Is the canonical model "useful"?

At the ACE anniversary conference in April, I delivered a plenary address in which I argued that the standard, canonical model in economics is discredited, has been effectively abandoned for research purposes, and needs to be abandoned for teaching and prescriptive purposes too. My interlocutors made the claim that the model should be kept because it is "useful." For some, this seemed to mean that it is useful the way a map is useful, using abstract symbols to present a model of reality accurate enough to give directions to reach a goal. If you want to get from Waco to Houston, it will get you there. This seems to echo the famous statement of Robert Solow: "All theory depends on assumptions which are not quite true. That is what makes it theory." (QJE, Feb. 1956) Others claimed that without a general model that connected different phenomena together in a common causal framework, we would have no way to get a handle on what we know, and no framework for conducting research. Gabriel Martinez even made the remarkable claim that having a false framework is better than having no framework at all.

In that famous paper, Solow went on to say, "(I)t is important that the crucial assumptions be reasonably realistic," which he did not think was true of the Harrod-Domar model. A map is not useful if it puts the freeway exits in the wrong places, so that you think you are in Houston when in fact you got off in Galveston. The canonical model assumes perfect competition, which is a crucial assumption, and is not realistic. It answers questions (as Martinez said), but it gets the answers wrong. So the model predicts there will be equilibrium in labor markets, when in fact there is unemployment. It predicts the law of one price will hold, when it hardly ever does. It predicts that financial markets will be efficient, when in fact they periodically collapse. And it doesn't answer questions about some extremely important issues, like the size distribution of income or the optimal scale of the economy for ecological sustainability. It ignores the complexity of human decision-making, and the reality of economic power. This is not useful, but pernicious.

In my talk, I made some proposals about basic principles that a new economics should be founded on. But the frustration expressed with heterodoxy (by Robbie Mochrie and others at the conference) is that it doesn't offer a general, all-encompassing model. My claim is that we don't need one. Post-modern methodology suggests that they are dangerous anyway, but our research in economics is being guided by new questions, new techniques, and new basic principles that don't issue in a comprehensive mathematical construct, and we are still learning more every day. There is no shortcut to truth. Often you have to dig for it with your bare hands. The principles we need come from a basic biblical understanding of the nature of human beings, our relationship with God, and God's will for our relationships with each other. That will tell us where to dig.

The cost of the stimulus

There's been a lot of talk about how much the stimulus will add to the national debt, and how much it will cost the economy in the long run. It reminds me of something I read once in an old textbook. Who actually paid for WWII? Was it those of us who paid taxes to service the national debt in the succeeding decades? Well, if you really believe in the concept of opportunity cost, the war was paid for by the people at the time who did without cream for their coffee, gas and rubber for their cars (and new cars), nylon for their stockings, and so on. Did the war crowd out private investment that would have contributed to growth later on? Not really. The government built new plants that were given to private companies (e.g. Alcoa), and the twenty-year postwar boom is hardly evidence of crowding out during the war.

And what will be the opportunity cost of the current stimulus plan? If it works the way it should, nothing. The resources to be used would have been idle anyway. More investment is likely to be crowded in than crowded out—construction companies buying new cranes to work on those highways and schools. It's not like interest rates are going to go up much. The deficit might even be smaller than it would have been with a full-blown depression. If we pay for the extra spending by printing money that will be discreetly drained away later, or by selling government bonds with rock-bottom interest rates, there won't even be much effect on the nominal national debt. So I wish everybody would just quit worrying so much. If there's any case against the stimulus, it has to be about all the non-stimulating things that are in there, like AMT relief. But that's just political horse-trading.

The important thing is that fiscal policy and monetary policy are working together for once. When they don't, we have disasters. In this case, the fiscal stimulus to aggregate demand has to run parallel to the repair of the financial markets and aggressive monetary ease. One without the other won't do much good.

Krugman/Brooks on the Economy

Paul Krugman is at his best in yesterday's article – explaining real world economics in understandable ways. His article talks about how we can get out of this recession, and his analysis is not encouraging. Here is a nice passage that would be very helpful in an introductory macro class:

So will our slump go on forever? No. In fact, the seeds of eventual recovery are already being planted.

Consider housing starts, which have fallen to their lowest level in 50 years. That's bad news for the near term. It means that spending on construction will fall even more. But it also means that the supply of houses is lagging behind population growth, which will eventually prompt a housing revival.

