Tuesday, July 22, 2014

Bayesian Superman

Consider Proposition H: "God is watching out for me, and has a special purpose for me and me alone. Therefore, God will not let me die. No matter how dangerous a threat seems, it cannot possibly kill me, because God is looking out for me - and only me - at all times."

Suppose that you believe that there is a nonzero probability that H is true. And suppose you are a Bayesian - you update your beliefs according to Bayes' Rule. As you survive longer and longer - as more and more threats fail to kill you - your belief about the probability that H is true must increase and increase. It's just mechanical application of Bayes' Rule:

P(H\mid E) = \frac{P(E\mid H) \cdot P(H)}{P(E)}

Here, E is "not being killed," P(E|H)=1, and P(H) is assumed not to be zero. P(E) is less than 1, since under a number of alternative hypotheses you might get killed (if you have a philosophical problem with this due to the fact that anyone who observes any evidence must not be dead, just slightly tweak H so that it's possible to receive a "mortal wound").

So P(H|E) is greater than P(H) - every moment that you fail to die increases your subjective probability that you are an invincible superman, the chosen of God. This is totally and completely rational, at least by the Bayesian definition of rationality.

If you think this is weird, consider a closely related question: Suppose H was true, and you were an invincible God-protected superman. How would you know? Simple: you'd go get in a bunch of dangerous situations, and when you failed to die, you'd gradually realize the truth. The more dangerous the situations you chose, the faster the truth would be revealed - if you jumped in front of a train and failed to die, that would be stronger evidence than if you just drove to the store without a seat belt and made it back safely.

But nevertheless, every moment contains some probability of death for a non-superman. So every moment that passes, evidence piles up in support of the proposition that you are a Bayesian superman. The pile will probably never amount to very much, but it will always grow, until you die.

So does this mean that any true Bayesian will eventually accept invincibility as his working hypothesis? No. There are other hypotheses that explain your failure to die just as well as H does, and which are mutually exclusive with H. The ratio of the likelihood of H to the likelihood of these alternatives will not change as you continue to live longer and longer. But this gets into a philosophical thing that I've never quite understood about statistical inference, Bayesian or otherwise, which is the question of how to choose the set of hypotheses, when the set of possible hypotheses seems infinite.

Anyway, it seems to me that "Bayesian superman" is not just a prescriptive definition of how a rational person reacts to his own failure to die, but also a description of the observed behavior of teenagers. Teenagers - especially boys - are commonly described as "thinking they're invincible." Often this belief noticeably decreases when a young man sustains a major injury, witnesses a major injury or death, or has a close call with death. This, I suspect, is because most people's belief in their own invincibility is a little more complex than the "Proposition H" I've written above - it includes things like "God is looking out for my friends," and "God will stop me from getting the s*** kicked out of me," etc. A lot of people seem to start life with a non-negligible belief that this kind of special protection is watching over them. Sadly, they all eventually learn otherwise.

Monday, July 21, 2014

You'll get no edge with Zero Hedge

(This post originally appeared at Bloomberg View.)

I can’t tell you that gold is a bad investment. Even after the recent plunge, if you bought gold in 2004, your investment would have earned you an annualized rate of about 10.4 percent, after accounting for inflation. That is darned impressive. If you bought in 1994, it would have earned about 3.9 percent per year -- not too shabby. Even if you bought all the way back in 1984, you would have earned 1.8 percent in real terms. (Of course, this assumes that shadowstats.com is wrong, and that inflation hasn’t been massively understated.)
In addition to delivering decent long-term returns, gold has been a way to spread or offset investment risk. As my co-blogger Yichuan Wang showed last year, gold’s return is somewhat negatively correlated with interest rates, so that a bet on gold is to some degree a bet on lower rates. This is actually the prediction of some old economic models, which also indicate that gold should have a positive rate of return over the long term. But a lot of the variance in the price of gold isn't explained by such factors, meaning that some small amount of gold is a valuable addition to any well-diversified portfolio.
But there are two big words of caution with respect to gold. The first is that you shouldn’t believe the standard story for why gold will go up. The second is that you should be very wary of websites and media outlets that constantly push you to buy gold.
The standard story for why you should buy gold is that it’s a hedge against the inherent weakness of the fiat money system. Unfortunately, it isn’t. For example, gold is a poor hedge against inflation. The correlation is very weak. Remember that gold had its huge bull run in the 2000s and a long slide in the '80s…but inflation was higher in the '80s than in the 2000s!
A more speculative and extreme version of the story is that the whole fiat money system is destined for collapse, and that after this happens we’ll go back to using gold as money. If that did happen, you’d want to own a lot of gold at that moment. Unfortunately, there are some big problems with this story, too. Technology has advanced to the point where we can use things like Bitcoin instead of heavy, easy-to-steal physical commodities like gold. And if civilization collapsed to the point where we couldn’t even use computers anymore, I’d advise you to invest in guns, ammunition, seeds and antibiotics instead of gold.
A bigger problem with the gold story is the question of why you should expect it to earn a good return. For gold’s price to keep rising steadily due to the failure of the fiat money system, it has to be the case that more and more people will steadily realize that the story is true. So a bet on this gold story is a bet that your macro perspective is way, way ahead of the macro perspectives of most other investors. That’s a highly speculative, risky bet.
So you should beware of media outlets that constantly push this story on you. The most important such website is probably Zero Hedge. If you read Zero Hedge, you’ll see this story about gold and fiat money being promoted again and again and again, often mixed with a healthy dose of political ideology and references to “Austrian economics.”
If you actually take Zero Hedge’s constant gold-flogging to heart, you could lose a lot of money. Since gold hit a peak in 2011, it has lost about 33 percent of its value in real terms. Zero Hedge kept touting gold all the way down. For example, in November 2011, Zero Hedge ran an article saying that gold could be “on its way to infinity.” In March 2012, Zero Hedge urged its readers to “stay long gold.” An October 2012 article made the same recommendation. As the price fell, Zero Hedge assured us that the collapse was only in “paper” gold, not the physical commodity. Needless to say, if you took Zero Hedge’s advice at any of these points, you would have lost a lot of money.
Now, if the gold crash is only temporary, and someday gold heads toward infinity, then losing money on paper is no problem…unless, of course, you have to sell to cover retirement expenses or pay some medical bills.
A lot of finance people seem to treat macro stories, like the one Zero Hedge pushes, as entertainment rather than actionable information. That’s a healthy attitude. And it’s true that Zero Hedge occasionally does some excellent reporting, or publishes other good information. So maybe you can read the site just for those tidbits, and either ignore or just smile indulgently at the huge volume of gold-flogging politics-tinged macro-propaganda that the site hurls at you day after day. But then you’re like one of those rare people who really does read Playboy magazine for the articles.
Zero Hedge is still pushing gold. It’s still pushing Austrian economics. But should you be listening? Only if you’re very good at separating bedtime stories from reality.

