Monetarists should be thinking about fiscal policy

"Market monetarists" like Scott Sumner and David Beckworth frequently make the case that countercyclical fiscal policy is unimportant - that we shouldn't be thinking about optimal fiscal policy. They make (at least) two basic arguments:

Argument 1: Fiscal policy doesn't matter for aggregate demand because the Fed will just cancel it out.

Argument 2: The Fed is much more technocratic than Congress, and also quicker to act, so stabilization policy is best left to the Fed.

I've addressed Argument 1 before, so now I want to focus on Argument 2. This is not a new argument, but Scott Sumner states it pretty concisely in this reaction to the new DeLong/Summers fiscal policy paper:

The optimal regime relies on monetary policy to steer the nominal economy, and fiscal policy to fix other problems.  So we are going to defend the model how?  A blueprint for failed states?  For banana republics?  Fair enough, but ask yourself the following question:  In a failed state, which is more incompetent branch of government; the central bank or the legislature? 

Yes, the Fed is bad.  But Congress is downright ugly.  Deep down most economists are technocrats.  They see the central bank as being the best and the brightest, the guys who are above politics, who will “do the right thing.”  And how do economists view our Congress?  The terms ’stupid’ and ‘incompetent’ don’t even come close to describing the disdain.  So are we supposed to change our textbooks in such a way that the fiscal multiplier is no longer zero under an inflation targeting regime (as the new Keynesians had taught us for several decades?)  And on what basis?  Because the Fed might be so incompetent that we need Congress to rescue the economy?  In what world does that policy regime actually work?  If you have a culture that has its act together, such as Sweden or Australia, the central bank will do the right thing.  If not, then all hope is lost.

Now, let's think about this for a second. As Scott Sumner says, in an optimal world the Fed is willing and able to costlessly stabilize aggregate demand. We probably do not live in that optimal world. Let's think about the kind of world in which we actually find ourselves. In the real world, there may be the following limits to Fed stabilization of aggregate demand:

Limit 1: Monetary policy may itself be of limited effectiveness (for example, because of model uncertainty and variable lags that mean that the Fed never really knows exactly what it's doing).

Limit 2: There may be political constraints on Fed policy. See Simon Johnson for a brief discussion of some of these.

Limit 3: There may be unavoidable costs to countercyclical monetary policy. The bigger the AD shock that must be canceled out, the larger the costs may be. Robert Lucas, who asserted that costless disinflations can't exist, certainly believed this.

First, let's ignore the first two problems, and just focus on the third. Suppose that whatever the Fed has to do to stabilize aggregate demand - print money and buy stuff, for example, or convince people that it is willing to do so - has some costs. In that case, the less the Fed has to do, the better for everyone. Now suppose that Congress has a procyclical fiscal policy - in booms Congress cuts taxes (as Reagan and Bush did), and in recessions Congress cuts spending ("austerity"). This will tend to amplify whatever AD shocks the world throws our way. It will raise the costs of Fed stabilization policy. In this case, Market Monetarists would naturally want to think about saying to economists like John Taylor, who in practice support this procyclical fiscal policy:

WOULD YOU PLEASE CUT THAT OUT, PLEASE??

So that gets Market Monetarists halfway to the Brad DeLong position. "Austerity" is bad, and boom-time tax cuts are bad, even if the Fed is the only one doing the stabilizing.

What about proactive fiscal stabilization policy? Here, we have to bring in Limits 1 and 2 from above. If there are technological or political constraints on Fed effectiveness, then it becomes an open question whether or not our best bet is to still stick with "Fed only," or whether to employ a mix of Fed and Congress. It is not immediately obvious that the answer is "Fed and Congress," since it depends on the way in which they interact. For example, if Fed and Congress act in sync, and are simply limited in the size of the actions they can take, then it's probably a good idea to have them complement each other by enacting fiscal and monetary stimulus at the same time. We probably tried to do something like this in 2009, when the ARRA and QE1 happened at roughly the same time. And this seems to be what DeLong and Summers would like. But if Congress is so slow that its actions are just as likely to cancel out the Fed as to help, then we had better stick with only the Fed, despite its limitations.

For a better and more technical discussion of some of these issues, and for a more technical argument against fiscal policy (by Mankiw & Weinzerl), see this post by Brad DeLong.

Anyway, my point is that it doesn't seem very fruitful for Market Monetarists to ignore fiscal policy issues and simply keep repeating "We should leave it all to the Fed." Fiscal policy is important even if you believe the Fed is best. Market Monetarists should be speaking out against "austerity" and boom-time tax cuts. And the argument that "Fed only" is the optimal stabilization policy is itself highly non-obvious and needs more empirical support, not just intuition or theoretical postulation.

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Thursday Roundup (3/29/2012)

OK, here's y'all's links! This week, Brad DeLong and Larry Summers release a paper about how people shouldn't be left without jobs for long, Paul Ryan re-enters the national discourse, Steve Williamson's blog explodes in an all-out comment war, and a couple of obscure bloggers write some absolutely magisterial stuff:


1. Mark Thoma and Steve Williamson make up and have a beer! Yay. All is at peace in the blogosphere. Now I want a beer.

2. However, the peace is short-lived! Steve Williamson attacks the notion that "Lucasian macro" is losing support among the younger generation of economists (warning: post is heavy on pointless Krugman-bashing, DeLong-bashing, and Summers-bashing), and an ABSOLUTELY EPIC comment thread ensues, of the kind that my humble little blog can only dream of. People gettin' gunned down in the streets by the Macro Wars!

3. Brad DeLong draws some pictures to explain some of the thinking in his new magnum opus on fiscal policy. Go, read, now, go!

4. Simon Johnson eviscerates the Paul Ryan plan. The Paul Ryan plan's entrails are now leaking out onto the floor, and Simon Johnson is wiping his katana with his eyes closed in peaceful contemplation.

5. Stock & Watson think that the economy will never return to its previous trend line. If it was HOLMES and Watson, I might be more inclined to believe them.

6. Tim Harford on forensic finance. Very cool stuff. An example of economics actually making real predictions and being applied usefully to the real world!

7. Simon Wren-Lewis explains the limitations of microfounded models for setting central bank policy. Central bankers, of course, realize this, and keep DSGE models around merely as a check on their other models and forecasts. Along with Paul the Zombie Octopus.

8.  Steve Randy Waldman has an absolutely magisterial discourse on zoning, property rights, and Matt Yglesias' new book. ABSOLUTELY MAGISTERIAL. I hereby change Steve's name to Steve Magisterialrandy Waldman.

9. Tyler Cowen has a roundup of links to research on labor hysteresis, a phenomenon which features prominently in the new DeLong/Summers fiscal policy opus. I can't think of any comment about this, so here is a picture of a butter sculpture of Darth Vader.

10. Asians are the fastest-growing immigrant group in the U.S.! Let's keep Asian immigration going strong! I continue to firmly believe that the United States' geopolitical future is to be the Alternative Asia, the way we were the Alternative Europe up through 1945.

11. Old news, but can't be repeated enough: Active investing is a loser's game! Remember, friends don't let friends day-trade.

12. Tyler Cowen asks: If stimulus and quantitative easing are politically unpopular, how about we combat labor hysteresis by forcing people to take low-paying jobs, by cutting unemployment benefits? I'm just going to let that question answer itself...

13. Mark Thoma links to Evan Koenig on NGDP targeting vs. Taylor rules. Basic argument: NGDP targeting is harder to commit to. Cue 13,403 posts from Scott Sumner and one comment from David Beckworth...

14. Read all about EMMY NOETHER, one of my favorite mathematicians ever. Hint: Go learn Noether's Theorem. It's awesome.

15. A very useful guide for prospective econ PhD students. Via my grandadvisor Greg Mankiw.

16. Already flagged by Mark Thoma, an ABSOLUTELY MAGISTERIAL post on top marginal tax rates, by David Glasner. It rivals Steve Randy Waldman's zoning post in its absolute magisterial-ness. "Magisterial" is the Word of the Week, in case you hadn't already figured that out.

