Matt Nolan

Uncertainty, policy, and recessions

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Via Anti Dismal, there is a post discussing regime uncertainty and recessions – and criticising some of the world’s Keynesian bloggers for ignoring the role of uncertainty.

Now I think the real options argument that uncertainty reduces activity is undeniable, but I also don’t think that any economist – Keynesian or not – disagrees with it.

Ultimately, we know uncertainty is a major driver of the business cycle – that is part of the reason why investment is the first thing to pull back, and one of the first things to recover when a “recovery in the economy” begins.

The difference lies in what CAUSES the uncertainty – specifically, when we think about the role of government in this context we need to ask “will this government action increase or decrease uncertainty for decision makers”.

We don’t live in a world where, without government, there is no uncertainty – in fact uncertainty appears “endogenously” during the economic cycle, it is something that is both always there and worsens when things change.  The real question isn’t whether uncertainty has a cost (it does) it is whether policy (which is what we control) makes things better or worse.

Matt Nolan

Workers are different

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It is true, and yes it is obvious … however, just because it is obvious doesn’t make it a useless fact – in truth it is an essential, and oft ignored point to keep in mind.  As raised here (ht MR):

Those of us who actually work in industry and are involved in large engineering projects of the type the stimulus was designed to ‘stimulate’ could have told you this without waiting for a study. We tried to. No one was listening.

It is maddening to hear ‘workers’ talked about as if they are interchangeable – Oh, a whole bunch of home construction workers have been layed off? Don’t worry, we’ll build a road or a bridge and employ them!” The only problem being that the type of construction home builders are trained for has nothing to do with bridges.

This is an undeniable fact – and is something that it is important to keep in mind when discussing labour market dynamics.  Now, the article goes on to say that only Austrain economists look at this issue – I call bull on that, there is a whole bunch of literature on heterogenous labour in labour economics, during the recession New Zealand economists have constantly talked about job mismatch (an understanding of that is one of the reasons why any stimulus spending has been more targeted), and the only reason it is often not modelled explicitly is because it can be hard to describe/make the model solve.

Even in the most general and non-detailed areas of applied macroeconomics, economists often use empirical models with some sort of implied labour market friction that is meant to proxy the mismatch – not a perfect solution, but definitely an indication that it isn’t being ignored.

In fact, I’ve been reading a lot of commentators in NZ discussing the areas where skill shortages still existed in the middle of the recession – in this country policy analysts, economists, and humans all seem to have a good understanding of the differences in labour and the value of human capital … maybe this is just an issue that NZ is more informed on.

Matt Nolan

An illustration that using data for a conclusion is not objective

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There is an interesting post over at John Taylor’s blog (ht Greg Mankiw). In it he shows that government spending as a % of GDP has a strong positive correlation with unemployment, and that investment as a % of GDP has a strong negative correlation.  His conclusion is to focus on cutting taxes to increase investment instead of spending.

Update:  Here is the point I’m trying to make written up more clearly and completely.

Now, this way of viewing the data is consistent with the model he has in his head – but it is only by stating that model that we can look at the value judgments involved to figure out what we agree with or disagree with.

Looking at the data alone, we cannot make this conclusion – we can just say there are correlations.

For example, I would note that investment responds disproportionately to the economic cycle – this is a well known “stylized fact”.  The excuse economists often use is that businesses and households cut back on durable good expenditures most heavily when we enter a downturn – as the durable products they already own act as effective substitutes for new durables.

As a result, assume that government spending is a constant (so the government is doing nothing to smooth the economic cycle).  When GDP falls, investment falls more steeply.  When GDP falls, unemployment rises.  In this case, even with no government smoothing, the existence of an economic cycle will lead to BOTH of the observed correlations above (note that GDP is a denominator) – there is no way we can reach any policy conclusion from them.

We need a model, with a counterfactual – then we can use the data, and value judgments, to reach policy conclusions.  His model says that these correlations are causal.  My model would probably say that all these correlations suffer from too much endogeniety, and I would state that appropriate monetary policy is the best way to move forward – as it would reduce the observed variability in investment, unemployment, and GDP.  Both conclusions use the same data, the underlying models are just a bit different.

