In real life, he explains, households and businesses are highly uncertain

TO BE NOTED: From Business Week:

"Macroeconomics: Adjusting the Big Picture

Three experts weigh in on how to better handle, and even avoid, the next global financial crisis

By Peter Coy

Is macroeconomics worthless? Far from it. Here are three economists trying to draw lessons from the global economic crisis so the world does a better job of keeping growth on track next time.

Hyun Song Shin, 49, Princeton University
Big Idea: The Federal Reserve should pop credit bubbles early by raising interest rates.
The financial crisis arose, in large part, because companies and households borrowed too much. Shin faults macroeconomists for developing models that didn't allow for the possibility of risks such as a bubble in lending or a deterioration of credit standards. "Over the past 10 years our mainstream colleagues in macroeconomics have somewhat neglected finance," he says.

The economists at the Federal Reserve, too, weren't looking at the right problems, says Shin: "These things crept up behind the backs of the central bankers. It was a blind spot."

Shin says the Fed should nudge rates up when credit is expanding rapidly. He's looking for data that give hints of trouble, such as heavy secured borrowing by financial firms. Creating better models of the economy is "not easy, but I think it's too defeatist to say it's impossible," says Shin.

Roger E.A. Farmer, 54, University of California at Los Angeles
Big Idea: The Fed should make large-scale purchases of equities to restore investor confidence and get the economy back on track.
Farmer thinks Fed stock purchases would be more effective than the Obama Administration's deficit spending. He frets that if the government puts more money in the public's pockets via increased spending or tax cuts, people won't spend it as long as they feel poor because of stock market losses.

The answer, in Farmer's view, is for the Fed to set a target for how high it wants the stock market to be by a certain date, then commit to buying enough shares (through broad-based index funds) to hit that target. Higher stock prices will make people feel wealthier and spend more, creating prosperity. Symmetrically, he would have the Fed sell to hold down prices in boom times.

Similar ideas have been tried before in Hong Kong, Taiwan, and Japan. They've had mixed results but are credited with helping to rescue Hong Kong from the Asian financial crisis in 1998. "I get a lot of interest from other economists," he says, "but it takes a long while for new ideas to spread."

Thomas Sargent, 65, New York University and Hoover Institution
Big Idea: The economy is volatile, in part, because households and businesses hold "fragile beliefs" that shift quickly.
In the 1970s, Sargent was one of the thinkers behind "rational expectations," which says that ordinary people can correctly anticipate the range and likelihood of possible future outcomes.

Sargent now says that theory was an oversimplification. In real life, he explains, households and businesses are highly uncertain. Developments such as an unexpected government action or a major company going bust can cause people to drastically revise their beliefs about what might happen next.

The good news: Beliefs may shift back again through unexpected positive events. Sargent is not willing to say how that might happen, but he notes that in the early 1980s the Federal Reserve was able to lower the public's expectations about long-term inflation. That, in turn, caused actual inflation to fall, ending a period of stagflation.

Coy is BusinessWeek's Economics editor."

Incentives matter. That is central to economics. It also is important for political economy

TO BE NOTED: From EconLog:

"More Thoughts on Masonomics

Arnold Kling

Tyler and Alex have new textbooks on micro and macro. Both begin with the same anecdote.

In 1787, the British government had hired sea captains to ship convicted felons to Australia...On one voyage, more than a third of the males died and the rest arrived beaten, starved, and sick...

Instead of paying the captains for each prisoner placed on board ship in Great Britain, the economist suggested paying for each prisoner that walked off the ship in Australia. In 1793, the new system was implemented and immediately the survival rate shot up to 99 percent.

That is economics on one foot--incentives matter.

What to do, then, about macroeconomics? In crude Keynesian economics, incentives do not matter. Consumption depends on income, investment depends on animal spirits, and prices have no impact. Much of the post-Keynesian synthesis has been devoted to bringing incentives back into the picture. The results have satisfied neither hard-core microeconomists nor hard-core Keynesians. Tabarrok and Cowen devote some space to Real Business Cycle theory, which is all about incentives. They also devote some space to the sticky-price version of New Keynesianism, in which incentives are combined with imperfect price flexibility.

