Interpreting information, markups, and the economic cycle

Over at Worthwhile Canadian Initiative, Nick Rowe bemoans the fact that economists keep ignoring the “very short run”, and the transition from that to the short-run.  In the very short-run, we may view a shock (an increase in demand) and interpret as noise – it is only when the shock persists that we may respond.

This reminded me of tacit collusion.  Why … well why not!  In a paper by Green and Porter, discusses collusion and competition between firms with market power in a way that I’ve always found compelling.  Essentially a firm sits around doing what it does, and then it observes a drop in demand for its product.  The question it then has to answer is, “is this due to the other firm undercutting me, or has consumer demand for my product fallen?”.  Given that the firm does not know, under some conditions it will respond as if the drop in demand was due to a cut in prices by the competing firm – leading to a break down in any “tacit collusion” that existed before.  Weak demand therefore leads to price wars!

Now this isn’t the only explanation of price wars – in fact Rotemberg and Saloner showed the opposite.  In their model, there was a greater “prize from deviating”  when demand is high, and so times of high demand see collusion break down!

What does this mean for markups over the business cycle?  Well in the Green and Porter case, where this issue of interpreting information is a key driver of behaviour, markups are procyclical – in the Rotemberg Saloner model, markups are countercyclical.  Furthermore, there are many other models that aim to explain changes in the markup over the business cycle – it isn’t all about models of tacit collusion.

At an industry level, things differ – and so in different cases, the different models are supported empirically when looking at this as an industrial economics issue.  But what about over the economy as a whole, which one holds?  Generally it seems markups have been shown to be procyclical and to be countercyclical… while a fair amount of economic modeling often assumes countercyclical markups (in response to demand shocks).  This is an interesting area, very interesting.

Will current expansionary policy lead to “bubbles”

An excellent post over at Marginal Revolution on this.  The points raised are:

1. If a more expansionary monetary policy helps an economy recover, yes it may well raise the risk of a later bubble.  We should then be cautious, but that is no reason to turn down the prospect of a recovery.  Anything leading to recovery could have a similar risk.

2. There are already plenty of reserves in the system and there is plenty of room for credit to expand over its current level.  Maybe we don’t know what triggers bubble-inducing investment behavior, but why should raising ngdp expectations and realities raise the risk of a bubble, if not for the factor cited in #1?

3. Arguably a flat yield curve induces a quest for higher returns elsewhere or in more dubious investment areas.  Yet the flattening yield curve did not follow quickly from the massive injection of reserves.  Rather it evolved slowly as prospects for real recovery deteriorated and the long-run outlook for the advanced economies turned down.  Real factors drove the flattening, and if monetary expansion brought a bit of recovery it likely would unflatten that curve a bit.  That could well lower the risk of a bubble.

4. I may consider Austrian theory, with regard to this question, in a separate post.

There are two points I would raise here though.

With regards to bullet three – although I agree that the flat yield cuve is likely the result of weak prosepects for the economy, we can’t really pretend that the long end of the yield curve is currently independent of relatively direct government involvement.  The Fed’s willingness to buy up longer term Treasury bonds in order to stimulate growth could indicate that the low yield curve is partially the result of intervention, rather than true expectations of long term inflation and growth propsects.

Interestingly, I agree with bullet point three – I think that if there were sufficient asset purchases we would actually see the yield curve steepen (through its impact on expectations).  But this is clear, or necessarily the mainstream, view of what is going on.

The second point is that bubbles aren’t necessarily bad – in any sense of the word.  They transfer resources between groups, groups who chose to take risk.  They lead to a change in the timing of investment, often in a way that is suboptimal – but not disasterous.  A “bubble” in of itself doesn’t lead to a failure of monetary policy, and it doesn’t lead to a large scale downturn – there are other significant factors that have lead to these things internationally, factors that were correlated with the bubble (maybe even related to it) but not caused by it!

