What do models tell us?

Josh Hendrickson has a new post that defends the use of models that might in some respects be viewed as “unrealistic”. I agree with his general point about models, and also his specific defense of models that assume perfect competition. But I have a few reservations about some of his examples:

Ricardian Equivalence holds that governments should be indifferent between generating revenue from taxes or new debt issuances. This is a benchmark. The Modigliani-Miller Theorem states that the value of the firm does not depend on whether it is financing with debt or equity. Again, this is a benchmark. Regardless of what one thinks about the empirical validity of these claims, they provide useful benchmarks in the sense that they give us an understanding of when these claims are true and how to test them. By providing a benchmark for comparison, they help us to better understand the world.

With all that being said, a world without “frictions” is not always the correct counterfactual.

Taken as a whole, this statement is quite reasonable.  But I would slightly take issue with the first sentence, which is likely to mislead some readers.  Ricardian Equivalence doesn’t actually tell the government how it “should” feel about the issue of debt vs. taxes, even if Ricardian Equivalence is true.  Rather it says something like the following:

If the government believes that debt issuance is less efficient than tax financed spending because people don’t account for future tax liabilities, that belief will not be accurate if people do account for future tax liabilities.

But even if people do anticipate the future tax burden created by the national debt, heavy public borrowing may still be less efficient than tax-financed spending because taxes are distortionary, and hence tax rates should be smoothed over time.

I happen to believe Ricardian Equivalence is roughly true, but I still don’t believe the government should be indifferent between taxes and borrowing.  Similarly, I believe that rational expectations is roughly true, and yet also believe that monetary shocks have real effects due to sticky wages.  I believe that the Coase Theorem is true, but also believe that the allocation of resources depends on how legal liability is assigned (due to transactions costs).  Models generally don’t tell us what we should believe about a given issue; rather they address one aspect of highly complex problems.

Here’s Hendrickson on real business cycle theory:

Since the RBC model has competitive and complete markets, the inefficiency of business cycles can be measured by using the RBC as a benchmark. In addition, if your model does not add much insight relative to the RBC model, how valuable can it be?

[As an aside, I agree with Bennett McCallum that either the term ‘real business cycle model’ means a model where business cycles are not caused by nominal shocks interacting with sticky wages/prices, or else the term is meaningless.  There is nothing “real” about a model where nominal shocks cause business cycles.]

Do RBC models provide a useful benchmark for judging inefficiency?  Consider the following analogy:  “A model where there is no gravity provides a useful benchmark for airline industry inefficiency in a world with gravity.”  It is certainly true that airlines could be more fuel efficient in a world with no gravity, but it’s equally true that they have no way to make that happen.  I don’t believe that gravity-free models tell us much of value about airline industry efficiency.

In my view, the concept of efficiency is most useful at a policy counterfactual.  Thus monetary policy A is inefficient if monetary policy B or C produces a better outcome in terms of some plausible metric such as utility or GDP or consumption.  (I do understand that macro outcomes are hard to measure (especially utility), but unless we have some ability to measure outcomes then no one could claim that South Korea is more successful than North Korea.  I’m not that pessimistic about our knowledge of the world.)

In my view, you don’t measure inefficiency by comparing a sticky price model featuring nominal shocks against a flexible price RBC model, rather you measure efficiency by comparing two different types of monetary policies in a realistic model with sticky prices.

That’s not to say that there are not aspects of RBC models that are useful, and indeed some of those innovations might provide insights into thinking about what sort of fluctuation in GDP would be optimal.  But I don’t believe you can say anything about policy efficiency unless you first embed those RBC insights (on things like productivity shocks) into a sticky wage/price model, and then compare policy alternatives with that model.  I view sticky prices as 90% a given, much like gravity.  (The other 10% is things like minimum wage laws, which can be impacted by policy.)

PS.  Just to be clear, I agree with Hendrickson on the more important issues in his post.  My support for University of Chicago-style perfect competition models definitely puts me on “team Hendrickson”, especially when I consider the direction the broader profession is moving.