I think a more promising approach is to look at the macroeconomic impact of signaling. Workers view wage rates as signals of their employer's long-term commitment to their welfare. Thus, a wage cut is a particularly negative signal, and it is difficult to cut wages in a downturn without causing major problems. See Lectures on Macroeconomics, number 4.

Also, as I have been arguing in recent posts, financial markets depend crucially on signaling. Perfect transparency in financial intermediation is impractical--if you can see through the intermediary you could have done without the intermediary and invested yourself. Thus, investorrs necessarily rely on signals when dealing with financial intermediaries. Under those circumstances, it is easy for confidence to fluctuate. We saw in recent years that there was extreme over-confidence in the financial engineering related to home mortgages. Now that confidence is gone. When confidence is high, financial intermediaries enlarge their balance sheets and economic activity expands. See lecture number 9.

So, here are some thoughts on Masonomics in general.

1. Incentives matter. That is central to economics. It also is important for political economy--Masonomics uses public choice, which says that government officials, rather than acting as benevolent omniscient stewards, respond to incentives.

2. Signaling matters. It matters in education, health care, finance, politics, marketing, and personal relationships. I would suggest that if there is to be a Masonomics perspective on macro, then signaling should be central.

3. Institutions matter. Formal and informal rules shape economic behavior, for better or worse. For example, differences across countries in the standard of living are determined largely by institutions.

4. Evolution matters. When others see a lack of planning or central direction as chaos, Masonomists see Hayek's spontaneous order. A system of decentralized trial-and-error decisions works better than many people realize. Central regulation works less well than many people expect."

But in order to be able to contribute whatever it can, the Fed must be able to speak with clarity and credibility.

TO BE NOTED: From Econbrowser:

"The first votes are in

The Federal Reserve can't be entirely pleased with markets' reaction to its announcement on Wednesday of quantitative goals for purchases of long-term assets.

The Fed's objective in this quantitative easing is to move the inflation rate back into positive territory. Let's begin by reviewing the new consumer price index data that were also released on Wednesday by the Bureau of Labor Statistics. These numbers show further modest movement away from a deflationary tendency prior to any actions by the Fed. The seasonally adjusted February CPI was 0.4% higher than in January, which would be a 4.8% annual inflation rate if sustained for a year. Although that's plenty for one month, it nevertheless is still substantially smaller in absolute value than the drops seen in October through December.

Month-to-month percent change (monthly rate) in seasonally adjusted headline CPI. Data source: FRED.

That leaves the seasonally unadjusted CPI just 0.2% above its value from February 2008.

Year-over-year percent change (annual rate) in seasonally unadjusted headline CPI. Data source: FRED.

If we leave out food and energy, the February increase (+0.2% monthly) implies an annual inflation rate of 2.4%,

Month-to-month percent change (monthly rate) in seasonally adjusted core CPI (excludes food and energy). Data source: FRED.

and the year-over-year core inflation rate now stands at 1.8%. Both of these last two numbers are a bit below what I think the Fed should want to see, but they continue to offer comfort that we had been moving away from the deflation threat before the Fed's announcement.

Year-over-year percent change (annual rate) in seasonally unadjusted core CPI (excludes food and energy). Data source: FRED.

In discussing the Fed's announcement of its plan for quantitative easing, I wrote:

What will be the indication that we've done all we can with this tool? I would urge the Fed to be watching the exchange rate and commodity prices quite closely for an indication that the deflation tide has turned.

Exchange rate (euros per dollar). Source: Yahoo Finance.