17. Blogger "M.S." (I always forget his name, but whose fault is that) has a great post about how the Ryan plan is emblematic of America's incipient state failure. He fails to mention, however, the hypothesis that the old Confederacy lives on as a cancerous tumor within our body politic that has metastasized during a moment when America's immune system was weak, and that this is what is strangling our institutions...

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Scientific failures: particle physics vs. macroeconomics

In a comment thread over at Steve Williamson's blog (yes, I am avoiding work, why do you ask?), I wrote:

As for the reason for my pessimism, well, yes, [macroeconomists] can make tons and tons of models, but how do we choose between those models? We seem to have done a generally crappy job of that. It seems to me that if macro theory is not disciplined by empirical verification of the microfoundations, then theorists can just make a universe of theories to describe anything and everything, and the theories that get accepted will simply be picked by consensus, "common sense" intuition, and sometimes even politics. So I decided to focus on understanding how financial markets work, in the hope that that will help discipline macro models. 

Or, put in the pugilistic tone of the blogosphere: If I wanted to spend my life doing clunky math to describe worlds that don't exist, I would have stayed in physics and been a string theorist. ;)

(Of course, this is a bit tongue-in-cheek. I do intend to do some macro modeling at some point. And it's doubtful I would have been able to become a string theorist even if I'd wanted to, because almost zero people get jobs in string theory anymore, and I was good at physics but maybe not that good.)

But it's hard to ignore the parallels between what's been happening in particle physics and what's been happening in macroeconomics. In both fields, almost everybody reached a consensus on an approach to use (string theory in physics, DSGE in macro). In both fields, theory diverged from empirical verification and took on a life of its own. And in both fields, a small group of dissenters decided to take their grievances to the public, resulting in a lot of negative attention and outside pressure.

In physics, those dissenters were Lee Smolin, a theoretical physicist at the Perimeter Institute, and Peter Woit, a math lecturer at Columbia. In 2006, Smolin published The Trouble With Physics and Woit published Not Even Wrong. Both are critiques of string theory - both the theory itself and the academic culture that has grown up around it. If you are interested in this sort of academic dispute, or in philosophy-of-science in general, I'd recommend both books (if you already know some physics, start with Woit's; otherwise, start with Smolin's). Woit also writes a blog on the subject. (Update: Lawrence Krauss, a theoretical physicist at Arizona State, is also a public critic of string theory; his book, which I have not read, is called Hiding in the Mirror. A number of famous physicists have been publicly critical of string theory, including Richard Feynman, Sheldon Glashow, and Robert Laughlin.)

Long story short: The problem with string theory was really a problem with particle physics. Our existing theories work too well. Every single thing that's come out of particle experiments in the past 40 years has agreed with the Standard Model to the nth decimal place. Of course, the Standard Model is pretty ugly, so people have been working on ways to make it more mathematically and conceptually simple (i.e. "beautiful"). Problem is, without new unexplained experimental observations to guide us along, that's an insanely hard task. Physicists have tried one beautiful theory after another for 40 years, nothing worked, and string theory just happened to be the one that most theorists converged on and decided was the best bet.

Unfortunately, string theory hasn't worked out either. Maybe there will be a breakthrough, but right now the situation doesn't seem to be looking so good. For one thing, much of the math that has come out of string theory has been pretty ugly itself. (Update: Actually, plenty of beautiful pure math has come out of the search for string theory, leading to two Fields Medals that I know of. The "ugly" part is that string theory so far doesn't have simple, beautiful equations like successful theories in the past.)

More importantly, though, string theorists haven't been able to get their theory to make any testable predictions. Usually this kills a theory, but physicists have stuck with string theory for quite a while now. Why? Smolin and Woit attribute it to the culture of the profession. I have a more prosaic hypothesis, which is that theoretical physicists basically have nothing to do, and are using string theory to keep their skills sharp until the day when the world needs them again...

In any case, whether or not because of the public shaming by Smolin and Woit, string theory's star has dimmed quite a bit. The media has stopped hyping the theory so much. And there is a sense that confidence in the theory has also fallen within the profession itself - not because of the rebel authors, just because of the general going-nowhere-ness of the theory. Universities have basically stopped hiring string theorists. 

In macroeconomics, the public insurgency has been led by Krugman, DeLong, Quiggin, and a few others. The complaint against DSGE (or "Lucasian macro," as Krugman labels it) has been similar to that against string theory: Lucasian models, say the insurgents, failed to predict the crisis, and failed to predict which policies would be the most effective in combating the recession that followed. If theories can't predict things, say the rebels in both fields, they should be junked. In macroeconomics, like in particle physics, the rebels claimed that a stifling culture of intellectual conformity is inhibiting the search for new approaches.

Now here's another striking parallel. In both controversies, a handful of defenders of the existing paradigm have resorted to arguing that theories shouldn't need to make predictions. 

In physics, Lenny Susskind, one of the inventors of string theory, has invoked the "anthropic principle" to defend non-predictive theory. Remember back in elementary school, when you'd ask some kid some question - "Why did class get out early today?" - and he'd say "So you would ask! Hurr hurr hurr!" That's the anthropic principle. It says that the laws of physics are the way they are because if they were any different, you wouldn't be here to study them. Susskind has argued that string theory's failure to make definite predictions is OK, because the anthropic principle fills in the gaps. Even though string theory allows certain laws of the Universe to be dang near anything at all, those laws are the way they are just because they had to be that way for you to ask why! Most string theorists, I should mention, are not on board with this idea. The empirical culture of physics is very strong and very old. Nevertheless, the anthropic argument has won string theory some bad press among the wider populace, since if it's true (and hey, it might be true!), it basically means that all the high energy particle theorists are no longer needed and can just go home.

In macro, no one invokes the anthropic principle, but there have been several reasons given why DSGE models - or the DSGE paradigm - should not lead to definite predictions. The first big argument is that economic models should not have to be validated by empirical data. Models' purpose, some economists say, is not to explain observed phenomena, but to "clarify our thinking" - in other words, to work out the logical implications of assumptions that we choose a priori to accept as true, based on our common sense or whatever. The second defense is that since macroeconomists have created a huge number of models that describe a huge number of different possible ways that the economy could work, any outcome that happens was successfully predicted by macro theory. Obviously, neither of these arguments is very scientific! Other "supporting" arguments include A) the (logically false) notion that financial market efficiency makes economic predictions impossible and B) the gross misuse of George Box's quote that "all models are wrong."

As in the case of anthropic string theory, these protestations fail to hold much water with the public, which naturally asks "Then what are we paying you guys for?", while also pissing off any economist who believes in the Francis Bacon notion of science.

This cycle of theoretical stagnation --> comfortable professional consensus --> internal revolt --> outside pressure seems to be common to a lot of scientific disciplines. However, there are a few big differences between the two insurgencies I've described, all of which suggest that Lucasian macro will be around long, long after string theory has disappeared behind the event horizon of history.

For one thing, physics is suffering from being too good. Our existing theories may be ugly, but they work devilishly well. This means that if physicists decide to abandon string theory, they will just dream up something else, possibly using many of the very mathematical insights that they gained from working on string theory! In macro, on the other hand, we basically have no theories that work well (or if we do, we don't know which ones they are!), so if we give up on DSGE, we're stumped...and people don't like to be stumped. Second, while demand for high energy particle theorists appears to have collapsed, demand for macroeconomists continues to be incredibly strong. Finally, economics as a profession does not have the experimental tradition that physics has, which means that not making predictions is a much less severe public relations blow to a physics theory than to an econ one.

So Lucasian macro will survive even as string theory evaporates. Yet with millions unemployed, it seems a lot worse to be ignorant about the economy than to be ignorant about black holes and the birth of the Universe. The Macro Wars have higher stakes than the String Theory Wars, at least in principle.

OK, back to work. Posting will be pretty sparse for the next month, while I finish up my dissertation.

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Behavioral finance people are doing experiments!

