Wednesday, December 30, 2009

Measuring the Impact of the Stimulus Package with Economic Models

It's been nearly a year since the stimulus package of 2009 was passed. Unfortunately most attempts to answer the question “What was the size of the impact?” are still based on economic models in which the answer is built-in, and was built-in well before the stimulus. Frequently the same economic models that said, a year ago, the impact would be large are now trotted out to show that the impact is large. In other words these assessments are not based on the actual experience with the stimulus. I think this has confused public discourse.

An example is a November 21 news story in the New York Times with the headline “New Consensus Sees Stimulus Package as a Worthy Step.” Authors Jackie Calmes and Michael Cooper write that “the accumulation of hard data and real-life experience has allowed more dispassionate analysts to reach a consensus that the stimulus package, messy as it is, is working. The legislation, a variety of economists say, is helping an economy in free fall a year ago to grow again and shed fewer jobs than it otherwise would.”

As evidence the article includes three graphs, which are reproduced on the left of the chart below. Each of the three graphs on the left corresponds to a Keynesian model maintined by the group shown above the graph. All three graphs show that without the stimulus the recovery would be considerably weaker. The difference between the black line and the gray line is their estimated impact of the stimulus. But this difference was built-in to these models before the stimulus saw the light of day. So there are no new hard data or real life experiences here.

Now what about the so-called “consensus?” In fact, a number of other economic models predicted that the stimulus would not be very effective, and, using the same approach, those models now say that it is not very effective. To illustrate this I have added two other graphs on the right-hand side of the chart which did not appear in the New York Times article. The first one is based an a popular and well-regarded new Keynesian model estimated by Frank Smets, Director of Research at the European Central Bank, and his colleague Raf Wouters. Focus again on the difference between the black and the gray lines, which is what is predicted by that model, as shown in research by John Cogan, Volker Wieland, Tobias Cwik, and me. Note that the impact is very small. The second additional graph on the right is based on the research of Professor Robert Barro of Harvard University. As he explained last January, “when I attempted to estimate directly the multiplier associated with peacetime government purchases, I got a number insignificantly different from zero.” So according to that research, the difference between the black and the gray line should be about zero, which is what that graph shows. So there is no consensus.

Menzie Chen has a post on Econbrowser which mentioned the three graphs in the original New York Times article as an illustration of his excellent analysis of the use of counterfactuals (the gray lines in the graphs). The additional two graphs illustrate how important it is to go beyond a few models and establish robustness in policy analysis. Moreover, in my view, the models have had their say. It is now time to look at the direct impacts using hard data and real life experiences.

Saturday, December 26, 2009

Implications of the Crisis for Introductory Economics

People ask how I think introductory economics teaching should change as a result of the financial crisis. It’s an important question. At the upcoming American Economic Association Annual Meetings, my colleague Bob Hall, next AEA President and Program Director, has included on panel on the topic.

Clearly we need to include more on financial markets, but based on my experience teaching in the two-term introductory course at Stanford, I think the single most important change would be to stop splitting microeconomics and macroeconomics into two separate terms. The split has been common in economics teaching since the first edition of Paul Samuelson’s textbook, which put macro first. Many courses now have micro in the first term and then macro in the second.

But regardless of the order now used, I think a reform that integrates micro and macro throughout is worth considering. There were arguments for doing this before the crisis, including the fact that in research and graduate teaching the tools of micro have now been integrated into macro.

The financial crisis clinches the case for full integration in my view. The crisis is the biggest economic event in decades and it can only be understood with a mix of micro and macro. To understand the crisis one must know about supply and demand for housing (micro), interest rates that may have been too low for too long (macro), moral hazard (micro), a stimulus package (macro) aimed at such things as health care (micro), a new type of monetary policy (macro) that focuses on specific sectors (micro), debates about the size of the multiplier (macro), excessive risk taking (micro), a great recession (macro), and so on. It you look at the 22 items that the Financial Crisis Inquiry Commission has been charged by the Congress to examine, you’ll see that it is a mix of micro and macro. Defining the first term as micro and the second term as macro, or visa versa, is no longer the best way to allocate topics.