Percent change in commodity prices between March 17 and March 20

aluminum	+6.4
coffee	+6.8
copper	+4.1
corn	+3.9
cotton	+3.2
gold	+4.0
lead	-1.7
silver	+6.3
tin	-0.4
wheat	-0.4
zinc	+0.3
crude oil	+3.9

That's why I doubt the Fed was pleased to see the dollar fall 5% against the euro last week. The Fed wanted everybody to wake up and notice that deflation is no longer on the table, but it's another thing if markets run off in the other direction fearful that a major inflation is coming. Notwithstanding, the dollar's move at the end of the week only served to undo an appreciation over the first part of the year, an appreciation that may have been unwelcome and unwarranted.

Prices of a number of commodities also zipped up about 5% on the news. Again this is a disturbing development, but again it still leaves the prices of many commodities below where they started the year, as the graph below demonstrates.

Value of prices of assorted commodities relative to value at start of year (Jan 2, 2009 = 100). Data source: WSJ commodity cash prices, via Webstract.

Commodity prices are quite sensitive to the level of real economic activity. If we had been about to repeat a global Great Depression with attendant significant U.S. deflation, maybe $35 oil could be justified. And if the Fed has now successfully communicated that's not going to happen, a commodities rebound might be quite appropriate.

But I think we also have to worry about whether this might be the start of a replay of what we saw a year ago, when excessively expansionary Fed policy provided fuel for commodity price speculation. In January of this year, Fed Chair Ben Bernanke offered this ex post appraisal of the Fed's policy in early 2008:

The [FOMC's] aggressive monetary easing was not without risks. During the early phase of rate reductions, some observers expressed concern that these policy actions would stoke inflation. These concerns intensified as inflation reached high levels in mid-2008, mostly reflecting a surge in the prices of oil and other commodities. The Committee takes its responsibility to ensure price stability extremely seriously, and throughout this period it remained closely attuned to developments in inflation and inflation expectations. However, the Committee also maintained the view that the rapid rise in commodity prices in 2008 primarily reflected sharply increased demand for raw materials in emerging market economies, in combination with constraints on the supply of these materials, rather than general inflationary pressures. Committee members expected that, at some point, global economic growth would moderate, resulting in slower increases in the demand for commodities and a leveling out in their prices--as reflected, for example, in the pattern of futures market prices. As you know, commodity prices peaked during the summer and, rather than leveling out, have actually fallen dramatically with the weakening in global economic activity. As a consequence, overall inflation has already declined significantly and appears likely to moderate further.

Bernanke seemed here to be taking the position that since the Fed got the long run correct-- the end of 2008 brought strong disinflationary pressures and commodity prices collapsed-- it was OK to ignore the commodity price boom of early 2008. I disagree with that assessment. In my opinion, the oil price increase of 2008:H1 was highly destabilizing for the economy and a key factor that turned an economic slowdown into a recession. One of the lessons for monetary policy that we should draw from the recent behavior of real estate and commodity prices is that the Fed can't ignore the consequences of its actions for speculative prices, even if (or perhaps, particularly if) that speculation reflects a basic misreading of fundamentals. If commodity speculators are erroneously about to declare the bull game is back, that in my mind would be a development that would require the Fed to scale back its plans for quantitative easing.

How would I handle that in practice? I think the best strategy is for the Fed to lay all its cards on the table face up, telling everybody exactly what it is hoping to achieve and how it is going to do it. The Fed needs to communicate that it's not going to allow the price level to fall, but it's also not going to allow runaway commodity prices. So why not announce a specific target of, say, 2-3% for headline inflation, which implies a direct commitment that the Fed will become more cautious if it observes a response to its actions of items such as oil and food? This could be accompanied by statements from Fed officials along the lines that they're watching commodity markets and exchange rates closely for an indication that quantitative easing has accomplished all it set out to do.

All this requires acknowledging from the outset that there is only so much the Fed can accomplish in this situation, a premise that in my mind has considerable merit. But in order to be able to contribute whatever it can, the Fed must be able to speak with clarity and credibility.

If the moves we saw in exchange rates and commodity prices this week are the end of the story, then I think all is well. But if they are the beginning of a new trend, the Fed will need to react."