Experimental finance, like all experimental studies of complex systems, suffers from a problem of "external validity" - it is not clear that a few inexperienced undergrads trading $20 worth of made-up assets in a lab is anything like a real-world market with thousands of supercomputer-armed professionals trading trillions of actual assets over the course of years. This doesn't mean that finance experiments are useless for studying market outcomes, but it does put a limit on their use.

This problem, however, is much less severe if what you are studying is not market outcomes, but individual behavior. An individual is easy to stick in a lab. The person sitting in the lab is probably pretty similar to the person sitting in front of eTrade buying stocks at home. This weakens the "external validity" critique; it's a lot easier to claim that individual trader behavior in a lab is similar to individual trader behavior in the real world.

There has long been a strain of behavioral finance that studies the mistakes that individual investors make. The most famous example is the work of Terrance Odean, who has shown in a number of empirical studies that small investors (a.k.a. you and I) trade too much, make dumb choices, and eventually lose money. This may or may not result in the overall market being efficient (so keep your pants on, EMHers!), but it is certainly bad for the average American household, which often ends up throwing its money in a toilet. Figuring out exactly why people are throwing their money in a toilet is a major goal of finance research. There are a number of hypotheses - Odean has suggested overconfidence and the disposition effect. One idea in my job market paper was that people over-rely on prices as signals of fundamental value.

But anyway, these aren't just theoretical questions that people can bandy about for fun. We can actually stick people in a lab and find out! Thus, it made me quite happy last Friday when I got to see Terry Odean present a paper in which he does exactly that. In "Bubbling with Excitement: An Experiment" (Lin, Odean, and Andrade 2012), the authors show their lab subjects videos designed to evoke various emotions - excitement, fear, boredom. The subjects then trade in small groups, in the classic market setup of Vernon Smith. They found that excited groups of traders give rise to bigger bubbles and longer-lasting bubbles. Unlike most papers in this literature, Odean makes sure to use a large number of trading groups (48, compared to the typical 5-20), allowing him to statistically test his hypothesis (naturally, this was more expensive than the typical experiment).

This is an important result, because it opens up avenues for more research. We need to find out why excitement makes people overpay for assets! This means more experiments, of course, but that's how science progresses. Compared to particle physics, experimental finance is incredibly cheap, and has potentially enormous consequences for human welfare (and for your pocketbook).

Of course, even though the "external validity" problem is reduced when asking about individual behavior, it is not eliminated. Real-world traders, even if they lack experience and sophisticated tools, often have huge amounts of time at their disposal and are playing for big stakes. These are critiques that future experiments will partially address, and eventually the results of experiments will have to make testable predictions about large empirical datasets. But the future for this sort of work looks bright. I think that one thing we need to do is to move beyond the simple setup pioneered by Vernon Smith, and create laboratory markets that can capture a wider array of phenomena (a view shared by Jorg Oechssler of the University of Heidelberg). This is one thing that I plan to work on while at Stony Brook next year.

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Cochrane blasts austerity AND stimulus...???

Another salvo in the Macro Wars. In a newish blog post, John Cochrane declares that austerity is hurting Europe:

Austerity isn't working in Europe...In addition to its direct economic costs, these “austerity” programs aren't even swiftly closing budget gaps. As incomes decline, tax revenue drops, and it is harder to cut spending. A downward spiral looms... 

Europe's experience is a warning that austerity -- a program of sharp budget cuts and (even) higher tax rates, but largely putting off “structural reforms” for a sunnier day -- is a dangerous path. 

Why is austerity causing such economic difficulty? What else should we do?

He then declares, in keeping with much of his past writing, that stimulus would also be a bad idea:

Lack of “stimulus” is the problem, say the Keynesians...They claim that falling output in Europe is a direct consequence of declining government spending...They -- and we -- just need to spend more. A lot more. 

Where will the money come from?...The U.S. can still borrow at remarkably low rates...But remember that Greece was able to borrow at low rates right up to the moment that it couldn’t borrow at all. There is nobody to bail out the U.S. when our time comes... 

Lately, Keynesians have been pushing an even more audacious idea: deficits pay for themselves... 

For deficit spending to pay for itself, then, $1 of spending must create more than $5 of output...[But] Keynesians made fun of “supply siders” in the 1980s, who made similar claims for tax cuts.

These two points of view just don't seem consistent to me. Here's a few reasons why:

1. How can austerity and stimulus both be harmful for the economy? Cochrane clearly states that austerity is not just ineffectual, but is actively harming Europe. This is important. Because he then claims that increasing government spending (stimulus) would actively harm rich economies (by raising default risk, causing rising interest rates and crowding out). He could have argued that the level of government spending simply doesn't affect growth one way or another. But he didn't. He claimed that either slashing or boosting government spending would cause a significant deterioration from where we are right now. It doesn't take a genius to see the logical implication of this position: Cochrane must believe that the level of government spending is exactly optimal right now.

So policymakers in every rich country (including Barack Obama) have gotten the level of government spending exactly right! That's nothing short of amazing. Who says government is inefficient? ;-)

2. If austerity increases deficits, why wouldn't stimulus reduce deficits? Cochrane laughs at the notion, currently being advanced by Brad DeLong and Larry Summers, that increased government spending could pay for itself. But just a few sentences earlier, he claims that austerity is failing to close budget gaps! Again, let's apply simple logic. Draw a graph with spending on the x-axis and deficits on the y-axis - basically, a Laffer Curve for spending. If austerity and stimulus would both increase deficits, we must be at a local minimum on that graph - in other words, our current level of spending must be exactly the level that minimizes fiscal deficits. Again, a huge win for government policy!

(Now, note that Cochrane has left himself a bit of wiggle room. Instead of saying austerity is increasing deficits, he says it simply isn't "swiftly closing budget gaps." But his talk of a "downward spiral" clearly invokes the notion that a substantial amount of austerity would have the opposite of the intended effect on the fiscal balance.)

3. How does the "downward spiral" work? This isn't related to the previous two points, but I just wanted to throw it in because it annoyed me. Cochrane writes: "As incomes decline [under austerity], tax revenue drops, and it is harder to cut spending. A downward spiral looms." Wait a second. This doesn't seem like a spiral. If austerity reduces incomes, which reduces tax revenues, which prompts policymakers to enact more austerity, then that could clearly cause a downward spiral. But if falling incomes make it "harder to cut spending" - i.e., harder to enact further austerity - then the spiral should arrest itself. Right? I just don't understand how Cochrane thinks this is supposed to work.

But anyway...

Over the past couple of years, stimulus opponents have been relentlessly pounded by the evidence. Countries that have cut spending have performed worse. This makes it hard to argue that government spending does not affect GDP during a recession. And it makes it very, VERY hard to argue that austerity works. Basically, if you are still saying that cutting spending would boost GDP in the current recession, most observers think you are disconnected from reality.

So how do the opponents of fiscal stimulus respond? All through the recession, they've been saying that boosting spending doesn't boost GDP. But if cutting spending hurts GDP, how is the anti-stimulus position tenable? Well, stimulus opponents could argue that government spending is simply irrelevant - that the correlation on the spending/GDP graph does not equal causation, and that the countries who enacted more austerity simply happened to be the ones that were hit by worse shocks to begin with. But like I said, that's proving a difficult case to make.

The only other out for stimulus opponents is to claim that we are at the perfect level of government spending right now - the level that maximizes GDP and minimizes deficits at the same time. If this is true, then austerity and stimulus would both be bad. But I have to say, this case doesn't seem credible either. How is it that every rich country just happens to be at exactly the right level of spending?

Cochrane's post goes on to extol the virtues of long-term structural reforms. I have no problem with that (though the reforms I'd suggest might be very different from his). But isn't it a bit beside the point? You can't have your anti-stimulus cake and eat it too! Opponents of government spending have been forced to bow before the overwhelming weight of evidence that cutting spending has been bad for GDP. But they still refuse to accept the logical implication of that evidence, that boosting spending would have boosted GDP. I just don't get it.