Sunday, July 20, 2014

Are liberals rescuing marriage?

(This post originally appeared at Bloomberg View.)
When we think about the issues of family, sex, and morality there’s a standard story that frames our thinking. Ross Douthat, writing back in January, did a good job of telling that story:
[Liberals might want to] acknowledge the ways in which liberalism itself has undercut the two-parent family — through the liberal-dominated culture industry’s permissive, reductive attitudes toward sex, and through the 1970s-era revolution in divorce and abortion law.
It seems obvious that sexual permissiveness discourages marriage. In the old days, marital sex was the only socially acceptable kind of sex, so if you wanted to have sex, you had to get married; allow people to have sex outside of marriage with no social sanction, and you take away a big part of the impetus to get married. Liberal values, therefore, are corrosive to families.
But is this true? Last year, I read a book that changed my outlook on American society: Charles Murray’s ``Coming Apart: The State of White America, 1960-2010.” In that book, Murray convincingly argues that a class divide has emerged in America, between educated people (“Belmont”) and uneducated people (“Fishtown”). The surprising thing is that Murray finds that the educated Belmonters, despite being much more socially liberal than their Fishtown counterparts, actually have more traditional family values -- they get married more, get divorced less and pay more attention to their children. After a period in the '70s and early '80s when educated people dabbled in single parenthood and high divorce rates, they went back to a traditional-family structure. Uneducated Americans, on the other hand, are abandoning marriage and two-parent child-rearing in droves.
It isn't just Murray finding this. Richard Reeves of the Brookings Institution has identified something very similar. In a landmark article in Atlantic magazine, he gave a detailed, data-driven case that educated Americas are rebuilding the institution of marriage:
[C]ollege graduates in the United States are reinventing marriage as a child-rearing machine for a post-feminist society and a knowledge economy. It’s working, too: Their marriages offer more satisfaction, last longer, and produce more successful children.
The glue for these marriages is not sex, nor religion, nor money. It is a joint commitment to high-investment parenting…Right now, these marriages are concentrated at the top of the social ladder, but they offer the best—perhaps the only—hope for saving the institution.
How can this be? How can the people who preach sexual license be the same ones who have rebuilt their families, while lower-class people who profess more conservative values are seeing their families crumble?
Social conservatives have a few hypotheses. One is that high-investment parenting is only for the wealthy -- that in our stratified society, lower-income people know that investing a lot of effort in the kids won’t pay off, so they just don’t bother. A variant of this is the idea that lower-class men are too risky for lower-class women to marry.
In his book, Murray implies that educated liberals are a bit hypocritical. He calls on them to “preach what they practice,” in the hope that they can spread their newly recovered family values to the Fishtown masses. But a thought occurs to me: What if that’s exactly what they’ve been doing all along? What if sexual permissiveness and feminism, instead of being toxic to the institution of marriage, are the key to saving it?
That might sound crazy, but here’s the case in a nutshell. If you wait until marriage to have sex, you’re taking an enormous risk. What if you’re not compatible? Or what if you regret not having shopped around?
Sexual permissiveness means that sex isn’t about marriage. But that means that marriage isn’t about sex. Most of the upper-class liberal educated Americans I know who are in stable, happy marriages had their share of premarital sex. Knowing what that lifestyle is like -- and realizing that they wanted more -- allowed them to be more content in their marriages, and more realistic about what marriage is all about (i.e., lifetime companionship and raising kids).
Feminism may be even more important for families. With traditional gender roles, only a man who can be a sole breadwinner is a worthwhile mate. That rules out a lot of men, and it might be a reason why less-educated Americans’ conservative values are holding them back from getting married. Feminism, on the other hand, rewards fathers for sharing child care and housework, and frees them from the heavy burden of antiquated expectations.
In other words, maybe liberal morality is simply better adapted for creating stable two-parent families in a post-industrialized world. Maybe conservative family values are hard but brittle, like diamond, while liberal family values are strong like titanium -- able to bend without breaking.
If this is true, then I feel hopeful about American families. In many cases, educated and upper-class Americans are social trend-setters, while less-educated Americans catch up eventually. Perhaps America’s “Fishtown” class is simply doing the same thing the “Belmont” class did 30 years ago -- experimenting with single parenthood -- and will eventually learn how to do gender-equal marriage and high-investment parenting.