Or consider the plunge in auto sales. Again, that's bad news for the near term. But at current sales rates, as the finance blog Calculated Risk points out, it would take about 27 years to replace the existing stock of vehicles. Most cars will be junked long before that, either because they've worn out or because they've become obsolete, so we're building up a pent-up demand for cars.

The same story can be told for durable goods and assets throughout the economy: given time, the current slump will end itself, the way slumps did in the 19th century. As I said, this may be your great-great-grandfather's recession. But recovery may be a long time coming.

David Brooks, on the other hand, in the aptly titled "Money for Idiots," makes the case for government intervention, and explicitly addresses the moral hazard problem involved with bailing people out when their problems are the result of bad choices:

The stimulus package handed tens of billions of dollars to states that spent profligately during the prosperity years. The Obama housing plan will force people who bought sensible homes to subsidize the mortgages of people who bought houses they could not afford. It will almost certainly force people who were honest on their loan forms to subsidize people who were dishonest on theirs.

And later:

These oscillations are the real moral hazard. Individual responsibility doesn't mean much in an economy like this one. We all know people who have been laid off through no fault of their own. The responsible have been punished along with the profligate.

It makes sense for the government to intervene to try to reduce the oscillation. It makes sense for government to try to restore some communal order. And the sad reality is that in these circumstances government has to spend money on precisely those sectors that have been swinging most wildly — housing, finance, etc. It has to help stabilize people who have been idiots.

I do not have much confidence in my own understanding of the macroeconomics involved, but it seems to me that the issues in these two articles are central to understanding the times we are in.

David Brooks on Urban Economics

I just had a little bit of a surreal experience reading Brooks' article today. I was expecting some behavioral economics or stimulas package concerns, but instead, I got to read an interesting reflection on urban economic trends, circa 2009, as well as (and this is the surreal part) his allusions to our (adopted) mother homeland - the Netherlands.

He hypothesizes that the economic crunch will get U.S. Americans back to thinking about an eco- and pocket-book friendly lifestyle - inner city, pedestrian/bicycle centered, etc., you know, like Amsterdam, he says.

"Well, Amsterdam is a wonderful city, but Americans never seem to want to live there. And even now, in this moment of chastening pain, they don’t seem to want the Dutch option."

He cites several conclusions from a recent Pew study suggest that, well, no really, we still want urban sprawl. We still want a spread out, car-dependent lifestyle, although now we want it with some scenic views - hence the preferences for Denver, San Diego, Portland, San Antonion, and the like. And, we still prefer McDonalds (for its drive-through, he takes that to mean) than to Starbucks (for its casual conversational, urban lifestyle I think he believes it stands for).

So, his conclusion is that:
"And that [McDonalds prefs > Starbucks prefs], too, captures the incorrigible nature of American culture, a culture slowly refining itself through espresso but still in love with the drive-thru. ...The results may not satisfy those who dream of Holland, but there’s one other impressive result from the Pew survey. Americans may be gloomy and afraid, but they still have a clear vision of the good life."

I had a different reaction to the Pew survey results. We are gloomy, afraid, and have a clear vision of the good life - for me - not for an entire community. We have a long ways to go before urban policies actually look at the effects of polices on the most vulnerable, too. Of course no one in the Pew survey wants to live in the city, who in their right mind, let alone those with kids, would want to live in the U.S. inner cities as they are now with horrible schools and crime poor infrastructure. They are the result of long years of tax and zoning polices that cared nothing about the effects on the community, only on the individual, and mostly the wealthy individuals, at that. And the point about McDonald's is not necessarily about drive-through. It is also an indoor playground that is actually one of the few places families can go with their kids and relax and be with other adults at the same time. Much more Amsterdam-like than what most of us would assume. (Yes, I admit, I have many hours of experience with that.)

Well, I have just about had all the news on the economy and the painful and confusing (to me) stimulus debate and bleary economic reality I can handle. When I need cheering up I often turn to Tom Bodett (yes, the Motel 6 guy). He's intelligent, funny, and helpful at telling the story of our realities in ways that make me smile rather than wince. Anyway, I really enjoyed and recommend his "Red State Blues" story (even thought is is a few years old), especially the line that seemed to explain why at the end of my week, after commuting back and forth soaking up my fix of NPR, I just don't have that spring in my step anymore...