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Thursday Roundup on Friday (3/21/2012)

Whoops! Forgot to post the weekly roundup yesterday. Here y'all go!

1. Paul Krugman notes that the stock market has been doing great under Obama, a fact that has (of course) been lost on Republican hackonomists like Larry Kudlow who tend to blame liberal politicians for every dip in stock prices.

2. Robin Hanson reports on an experiment that shows that people do not learn optimally. Learning is one of those areas where I feel that experimental economics may have a huge and game-changing impact (if people pay attention to the data).

3. Matt Yglesias really lets Ben Bernanke have it. I don't agree with this criticism, though, since I believe that the Fed chairman is not a dictator and must at least partially bow to the wishes of the board of governors (which includes Plosser, Lacker, Kocherlakota, etc.).

4. Simon Johnson is of the opinion that although "populism" is often a dirty word, American populism has often proven beneficial for the country's institutions...

5. Robert Waldmann makes an analogy between microfoundations and the spurious theories that used to be known as "organic chemistry." I disagree, as I've said, but I always love Waldmann's histories-of-bad-science.

6. Tyler Cowen utters the phrase "That is from Scott Sumner, Q.E.D.", thus egregiously violating my First Principle For Arguing With Economists. Bad Tyler! Bad! (smacks wrist)

7. Nick Rowe asks: What on Earth are SRAS shocks? I also have always had trouble explaining these in class. Greg Mankiw has one answer.

8. Mark Thoma has an excellent conjecture about why prices aren't moving as much as output gaps say they should be. Go read it. Incidentally, Thoma is not too worried about labor hysteresis. Greg Ip, however, is.

9. A homeless girl turns out to be a science genius. I see stuff like this all the time. My brother-in-law grew up in a trailer with a teenage single mom, and he's now completing his PhD. My friend grew up poor in rural Northern California with a drug-abusing single mom, and now she's a neurosurgeon. There is so much human capital hidden in the poverty-stricken backwaters of America, it's absurd. And yet I still read pronouncement after smug pronouncement from guys like Bryan Caplan, declaring that success is all about I.Q., and that it's no use trying to increase economic opportunity because everyone is already just where their I.Q. dictates they should be. What a load of poppcock, rubbish, stuff & nonsense. Okay, /rant.

10. Martin Wolf with a masterly article on interest rates and global capital flows. I love Martin Wolf. I also love the word "masterly." Luckily, the two often go together.

11. Bill McBride shows that stocks have been flat since 1999. However, I would like to point out that stocks did considerably better in 1982-2012 than in 1952-2012 (go check this yourself, I'm too lazy to make a graph).

12. Matt Yglesias is in his element when talking about land use.

13. Tyler Cowen links to a Bob Hall paper that shows that DSGE is not the only way to go when making microfounded models. Very important!

14. Cowen also links to some Mike Mandel research showing that much of the "productivity gains" in U.S. manufacturing over recent decades haven't been the type of gains we'd most like to see.

15. Cowen is on a roll, linking to a paper that shows that government transfers never seem to go down, meaning that government purchases (i.e. the actually useful stuff) have to fall more and more in order to balance the budget after each cyclical downturn. Conservatives to the rescue? Only if they can embrace Peter Thiel Conservatism, and make a mental distinction between govt. purchases and transfers!!

16. JW Mason has a great explanation of how trade balances adjust (or don't adjust). Basically, the nominal exchange rate can change, the real exchange rate can change, and/or the price level can change. And these have very different consequences. I think I would have liked to have been Mason's TA for intro macro...

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Did the Krugman insurgency fail?

Is New Old Keynesianism dead? I encourage everyone to read Henry Farrell and John Quiggin's new article, "Consensus, Dissensus and Economic Ideas: The Rise and Fall of Keynesianism During the Economic Crisis." Basically, Keynesian policy briefly regained its old throne when everyone was panicking in 2009 - everyone became a Keynesian in a foxhole, as Bob Lucas would say - but this brief consensus fell apart under an assault from austerity-minded European central bank economists in 2010-11.

This makes me step back and think about the whole econ blogosphere over the past several years. The thing that inspired me to start blogging was the famous Paul Krugman article, "How Did Economists Get It So Wrong", published in September 2009 (that, and John Cochrane's dismissive response). Before that article, I had seen the econ blogosphere as mostly about micro, and mostly about "everyday economics" - pointing out cute little observations about how daily life reflects economic behavior and incentives. It was kind of interesting, but not really. Then, suddenly, it became something very different. A war was on. The blogosphere was Ground Zero for a very deep and fundamental argument about the purpose and practice of macroeconomics. And suddenly, the policy consequences couldn't be more important. After spending a year sitting on the sidelines of that argument, I decided to turn Noahpinion - which had just been a personal bullshit diary - into an economics blog.

Now it seems that the war is winding down. Arguments still flare up over the proper use of microfoundations, or over monetary policy. But - and this is just a feeling I get - the frequency of titanic clashes seems to have peaked.

Undoubtedly, this is just because of the economic situation. We're not in a boom by any means, but we're no longer in a crisis, or even obviously stagnating. Policymakers have emerged from their foxholes; they no longer feel a need to deviate from the comfortable pre-2008 consensus that monetary policy is the only necessary tool of demand management. I believe that this is the reason for the "fall of Keynesianism" described by Farrell and Quiggin.

So does that mean Krugman's insurgency failed? Seen narrowly as a push for countercyclical fiscal policy, I'd have to conclude "yes." Even Obama's "stimulus" bill was mostly just temporary tax breaks, not spending increases as Keynesian theory would recommend. All around the developed world, instinctive fear of debt made the policy recommendations of Krugman and other Old Keynesians a political non-starter regardless of their theoretical justification.

What about in academia? The crisis provoked a mini-boom in macro papers focusing either on Keynesian theory (e.g. Eggertsson & Krugman 2010) or empirics (e.g. Nakamura & Steinsson 2011). But I don't see this as a big deal. The theorizing is just DSGE with a couple frictions; the profession has not yet felt a collective need to overturn the basic methods and philosophy of macroeconomics, as Robert Lucas and others did in the 1970s. The analytical framework that emerged from that 1970s revolution, which remains absolutely dominant in macro to this day, has again and again proven itself flexible enough to build models to suit any passing fad or consensus opinion. This is not to say that DSGE can accurately describe any phenomenon - merely that it is capable of telling a mathematical story that delivers basically any desired policy conclusion. So after fiscal policy goes out of vogue, Old Keynesian models may go back to near where they were pre-crisis - subjects of study for smart people, but not accepted by the main body of the profession. The consensus may shuffle toward the ideas of Hall and Eggertsson and Krugman, but the change will be marginal.

Like the wars of Louis XIV, the push for a rehabilitation of Old Keynesianism has resulted in a lot of sound and fury, but only modest territorial gains.

Nor do I think Krugman's push against microfoundations will provoke a return to aggregate-only models. First of all, that assault was always a bit half-hearted - in principle, microfoundations are highly desirable for any macro model. The problem is more with the poor (but convenient) choice of microfoundations that macroeconomists have been willing to accept since DSGE came into vogue.

So a layperson might conclude that the insurgency that Krugman launched in September 2009 - and which has consumed and defined the econ blogosphere since then - was ultimately defeated. But I do not believe that this is the case. Although the battle for New Old Keynesianism is mostly over, the Krugman insurgency launched a much deeper, more profound, and more long-lasting war. It shook the philosophical foundation of macroeconomics, and that foundation is still shaking.

Since 2008, everyone had been asking: "Why did macroeconomists miss the crisis?" Even the Queen of England asked it! Shouldn't we expect macro theory to help us avoid macroeconomic disasters? Of course, the profession at first closed ranks against the criticism. Economists protested that Rational Expectations or the Efficient Markets Hypothesis made it impossible to predict a crisis. These protests mostly fell on deaf ears (and rightly so, because they are logically fallacious). Still, the reflexive wagon-circling made it hard to pin down exactly where economists had gone wrong - after all, if all the experts insist that experts have value, who are non-experts to disagree?