Read More

IMF Lending During the Pandemic and Beyond

By Robert Gregory, Huidan Lin, and Martin Mühleisen In the face of unprecedented uncertainty and the severe economic impact triggered by COVID-19, the Fund continues to adapt its lending. At the same time, it aims to ensure realistic targets, uphold the credibility of programs, and foster national ownership. To date, the Fund has provided financial […]

Read More

One Thing Rationally Ignorant Voters Don’t Know

A Twitter follower of mine just praised president Trump for saving money by donating his salary back to government departments (I didn’t bother to add  the many justified “sic”):

“He takes a ZERO salary from the american people. How much did americans paid for Obama, Biden, Pelosi, Schumer, etc?”

Is this a significant saving for “the American people,” that is, American taxpayers? To check that, the voter must do some simple calculations. But even among those voters who can easily find the data sources and do the calculations, “rational ignorance” (as public choice economists say) will prevent most from doing it. Rational ignorance is the fact that the voter remains rationally ignorant of politics because he or she, individually, has no impact. It’s not as when he buys a car: he pays the money and gets the car he ordered. Politics and voting are very different: Why take the trouble and cost of finding information when your vote is not going to change the result of the election anyway? You’ll get the same political car anyway. Add partisanship to the mixture, and a perfect anti-Enlightenment storm is forming.

So let’s calculate if we should be grateful to the president for being so thrifty with public money. The annual salary of the president is $400,000—which means at most $300,000 after tax. This corresponds to 1/16,000,00o (one sixteen-millionth) of the annual expenditures of the federal government, which were roughly $4.8 trillion ($4,800,000,000,000) in 2019, before the pandemic struck. It can be easily calculated that in 2019 (note again: before the pandemic), the amount by which Trump increased the annual expenditures of the federal government was a bit more than $600 billion ($600,000,000,000) compared to the last year of Obama’s presidency (see https://fred.stlouisfed.org/graph/?g=vzfE).

Thus, by foregoing his presidential salary, Trump saved the American taxpayer $300,000 a year and, by the end of 2019, was spending $600,000,000,000 more of their money on an annual basis. This means that what Trump saved the taxpayers is 1/2,000,000 (one two-millionth) of what he ended up spending over and above what Obama spent during his last year. (It is of course much worse since the beginning of 2020.)

Many taxpayers, if they knew, would have preferred that Trump ran with his $300,000 and showed frugality with the trillions of dollars of federal expenditures. According to USA Today, two previous presidents, also very wealthy, John Kennedy and Herbert Hoover, also donated their salaries. But they did not increase annual federal expenditures by half a trillion dollars.

PS: Thanks to Jon Murphy for his comments on a draft of this post.


Read More

How Strong Infrastructure Governance Can End Waste in Public Investment

By Gerd Schwartz, Manal Fouad, Torben Hansen, and Geneviève Verdier COVID-19 has had a profound impact on people, firms, and economies all over the world. While countries have ramped up public lifelines to individuals and firms they will face enormous challenges to recover from the pandemic, amidst low economic activity and unprecedented levels of debt. […]

Read More

Good News from Georgia

Start with the state’s economy, which had a relatively low jobless rate of 7.6% in July. Construction was never shut down, and schools in much of the state are opening for classroom instruction. The state expected a budget shortfall of $1 billion for the year but the actual deficit was $210 million. Mr. Kemp says sales tax revenue is rebounding and the state hasn’t exhausted its $700 million reserve fund.

This is from a Wall Street Journal editorial titled “Georgia’s Pandemic Progress,” August 24, 2020 (electronic) and August 25 (print).

Recall all the flak that Governor Brian Kemp got for opening too soon. Well, it paid off.


Read More

What if the economy does not tank in August?

In late July, there were increasingly frantic claims in the media that failure to enact another massive fiscal package would hurt the economy. I’ve pointed out that disposable income growth in 2020 has been astounding, and argued that a lack of fiscal stimulus is not the problem. So what will people say if the economy does not tank in August?