He is of course world famous and ridiculously intelligent, while I’m an arbitrary blogger – but I still prefer my conclusion, that’s what value judgments are for right 😉

Matt Nolan

Fiscal spending: Cycles and structures

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No, I’m not talking about the cycleway – although if Bill English does want to cut “nice to haves” surely this is a place to start 😉

I’m talking about this comment from Ganesh Nana, where I both agree with him and disagree with him simultaneously.

The plans (to cut spending) were criticised by BERL chief economist Ganesh Nana, who said cutting more state sector jobs and squeezing spending further at this point in the cycle risked keeping the economy down for longer.

It is true that when we have a cyclical downturn, cutting spending without a coordinated cut in interest rates from the central bank is likely to exacerbate the cycle.

And it is true we are in a cyclical downturn – output in the economy is below its potential level.

However, there are three factors that could well justify SOME cuts to government spending – as long as they don’t try to close the deficit immediately.

  1. The Reserve Bank still has the ability to respond by loosening monetary policy (although the effectiveness of cutting at current lows is a matter of debate),
  2. The cuts are focused on extremely low productivity elements of spending, as a result the contractionary impact will be smaller than in the case of indiscriminate cuts.
  3. Most importantly, the focus of the cuts are to remove the “structural” deficit.

The third point needs more explanation.  Fundamentally, the “potential size” of the New Zealand economy is now believed to be smaller than it previously was.  As a result, in order to have government taking up the same share (a share that is determined by the tax take, which is hopefully set according to the share society desires) the level of government spending does need to be lower – or else we run a structural deficit.

Structural deficits are not cool, it implies that the government won’t balance the books over the economic cycle and will cause unnecessary disruption to economic activity when it does try to – and as a result, it is often seen as a good idea to minimise them.

Now, for an economist I am actually relatively comfortable with short-term structural deficits.  I believe that estimating “potential” is tough, and as long as spending is transparent small structural deficits and surpluses are hard to separate from cyclical ones.  However, while the government should buffer the economy over the “cycle” it is true that in its structural sense it does need to balance its books like a household.

As long as any tightening is based on the three points listed above, I don’t think Dr Nana needs to be too concerned regarding the impact on the broader economy.  However, if they do go further just for the kicks, then his concerns are very relevant.

Matt Nolan

Understand before you tinker

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I would be lying if I said this didn’t depress me.  Economists, great economists, economists I idolize stating that there are “imbalances” we must solve – and then telling us how to solve them without actually describing what the imbalance is and why it exists.

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Matt Nolan

Bubbles, stability, Stiglitz

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As soon as you guys have read the title and saw the article I’m discussing, you are probably expected me to go off about Stiglitz – given that, although he’s a genius, his views tend to be a touch unorthodox and I’m a slave to orthodox economic theory.  But this isn’t the case.  There are a couple of things I disagree with in the article, but I actually felt what he wrote was pretty good – in fact most of it is more orthodox than many may realise.

Now, I disagree with his assertion that:

They failed to predict the crisis; standard models even said bubbles couldn’t exist — markets were efficient.

Of course, the EMH suggests that we can’t predict crisis – and doesn’t say their can’t be bubbles.  Hell, the macro text book I’ve got next to me has a great deal on where bubbles pop up in models.  Personally, I’d go as far as saying that the “popping bubble” was not the main issue at stake during the GFC – it was the break down in trust and reputational capital in the finance sector combined with a slow policy response.  But I digress.

He also states:

The ultimate objective of a central bank is to stabilize the real economy, and financial and price stability both need to be seen as instruments toward this and other ultimate objectives.

This is a little loose.  The objective the central bank is to run a fiat money system without incurring undue variability in the real economy – we want the certainty and efficiency associated with fiat money and price stability, but we want to avoid ADDING to variability in real output.  My only real disagreement here is that I still believe ensuring price stability is the best way to achieve any cyclical goals from monetary policy – when he does not believe this.

But ignore this, he has some great insight, namely:

Perhaps the major failing of some of the earlier models was that, while the attempt to incorporate micro-foundations was laudable, it was important that they be the right micro-foundations.

The discipline needs to build and develop – and recognising that helps us understand that the discipline isn’t in some magical “final state” where it can provide all knowledge.  This isn’t a critique of the discipline – it is an admission that the discipline needs to keep learning and growing.  Furthemore, it shows he still believes in reductionism – which I’m glad to hear.

Nice.