But when Krugman, a Nobel Prize winner, came out and said publicly that the macro profession had allowed itself to be satisfied with uselessness and irrelevance, it broke the facade of unity. Like Greg Smith departing Goldman Sachs, here was an insider who was willing to stand up and say that the whole system was rotten. And then Krugman went further. After revealing that top economists were dissatisfied with macro's ability to predict crises, Krugman revealed that they also couldn't agree on how to deal with crises. That's where the push for Old Keynesianism came in. It may not have resulted in a permanent sea change in macroeconomists' modeling consensus, but it told the public that there were deep divisions within the profession on the question of how to fight recessions.

And that, really, was all the public needed to know. If macroeconomists hadn't conclusively discovered how to avert crises and also hadn't conclusively discovered how to recover from crises, what good had they done for society? Why were we paying professors hundreds of thousands of dollars to study this subject if nothing usable had emerged?

Of course, it would be wrong to paint the challenge to macro as a one-man Krugman Show. It isn't. Even the stalwarts of the profession have been questioning how much macroeconomists really understand - see John Cochrane and Greg Mankiw, for a couple of examples. But it was Krugman who took this argument public, who took the case to the wider educated lay populace, and aired macro's dirty laundry to millions of engineers, scientists, financiers, businesspeople, politicians, lawyers, and journalists. What Krugman (and Brad DeLong) did to macro was similar, in some ways, to what Lee Smolin and Peter Woit did to string theory - except on a much bigger stage, since Krugman is such a huge name in his field, and macroeconomics has a lot more important policy ramifications than the theory of black holes.

So the battle over Keynesianism may be over, with the New Old Keynesians fought to a bloody standstill, but the wider Macro Wars have only begun. As for how this affects the blogosphere and the rest of econ's public face, one thing is for sure - we're not going back to talking about how abortion affects crime rates.

(Side note: Since my PhD will be done soon, I think I may turn this post into a book this summer, if I have the time...)


Update: Krugman comments, and notes that A) were it not for the New Old Keynesians, damaging austerity might have been implemented to a greater degree, further harming the world economy. That's a good point; policy is all about the balance of forces. Krugman also says - and I absolutely agree with this - that tere is a deep rumbling of dissatisfaction and disillusionment with the current paradigm among grad students and assistant profs, which will eventually build into a large wave of change. The Krugman insurgency was the beginning of the new Macro Wars, not the end.

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Sizing up Adobe

Adobe's Touch Apps, running on the iPad, will open new markets.

Adobe's latest quarterly numbers are out, and while the market reaction has been distinctly negative (the stock plunged 4% mere minutes after numbers were released), I think it's possible the market has missed the bigger picture.

The company's total revenue for the quarter ending March 2, 2012 was $1.045 billion, up from $1.027 billion for the same quarter last year. Operating income was $288.9 million versus $302.3 million for the same period a year ago, with the drop coming because of higher operating expenses (mostly relating to sales and marketing) in Q1 of FY2012.

Net income saw an unpleasant 21% YOY drop, to $185.2 million for Q1 of 2012 compared to $234.6 million for Q1 of last year. Diluted net income per share came in at $0.37 for the quarter (versus $0.46 for Q1 of 2011).

Analysts and pundits seized on the net-income drop as evidence of a slowdown in Creative Suite sales ahead of the much-anticipated release of CS6 later this quarter. Some also tried to read into this a decline in Document Services business and/or deceleration in LiveCycle business. (In truth, Doc Services is flat but not down.)

Where things get tricky, of course, is in trying to extrapolate from the current state of Adobe's business to the state of the business, say, six months from now.

Let's just go ahead and run through the bear case first, then follow up with the bull case, and finally, my own take.


The Bear Case

Bears like to point to the following factors:

1. LiveCycle business is decreasing. The company has, in fact, expressed downward guidance on LiveCycle, to the tune of possibly as much as $150 million in FY2012 (although in the conference call, it was noted that LiveCycle business is actually doing better than expected and will most likely not be down a full $150 million on the year).
2. CS6 could be late, and meanwhile customers have put purchases on hold pending the release of CS6 (5.5 is already seen as "last year's version").
3. Even if CS6 is not late, Adobe is trying to transition customers from a perpetual-license model to a recurring-charge (subscription-based) model, and this could represent a difficult transition.
4. Revenues will decelerate if customers start paying by subscription (month to month) instead of buying a single Photoshop (or other product) license all-at-once.
5. Because of Flash, Adobe may not be able to participate fully in Apple-platform success.
6. The company is making a big bet on its Creative Cloud strategy, and the payoff from that may take longer than expected.

The Bull Case

The bullish case for Adobe starts with pent-up demand for CS6. It's always possible that CS6 could be late (just as any software release can be late), but with as much riding on CS6 as there is, you can bet Adobe won't let schedules slip if it can be avoided.

Bulls will point out that the transition to a subscription-based model is not likely to be terribly disruptive, because Adobe in fact plans to continue to offer perpetual licenses in parallel with its subscription business, so that customers can choose whichever payment mode they want.

And while it's true Adobe will lose a certain amount of "revenue front-loading" if people suddenly move to the subscription model, this will likely be offset by the availability of new customers who otherwise couldn't afford (or don't want) the big bite of a full Photoshop purchase.

Likewise, although it's true that Flash has no future in mobile devices (something Adobe acknowledged back in November), Adobe does have a big investment in HTML5 technology, which should clear the way for greater involvement with the iOS platform.


My Take

I like to look at this from the standpoint of catalysts that could move the needle for ADBE stock. And I think there are, indeed, several catalysts that people have either overlooked or are slow to comprehend the possible impact of.

Let's start with the (often-avoided) fact that Adobe has long had a significant worldwide problem with piracy. Simply put, there are tons of unlicensed copies of Photoshop, Illustrator, Acrobat, etc. out there in the wild. An utterly staggering opportunity presents itself if Adobe were able to recapture even a portion of that lost revenue.

Exactly that opportunity is implicit in the subscription pricing model. When the "entry cost" for owning an Adobe product drops from almost $1000, to perhaps $50 (or just $9.95, for a Touch App), it means a lot of illegal users will suddenly consider becoming legal users.

That's big.

Another catalyst: Adobe's total addressable market is set to grow by an incredible 60 million people or more as the company begins to penetrate the iPad user base with Touch Apps. It's probably safe to say that a large percentage of the iPad user base has never bought an Adobe product before (certainly not for the iPad!). This is an enormous opportunity for Adobe to connect with a whole new generation of customers. (Bear in mind, Touch Apps are in the sweet spot for most iPad users, at $9.95.)

Since you probably won't want to store gigabytes of photos or artwork on your iPad, this also becomes an important springboard for Creative Cloud adoption. In addition to giving people a place to store files (and an easy way to sync them to web-connected devices), Creative Cloud gives users access to thousands of web fonts and an easy way to try other Adobe tools without going through a huge download and installation process. This is potentially a very big win for Adobe.

Another Adobe catalyst that doesn't get its fair share of coverage has to do with the pain of web development. These days, it's not enough to develop apps or content for just one device (such as a laptop): You also want your app (or content) to run, and look good, on multiple devices (phone, tablet, etc.). But developing content or apps for multiple targets is an enormous pain, because it typically involves multiple development cycles using multiple tools on multiple devices. Adobe is taking aim at this problem with powerhouse tools like Dreamweaver, InDesign, and Flash Builder that allow you to do all your development work in one place, and debug the results (using appropriate emulation) in one place, then assemble and deploy your finished product to any target (iOS, Android, Windows, Mac, whatever).

And by the way, don't be misled by the name Flash Builder. You can use Flash Builder to output your work in HTML5. It doesn't just output Flash.

As far as I know, Adobe is the only major software vendor that has succeeded in bringing advanced cross-platform development tools to market.

Think of how many developers are working on apps (and/or content) right now for Apple iOS. Think of how many are targeting Android. Think of Windows. Think of MacOS. Add it all up. That's the total addressable market for the tools I just mentioned.