One prediction I can make with near 100% certainty is that a continued recovery in August would not be viewed as evidence against the (old) Keynesian view of fiscal stimulus and in favor on the New Keynesian/monetarist view. The efficacy of fiscal stimulus is now accepted almost as a matter of faith, despite the 2013 debacle. Instead, other explanations will be sought.

Here’s the headline and subhead to a new Bloomberg piece by Conor Sen:

The Stealth Sunbelt Virus Turnaround Will Boost the Economy

Even without a new stimulus package, there are reasons for optimism.

It’s worth noting that those reasons for optimism were typically not cited in late July, before the recent data on falling unemployment claims and rising stock prices.  So we need to figure out whether the “reasons for optimism” reflect new economic data, or actual external shocks that would justify an increased level of optimism.  I suspect it’s the recent economic data.

Sen cites the recent Covid-19 data from Arizona, which has indeed improved sharply in recent weeks, after a very bad July.  But Arizona is only a tiny fraction of the overall economy.  Here is daily Covid-19 fatality data for the US:

Deaths peaked at just over 2000/day in April, fell to just over 500/day in late June, and then doubled again by late July.  Ignoring day of the week fluctuations in Covid reporting, the first half of August is still near the July peaks.  So one does not see the Arizona improvement in the national fatality data.

On the other hand, reported new cases are trending downward nationwide, although they are still several times higher than in June. (The recent decline is a bit smaller than it might appear to the naked eye, as the most recent two days are weekend data (reported Sunday and Monday), and today will probably see a jump upward).

This decline may partly reflect reduced testing, but a portion of the decline is almost certainly real.  The question is whether that’s enough to explain a modest improvement in the economy in August, despite the end of fiscal stimulus.  I doubt whether consumers are that sensitive to a drop in reported cases that is not showing up (yet) in the fatality data, but I can’t rule it out.

Even so, you have to wonder how important fiscal policy actually is if a fairly modest improvement in Covid-19 can explain why dire economic predictions don’t seem to be coming true.  If anything, I believe this supports my claim that it’s the virus, not a lack of disposable income, which is driving the economy right now.

PS.  I always need to point out that a major increase in the budget deficit was appropriate this year.  I am merely questioning stimulus for stimulus sake, such as giving $1200 to middle class people with jobs and giving unemployed people more than they earned on their previous jobs.  I favored the provisions that expanded unemployment compensation to a wider range of people during recent months.  So I’m not suggesting that doing nothing right now is appropriate; rather this post is aimed at the macroeconomic effects of using fiscal stimulus as a tool to boost disposable income.


Read More

Consumption is not a part of GDP

I used to teach my students that consumption was roughly 2/3rds of GDP. Actually, consumption is not a part of GDP.

Consider this analogy. You have an annual income of $100,000.  You might say:

1. Income = wages + capital income

You might also say:

2. Income = consumption + saving + taxes

And you can make the second equation more complex by breaking consumption down into spending on clothes, haircuts, restaurant meals, etc.

It makes sense to say wages and capital income are both a part of income. On the other hand, to me it doesn’t make much sense to say spending on haircuts is “a part of” income.

Of course that’s a question of semantics. So let’s look at some statements with real implications:

1. My decision to earn more wages will cause my income to rise.
2. My decision to get more frequent haircuts will cause my income to rise.

The first claim is obviously plausible (assuming I find employment), while the second claim would require some pretty fancy footwork to justify.

In the textbooks, GDP = C + I + G + (X-M)

That makes it look like consumption (C) is a part of GDP. But it isn’t—consuming adds to C and subtracts from I (inventories). GDP measures aggregate production, and consumption is obviously not production. If I go and spend $100 on a new product, it doesn’t cause GDP to rise by $100, even if the good is domestically built. Rather investment falls by the value of the good, as inventories fall. (GDP may rise slightly, as my decision to buy the good boosts retailing services.)

The decision to consume more only causes GDP to rise if it causes production to rise.