Thursday, July 17, 2014

Austrianism, wrong? Inconceivable!

I see that Robert Murphy of the Mises Institute has taken the time to pen a thoughtful critique of my gentle admonishment of followers of the school of quasi-economic thought commonly known as "Austrianism." Robert deserves a response, so here is one.

First, Robert takes pains to point out that the image I included in my original blog post was not a picture of an Enterprise crewmember who had been subverted by Khan's "brain worms" (actually "Ceti eels"), but rather of a minor character in an unrelated episode of the original Star Trek series. This is correct, of course. Searching for an image to use in my post, I found the pictures of the actual Ceti eels too visually unappealing, while the pictures of the subverted Enterprise crewmen did not look particularly out of the ordinary (much as a devotee of Austrianism may appear, when encountered in a bar or on a trading floor, to be a normal human being in full possession of his faculties). So I instead chose an unrelated picture that I thought would better convey the general idea of the post, rather than remaining faithful to the canon of the original Star Trek series. Robert might also have noted that the picture used by Bloomberg was not of a Ceti eel, but of a handful of garden-variety earthworms. I apologize for this canonical inaccuracy as well. And before anyone starts giving me a hard time, let me note that the image at the top of this post is actually not a picture of Robert Murphy; it's actually an image of the alien "Balok" from the original Star Trek series episode "The Corbomite Maneuver."

So now that that's cleared up, let's examine Robert's critique. Much of my original article discussed the failed Austrian prediction that QE would cause inflation (i.e., a rise in the general level of consumer prices). Robert reiterates four standard Austrian defenses:

1. Consumer prices rose more than the official statistics suggest.

2. Asset prices rose.

3. "Inflation" doesn't mean "a rise in the general level of consumer prices," it means "an increase in the monetary base", so QE is inflation by definition.

4. Austrians do not depend on evidence to refute their theories; the theories are deduced from pure logic.

This is sort of an intellectual defense-in-depth. Each argument, if true, obviates the need for all the former arguments. For example, if asset price rises really are the same as consumer price rises, who cares if consumer prices rose more than the official statistics suggest? And if QE really is defined as inflation, why does one need to point out rises in asset or consumer prices? And if Austrian theory is not vulnerable to falsification by data, then why bother citing any evidence at all?

In other words, the fact that Robert is making all of these arguments at once seems to me like a tacit admission that each one of the arguments, on its own, is very shaky.

But be that as it may, all of the arguments are either unsupported assertions or deeply flawed. Let's go through the list.

1. Robert:
2) "prices are rising much faster than anyone thinks" There are plenty of people who think the “cost of living” is a lot higher now than it was in 2007. No, I’m not saying we’re living amidst hyperinflation but the government is hiding it; but I do think the official Consumer Price Index is understating things.
Rebuttal: There are plenty of people who think the "cost of living" is a lot lower than it was in 2007. No, I'm not saying we live amidst deflation but the government is hiding it; but I do think the official Consumer Price Index is overstating things.

See what I did there?

2. Robert:
UCLA giants Alchian and Klein argued in a 1973 paper that asset prices should be included in a proper measurement of monetary policy. By that criterion, the Fed definitely has been “loose” and “inflationary” since 2008; indeed that was the whole point. People look at soaring stock prices and say, “Good job Bernanke!”
Rebuttal: Imagine yourself saying this: "Oh, no, the price of stocks is going up! Jeez, how will I be able to afford my weekly purchase of 100 shares of my favorite ETF? I better ask my boss for a raise!" You can't, right? Because when stocks go up, that's good.

Now an Austrian may be tempted to retort: "But this price rise is only temporary; it's going to crash later!"

OK, even if that were the case, it would be the crash, not the rise in stock prices, that would be the bad thing. Whereas if you're worried about increases in the price of say, TVs, your chief worry is not that the price of TVs will subsequently crash - in fact, you probably hope that it does, so you can get a cheap TV.

So you see, stock price rises are not actually good to include in inflation. (Homes are more complicated, of course, since they involve a consumption component.)