I'll mention just one other catalyst for Adobe, which has to do with its enterprise business. In 2009, Adobe completed its acquisition of Omniture, and a year later it acquired the former Day Software (whose WCM products power the websites of McDonalds, Mercedes, and other Fortune 100 customers). More recently, the company acquired Efficient Frontier, a leader in multichannel and auction-based digital advertising optimization across search, display, and social media. Adobe's Digital Marketing business unit is completing the integration of these platforms to provide a uniquely compelling story for any enterprise that wants to create, manage, deploy, and optimize the consumption of potentially very sophisticated digital content on the Web, in multiple languages, across multiples geos, on multiple devices. Adobe is just beginning to monetize this breathtakingly comprehensive offering, and I think it's fair to say the downstream revenues from it will be measured in the multiple billions of dollars and/or Euros, etc. But that's another article unto itself.

I can think of additional catalysts (I haven't even touched on Project Primetime, for example), but it should be evident by now that the outlook for Adobe isn't constrained to how many copies of Photoshop can be sold to how many Mac or PC owners. It's a far, far bigger story than that.

ADBE stock (P/E: 20) has been trading recently in the low 30s, with a 52-week range of $22.67 to $35.99. The stock is 90% institutionally owned and the company has a market capitalization of approximately $17 billion.

Disclosure: The author has a long position in this company's stock.

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What do inflation hawks know that we don't?

(First, a disclaimer: I am not using the word "inflation hawk" in a pejorative way; I am using it to mean "Someone whose inflation expectations are higher than the consensus forecast.")

Steve Williamson expects higher inflation:

Bottom line: I think some serious inflation is coming, maybe sooner than later. The Fed thinks it can control this with reverse repos and term deposits at the Fed. No way. When will the inflation happen? In line with this post, look out for increases in house prices. The higher house prices will support more credit, both at the consumer level, and in higher-level financial arrangements. The "bubble" will grow, and support the creation of more private liquid assets, which will in turn substitute for publicly-issued liquid assets, causing the price level to rise.

If Steve is right, then he can make a lot of money by buying assets that are good inflation hedges. Why? Because currently, financial markets do not share Steve's expectations of "serious inflation sooner than later." As Steve points out, the 10-year TIPS spread is now about 2.5%, meaning that financial markets expect inflation to be about 2.5% - above the Fed's 2% target, but not very serious by historical standards. (Update: Ryan Avent notes that the Cleveland Fed's alternate measure of inflation expectations indicates that people believe inflation will be even lower than that!) If Steve is right and the market is wrong, he can beat the market. If he's confident enough in his forecast, this is exactly what he should do.

But remember, a word of caution! Before you conclude that you're smarter than the market, you should think very carefully about why the market disagrees with you. If you don't have a good idea about why the market disagrees with you, then you shouldn't trade.

Then again, Steve Williamson is a monetary economist, so maybe he is smarter than the market (Update: Steve drops by in the comments to explain that he does in fact think that this is the case. So the rest of this post is a little beside the point, but still possibly worth reading)! Why does he think serious inflation is coming soon? Well, maybe he has some reasons he doesn't say, but in his post, he cites two things. The first is Jim Bullard's theory of why there is currently no output gap. Steve says he likes this theory. The second thing he cites is the amount of money that has been created in recent years - which, according to the idea that inflation is a monetary phenomenon, should eventually cause higher inflation.

But is it worth making an above-market inflation prediction on the basis of these things alone? After all, Bullard's speech is public knowledge. Even without the Bullard theory, the notion that there is no output gap is not exactly restricted to ivory-tower academics (see Felix Salmon and Greg Ip). Nor is the idea that creating money causes inflation. Presumably, these ideas are not new or secret.

So maybe Steve thinks there is some reason why the public isn't buying into these correct theories? Perhaps he thinks that wrong theories of inflation forecasting (e.g. Phillips Curve forecasting) have gained widespread support? Maybe so, but Steve's colleague David Levine might take issue with such a blithe rejection of Rational Expectations.

Or maybe Steve knows something else, something that the rest of us don't know, and is even now buying inflation hedges based on that knowledge? If so, he'd be wise to keep his reasoning secret from the hungry eyes of the market.

Or maybe I've just read Steve's language wrong. Maybe he thinks 2.5% inflation is "significant". It is certainly above the Fed's official target by half a percentage point. (Note: In the comments, Andy Harless points out that the Fed targets a measure of inflation that is slightly different from what TIPS are pegged to.)

In any case, I'm not disagreeing with Steve's prediction, nor agreeing with it. I'm not a monetary economist, and I really am quite ignorant about the theory involved. I just think it's interesting to try to understand the thinking of inflation hawks (again, no insult intended).

Update: Well, it appears my question has been answered. Steve Williamson, from the comments:

Knowledge of money and banking theory is scarce. In many Economics PhD programs...they don't teach much of it, if any. Knowledge of the theory is even more scarce on Wall Street. I spent a good part of last week in New York City...and I overheard plenty of street conversation among people who were apparently market participants, and who were also shockingly naive. The monetary regime we are in is very different from what it was pre-crisis, in ways that I don't think the market, or the Fed, for that matter, completely understands. I have been thinking about money and banking theory for a long time. I could be wrong, but I think I know something that other people don't.

It's theory. Some combination of the theories he cites in the post, and various others that he knows - most of which he thinks Wall Street people either don't know or refuse to believe - make him think the market is wrong and inflation is on its way...

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How can debt affect GDP?

Via Tyler Cowen, I just saw this from Felix Salmon:

 

There’s a whole narrative in this chart. From 1970 through the beginning of the crisis in 2008, GDP grew at a pretty steady pace. But the amount of debt required to generate that output just got bigger and bigger — the rate of growth of the credit market was much faster than the rate of growth of GDP...

In other words, in order to keep up a steady rate of GDP growth, we had to saddle ourselves with ever more cheap and dangerous debt... 

It makes sense that if we needed ever-increasing amounts of debt to keep up that long-term GDP growth rate, then when the growth of the debt market stops, our potential growth rate might fall significantly... 

[W]e might indeed have to resign ourselves to lower potential growth going fowards. If only because we’re taking ourselves off the artificial stimulant of ever-accelerating credit.

I have one problem with this, and one question.

The problem is this: The way Salmon talks about debt, and debt's effect on GDP, seems to reinforce a common quasi-fallacy in pop economics - the idea that debt can create temporary but "fake" or "artificial" growth.

As Paul Krugman is fond of pointing out, the economy is not like a household. A household can temporarily increase its consumption by borrowing money. But how can a nation artificially increase its maximum possible production by borrowing money? A nation's total productive capacity is determined by things like how many workers it has, how good their skills are, how much physical capital it has, what kind of production technologies it has, etc. How can borrowing money increase any of these things?

Now, as it turns out, there are ways this could happen to a small degree. People can work overtime. Machines can be operated for more hours, at the cost of wear and tear. These things will temporarily increase total production. And maybe debt could give people an incentive to work overtime and to wear out their machines (especially if people repeatedly make mistakes about how likely the debt is to be paid back). But these things aren't very sustainable. Capital will wear itself out. People will probably burn out. Even if you believe that exponentially increasing debt could force us to overwork ourselves and our capital for 40 years, you'd be right to doubt whether we could keep it up for that long. And even if we could, the effect would only be marginal.

So, to reiterate: Production is not consumption, and a nation is not a household. The idea of debt as an "artificial stimulant" that allows us to juice GDP has big problems, since potential GDP is determined by real factors of production. I'm not sure if Felix Salmon is buying into the quasi-fallacy, or just using unfortunate language that brings it to mind (I suspect the latter).

Now on to my question: How can debt affect potential GDP in the long run? Salmon's thesis is, basically, that the collapse of credit markets will permanently lower our potential (i.e. maximum possible) level of GDP. How can this be true?

It's clearly possible for dysfunctional credit markets to lower potential GDP in the short run. Financial intermediation (matching of borrowers and lenders) is a kind of technology, and if this technology is malfunctioning, that means our economy isn't capable of producing as much as it could if credit markets were functioning well. No surprises there.

