if you can’t explain the propensity to hoard, then you can’t explain our current predicament.

From Free Exchange:

"Blanchard roundtable: Where economists fear to tread

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The Economist | DELHI

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Blanchard roundtable

OLIVIER BLANCHARD provides a disturbing account of what Knightian uncertainty means for the economy; let me offer a few untutored thoughts about what it means for economics.

Economists do not, in fact, follow Knight’s work very much. The discipline shys away from his concept of uncertainty (as distinct from risk), because it is, by definition, so hard to model. If economists could model it, then so could firms and investors. The future would be calculable, if not knowable, and there would be less excuse for bewildered inaction.

Paul Samuelson once went so far as to argue that economics must surrender its pretensions to science if it cannot assume the economy is “ergodic”, which is a fancy way of saying that Fortune’s wheel will spin tomorrow much as it did today (and that tomorrow's turn of the wheel is independent of today's). To relax that assumption, Mr Samuelson has argued, is to take the subject “out of the realm of science into the realm of genuine history”.

The scientific pose has great appeal. But this crisis is reminding us again of its intellectual costs. Knightian uncertainty may be fiendishly hard to fathom, but ignoring it, as economists tend to do, makes other phenomena devilishly hard to explain. The thirst for liquidity—the sudden surge in the propensity to hoard—is one example. If risks are calculable, then investors will place their bets and roll the dice. Only if they are incalculable will they try to take their chips off the table altogether, in a desperate scramble for cash (or near-cash). As Keynes put it, “our desire to hold money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future.”

We journalists make great sport poking fun at the techniques on which financial markets have relied—the value-at-risk models with their normal distributions—much as Keynes scorned all those “pretty polite techniques, made for a well-panelled board room and a nicely regulated market”. But as economists (or as friends of economics) we have to fess up that the models that led banks astray are, fundamentally, ours—they spring from the same intellectual tradition. My suspicion, perhaps unfair, is that in recent years too much macroeconomic theory itself became “one of these pretty, polite techniques which tries to deal with the present by abstracting from the fact that we know very little about the future.”

As Mr Blanchard’s article makes clear, if you can’t explain the propensity to hoard, then you can’t explain our current predicament. And a macroeconomics that cannot explain this crisis is hardly worthy of the name."

Me:

Don the libertarian Democrat wrote:

Paul Samuelson once went so far as to argue that economics must surrender its pretensions to science if it cannot assume the economy is “ergodic”, which is a fancy way of saying that Fortune’s wheel will spin tomorrow much as it did today (and that tomorrow's turn of the wheel is independent of today's). To relax that assumption, Mr Samuelson has argued, is to take the subject “out of the realm of science into the realm of genuine history”.

Much of economics is Correlative Explanation and Reasoning. It is not cause and effect. Math can be useful in describing relations, as long as those relations continue to hold. Where behavior is concerned, or any teleological action, you will have correlative reasoning and explanation.

The math models used are simply useful in simple ways. What is shocking is that, compared to the old practitioners of political economy, which will always be the really important realm of understanding these issues, current economists don't seem to have a philosophy of action or math that can explain their assumptions. Consequently, many spit out mechanistic explanations, or versions of dubious psychological theories like behaviorism.

The only way to explain Political Economy is through a Human Agency approach or explanation. The only way to explain hoarding is such an approach. I have found Fisher's Debt-Deflation model to be of great help, but that model also needs a more robust human agency explanation to fill it out.

One famous economist recently mocked Shiller's 'trust' as hard to measure. In saying this, he showed that he had no clear idea of what is involved in a human agency explanation, nor a clear idea of what the limitations of measurement are. It is would interesting to hear the assumptions and presuppositions underlying his basic view of human behavior, if he has one.

Incidentally, I find Bagehot to be still valuable for understanding our current crisis.

2/1/2009 4:25 PM GST

"When it comes to macroeconomic stimulus measures, however, policy is in disarray. "

Richard Baldwin on Vox:

"No one knows exactly how to stop the global economic crisis, but all agree that fiscal stimulus has a key role to play( NOT EVERYONE ). By reducing the length and depth of the recession, it should reduce bankruptcies, foreclosures, and further asset-price drops( THAT'S THE HOPE ). This column presents the main logic in a recent IMF paper authored by one of the world’s leading macroeconomists, Oliver Blanchard, and others.

There is near consensus among economists that fixing the world’s economy will involve at least these two steps:( 1 ) repairing the financial sector, and( 2 ) restarting economic growth. When in comes to financial sector policies, governments are already “on the case”. Much more surely needs to be done but governments are already deploying( PLEASE STOP ) all the policies( YEP. THAT'S HOW WE DO THINGS ON PLANET EARTH, AS OPPOSED TO PLANET THEORY. ) that eventually fixed every financial crisis since the dawn of the financial sector.