3. Robert:
Noah [argues] that the Austrians in response to the modest CPI hikes of 2009-2013 attempted to redefine inflation. No, Noah, this is not some new position. Here’s Mises on page 420 of Human Action:
...What many people today call inflation or deflation is no longer the great increase or decrease in the supply of money, but its inexorable consequences, the general tendency toward a rise or a fall in commodity prices and wage rates...
Now that was originally published in 1949, so I’m pretty sure Mises wasn’t providing cover for Peter Schiff and me in light of CPI after various rounds of QE. 
If Noah doesn’t trust such a dodgy source as Mises, maybe he’ll heed the statements of an official Federal Reserve publication? Joe Fetz provided me with this 1997 Cleveland Fed paper, which says: 
Today, we commonly hear about different kinds of inflation. Indeed, the word inflation is often used synonymously with “price increase.” But there is also a different, more specific, definition of inflation–a rise in the general price level caused by an imbalance between the quantity of money and trade needs. This “inflation” has but one origin–the central bank. It is the latter definition that drives many of those advocating an anti-inflationary policy for the Federal Reserve, and that more closely conforms with the word’s original meaning. 
Oops, sorry Noah. Maybe next time you should do some research before writing on a topic. 
Historically the word “inflation” did indeed mean what (some) Austrians currently insist is a better definition–namely an increase in money rather than an increase in prices[.]
Hmm. First, note that the Cleveland Fed paper defines inflation as "a rise in the general price level caused by an imbalance between the quantity of money and trade needs." For that to exist, you need the general price level to rise. If it doesn't, then by the Cleveland Fed's 1997 definition, there is no inflation. So by the Cleveland Fed definition Robert cites, there has also been very low inflation since QE began.

Let me humbly suggest that perhaps Robert should actually read his own sources before writing on a topic.

But in any case, yes, it is true that Ludwig von Mises also wanted to define "inflation" as an increase in the monetary base (note, however, that the rise in prices that he considered to be an "inexorable" result is looking less inexorable by the day). But so what?

Here's the real point: Defining QE as inflation, no matter who came up with the idea and when, is merely a distraction from the fact that QE has not led to a rise in consumer prices. What kind of prediction is it to say that "QE is inflation, therefore of course QE causes inflation, HA!" No prediction at all.

But this brings us to Austrian Defense #4...

4. Robert:
But Noah’s claim that my prediction about CPI movements has something to do with Austrian theory is nuts. Notice that the mainstream economists like to mock Austrians (Misesians in particular) on two different counts: In the first place, they mock us because we adhere to “praxeology,” which says that pure economic theory is deduced a priori, rather than through empirical observation. (Here’s Noah admitting he knows this, in point #2 of a February blog post.)
This is basically saying "Noah, you can't use evidence to disprove our theories, because you know very well we don't care about evidence!"

Which is sort of the whole problem, isn't it? Austrians are looking at real events and saying "Inconceivable!"...er, make that "Inexorable!" But I do not think that word means what they think it means.

See, most people do care about the evidence, very much. They do not care if Austrian theories were logically deduced from the Human Action Axiom. They care whether their financial portfolios increase or decrease in value. And if they bet on the Austrian predictions that inflation (the real kind) would go up as a result of QE, they lost money. Praxeology might be logically satisfying, or it might not, but it's cold comfort when extant reality is kicking you in the head.

(Incidentally, people also mostly don't care about whether "inflation" means the rate of change of the monetary base or whether it means the rate of change of the CPI. What they care is whether the former causes the latter. Word games are even less comforting than logical syllogisms.)

My article was not intended to point out that Austrian theory failed its own test of validity following QE. It can't possibly fail its own test - it designed the test so that it could not fail it.

My point was that Austrian theory has failed other people's test of validity.

Now, that's obviously not enough to convince a lot of Austrians to abandon Austrianism - once you have accepted a belief system that creates its own criteria for success, you're very unlikely to change (that's what I meant by calling Austrianism a "brain worm"; it is by no means unique in having this Ceti eel-like property). But from where I'm standing, failed empirical predictions are a big deal. And it's not just inflation, either - it's gold, the dollar, etc.

Anyway, there are some other miscellaneous points I could make about Robert's critique (For example, he blatantly overlooked the one point at which my rant was actually charitable to Austrian ideas! Can you find it?). But this is the main thrust. In any case, I thank Robert again for taking the time to write a response to my article.

Monday, July 14, 2014

How are macro methods evolving?

I realized long ago that I'm much more interested in the philosophy-of-science issues of macroeconomics than in the subject matter itself! So when John Cochrane came back from the NBER Summer Institute with a big post about the latest trends in macro methods, I was understandably excited. I don't have a heck of a lot to add, but here are the highlights:

Math as Storytelling

Back in 1991, Larry Summers complained that macro models create the illusion of science-y-ness by pretending that the parameters in their model represented real things instead of stylized allegories. In 2010, Ricardo Caballero argued something similar, saying that the crisis had exposed the faults of the overly-precise "fully-specified DSGE" approach.

The argument is really not about the content of models - it's about the use of math itself. One way to use math is the way physicists and chemists use it - to make quantitative predictions of stuff. The other, less ambitious, way is to use math to be precise about your ideas, to check your logic, and to explain your ideas in a universal language. The latter way isn't bad; what's bad is when you mistake the latter for the former, and take your models "too seriously."