Black box modelling

Nick Rowe is concerned that agent-based modelling (ABM) is a black box that provides no intuition and doesn’t really add to our knowledge:

Agent-based models, or any computer simulations, strike me as being a bit like [a] black box. A paper written by a very reliable economist where all the middle pages are missing and we’ve only got the assumptions and conclusions. I can see why computer simulations could be useful. If that’s the only way to figure out if a bridge will fall down, then please go ahead and run them. But if we put agents in one end of the computer, and recessions get printed out the other end, and that’s all we know, does that mean we understand recessions?

My question is how a model where you set the rules can ever be a black box? Shouldn’t the results always be understandable by reference to the initial conditions and ‘rules of the game’? Read more

The attempt to make everything a “generation war”

Via Blaise Drinkwater (on Google+ of all sites!) was this link from Marginal Revolution.  The generational war component comes through this:

By speeding the flood of less expensive imported products into Japan, the strong yen is contributing to a broader drop in the prices of goods and services, known as deflation, that has helped retirees stretch their pensions and savings. The resulting inaction on the yen, according to a growing number of economists and politicians, reflects a new political reality, with already indecisive leaders loath to upset retirees from the postwar baby boom who make up nearly a third of the population and tend to vote in high numbers.

To me, this comment is relatively nonsensical for two reasons.

Firstly, The Yen has “strengthened” from an incredibly weak level in 2007 – incredibly weak by historic standards!  Yes the Yen is now strong against the US dollar, but if you compared it to a wider basket of currencies this is hardly the case.

When talking about currency, historical context isn’t particularly useful.  Instead we need to ask things such as “what is purchasing power parity like” and “are they running a trade surplus”. It turns out that Japan is still running sizable trade surpluses, suggesting that (if anything) the Yen may still be too weak …

My second complaint is this view of the Yen and inflation – inflation is the growth in the general price level over time, a “high Yen” is a one-off price level shock … it doesn’t change the rate of growth in the general price level it merely knocks down the level as a one-off.  The endemic deflation in Japan isn’t a result of “fiddling with tradable prices”, it is the result of persistent deflation expectations feeding into the wage and price setting behaviour in the country.

Now if there is a generational war in this context, it relies on Japan’s pensions not being inflation adjusted.  Is this the case?  If not, this is much ado about nothing.

 

Does macroeconomics have a right-wing bias?

Noahpinion:

…it’s really hard to make a DSGE model in which government policy plays a useful role in stabilizing the business cycle. By contrast, it’s pretty easy to make a DSGE model in which government plays no useful role, and can only mess things up. So what ends up happening? You guessed it: a macro literature where most papers have only a very limited role for government. …Thus, the conservative slant of modern macro comes not from the weight of evidence, but from the combination of publication bias and the inherent unwieldiness of the DSGE framework.

Update: The comments below make it clear that I should have explained what I think is interesting about this quote, and it’s got nothing to do with DSGE in particular. It is the general point that assumptions are often made for tractability, rather than realism, yet still influence our conclusions. It isn’t possible to control for the unrealistic assumptions; if it were we wouldn’t have made them. That means our conclusions will be biased by assumptions we’ve made only for convenience and we need to bear that in mind when considering the policy implications of our models. For example, if our model assumes perfect competition and our conclusions rely on prices adjusting then we might need to be a little sceptical.

How do habits help?

We’ve posted over the past couple of days about habit persistence and you might be wondering why anyone would care. It turns out that habit persistence is extremely powerful in explaining some important macroeconomic dynamics:

When habits are formed at the level of individual goods, firms take into account the fact that the demand they will face in the future depends on their current sales. This is because higher consumption of a particular good in the current period makes consumers, all other things equal, more willing to buy that good in the future through the force of habit. Thus, when habits are deeply rooted, the optimal pricing problem of the firm becomes dynamic.

[This paper embeds] the deep-habit-formation assumption in an economy with imperfectly competitive product markets. This combination results in a model of endogenous, time-varying markups of prices over marginal cost [with] markups [that] behave counter-cyclically. In particular, expansions in output driven by demand shocks are accompanied by declines in markups. This implication …is in line with the existing empirical literature. In addition, …because of the strong counter-cyclical movements of markups, [habit persistence] is capable of explaining increases in wages and consumption in response to a positive demand shock as is observed in the data. This latter empirical regularity has proved difficult to explain with standard models of the transmission of demand shocks.