When it comes to macroeconomic stimulus measures, however, policy is in disarray( EXCEPT FOR THE MILDLY HELPFUL IDEA THAT KEYNES IS BACK IN VOGUE ). The US, UK and Japan have committed to fiscal stimulus, but other nations, such as Germany, don’t see the urgency of the situation – or, according to a more cynical interpretation – are hoping to free ride on the fiscal stimulus of others( THE SAVER COUNTRIES DO NOT WANT TO END THE CURRENT SAVER/SPENDER SYMBIOSIS. THE FREE RIDE IS TRYING TO GET OUT OF THIS CRISIS WITHOUT THE SYMBIOSIS COMING APART. ). Indeed, some economists question fiscal policy’s effectiveness.( TRUE )

The IMF’s paper on fiscal policy in the crisis

Given the lack of clarity on fiscal policy, the IMF paper released on 29 December 2008, “Fiscal Policy for the Crisis”, presents some very welcomed words of wisdom. Written by one of the world leading macroeconomists – Olivier Blanchard (who also happens to be the IMF’s chief economists) – with 3 coauthors, the report distils the lessons of five of the most relevant crises, namely the( 1 ) Great Depression,( 2 ) the Japanese 1990s banking crisis,( 3 ) the 1997 Asian crisis,( 4 ) the US 1980s S&L crisis, and the( 5 ) 1990s Nordic crisis.( DIDN'T ROGOFF AND REINHART SURVEY 800 YEARS? )

Why the drop in aggregate demand?

The paper starts by reminding us that there are indications that this recession could be deeper than any since the Great Depression. The sources of the decline in aggregate demand are:

· Drops in real and financial wealth( FROM THE FORECLOSURE AVALANCHE AND CALLING RUN );

· An increase in precautionary saving( FEAR AND AVERSION TO RISK ) on the part of consumers,

· A wait and see attitude on the part of both consumers and firms( FEAR AND AVERSION TO RISK ); and

· Increasing difficulties in obtaining credit( FEAR AND AVERSION TO RISK ).

Things that won’t work

The specific features of this crisis mean that two of the standard anti-crisis macro tools are ineffective.

· The global synchronisation of recession means export-promotion policies – such as devaluations ( DON'T EXACTLY AGREE. PRINTING MONEY MIGHT HELP. )– cannot work for the major economies (and they risk making thing much worse if the ‘echo chamber’ of beggar-thy-neighbour policies starts resonating). ( GOOD LUCK. IT'S HAPPENING )

· The financial source of the crisis weakens the link between policy rates and banking lending – thus rending the traditional( YES. WE'VE TRIED THAT. ) monetary transmission mechanism much less effective.

In any case, key nations have very little room to lower policy rates, so fiscal policy is the best last policy option for avoiding a deepening of the recession which could well exacerbate the financial sector crisis.

Optimal fiscal policy in the crisis

Based on lessons extracted from past crises, the IMF argues that fiscal stimulus should be

· Timely (as there is an urgent need for action),( TRUE )

· Large (because the drop in demand is large),( TRUE )

· Lasting (as the recession will likely last for some time),( NOT SO SURE )

· Diversified (as there is uncertainty regarding which measures will be most effective),( OK )

· Contingent (to indicate that further action will be taken, if needed),( OK )

· Collective (all countries that have the fiscal space should use it given the severity and global nature of the downturn), and( HERE THERE'S A PROBLEM. )

· Sustainable (to avoid debt explosion in the long run and adverse effects in the short run).( TRUE )

The challenge facing each national government is to gauge the right balance between these features – particularly, large-and-lasting actions versus fiscal-sustainability.

Lessons from earlier crises

The IMF paper provides a survey of five well‑known crisis: Korea in 1997, Japan in the 1990s, the Nordic countries in the early 1990s, the Great Depression in the 1930s, and the US during the Savings and Loans crisis in the 1980s.

Countries have reacted to these downturns quite differently, thus providing us with some evidence on how best to manage fiscal policy in a crisis. The key lessons are:

· Successful resolution of the financial crisis is a precondition for achieving sustained growth.( MAKES SENSE )

The counter-example is Japan where fiscal policy failed because financial sector problems were allowed to fester. By contrast, prompt and sizeable support to the financial sector by the Korean authorities limited the duration of the macroeconomic consequences thus limiting the need for other fiscal action.