The crisis and recession seemed like it should have told macroeconomists that they were taking their models a bit too seriously. And in fact, that seems like exactly what has happened. Cochrane:
Most of the theory papers had some "motivating" facts...Not one paper wrote down a model, estimated or calibrated its parameters, and compared that model to data...This isn't a complaint, really, it's just where we are. The kinds of things people want to investigate are just too hard to write down models rich enough to take to the data... 
[B]oth of the macro theory papers stopped well short of serious confrontation with data. We didn't see anything like the standard fully specified models...compared to, say, impulse-response functions. The models are so stylized you can't begin to quantify them...This too is not really a criticism. I've been working with simpler and simpler models, as I find it hard to keep the intuition and quantitative parable aspect alive as models get more complex.
So mainstream macro people seem to have converged on the Caballero idea. This also provides yet more evidence that modern mainstream macroeconomics is very much alive and kicking as a research program.

More stylized models doesn't necessarily mean simpler models, though:
Sam [Kortum] gently chided Ufuk et al. for presenting 24 pages of complex model all to "motivate" some regressions.
It will be interesting to see whether the move toward stylization will be followed by a move toward simplicity in model-making. Maybe macroeconomists, groping for big ideas to explain the unprecedented events we've just seen, will go back to telling the kind of simple stories that Milton Friedman used. Or maybe even "24 pages of complex model" is so simple compared to the real thing it's trying to model that to make it even simpler would lose too much of the logic.

Growth vs. Business Cycle Theory

The idea that growth and development econ were two completely different fields always struck me as a little weird. I mean, sure, maaaaaaybe you could use an endogenous-growth model to tease a couple extra bips of growth out of a mature economy for a few years, if you had enough data to really find the best endogenous-growth model, which (let's be honest) you don't. Endogenous growth theory is very kewl and interesting, but it just doesn't seem that important relative to development econ, which deals with the monumental challenge of boosting poor countries to middle-income level. (Robert Lucas seems to agree.)

I don't follow growth theory much, but according to Cochrane, the top growth people are indeed becoming more interested in development issues, and adopting the methods more commonly associated with development econ:
Economic Fluctuations merged with Growth in the mid 1990s. At the time there was a great confluence of method as well as interest. Growth theorists were studying growth with Bellman equations, dynamic general equilibrium models of innovation and transmission of ideas, thinking about where productivity shocks came from... 
That confluence has now diverged. I enjoyed spending an hour or two thinking about how religion has blocked or adapted to ideas over the centuries, and Paul [Romer]'s view on social norms or neuroeconomics. But I don't really have any expertise to contribute to that debate...[W]hen Daron Acemoglu, who seems to know everything about everything, has to preface his comments on macro papers with repeated disclaimers of lack of expertise, it's clear that the two fields really have gone their separate ways. Perhaps it's time [for] growth to merge with institutions and political or social economics.  
Cool. Though this may not sit well with Japanese macro people, a lot more of whom do growth econ rather than business-cycle theory.

Verbal Arguments and the Wisdom of the Ancients

Probably the most striking sentence in Cochrane's post was the following:
In my 30 years as an economist, our field has become much more literary and less quantitative.
That's interesting. I had thought it was the opposite. Was there a U-shaped pattern, where things became more quantitative leading up to the mid-80s, and then trended back toward literary-ness?

In times of uncertainty, we humans have a natural tendency to reach for the wisdom of the ancients. Cochrane isn't such a fan of this, but recognizes that he may be swimming against the tide:
The use of ancient quotations came up several times. I  complained a bit about Eggertsson and Mehrotra's long efforts to tie their work to quotes from verbal speculations of Keynes, Alvin Hansen, Paul Krugman and Larry Summers. Their rhetorical device is, "aha, these equations finally explain what some sage of 80 years ago or Important Person today really meant."  Ivan Werning really complained about this in Paul Beaudry's presentation. What does this complex piece of well worked out "21st century economics" have to do with long ago muddy debates between Keynes and Hayek? It stands on its own, or it doesn't... 
Physics does not write papers about "the Newton-Aristotle debate." Our papers should stand on their own too. They are right or wrong if they are logically coherent and describe the data, not if they fulfill the vague speculations of some sage, dead or alive... 
Sure, history of thought is important; tying ideas to their historical predecessors is important; recognizing the centuries of thinking on money and business cycles is important. But let's stand up for our own generation; we do not exist simply to finally put equations in the mouths of ancient economists. 
But...perhaps I'm just being an old fogey. Adam Smith wrote mostly words. Marx like Keynes wrote big complicated books that people spent a century writing about "this is what they really meant." Maybe models are at best quantitative parables. Maybe economics is destined to return to this kind of literary philosophy, not quantified science.
My instincts are with Cochrane on this issue. There is nothing more annoying than when you argue with some idea, and then some guy comes along and says "Go read Ludwig von Mises, then you'll understand everything." No you won't. You'll just get a warm glow of understand-y-ness, and you'll end up parroting words and phrases from the Old Master without being any better able to think critically and originally about the issues.

Then again, a lot of those old folks were really smart, and there are probably insights embedded in their writings that are too vague or complex to be translated directly into math, but which contain information, the way the priors of a portfolio manager carry valuable information in a Black-Litterman model. But the flip side of that is that you probably have to be a really, really smart person to extract that deep-buried insight. Economic history, in other words, seems like very dangerous sauce to me - in the right hands it can be useful, but it is usually in the wrong hands.