Moreover, the introductory course can be integrated in a way that makes economics more interesting for students. This year at Stanford we have been experimenting with such an integration in our principles course, and so far it seems to be working well. (The course, Economics 1, is taught this year by me (1A), Marcelo Clerici-Arias (1B), Gavin Wright (1A), and Michael Boskin (1B)). In 1A, which has been mainly micro until this year, I shuffled in macro concepts at various places. When I talk about aggregate investment demand I said it came right out of the micro demand for capital. Similarly aggregate employment and unemployment can be explained in the context of micro labor supply and demand. The proof that aggregate production (GDP) equals aggregate income can be stated at the time one defines profits as equal to revenues minus cost of labor and capital. In the second term we then go into such topics inter-temporal consumption which is at the heart of both micro and macro and time inconsistency, which has both macro and micro aspects. The demand for money as a function of the interest rate is easily explained with the opportunity cost concept.

Such curriculum changes incur some transition costs. For example, the economics textbooks are not quite ready for this. We are using my textbook with Akila Weerapana this year and it has the usual micro/macro split. But it is not too hard to mix and match pages, and many publishers custom design texts.

This approach also has the advantage that the traditional split does not have. It lends itself to a system where students can take a one term overview course in 1A (mainly non-econ majors) and not have to miss all of micro or all of macro. I hope that others can benefit from this approach and have constructive comments about it.

Tuesday, December 22, 2009

Financial Crisis Inquiry Commission Gets Started

Today the Financial Crisis Inquiry Commission announced its first public hearing, which will start at 9 am on January 13 and continue through January 14. The topic: Causes and Current State of the Financial Crisis.

That public hearings are about to start is excellent news. Without such an investigation, followed by a clear explanation to the American people of what went wrong, the Congress is unlikely to enact financial reforms that actually fix the problem. To repeat a phrase from the Chairman of the Brady Commission on the 1987 crash (their report took only 4 months to complete), "You cannot fix what you cannot explain."

Though not part of its Congressional mandate, I recommend that the FCIC follow the approach of the Brady Commission and the 911 Commission and make some recommendatiions. It could then even issue a report card on how the recommendations are implemented. Such a Report Card was issued by the 911 Commission and it proved quite useful.

Sunday, December 20, 2009

Estimating the Impact of the Fed's Mortgage Portfolio

Some of the big questions looming about the Fed’s exit strategy are if, when, and at what pace the Fed should draw down its huge portfolio of mortgage backed securities (MBS). At its meeting last week the Federal Open Market Committee announced that it is continuing its MBS purchases at a “gradually slowing pace,” but that will still leave $1,250 billion in MBS on its balance sheet at the end of the first quarter. Another, more long-term, question is whether such price-keeping operations—a term used by Peter Fisher who once ran the trading desk at the New York Fed—should be a regular part of monetary policy in the future. Brian Sack, who now runs the trading desk, concludes in a recent speech that they should be.

The answer to these important questions requires on an empirical assessment of the impact of the MBS purchase program. Unfortunately, publicly available assessments are sorely lacking. For this reason, Johannes Stroebel and I undertook an econometric study of the impact; the study is part of a larger research project by us and our colleagues on central bank exit strategies.

Such an assessment requires that one carefully consider other influences on rates on mortgage backed securities. We focused on two obvious ones: prepayment risk and default risk. If we control for prepayment risk using the swap option-adjusted spread, which is regularly used by MBS traders and investors, and if we control for default risk using spreads on senior or subordinated agency debt, we find that that the program has not had an economically or statistically significant effect on mortgage spreads. If we use other measures to control for prepayment and default risk we can see statistically significant effects, but they are small. Even in these cases it was the announcement or the existence of the program, rather than the size of the portfolio that mattered for spreads. We find that there is no statistically or economically significant effect of the size of the portfolio, a finding which we show is quite robust. If our estimates hold up to scrutiny, they raise doubts about such price-keeping operations and suggest that the Fed could gradually reduce the size of its portfolio without a significant impact on the mortgage market.

The graph illustrates our findings. It shows the swap option adjusted spread (with its prepayment risk adjustment) in red and the predictions of that spread using the agency debt spread (a measure of risk) in blue. The residual between these two, shown in green at the bottom of the graph, indicates that there is little left for the Fed's MBS portfolio to explain. Details and other cases are in the paper.

