Monday, November 24, 2008

Heterogeneous Expectations and "Good" Macro Outcomes

Shock therapy is back. Austan Goolsbee is quoted as saying "The point is to, kind of, get people back on track and startle the thing into submission.” Do new macro policies have this common "homogenous" treatment effect on individual expectations of the future? Can Joe the Plummer be convinced that 2009 will be a great year once Obama announces his economic "shock and awe"?

Implicit in the Goolsbee TV quote is a belief that there is a common "expectations function" such that if Government takes action X that EVERYONE believes that the probability of good events such as stabilized housing markets and rising stock market = Y. In English, if government spends 2.5 trillion bailing out Detroit, bailing out Citigroup, bailing out New York City that GNP growth will equal 2% in 2009 and that everyone will act as if this is true and take actions that help to realize this expectation.

But, we live in a diverse world where people differ with respect to tastes, talents, resources, and expectations of the future. The best thinkers in dynamic macro are now studying this. See Tom Sargent's AER Presidential Address and this The Communism of Rational Expectations Interview .

Suppose that the world is X% Keynesians and 1-X% Bob Barros. The Keynesians will take their stimulus package and buy and the Barros anticipating higher taxes in the future will save (dynamic balanced budget conditions). The net effect of this intervention hinges on what "X" equals. If X=.2, then this policy does little.

A major idea in economics since the 1970s has been commitment and time consistency. Now that the government has signaled its willingness to enter and bailout every market, key game theory issues arise and moral hazard issues arise. The "too big" to fail industries recognize the positive probability of a bailout and this affects their dynamic decisions along many margins. This encourages rent seeking by these firms as they lobby Washington and it encourages them to merge into bigger firms (i.e AIG and Citigroup) to increase their leverage if the bad states of the world are realized.

The costs of government activism haven't been fully discussed in the midst of all this excitement.

Making matters even worse, Bill Kristol thinks we economists are dumb. Kristol sounds like he wants to sell short the stock of academic macro economists.

The real issue here is non-stationarity. Economists are able to study stationary processes. We can reverse engineer what is generating the staionary data we see. Once we have reverse engineered the process , we can calcuate effeciency effects and conduct policy counter-factuals. As new products, such as ARM mortgages and financial products are introduced, we can't generate enough data to figure out the stochastic process before the world changes again. Slow down the world, and we can figure its dynamics out!

New York Times
November 24, 2008
Op-Ed Columnist
Admit We Don’t Know

“In my view it has to be between five and seven hundred billion dollars,” proclaimed Senator Charles Schumer Sunday on ABC’s “This Week.” The “it” is the economic stimulus package the new Congress intends to send to the new president, Barack Obama, in January.

The truth is, Schumer hasn’t a well-grounded view, or even a well-informed clue, as to how large the stimulus package “has to be.” I’d be amazed if he could give a coherent explanation of why it should be $500 billion to $700 billion instead of, say, $300 billion or $900 billion. On TV, he simply invoked the authority of “most economists,” who, according to Schumer, “say, to make this work, you need about 5 percent of G.D.P., which would be $700 billion.” Nor do I think Schumer could begin to explain why a demand-side stimulus package oriented toward employment, infrastructure and consumer spending will “work” in dealing with an economic crisis whose origins seem to be in the collapse of a housing bubble and the deleveraging of overstretched financial institutions.

Now I hasten to add — wait a second, Senator Schumer, put down the phone, no need to call me at home this early in the morning! — that I don’t mean to pick in any way on Chuck Schumer, who is surely among the more economically literate members of Congress. It’s not as if his colleagues have a better understanding of what has happened, or of what should be done. And it’s not as if the rest of us do.

In his interview, Schumer appealed to the authority of economists. Economists still do have considerable sway in our public life — even though it doesn’t seem that a large number of them have been particularly prescient in warning about, or strikingly persuasive in explaining, the current economic situation.

In any case, the Obama economic adviser Austan Goolsbee also weighed in Sunday on television and said: “I don’t know what the number is going to be, but it’s going to be a big number. It has to be. The point is to, kind of, get people back on track and startle the thing into submission.”

So a key member of Obama’s economic team hopes a big federal spending number will “startle the thing into submission.” That’s reassuring. On the other hand, it’s not as if the analysis of many conservative economists is much more persuasive. At least the liberals, being more or less Keynesians, tend to agree on what should be done. The more idiosyncratic conservatives tend to be all over the lot. But, basically, it seems to me, we’re all flying blind. The markets are spiraling down, and our leading experts don’t have much of a clue as to what to do.

Given that, one has to welcome the expected appointment to senior positions in the Obama administration of economists like Lawrence Summers, Timothy Geithner, Jason Furman, Peter Orszag, and Goolsbee himself. They’re sober and competent people who know we face a real crisis — and who, importantly, may be more willing than many of their colleagues to adjust their thinking early and often.

Indeed, one hopes they’re not too invested in the findings of the economics profession of which they’re such distinguished products — because one suspects many of the conventional answers of that profession aren’t much applicable to the current situation. After all, wasn’t it excessive confidence in complex economic models and sophisticated financial instruments on the part of people well educated in modern economics that helped get us into the current mess?

So I hope the best and the brightest who will be joining the new president will at least entertain the possibility that a lot of what they think they know is wrong. I trust they’ll remember that successful economic policies in the past have pulled together elements from unlikely sources, and that they’re as likely to find wisdom from reading political economists like Friedrich Hayek or Joseph Schumpeter, or Keynes himself, as from poring over the latest academic paper in a peer-refereed economics journal.

During his two years on the campaign trail, Barack Obama has often cited Abraham Lincoln. Well, it turns out Obama could be taking over the presidency at something more closely resembling (though still far short of) a Lincolnian moment than one would have expected. And it was Lincoln who wrote, in his second annual message to Congress, in December 1862: “The dogmas of the quiet past are inadequate to the stormy present. The occasion is piled high with difficulty, and we must rise with the occasion. As our case is new, so we must think anew, and act anew. We must disenthrall ourselves, and then we shall save our country.”

I’ve worked in government. It’s hard to do much thinking there at all, let alone thinking anew. But Obama and his team will have to think anew, and those on the outside who wish to help will have to think anew too, if we’re to have a chance of rising to this daunting occasion.

Paul Krugman is off today.