Blue State people, on the other hand, chase their Zoloft down with iced chai while they listen to twelve hours a day of public radio programming which ceaselessly and thoughtfully points out in genteel and condescending tones that we are all pretty much screwed.

Of course, now, even the regular news concurs with that.

Taylor's analysis of the crisis

John B. Taylor of Stanford has an analysis of the financial crisis as an op-ed in today's Wall Street Journal. He is so anxious to prove that government action caused the crisis that he ends up not making  a lot of sense.

He claims the first mistake was excessive monetary ease during 2003-05, which created the housing bubble. Later on, he says it was a mistake to ease monetary policy after August 2007, a move he says created the short-lived bubble in oil prices in 2008. (How these bubbles get burst remains mysterious.) In standard monetary theory, excessive monetary ease is supposed to create inflation, i.e., a general rise in the price level, NOT a change in relative asset prices. General inflation remained remarkably tame throughout the decade. I hesitate to blame the Fed for bubbles it could not have reasonably foreseen.

Taylor also asserts that the problem in the markets was not liquidity, but rather counterparty risk. Therefore, he claims that adding vast amounts of liquidity to the system was the wrong approach. He seems to think there are two kinds of financial crisis that call for different policy approaches. I think he is wrong. All financial crises start off as a concern about the risks of dealing with certain counterparties. As the dominos fall and the list of toxic assets lengthens, the demand for liquidity increases, and things spiral downward from there. No matter how the crisis began, the demand for liquidity has to be satisfied before confidence can be restored and risky assets can begin trading at appropriate prices again.

I think he is also wrong about the low interest rates of the mid-aughts leading to excessive risk-taking. The standard theory of financial crisis suggests that high interest rates, not low ones, lead to greater risk. Moreover, the housing bubble contributes to the problem. 

But the main thesis--that the crisis was not caused by "any inherent failure or instability of the private economy"--is undercut by his own list of "complicating factors": the overuse of subprime and adjustable rate mortgages, excessively complex mortgage-backed securities, and irresponsible behavior by the ratings agencies. Add that to the unpredictable market bubbles in residential real estate and oil, and you have the recipe for disaster.

Teaching Institutionally?

David Brooks (yeah, I read him a lot) wrote another interesting article, this one about a book by Hugh Heclo titled On Thinking Institutionally. Brooks uses the following quote as a foil:

A few years ago, a faculty committee at Harvard produced a report on the purpose of education. "The aim of a liberal education" the report declared, "is to unsettle presumptions, to defamiliarize the familiar, to reveal what is going on beneath and behind appearances, to disorient young people and to help them to find ways to reorient themselves."

He then explains how "thinking institutionally" is preferable. It asks that people adopt the roles that are given to them within the institutions that they find themselves, and that they be faithful to their rules and obligations out of respect for those around you.

This made me think about some of the readings and discussions from the recently completed Kuiper seminar.

I am uncomfortable with the philosophy of teaching that the Harvard professor espouses. The "question everything" attitude is an academic mask that can be used to make cynicism look respectable. Academic work that is based on "unsettling, defamiliarizing, and disorienting" seems fundamentally destructive. It is easy to fall into the trap of teaching "critical thinking" as if it means tearing apart artifacts and taking them out of context, as if pulling apart someone's work into its smallest contemptible parts is the same as knowing it. This does a disservice to our colleagues, the material we study, and most importantly, it leaves our students empty.

Instead we should strive to embrace what Susan Felch has called a "hermeneutic of delight," in which we teach students to think carefully about an artifact by understanding it completely, approaching it charitably, and then finally searching for ways to improve it. The result is scholarship that is no less rigorous, and it is more complete. Most importantly it instills in students a sense of intellectual decorum that is often lost, and preserves wonder and hope. I suspect that this is what most good teachers do instinctively, though it does not seem to be the norm in the academy overall.

Back to Brooks' article: this "thinking institutionally" idea seems to be very compatible with a hermeneutic of delight. Instead of tearing apart conventions and institutions, we should always start by understanding how and why they were developed, how they are helpful, and only then, how they can be improved. I will try to teach public finance this way as we examine many different policies. It is easy to dismiss many policies as the result of this or that ideology which I reject, but that easily devolves into the cynicism that I would like to avoid.