Hayek imagines competition as a constantly moving dynamic system. Even if the economy looks stable, “the task of keeping cost from rising requires constant struggle.”

Spontaneous Order

[M]any of the ‘mere habits’ and ‘meaningless institutions’ that we use and presuppose in our actions are essential conditions for what we achieve; they are successful adaptations of society that are constantly improved on and on which depends the range of what we can achieve. While it is important to discover their defects, we could not for a moment go on without them
F.A. Hayek, The Constitution of Liberty, 1960

In the end, the actions of individuals acting on their preferences and knowledge create a “spontaneous order,” an organization of society that is  the “result of human action, but not of human design” (a quote used by Hayek, but which was originally written by Adam Ferguson in 1767). In other words, even without top down planning, there is an order to society that arises naturally. This idea applies not only to a market economy and the price system, but also to political systems, the rule of law, and more informal orders like societal norms and customs. The institutions that society develops are continuously evolving as people explore new ways to accomplish their goals. These institutions provide the basis for the market system, providing incentives for entrepreneurs to develop new products and methods of production as well as accurately set prices. They are essential to tie together the three pieces explained above.

While this brief post can only give a taste of Hayek’s work (look here for some videos and a free ebook that go into more detail), I think it highlights the main differences between his approach and that of mainstream economic theory. Disequilibrium, fundamental uncertainty, and the discovery process of entrepreneurs are all essential pieces of Hayek’s analysis that are challenging to model using the most commonly used methods of modern economic analysis. But rather than throw these concepts aside because they do not conform to these methods, I believe the right path forward is to change the methods themselves.

More on this in future posts.