Wednesday, October 26, 2011

The Texts They Are A-Changin'

How should the introductory economics text change in response the financial crisis, the recession and the very slow recovery? The question will be discussed at a big economics teachers’ conference in New Orleans this week. I will be there to give a talk on the issue by describing the just released 7th edition of my text with Akila Weerapana of Wellesley. We incorporated many crisis issues in the 6th edition in 2009 (the first text to do so), and gained experience for the 7th which I will share with other teachers at the conference.

The answer to the question depends a lot on what you think caused the crisis. If you think that it shows our economic theory—especially our macroeconomic theory—was wrong, and thereby gave the wrong policy prescriptions, then you have to think about massive changes. If you think the crisis shows that our economics was basically correct and that policy deviated from the recommendation of the theory, then you want to revise the text differently, and show with example after example how this happened. It is a unique teaching moment.

While there is some truth in both of these views, my research has led me to conclude that the second is closer to the reality. Certainly room should be given for different views, but this second view must be represented. My principles text with Akila Weerapana reflects this.

Here are the slides for my talk

Monday, October 10, 2011

Congratulations and Thanks to Tom Sargent and Chris Sims

The Nobel Prize committee made an excellent choice in awarding the 2011 economics prize to Tom Sargent and Chris Sims for their influential contributions to macroeconomics.

One of the first papers of Tom Sargent I read was his little “Note on the Accelerationist Controversy” published 40 years ago in 1971. It showed how commonly-used statistical tests rejecting the vertical long run Phillips curve were flawed because they did not take expectations into account properly. Then his 1975 Journal of Political Economy paper with Neil Wallace, which showed that monetary policy was ineffective in models with rational expectations and perfectly flexible prices, made it clear to me that we had to find a tractable way to put sticky prices into rational expectations models. Tom’s 1978 paper with Robert Lucas “After Keynesian Macroeconomics” pointed out many of the problems with Keynesian approach to economic policy. I recently found that our current policy experiences, 30+ years later, confirm that view. Tom’s emphasis on “cross equation restrictions” in rational expectations models set new standards for empirical estimation as he showed in his 1980 paper “Formulating and Estimating Dynamic Linear Rational Expectations Models” with Lars Hansen. Tom has also made his technical research accessible to economics students. His book Macroeconomic Theory published in 1979 is an early example, and last spring we used his more recent textbook with Lars Ljungqvist in the first year Ph.D. program at Stanford. His 1986 book Rational Expectations and Inflation made the technical subjects accessible at a non-technical level.

Chris Sims introduced the use of vector auto-regressions into macroeconomics in his1980 paper “Macroeconomics and Reality.” This work has had a deep and pervasive effect on macroeconomics which persists today. I first used his methodology in a paper published that same year (in the same journal and issue as the Hansen-Sargent paper mentioned above) to demonstrate that the stochastic dynamics of the business cycle in all the major industrial countries could be explained by a combination of a monetary reaction function and a particular form of staggered price setting, revealing a trade-off between output and price stability. Work I did in 1985 on nominal GDP targeting used estimated and theoretical impulse response functions as suggested by Sims. That research indicated that nominal GDP targeting had several flaws and pointed the way to a different kind of policy rule.

Both Chris Sims and Tom Sargent are of the school that you should evaluate policy proposals rigorously with estimated and theoretically well-founded models, rather than just speculate on how a policy would work or did work, and that is also an important model to follow.

Congratulations and thank you, Tom and Chris.

Friday, October 7, 2011

Higher Inflation Is Not the Answer

Today's NPR Morning Edition presented two sides to the question "Does The Economy Need A Little Inflation?"  By "a little" they mean 5 percent per year for a few years.   The former IMF chief economist and Harvard professor Ken Rogoff argued in the affirmative and was featured in the radio segment, as he has been arguing this view along with his successor at the IMF, Olivier Blanchard, for a while now. I argued for the negative in the segment saying it would do more harm than good to the economy, a point Paul Volcker has been making forcefully. A recent column by George Will puts the issue in the broader context of U.S. economic policy and also comes out on the negative side.

Thursday, October 6, 2011

The Dangers of Misrepresenting Past Economic Debates

“What’s past is prologue,” says Future, the statue at the National Archives. But in macroeconomic policy—monetary and fiscal—the past is often misrepresented, and that unfortunately leads Future astray.  A common misrepresention these days pertains to past views of economists about monetary and fiscal policy. Consider David Frum’s recent opinion piece for NPR’s Marketplace Radio claiming that “The Great Recession has changed the way many conservatives talk about economic policy.” I don’t see the kind of change Frum and others claim has taken place.