Sunday, December 13, 2009

David Wessel’s Doubts About “Whatever It Takes”

Big Think is conducting a series of video interviews with economists, market participants, journalists, policymakers and others on the financial crisis to try to answer the pressing question of “what went wrong.” This is an excellent idea. As former Treasury Secretary Nicholas Brady said last week “you can’t fix what you can’t explain.” The Financial Crisis Inquiry Commission should take note.

The interview with David Wessel of the Wall Street Journal was the first in the series. Among many good questions put to David, one of the most interesting was “Did Bernanke’s mantra of ‘whatever it takes’ lead us astray?” In David’s 575-word answer, he offers 5 positive words that it “got us through this crisis,” but gives no explanation for that and instead goes on for the remaining 570 words talking about the problems the approach has caused and is causing, including that “it can justify almost anything.” Among other problems he mentions the Bernanke-Paulson-Geithner “mistake” of “wasting the time after Bear Stearns” and “not coming up with a more articulated game plan for what they would do if they had to cope with a collapse with another financial institution.” In effect what you see in the video is a cogent argument that the approach may have seriously worsened the crisis even if it eventually got us through it. So it seems like the answer to the question is: yes, it led us astray. And since the problem has not been addressed--as David points out in the last few sentences—it is likely to continue to lead us astray.

Saturday, December 12, 2009

A Perfect Storm or It's Not My Fault?

This past week we held a conference on Ending Government Bailouts As We Know Them. One of the biggest surprises coming out of the conference was the growing recognition that the bankruptcy process--perhaps amended with a new Chapter 11F--is quite viable for financial institutions, and that a new FDIC-like resolution process that goes beyond banks may not be neeeded. In addition, all three keynote speakers, former Treasury Secretaries George Shultz and Nick Brady as well as former Fed Chairman Paul Volcker spoke in favor of constraining the activities of banks that have access to Fed loans and guaranteed deposits. The biggest concensus item, however, was that Congress and the Administration should wait for a report explaining the causes of the crisis before moving ahead on reform legislation. And Brady shot down a common explanation very effectively. "The least convincing explanation [of the crisis] is one floating around the industry that attributes the events to 'a perfect storm.'—i.e., it’s not my fault."

Sin Rumbo

The just-released Spanish translation of my book, Getting Off Track, is titled Sin Rumbo, which translates back to English as “without direction” or “aimlessly." Although the Spanish title has a somewhat different connotation than the English, it is actually an excellent title because it portrays another problem with government policy during the financial crisis, namely that there is no coherent strategy—no direction—for dealing with the crisis once it flared up in August 2007. The Spanish translation of the subtitle is more straightforward: De cómo las acciones e intervenciones públicas causaron, prolongaron y empeoraron la crisis financiera.

Sunday, December 6, 2009

Monetary Policy and the Wisdom of Wayne Gretzky

I’m always trying to find good ways to teach beginning economics students about monetary policy. For years I compared it to flying a fighter jet where you have to anticipate the actions of the other pilots, and if you get it wrong you crash and burn in a great depression or a great inflation. I liked to show the scene from the movie Top Gun where, in a classroom scene after a flight, instructor Kelly McGillis (Charlie) chastises fighter pilot Tom Cruise (Maverick) for a near crash and burn because of his risky behavior. I stopped showing that scene because the next scene is quite a bit more intimate, not really appropriate for an introductory economics class, and if you do not stop the DVD just in time the students get completely distracted from the subject of monetary policy. Once while I was lecturing at West Point the DVD didn't stop and the movie rolled on past the classroom scene to the next scene to a roar of laughter from hundreds of Army cadets in the lecture hall watching the big screen behind me.

So I was pleased that Philadelphia Fed President Charles Plosser, in a speech last Tuesday in Rochester, came up with an even better analogy: hockey. He tells the story of how “Hockey great Wayne Gretzky was once asked about his success on the ice. He responded by saying, ‘I skate to where the puck is going to be, not to where it has been.’ He didn’t chase the puck. Instead, Gretzky wanted his hockey stick to be where the puck would be going next. He scored many goals with that strategy, and I believe monetary policymakers can better achieve their goals, too, if they follow the Gretzky strategy.”