· The solution to the financial crisis always precedes the solution to the macroeconomic crisis.( OK )

· A fiscal stimulus is highly useful (almost necessary) when the financial crisis spills over to the corporate and household sectors with a resulting worsening of the balance sheets.( OK )

· The fiscal response can have a larger effect on aggregate demand if its composition takes into account the specific features of the crisis( THIS I AGREE WITH ).

In this regard, some of the tax and transfer policies implemented early in the Nordic crises did little to stimulate output.

Composition of a fiscal stimulus

Governments around the world are struggling with how to apply fiscal stimulus. The IMF’s analysis points out two features of the crisis that are important when thinking about the nature of the fiscal stimulus.

First, this crisis is here for while, so slow-acting fiscal spending can be part of the picture( INFRASTRUCTURE SPENDING IS FINE. ). (In the usual recession, the simulative spending often( MIGHT HAPPEN HERE AS WELL ) kicks in after the recession is past and thus become part of the problem rather than part of the solution.) Moreover, expenditure measures have the advantage of directly stimulating demand rather than give money to consumers and companies who might not spend it( THAT'S THE REASON FOR GOVERNMENT SPENDING THE MONEY. ).

Second, the usual macroeconomic conditions mean existing estimates of fiscal multipliers are less reliable guides to the relatively effectiveness of various fiscal policies. This is why the IMF argues for fiscal policy diversification.( IT'S A GOOD IDEA )

Direct government spending

While each government will have to deal with national concerns, constraints and circumstances, the IMF offers some general words of wisdom.

· Governments should make sure that existing programs are not cut for lack of resources.( OK )

This bit of advice is aimed particularly at the US states, many of whom operate under constitutional balanced-budget rules that are forcing them to cut back spending on current programmes. (See Krugman’s column for examples.)

· Look for spending programs can be started or restarted quickly.

For example, the state could up its share in private-public partnerships for projects that would otherwise be suspended for lack of private capital. Public sector wage increases should be avoided as they are not well targeted, difficult to reverse, and similar to transfers in their effectiveness. Nevertheless, a temporary increase in public sector employment associated with some of new programs and policies may be needed( A JOBS BILL ).

· Public perceptions matter.( VERY IMPORTANT )

Much of this recession is coming from the sharp deterioration in expectations, and the sharp increased in perceived uncertainty about the economy’s prognosis( ABSOLUTELY. THE FEAR AND AVERSION TO RISK.). A few high profile programs – especially those good long-run justification and strong externalities – could help restore consumers’ and firms’ belief that things will get better. Such confidence can itself improve aggregate demand by reducing wait-and-see behaviour.( I WOULD ARGUE THAT THIS IS IN FACT THE SOLUTION )

Stimulus aimed at consumers

Getting consumers to spend again faces three crisis-specific factors: 1) wealth reductions are a key cause of reduced consumption ( TRUE. BUT PERCEPTIONS OF IT VARY. ); 2) credit constraints( REALLY THE FEAR AND AVERSION TO RISK. ) in some nations are forcing consumption reductions; and 3) uncertainty has spawned a wait-and-see attitude that results in the delay of planned purchases( THE MOST IMPORTANT REASON ).

These factors suggest two broad recommendations: Tax cuts should target consumers who are most likely to be credit constrained( I AGREE ), and should aim at restoring consumer confidence by committing to do ‘whatever it takes’( I AGREE. THAT'S WHY GOVERNMENT GUARANTEES ARE SO IMPORTANT, AS WELL AS INCENTIVES TO ALLEVIATE THE FEAR AND AVERSION TO RISK. ). The goal is to overcome the waiting-and-see attitudes( EXACTLY ).

Fiscal stimulus aimed at firms

The high degree of uncertainty surrounding this crisis fosters a wait-and-see attitude when it comes to firms’ investments. Consequently, subsidies are unlikely to have much effect( I BELIEVE THAT TAX INCENTIVES MIGHT ). While acknowledging the political economic pitfalls, the IMF argues that there is also some scope for governments in supporting firms that are facing particularly difficult problems, could survive through restructuring, but find it difficult or impossible to receive the necessary financing from dysfunctional credit markets. Sector-wide policies like the US auto bailout are bad idea( THIS WAS DONE FOR SOCIAL REASONS, WHICH ARE IMPORTANT IN RESTORING CONFIDENCE. ).