But that's just my thought. I feel like I may annoy Brad DeLong with this thought...

The Upshot: Halfway Back to the Drawing Board

So from what Cochrane saw at the NBER macro meeting, the field is becoming more literary, more stylized in its modeling, and more eclectic in its approach. To me, these all seem like manifestations of one single, underlying process: Macroeconomists are going back to the drawing board in the wake of the crisis and the recession. Not all the way back, but part of the way back. They are searching for new ideas, by making their models more conjectural and conceptual, by bringing in a mix of techniques and "out-there" ideas, and by picking through ideas from the past.

It seems to me that this is exactly what good scientists do. If you are one of the people who thinks that macroeconomics is utterly compromised by dogma, politics, or non-scientific thinking, Cochrane's report should cause you to update your priors somewhat.

One More Thought: The Impact of Blogs

I suspect that blogs have played a largely helpful, though marginal role in the evolution of macro since the crisis - encouraging macro people to realize that something big was broken and needed fixing, tossing around ideas and brainstorming, etc. But I've come to think that blogs have also injected too much contentiousness and aggression into the discussion. For example, Cochrane writes:
[Paul Romer] pointed to my use of "paleo-Keynesian" to describe the static models from the 1960s, guessing nobody would remember anything else from my discussion. When I complained that Paul Krugman invented the term, he pointed out (correctly) that such borrowing just made its use more rhetorically effective. There go the cortisol levels.
When I started blogging a few years ago, I took a very confrontational and sometimes even insulting tone. That was because I thought A) this is the internet, B) everything on the internet is a joke, and C) everyone gets that it's a joke. I guess I had spent too much time in the bowels of the net. I always meant it as a joke, and I never imagined that top academic people would read, much less care about, my blog.

Turns out I was naive. Over time, fellow bloggers like Tyler Cowen and Adam Ozimek convinced me that more civility was needed, so I try to confine my chain-yanking to those who are more used to getting their chains yanked. Academics need to be able to think clearly and objectively, without their cortisol levels being spiked.

Basically, in the wake of the crisis, blogs have fulfilled the same role as the verbal debates between Keynes, Hayek, Sraffa, Robinson, etc. during the Depression. But like those debates, it has generated its fair share of acrimony.

Sunday, July 13, 2014

Should the Fed crash the economy now to prevent a crash later?

(This post originally appeared at Bloomberg View.)

Asset prices, by historical measures, are high across the board. The reason seems simple: Low risk-free rates, courtesy of the Federal Reserve, are driving investors out of cash and into risk assets. To many, the implication is clear: The Fed needs to raise interest rates in order to prevent a destabilizing market crash.
That isn't a good idea. Let me explain why.
First of all, higher asset prices due to lower safe interest rates aren't some kind of nefarious plot -- this is just Finance 101. The value of a financial asset is the discounted present value of its future payoffs, and when the discount rate -- of which the Fed interest rate is a component -- goes down, the true fundamental value of risky assets goes up mechanically and automatically. That’s rational price appreciation, not a bubble.
OK, but what if a bubble does occur? At this point, pretty much everyone except for a small handful of aging academic economists believes that bubbles really do happen. What if the Fed’s easy policy has fed a big one?
Well, of course that can’t be ruled out, but everything we know about bubbles goes against that idea. The theory of speculation tells us that bubbles form when people think they can find some greater fool to sell to. But when practically everyone is convinced that asset prices are relatively high, like now, it’s pretty obvious that there aren’t many greater fools out there.
If you look at past bubbles, such as the late-'90s tech bubble or the mid-2000s housing bubble, you see that there was always a large contingent of society that thought it wasn’t a bubble at all -- that “this time, it’s different.” Who nowadays thinks that there’s some special Big New Thing that’s going to push stocks and bonds and commodities all to stratospheric heights forever? Who has a story for why recent asset price rises should be followed by even more asset price rises, and then even more? No one I know of. Paradoxically, the one time it’s hardest to have a bubble is when everyone and their dog is unhappy about asset prices and scared that there’s a bubble.
Actually, there’s laboratory evidence for bubbles, too -- it’s by far the most-researched phenomenon in experimental finance. And it’s true that when you give traders in the lab more cash, you get more and bigger bubbles. Unfortunately, it’s also the case that raising interest rates doesn’t pop the bubbles, which tend to form whenever some people don’t understand fundamentals.
Conclusion: The Fed has raised asset prices, but there’s no sign that it has caused an irrational rise in prices.
Basically, the people calling for Fed Chief Janet Yellen and the Fed to raise rates are demanding that the Fed crash asset prices in order to avoid an asset price crash. That may sound like a good idea if your mental model is a little pain now to prevent a lot of pain later. But if the rise in prices has been a rational response to Fed easing, then there’s no need for such medicine; causing a crash today will just cause a crash today, period.
There is also the idea that the rise in asset prices is simply unnatural or artificial. But the Fed has been regulating the monetary base for many decades, and for a lot of that time there were no big bubbles. Like it or not, the Fed is a natural part of the financial ecosystem, and we just happen to find ourselves in a time in which the Fed is more important than usual. Also, it seems to me that “naturalness” is a pretty weak justification for deliberate government action to crash the value of Americans’ retirement accounts.
If you talk to the people at the Fed, it’s very clear that they worry about asset bubbles -- how could they not, when they’ve been partially blamed for two big ones less than 10 years apart? But the Fed isn’t yet worried enough about bubbles to use the blunt hammer of rate hikes. Its cautious, middle-of-the-road policy seems very at odds with the extremism that a lot of people in the finance industry seem to attribute to it. I say we hold off on our calls for anti-bubble rate hikes.