But do we expect a credit crisis to destroy financial intermediation forever? It seems unlikely. And if financial intermediation recovers, how will the impact of the credit collapse be permanent? After all, long-term output is just determined by technology, right?

Now, you could invoke an endogenous growth model, and say: "During the time we spent recovering from the credit crisis, we were unable to invest in researching new technologies, so our technology level stayed on a permanently lower path." Fine. But in that case, we'd expect a small open economy to recover from a credit crisis, since most technology would come to that country from outside. Yet Greg Ip finds that slow recoveries from credit collapses are common in countries like Sweden, even when the rest of the world is doing fine. So endogenous growth does not seem to be the story here.

An alternative story is this: "Technology," defined as long-term productivity levels, is a complex phenomenon, driven as much by the arrangement of economic institutions and relationships as by the stock of human knowledge. This is an "Austrian" or "PSST" story, and one that requires multiple long-run equilibria. But if something like this is going on, it means that a credit collapse might be able to permanently bend the shape of our economic network into a less efficient pattern.

I'm willing to entertain this notion in principle. File this with the rest of complex-systems theory, under "needs a lot more research". (And, just for fun, note that Tyler Cowen might think twice about accepting this kind of explanation, since it directly challenges his "Great Stagnation" hypothesis...if productivity is a function of economic relationship networks instead of just knowledge, then our stagnation could just be due to dysfunctional institutions and arrangements, rather than a slowing of technological progress.)

Anyway, to sum up this post: It seems clear to the average layperson (and it once seemed clear to me) that debt just feeds directly into GDP. But actually, this is not true. We need to think carefully about how debt could boost actual GDP during a boom, and how it could boost potential GDP in the long run. Neither effect is simple or obvious.


Update: Tim Duy says some similar things. Greg Ip, echoing JW Mason and other commenters on this post, suggests hysteresis as the explanation for the interaction between debt-fueled demand and long-run supply.

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Is solar a bigger deal than people realize?

In November, Tyler Cowen had this gloomy prediction about solar power:

If a solar breakthrough is now likely, in which market prices do we see it reflected?  It is true that fossil fuel prices took a steep tumble in the last few months, but I’ve never heard anyone suggest that price plunge had to do with a forthcoming solar revolution...For better or worse, those shale oil and natural gas discoveries — which by the way will create lots of jobs — will further raise the bar against solar power, and it’s not just the Republicans who will promote them...Is there any reason, based in industry-wide market prices, to be optimistic about the near-term or even medium-term future of solar power?  I don’t see it.

However, the numbers are in, and solar power installation only continues to grow:

Last year seemed like a dark one for the solar industry: stiff competition from China drove American manufacturers to layoffs and even bankruptcy, while the low price of natural gas and the loss of a critical government subsidy weakened incentives for new solar developments. And then there was the long shadow of Solyndra, whose bankruptcy after receiving federal loans cast a pall over other green-energy endeavors. 

And yet, by the numbers, 2011 was a banner year for all those sparkling blue modules, according to a report published on Wednesday by the Solar Energy Industries Association and GTM Research. About 1,855 megawatts of new photovoltaic capacity was installed, more than double the 887 megawatts of the year before. The number of large-scale installations grew as well, to 28 from just 2 in 2009. 

Globally, the United States represents only 7 percent of all photovoltaic capacity, the report found, but that’s up from 5 percent in 2010... 

System prices fell 20 percent because of cheaper components (the average price of a panel dropped 50 percent), more options for financing, better installation methods and the shift to larger arrays. In addition, with the expiration of the Treasury Department’s 1603 tax grant program, many developers rushed to get their projects going before the end of the year. 

Elsehwere, the Wall Street Journal reports that more than 15% of new U.S. power generation capacity in 2012 is expected to come from renewables other than wind and hydropower - in other words, solar (weird that they don't identify solar by name, eh?). This is twice as much as coal, and more than three times as much as nuclear - and keep in mind, these are percentages of total new U.S. electricity generation, not percentage growth rates. Solar is booming!

Two caveats here. The first - as solar energy's detractors are quick to point out - is that the industry survives on government subsidies. That is true. Keep in mid, though, that the cost gap with fossil fuels - which needs to go well below zero in order for solar to take over - is less than it appears, since fossil fuel energy receives government subsidies as well.

The second caveat is that even as the U.S. has installed lots more solar power, the U.S. solar manufacturing industry has shed jobs and suffered bankruptcies. That is very true. And it is a good reason to be wary of buying the stock of U.S. solar manufacturers.

But the U.S. industry's troubles were a function not of stagnating solar technology, but of plummeting prices for their final products, brought about in large part by Chinese competition. Basically, China threw its industrial might (and government subsidies) into building up its solar industry, causing a global glut that made it hard for U.S. manufacturers to compete. But while that is bad news for U.S. companies, it's good news for solar energy technology, since it will lead to large permanent cost reductions in solar manufacturing.

Remember, the disappearance of the U.S. textile industry doesn't mean you're in danger of going without pants. Quite the opposite, in fact.

Basically, there is lots of good news for solar as a technology. Solar costs have been falling exponentially, and with new cost-reducing technologies on the horizon there is no reason to believe that this process is flattening out. And keep in mind, the deck is stacked against fossil fuel energy; technological improvements that reduce fossil fuel costs (e.g. fracking or horizontal drilling) are fighting against a mighty tide, because extraction costs tend to rise as easily accessible deposits are exhausted. Cost reductions in solar, on the other hand, are essentially permanent.

Proponents of a "Great Stagnation" hypothesis should take another look at solar. The area in which human progress has most stagnated over the past half century has been energy; nuclear power has been a bust, and fossil fuels have gotten more expensive. Barring a miracle technology like nuclear fusion, solar is our best long-term hope to reverse that stagnation. For now, fortunately, solar is booming. Let's hope it continues.

Update: As I now recall, Paul Krugman was very optimistic about solar back in November. The new numbers appear to bear his predictions out. Score another one for the Krug-man, I suppose. Is it just me, or does the issue of energy technology seem bizarrely politicized? Optimism and pessimism about solar seem to break down almost exclusively along ideological lines (here's National Review trashing Krugman's optimism; here's Cato blogger Arnold Kling being pessimistic). Is there a reason that conservatives should want to be pessimistic about new energy technology? I mean, besides the fact that many conservative outlets are funded by a certain pair of fossil fuel barons. That can't be all of it, can it? If I were a conservative, I'd take a second look at solar and ask myself very carefully if its success would be a good thing for them or a bad thing. I think on balance it would be a good thing.

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Thursday Roundup (3/15/2012)

This week in econ: A bunch of people are talking about philosophy-of-macroeconomics, which I like...things like microfoundations, rational expectations, bounded rationality, learning, and untested hypotheses. This is just my kind of nerdery! Elsewhere, people are arguing about monetary policy even more than usual. It's another day in the ER...er...econosphere...

1. The great Microfoundations Discussion continues!
  1a) Steve Williamson has a detailed explanation of why macroeconomists think microfoundations are important, and when a model is really "microfounded". I basically agree with everything in the post, except that I'm a bit more optimistic than Williamson about the potential for microfoundations to improve forecasting performance. Also, I wish Steve wouldn't use that horrid "All models are wrong" line...
  1b) Paul Krugman alleges that microfounded models have only performed better than aggregate-only models in one case: the stagflation of the 70s. I think that this is correct. I think that what it means is that we need better microfoundations.
  1c) Simon Wren-Lewis, however, thinks that microfoundations have improved our macro models a lot, particularly in the transition from Old Keynesian models to New Keynesian ones.
  1c) David Glasner thinks that economics journals and other institutions of the profession have arbitrarily restricted the type of microfoundations that macroeconomists are "allowed" to use, with disastrous results. I am not familiar with the history that he is talking about, but I've seen this type of methodological tyranny (or herd behavior?) in other areas, so I wouldn't be astonished if he was right.