Frum says that in the past “Liberals favored active government measures: government spending to fight recessions, tax increases to curtail inflation. Conservatives by contrast preferred monetary instruments: raise interest rates to stop inflation, loosen money during recessions.” And because many conservatives are now against the monetary activism of the Fed, they have “changed their minds,” says Frum.

But nowhere in his piece does Frum refer to the major distinction between liberals and conservatives in economic policy: liberals prefer active interventionist policy and conservatives prefer predictable rule-like policy. At least since the macroeconomic debates began in Washington in the 1960s, this has been the major difference. Consider two of the most influential policy documents published in the 1960s: The 1962 Economic Report of the President, largely authored by James Tobin, who was recruited by Paul Samuelson to go to Washington, and Capitalism and Freedom authored by Milton Friedman and published that same year. The Report made the case for macroeconomic activism—both monetary and fiscal. Capitalism and Freedom made the case for rules and less discretion—both monetary and fiscal, and argued strongly for less interventionist policies. Earlier Friedrich Hayek was making the same conservative arguments against Keynesian activism when Keynes himself was on the other side.

And this is exactly what conservative are saying now. Stop all the interventions—the short-term discretionary fiscal stimulus packages and the massive quantitative easings and the operation twists of monetary policy. The unpredictability caused by these policies is causing uncertainty and holding the recovery back. Instead put in place more permanent reforms which will create economic recovery and return the economy to the kind of performance we saw in the 1980s and 1990s.

So conservatives have not changed their minds, at least not in the way Frum claims. He may believe, as he says in his piece, that “conservatives have little useful to say.” But when rules-based, less intervnetionist policies were followed we saw good economic preformance as in the 1980s and 1990s.

Tuesday, October 4, 2011

Good Economics Is Good Politics

My oped today with John Cogan in the Wall Street Journal shows that temporary fiscal stimulus packages are not good politics.  Historical evidence reveals that politicians who enact them tend not to get re-elected.  Our previous Wall Street Journal articles here and here showed that these packages are not good economics either. 

The lesson for students of economics is that, more often than not, good economics is good politics.   

Monday, October 3, 2011

In Praise of an Extraordinary Teacher of Economics

Those of us who teach economics stand on the shoulders of those who taught us economics.

I just heard the sad news that one of my truly extraordinary economics teachers, E. Philip Howrey, recently died in a biking accident. When I was an undergraduate, Phil taught me an approach to macroeconomics—very new at the time—which has served me well throughout my career, and for which I will forever be grateful. Several years ago Robert Leeson asked me “Who influenced you most when you were an undergraduate at Princeton? What sparked your interest in policy rules?” I talked mostly about Phil in my answer.

Looking back I would say that Phil Howrey had the most influence on me, at least in areas that turned out to be closely related to my career as an economist. Phil had a great deal of interest in time series analysis as it applied to macroeconomics. For example, he had written an important paper on the "Long Swing" hypothesis with Michio Hatanaka. Hatanaka had published a book in 1964 with Clive Granger on Spectral Analysis of Time Series. Granger visited Princeton at the invitation of Oscar Morgenstern who had an interest in applying frequency domain techniques to economic data. While I met Morgenstern then, I did not meet Granger until many years later.

I think my initial interest in policy rules goes back to a course I took from Howrey. Except for Economics 101, it was probably my first introduction to macroeconomics. But we didn't study ISLM or the other textbook models of the time; instead we studied dynamic models of the economy, with equations that included lags and shocks defining the stochastic processes. In retrospect it was quite unusual that I had the opportunity to learn about these methods as an undergraduate, but at the time I had no idea that it was unusual. The methods forced me to think of the economy as a moving dynamic structure. So the only way one could think about policy was with some kind of policy rule. You couldn't say let's shift the LM curve by increasing the money supply by one unit or do whatever people would be doing at the time. Instead you had to have some kind of policy rule. So to me it was natural. I couldn't think of how else you would do it in those models.

When it came time to choose a topic for a senior thesis, I approached Phil Howrey saying that I was interested in macroeconomic policy issues and wanted to work with the types of models we studied in his course. He suggested that I look into stabilization policy in a model that combined economic growth and the cycle, which we called "endogenous cyclical growth" at the time; he said that no one had done this before, and so it sounded like a great topic and that is what I did. In the preface to my senior thesis I thanked Phil "for suggesting the topic and indicating how I might proceed." In the end the thesis was about simulating different types of monetary policy rules.