Sustainability concerns

While the IMF’s call for deficit spending is unusual, the authors stay true to form in arguing that questions about debt sustainability would, especially in nations starting from weak fiscal postures, undercut the stimulus via adverse effects on financial markets, interest rates, and consumer spending( A GOOD WARNING ). A fiscally unsustainable path can eventually lead to sharp adjustments in real interest rates, and these in turn can destabilize financial markets and undercut recovery prospects.( A PROBLEM GOING FORWARD )

The IMF suggests a number of things that could help:

Measures should be reversible or have clear sunset clauses( WHICH IS WHY I FAVOR A SALES TAX DECREASE OR PAYROLL TAX REDUCTION ) contingent on the economic situation;

Measures that increasing the scope of automatic stabilizers are useful;

Pre-commitments to future policies that help shore up fiscal accounts are useful.( I AGREE )

Pre-commitment to unwinding stimulus measures either at a specific date (like lowering VAT for just two years as the U.K. recently did) or on a contingent basis (reversing the VAT cut once GDP growth has risen above a certain level) are a good idea;( I AGREE )

Strengthening fiscal governance by, for example, setting up an independent fiscal council( NOT SO MUCH );

Coordination: The G20’s role

Sizable fiscal stimulus is required at the global level since this crisis is global. However not all nations are in a position to widen government deficits. Many low income and emerging market countries are constrained volatile capital flows, high public and foreign indebtedness, and large risk premia – features that plague some advanced countries as well.

Given that some countries cannot pump up demand with fiscal policy, the IMF argues that it is imperative that the nations who can do. This includes some large emerging economies such as China. As fiscal stimulus is a policy that suffers from the classic free-rider externality, it is exactly one area where international coordination by the G20 nations would yield great benefits."( THE SAVER COUNTRIES AND STIMULUS PROBLEM )

Some good points.

"Big bets on the “great moderation” throughout the economy helped to create the financial basis for a potentially big slump."

Brad Setser talks about the Great Moderation:

"The great moderation – a theory that become quite popular once the big financial party of this decade really got going after 2004 (see the New York Times graphic on LBOs) – had two components.

One: Macroeconomic volatility was a historical relic. Downturns were not going to be as severe as in the past – in part because of the success of counter-cyclical monetary policy.

Two: Financial volatility also was a thing of the past. The combination of reduced macroeconomic policy and the credibility of monetary policy meant that financial markets weren’t as subject to wild gyrations.

The implication of course was that leverage was safe. Financial firms could enhance their returns by borrowing more and taking bigger bets. And everyone else could increase take on more debt too – whether firms or households.

I guess it is now time to go back to the drawing boards."

It might be time to read some philosophy and history. Exactly how long was this "Great Moderation"? Was it even 20 years? Did it include the S & L Crisis, the Tech Bubble, the Inflation of the 70s?

From Bernanke:

"One of the most striking features of the economic landscape over the past twenty years or so has been a substantial decline in macroeconomic volatility. In a recent article, Olivier Blanchard and John Simon (2001) documented that the variability of quarterly growth in real output (as measured by its standard deviation) has declined by half since the mid-1980s, while the variability of quarterly inflation has declined by about two thirds.¹ Several writers on the topic have dubbed this remarkable decline in the variability of both output and inflation "the Great Moderation."

I lived through it and I didn't even know it. 20 years. Great. What are we going to call what we're going through now? Tiny.

"Financial volatility has come back, with vengeance. And not just in the equity markets. After a period of (relative) stability, there have been a series of sharp moves in the foreign exchange market. The yield on the thirty year bond has swung wildly. The pros are amazed at some of the strange permutations that derivatives markets have churned up under stress.

And Friday’s employment data leaves little doubt that macroeconomic volatility is back with a vengeance. The pace of contraction in economic activity in the US – and probably globally – this quarter is likely to be brutal. Wall Street economists are increasingly starting to sound like Dr. Doom.

Alas, adjusted to a more volatile world won’t be easy. Belief in the great moderation meant that the US economy was operating with a smaller buffer of capital and liquidity than it had in the past. And here at least much of the world seems to have emulated the US. The easy way to increase equity returns over the last few years was to take on more debt. That in turn is likely to augment the amount of volatility in the economy.

The risk, obviously, is that firms that borrowed to buy back their stock – or hadn’t run down their cash reserves – won’t be able to avoid Chapter 11. Or Chapter 7. And financial firms won’t be able to support their existing balance sheets with their now-depleted capital and will have to scale back (even after government capital injections), adding to the downturn.

Ideas have consequences. Big bets on the “great moderation” throughout the economy helped to create the financial basis for a potentially big slump."

Ideas have consequences. Yes, I suppose they do. So do foolish and shallow views of Human Agency and of Reason and of Mathematics and of what we can actually know. Why do people have to make every hypothesis and theory grand? Isn't it enough to accumulate some general wisdom that actually proves useful in helping us meaningfully and successfully lead our lives? In reality, that's all we do.

Instead of a drawing board, how about something less grand? Like a notebook?