2. Mark Thoma turns Republican hackonomist Kevin Hassett into a small purplish stain on the carpet with a concentrated blast of Gotcha.

3. Brad DeLong explains why he doesn't think monetary policy does the trick in a liquidity trap. Scott Sumner, of course, disagrees.

78. Robert Waldmann doesn't think that boundedly rational learning models are likely to get us very far. Simon Wren-Lewis is more hopeful.

sqrt(-17). Nick Rowe explains how nominal rigidities can arise from coordination failures. Not really new ground, but a good read for people who are learning to think about nominal rigidities.

4. Scott Sumner is not happy with Eugene Fama's denial of the liquidity effect. Not happy at all!

5. The Economist reminds us that nuclear power is the great failed dream of human science and technology. If we had found better ways to unlock the vast stores of energy that we know are lurking inside the nuclei of atoms, we'd have those flying cars and Mars colonies and everything people thought we'd have back in the 50s (OK, the Economist doesn't say that, but it's true).

6. Dani Rodrik does a great piece on the complicated politics of free trade. The "consensus" many people think exists may be an illusion!

7. I may be mistaken, but Nick Rowe seems to have joined the ranks of the "MMT" people. Those are the people who think that money is not a central bank liability, right? (Update: Or not; see comments. It just goes to show I don't really know exactly what MMT is and am not really interested enough to take the time and go learn. Sigh.)

8. Ryan Avent claims that China's currency has appreciated enough...even though China hasn't "rebalanced." And even though China still runs a big trade surplus with the country whose currency it pegs to. What?

9. Raghuram Rajan spends an entire column arguing that inequality makes people borrow too much money and makes politicians too willing to let people borrow money...then he closes by saying: "In general, expanding access is beneficial (just not before a crisis!), but finance is a powerful tool that has to be used sensibly. Access is good; excess is bad." Looks like someone's suffering a little cognitive dissonance!

10. Paul Krugman catches Amity Shlaes rewriting economic history. Which, to be fair, is kind of like catching a raccoon stealing your garbage...not exactly a surprising catch.

11. If you want to know all about DSGE models, follow this link from Greg Mankiw. Yes, there is math involved...but you don't mind a little math, right?

12. Ayn Rand is the new Karl Marx. Everyone knows this already, but it bears repeating. Anyone who has spent an hour talking with a hardcore Marxist and an hour talking with a hardcore Randian knows exactly what I mean.

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Can people be fooled again and again? (Goldman Sachs edition)

A very interesting article in the NYT today, in which Greg Smith gives his reasons for resigning as an executive director at Goldman Sachs. Apparently, he's tired of his firm's practice of ripping off its clients:

What are...quick ways to become a leader [at Goldman today]? a) Execute on the firm’s “axes,” which is Goldman-speak for persuading your clients to invest in the stocks or other products that we are trying to get rid of because they are not seen as having a lot of potential profit. b) “Hunt Elephants.” In English: get your clients — some of whom are sophisticated, and some of whom aren’t — to trade whatever will bring the biggest profit to Goldman. Call me old-fashioned, but I don’t like selling my clients a product that is wrong for them... 

It makes me ill how callously people talk about ripping their clients off. Over the last 12 months I have seen five different managing directors refer to their own clients as “muppets,” sometimes over internal e-mail. Even after the S.E.C., Fabulous Fab, Abacus, God’s work, Carl Levin, Vampire Squids? No humility? I mean, come on. Integrity? It is eroding. I don’t know of any illegal behavior, but will people push the envelope and pitch lucrative and complicated products to clients even if they are not the simplest investments or the ones most directly aligned with the client’s goals? Absolutely. Every day, in fact. 

It astounds me how little senior management gets a basic truth: If clients don’t trust you they will eventually stop doing business with you. It doesn’t matter how smart you are.

If Smith is to be believed, and Goldman makes a large portion of its money by tricking clients into making financial mistakes, then this raises an extremely interesting question: How has Goldman gotten away with this for so long? 

Economists generally believe that you can't fool people for very long. In fact, this idea is the cornerstone of many very important models. George Akerlof's legendary "Lemons" Model, for example, assumes that if people know that they might be getting ripped off, they'll just exit the market (and hence avoid getting ripped off). In macro, Robert Lucas' Rational Expectations Hypothesis rests on the idea that policymakers can't repeatedly trick agents in the economy.

So before we conclude that something is very wrong with basic economic axioms, let's think of some ways that Greg Smith's report might be consistent with our prior beliefs:

Possibility 1: Goldman's clients aren't really getting ripped off that much. In real markets, every transaction involves some "surplus" for both the buyer and the seller. It may be that Goldman's "ripping off" of clients is just the way Goldman takes its share of the surplus - i.e., that getting slightly "ripped off" is an inevitable but bearable cost of doing business with Goldman. It might be that all of Goldman employees' braggodochio ("We took those clients for a ride, hahaha") might just be hot air.

Possibility 2: The government somehow forces people to do business with Goldman. In some markets, the government guarantees a firm a monopoly, through regulation, preferential deal-making, etc. An example is utility companies; another is the notorious ratings agencies. It may be that some combination of government regulation, preferential deal-making, or implicit bailout guarantee may be forcing businesses to do business with Goldman instead of some smaller or less well-known or well-connected (but more honest) investment bank.

Possibility 3: Learning takes a long time. Smith says that "if clients don’t trust you they will eventually stop doing business with you." But how long is "eventually"? Maybe if your firm hires a bunch of the smartest (and least scrupulous) finance people, they can keep tricking people for decades on end. Maybe Goldman will die now that people have caught on.

But suppose these don't fully explain the situation? As scientists - or even just as rational thinkers - shouldn't we entertain the possibility that people can be fooled again and again, and simply never learn that they're being fooled? Last fall, I saw George Akerlof (he of the Lemons Model) give a talk called "Phishing for Phools," in which he raised exactly this possibility. How could that happen? Well, let's think of some ways:

Possibility 4: Behavioral effects are very strong. It may be that some sort of deep-seated psychological processes in human beings are too strong to be overcome by rational learning within any reasonable time scale. In other words, maybe we are built to just keep believing the same lies over and over and over. That may sound improbable, but sometimes when I look at U.S. politicians' campaign promises (How long have Republicans been promising to cut spending?). I wonder. Alternatively, people may un-learn what they learned in the past.

Possibility 5: The influx of trick-able people may be faster than the learning process. If enough suckers are born every minute, it may be that the total number of suckers grows over time, even if some fraction of the suckers are always wising up. Thus, there may always be more clients for Goldman to rip the faces off of, even if no one keeps getting their face ripped off forever.

Possibility 6: Rapid structural change may make learning impossible. As Andrew Lo demonstrates in this paper, if the underlying structure of the economy changes at about the same rate that we learn about it, there may never be a model that allows us to understand the economy. This goes for individuals' rationality as well. If the financial world undergoes continuous structural transformation, it may be possible for a Goldman Sachs to keep ripping people off as new structural changes emerge.

I'm sure there are some possibilities I've left off of this list. But I think that figuring out the relevant importance of these effects is crucial if we want to understand what we should do - if we should do anything at all - about the shenanigans of firms like Goldman Sachs. I don't pretend to have the answer. But simply assuming that people can't be fooled is a luxury that we economists may no longer have.


Update: A bunch of people are putting forth another hypothesis: that Goldman has only been ripping people off for a relatively short time. But in Liar's Poker, Michael Lewis discusses a culture at Salomon Brothers in the 1980s that is almost identical to what Greg Smith describes at Goldman. Furthermore, Lewis says that all the big U.S. investment banks (of which Goldman was one) were doing the same thing, and that Europeans often marveled at the willingness of American investors to keep their money within a small circle of oligopolistic investment banks that were obviously ripping them off. Yes, Michael Lewis' book is just an anecdote, but then again, so is Greg Smith's article. 25 years of face-ripping is a long time.

Update 2: Justin Fox also pooh-poohs the idea that Goldman's face-ripping is a recent phenomenon.

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