Demand in the gaps?

In a very good post, John Quiggin talks about some of the problems that have cropped up with labor search models. Personally I think labor search models are awesome, since - unlike most business-cycle models - they actually try to take into account the way economic actors behave in the real world. There's generally a "matching function" that tries to describe the technology that job-seekers and companies use to find each other - newspaper ads, human networks, websites, or whatever. Quiggin is right that changes in this technology itself are not enough to explain all the changes we see in employment and unemployment. More important might be the ways that people decide whether to take a job or to keep searching. For just a taste, see this paper by Mike Elsby and Matt Shapiro, which tries to model the fact that people get experience when they work. That is probably what Kartik Athreya meant when he wrote that "search models aren't really about search."

So search models still haven't fully explained employment patterns. What mental model of unemployment should we have in the meantime? At the end of his post, Quiggin writes:
If search models aren’t the right way to think about unemployment, what is the right way? The simple answer is that unemployment is primarily a problem of macroeconomics not of labor markets. If aggregate demand is far below the productive capacity of the economy, workers will be unemployment and capital will be idle.
This is a simple answer, since it basically just thinks of the economy as an AD-AS model, and unemployment as being determined by Okun's Law or a short-run Phillips Curve. Economists are used to thinking in terms of supply and demand, so the AD-AS model comes naturally to mind. Inflation and output are both low, which looks like a negative demand shock on a supply-and-demand graph, so we look at the economy and say "it's a demand problem".

But on a deeper level, that's unsatisfying - to me, at least.

First of all, what causes aggregate demand curves to shift? You could have a monetary policy regime change. You could have a liquidity preference shock, possibly produced by financial market disruptions. You could have some kind of news about future productivity, or some kind of confusion about which sector is going to do well. You could have swings in sentiment - pure "animal spirits" - that become self-fulfilling prophecies. Really, you could have all kinds of stuff. This question is interesting, since different determinants of demand will entail A) different ways to predict recessions, B) different ways to prevent recessions, and C) different ways to combat recessions.

Second of all, how does aggregate demand affect unemployment? The usual explanation for this is downward-sticky nominal wages. But why are nominal wages downward-sticky? There are a number of explanations, and again, these differences will have practical consequences.

(Third of all, is an AD-AS model really a good way of modeling the macroeconomy? Supply-and-demand has its uses, and is sort of the iconic model of economics, but it has its limitations. The curves might exhibit hysteresis, for example, or randomness. The idea of abandoning the friendly old X of supply-and-demand is scary, I know, but maybe it just isn't the best descriptor of booms and recessions.)

So I'm not really satisfied by the practice of putting "demand in the gaps". If "demand" is not to be just another form of economic phlogiston, we need a consistent, predictive characterization of how it behaves - its causes, its effects, and its domain of validity.

Saturday, July 12, 2014

Nature, nurture, or mindset?

(This post originally appeared at Bloomberg View.)

If you ever have the time, read Mindset: The New Psychology of Success, by Carol Dweck. Actually, if you don’t have the time, try to make it. Because trying to do things you think you can’t do is the whole point of Mindset.
There’s a belief out there that Americans don’t try as hard at things as they used to -- that we used to persevere and hustle and have grit, but now we coast on our natural abilities and quit when the going gets tough. I’m not sure how to check if this is true, but Carol Dweck -- a Stanford psychologist whose life work has been to study this sort of thing -- agrees. Whether Americans are getting wimpier and more entitled, Dweck’s message is an absolutely crucial one. She’s truly a thinker for our age.
Dweck’s message, in a nutshell, is this: If you think you can’t improve, you won’t. If you think you can improve, you probably will, and you will be happier along the way. People with a “fixed mindset” live in constant fear of failing at things, because failure represents proof that their natural ability is low; they also don’t try hard, because they think it’s all in the genes. People with a “growth mindset,” on the other hand, enjoy a challenge and relish hard work, so they end up getting better and better.
Many of us stumble on that idea independently. In October 2013, I co-authored an article about math education with my doctoral adviser Miles Kimball, which turned out to be the most popular thing either of us had ever written. Our article was about how people who think they are bad at math -- that is, most Americans -- end up not making the effort required to actually become good at math. We cited one of Dweck’s papers, but we had no idea how sweeping her vision is.
The book comes at a very important time in U.S. history. There are two faddish intellectual currents driving American thinking about success, and both have a gaping hole where Dweck’s insight should be.
The first of the two new American worldviews is nature-ism, which holds that life outcomes are basically frozen from birth. This idea is popular among libertarians, as well as some more extreme elements of the political right. Racism, of course, is steeped in nature-ism, but so is the idea that education is valuable only as a signal of inborn ability. Economist Bryan Caplan -- who, I should mention, is a personal friend of mine -- has been a champion of this idea.
On the political left, a more popular idea is nurture-ism, which holds that societal and parental influences can mold a child into any desired shape. This is the premise of Amy Chua’s book Battle Hymn of the Tiger Mother, in which she advocates an aggressive, controlling style of parenting. Another strain of nuture-ism blames society for any individual outcome, and puts too much emphasis on privilege.
I’m sad to see these two views gaining such currency in the U.S. They remind me uncomfortably of our two great opponents in the ideological contests of the 20th century -- fascism, which held that superior races would come to dominate inferior ones, and communism, which held that social engineering was the key to national greatness.
Carol Dweck asserts that there is a third way -- free will. Free will as a philosophical concept can be confusing (what makes you use your free will in a certain way, if not nature or society?). But as a practical tool, it has enormous value. When you exercise your free will and try hard at things, some social influence or subtle genetic effect may have played some part in your choice, but no one will ever know. So in the meantime, as the Nike ads used to say, “Just do it.” The first step is to pick up a copy of Mindset.