Now it’s certainly possible that my decision to get up off the couch and go buy something does in fact cause GDP to rise. But if GDP does rise, it is for reasons that are completely unrelated to the myth that consumption is a part of GDP. Consider the following analogy. Getting a haircut might make my income go up because I look more presentable and find it easier to get a job. But in that case the reason my income goes up has nothing to do with the claim that my consumption of haircuts is “a part of my income”. It’s a use of my income. There has to be some other indirect effect, which needs to be explained.

In order for consumption to boost GDP, we need two assumptions to be met.  First, more consumption must boost nominal GDP.  Second, more NGDP must boost real GDP.

The first assumption requires an incompetent central bank.  The Fed is supposed to keep NGDP growing at rate that best allows it to meet the dual mandate.  Even if the optimal NGDP growth rate is not constant, it surely doesn’t depend on whether you decide to go get a haircut.  There’s some growth rate in NGDP that best meets the Fed’s mandate.  For your decision to get a haircut to boost NGDP, the Fed must respond incompetently, allowing aggregate demand to go off course.  That might happen, but in that case NGDP is not rising because “C is part of GDP”.  Perhaps velocity rises by more than M falls—they screw up.

Even if NGDP does increase, there’s no necessary increase in RGDP.  If more NGDP always did cause RGDP to rise, then Zimbabwe would be the world’s richest country.  For an increase in NGDP to boost RGDP you also need the assumption of sticky wages.

So it’s just possible that consumption does boost GDP, but not for the reason you were taught in school.  If we were honest with students we’d say, “Spending more might cause Jay Powell to screw up while doing his job at the Fed.  This causes the total dollar value of spending (NGDP) to rise.  And because people have money illusion, they are fooled into thinking that work has become more lucrative, and so they decide to work more.  Output (RGDP) also rises.

I think you see why we don’t teach students this way. It’s confusing.  So we make up a fairy tale. But the fact that students are taught the wrong explanation means that they never really learn macro, even if they are absolutely straight A students, the best in their university.  How can they learn what actually happens if they are taught that consumption is part of GDP, so spending more causes GDP to rise?

You might argue that Jay Powell doesn’t know when I go out to buy something, so the lack of monetary offset is a plausible assumption.  But the consumption shocks that matter are not the whims of individuals (which balance out due to the law of large numbers), they are the collective decision of millions of people to spend more, perhaps due to a federal tax rebate.  In 2008, the tax rebate did boost GDP a bit in the second quarter, but the Fed responded with tighter money and it led to lower GDP in the 3rd and 4th quarters.  For the year as a whole, the tax rebate added nothing to GDP.  Students wouldn’t know that based on the models they are taught in macro.  It seems like a policy that gets people out shopping should boost GDP.  It doesn’t.

The only even halfway plausible argument that consumption boosts GDP occurs at the zero bound, where there is some debate as to whether the Fed offsets consumption shocks.




Read More

Top 10 Blogs on COVID-19

By IMFBlog The pandemic has altered people’s lives in both enormous and small ways. Our editors have picked the top recent blogs that dig into the details of what COVID-19 means for people: the impact on women and the young, what it means for the food supply, and how it can increase already growing inequality, […]

Read More

Chart of the WeekAging Economies May Benefit Less from Fiscal Stimulus

By Jiro Honda and Hiroaki Miyamoto In the midst of the current COVID-19 pandemic, policymakers around the world are undertaking fiscal stimulus—a combination of spending increases and tax reductions—to support their economies. Even before the present crisis, the importance of fiscal policy has been increasing, with monetary policy constrained by near-zero interest rates. Our new […]

Read More

Global Imbalances and the COVID-19 Crisis

By Martin Kaufman and Daniel Leigh The world entered the COVID-19 pandemic with persistent, pre-existing external imbalances. The crisis has caused a sharp reduction in trade and significant movements in exchange rates but limited reduction in global current account deficits and surpluses. The outlook remains highly uncertain as the risks of new waves of contagion, […]

Read More