Thursday, July 10, 2014

Another probably useless plea for more high-skilled immigration

(This post originally appeared in Bloomberg View.)

It’s hard to believe passionately in an issue that almost nobody cares about, and when those that do care usually disagree with you. But life is hard, so here I am: a passionate believer in letting more high-skilled workers immigrate to the U.S.
There’s really no natural constituency for high-skilled immigration. The potential immigrants themselves aren’t in the country yet. High-skilled Americans are afraid that high-skilled immigrants will take their jobs and depress their wages (though the evidence says this isn’t really true). And of course the low-skilled Americans don’t even have the issue on their radar.
The closest thing to a constituency for high-skilled immigration is Silicon Valley, because tech companies naturally want plentiful, cheap high-skilled employees. And Silicon Valley has done an admirable job of lobbying for increasing the number of H-1B visas, even if it lost the fight this time around. The problem is that H-1B holders aren’t actually immigrants -- they’re guest workers. H-1B allows workers to have so-called dual intent -- i.e., they won’t be kicked out of the country if someone overhears them saying they would like to become a U.S. citizen. But H1-B holders are at a large disadvantage with respect to permanent residents with green cards or citizens when it comes to job mobility and negotiating leverage with their employers. The H-1B program isn’t indentured servitude (as its critics allege), but it isn’t immigration either.
What about the political parties? Some people have suggested that the Democratic Party is holding high-skilled immigration policy hostage, demanding a deal on illegal immigration as part of the package. Vox recently suggested the exact opposite -- that Republicans might be willing to cut a deal on high-skilled immigration, but only in exchange for a crackdown on undocumented workers. Either way, don’t expect the parties to push the issue much.
So who does that leave in support of high-skilled immigration? A bunch of random libertarian oddballs and economics bloggers, such as Adam Ozimek and Vivek Wadhwa. Those guys have their hearts is in the right place, but you will pardon me if I say I’m not optimistic about their chances of getting legislation passed. High-skilled immigration seems destined to remain a political football.
With no natural allies, the potential entrepreneurs and inventors who might boost our economy are left out in the cold. Security agencies treat them like criminals. And heedless bureaucracies, seemingly running on autopilot, randomly come up with new ways to keep them out of the country. It’s shameful, but no one is standing up and trying to stop it.
Essentially, I’m fighting for a lost cause here. But ever since I read ``Don Quixote'' during in-school suspension for spitting in a bully’s face in the seventh grade, I’ve been a fan of lost causes, so once more unto the breach.
The U.S. needs high-skilled immigrants. They represent one of the last big juicy pieces of low-hanging fruit out there for the taking. They start lots of companies, which give people jobs. They power most of our highest-value-added industries. They don’t compete with working-class Americans; they employ working-class Americans, and their demand for local goods and services gives income to working-class Americans.
The main arguments against high-skilled immigration are wrong. Brain drain is less important than brain gain -- immigrants to the U.S. end up helping their source countries over the long run. Nor is a skills shortage a necessary condition for bringing in high-skilled immigrants.
Some even see bigotry in the call for high-skilled immigration -- what, are we trying to create some kind of high-IQ utopia here? Why is a high-skilled immigrant any more desirable than a low-skilled immigrant? Well, I support low-skilled immigration too! But low-skilled immigration is easy to get, since the U.S. has high wages for manual labor, relative to most counties. High-skilled immigration, on the other hand, requires more active recruitment. Also, there’s the possibility that low-skilled immigration pushes down the wages of working-class and poor Americans; high-skilled immigration, in contrast, will boost the wages of low-skilled Americans.
In an ideal world, what would we be doing to increase high-skilled immigration? By far the most important thing is to increase the number of green cards -- not H-1Bs -- and to base the new crop of green cards on skills instead of family reunification. The idea of stapling a green card to the diplomas of foreigners who study in the U.S. is a good one, and something like this should be made a reality. Beyond that, we should increase the number of entrepreneurship visas, boost the number of H-1Bs, and reform the H-1B visa to make workers less tethered to specific employers. But green cards are really the key.
By keeping out high-skilled immigrants, the U.S.’s government is like a quarterback running the wrong way and scoring a touchdown against its own team. We need to stop doing that, and we need to stop now.