Tuesday, June 21, 2016

Should We Think of Confidence as Exogenous?

I don't always agree with Roger Farmer, but I admire his independence. Roger doesn't like to be bound by the constraints of particular research groups, and typically won't accept the assumptions decreed by some New Keynesians, Monetarists, New Fisherites, or whoever. Farmer is a Farmerite. But, Roger falls into a habit common to others who call themselves Keynesians, which is to describe what he does in terms of some older paradigm. The first time I saw Roger do this was in 1994, when he gave this paper at a Carnegie-Rochester conference. The paper was about quantitative work on a class of models which were one step removed from neoclassical growth models. Such models, with unique equilibrium and exogenous stochastic productivity shocks, had been used extensively by real business cycle (RBC) proponents, but Roger's work (and that of other people, including Jess Benhabib) was aimed at studying indeterminacy and endogenous fluctuations. The indeterminacy in Roger's work came from increasing returns to scale in aggregate production. Sufficient increasing returns, he showed, permitted sunspot equilibria, and those equilibria could look much like the stochastic equilibria in RBC models. That seemed promising, and potentially opened up a role for economic policy aimed at dealing with indeterminacy. Old Keynesian economics says we should offset exogenous shocks with fiscal and monetary policy; baseline RBC theory says such stabilization policy is a waste of time. But with indeterminacy, policy is much more complicated - theoretically, we can construct policies that eliminate particular equilibria through off-equilibrium promises. In equilibrium, we wouldn't actually observe how the policymaker was doing his or her job. While promising, this approach introduced some challenges. How do we deal econometrically with indeterminacy? How would we know if real-world policymakers had actually figured out this problem and were solving it?

Though teaching and entertaining ourselves has a lot to recommend it, most economists are interested in persuading other people of the usefulness of their ideas. Though I haven't had a lot of experience with dissemination of ideas in other professions, I think economists are probably extreme in terms of how we work out ideas in public. Seminars and conferences can be combative. We have fun arguing with each other, to the point where the uninitiated find us scary. And all economists know it's an uphill battle to get people to understand what we're doing, let alone to have them think that we've come up with the greatest thing since indoor plumbing. There's an art to convincing people that there are elements of things they know in our ideas. That's intution - making the idea self-evident, without making it seem trivial, and hence unpublishable (horrors).

So, what does this have to do with Roger, indeterminacy, and 1994? In the talk I heard at CMU in 1994, to make his paper understandable Roger used words like "demand and supply shocks," "labor supply and demand curves," and, particularly, "animal spirits." Given that language, one would think that the elements of the model came from the General Theory and textbook AS/AD models. But that was certainly not the case. The elements of the model were: (i) the neoclassical growth model, which most of the people in the room would have understood; (ii) increasing returns to scale which, again, was common currency for most in the room; (iii) sunspot equilibria, which were first studied in the late 1970s by Cass and Shell. This particular conference was in part about indeterminacy, so there were people there - Russ Cooper, Mike Woodford, Rao Aiyagari, for example - who understood the concept well, and could construct sunspot equilibria if you asked them to. But there were other people in the room - Alan Meltzer for example - who would have no clue. But having Roger tell the non-initiated that his paper was actually about AD/AS and animal spirits would not actually help anyone understand what he was doing. If Roger had just delivered his indeterminacy paper in unadulterated form, no undergraduate versed in IS-LM AS-AD would have have drawn any connection, and if Keynes had been in the room he would not have seen any similarity between his work and Roger's ideas. But once Roger said "animal sprits," Keynes would have thought, "Oh, now I get it." He would have left the conference with the impression that Roger was just validating the General Theory in a more technical context. And he would have been seriously mislead.

Roger was hardly the first macroeconomist who made use of language from the General Theory, or Hicksian IS-LM, or post-Hicksian static AS-AD language, to provide intuition for ideas they thought might appeal to people schooled in those traditions. Peter Diamond did it in 1982 – “aggregate demand” was in the title of the paper in which Diamond constructed a model with search and increasing returns in the matching function. That model could give rise to multiple steady states – equilibria with high output and low "unemployment" could coexist with equilibria with low output and high unemployment. If you knew some combination of one-sided search models, the Phelps volume, or had seen work by Dale Mortensen and Chris Pissarides on two-sided search, you could get it. People like Peter Howitt, Ken Burdett, and John Kennan could get it, because they were Northwestern students and been in contact with Mortensen. But an IS-LM Keynesian wouldn’t get it. For those people using the words “aggregate demand” is a dog whistle – a message that everything is OK. “Don’t worry, we’re not doing anything that you would object to.”

New Keynesians took some of these lessons in presentation to heart, and went far beyond dog whistles. A New Keynesian model is basically a neoclassical growth model with exogenous aggregate shocks, and with sticky prices in the context of price-setting monopolistically-competitive firms - and with something we could think of as monetary policy. Again, Keynes would not have the foggiest idea what this was about, but in some incarnations (three-equation reduced form), this was dressed up in a language that had for been taught to undergraduates for about thirty years prior to the advent of New Keynesian frameworks in the late 1990s – the language of “aggregate demand,” “IS curves,” and “Phillips curves.”

New Keynesian economics was no less radical than what Lucas, Prescott, and others were up to in the 1970s and 1980s, but Lucas and Prescott were very in-your-face about what they did. That’s honest, and refreshing, but getting in the faces of powerful people can get you in trouble. I think Mike Woodford learned from that. Better to calm the powerful people who might have a hard time understanding you – get them on your side, and give them the impression that they get it. If Woodford had been in-your-face like Lucas and Prescott, he would probably have the reputation that, perhaps surprisingly, Lucas and Prescott still enjoy among some Cambridge (MA) educated people of my generation. For some, Lucas and Prescott are put in a class with the low life of society – Ponzi schemers, used car salespeople, and other hucksters. Not by the Nobel committee, fortunately.

But, there’s a downside to being non-confrontational. Woodford’s work, and the work of people who extended it, and did quantitative work in that paradigm, is technical – no less technical than the work of Lucas, Sargent, Wallace, Prescott, etc., from which it came. Not everyone is going to be able to do it, and not everyone will get it if it is presented in all its glory. But the dog whistles, and other more explicit appeals to defunct paradigms - or ones that should be - makes some people think that they get it. And when they think they get it, they think that the defunct paradigms are actually OK. And, if the person that thinks he or she gets it is making policy decisions, we’re all in trouble.

Why are we in trouble? Here’s an example. I could know a lot more math and econometrics than I do, and I’ve got plenty of limitations, as we all do. But I’ve had a lot of opportunities to learn firsthand from some of the best people in the profession – Rao Aiyagari, Mark Gertler, Art Goldberger, John Geweke, Chuck Wilson, Mike Rothschild, Bob Lucas, Ed Prescott, Larry Christiano, Narayana Kocherlakota, etc., etc. But I couldn’t get NK models when I first saw them. What’s this monetary model with no money in it? Where’s that Phillips curve come from? What the heck is that central bank doing without any assets and liabilities? I had to read Woodford’s book (and we know that Woodford isn’t stingy with words), listen to a lot of presentations, read some more papers, and work stuff out for myself, before I could come close to thinking I was getting it. So, trust me, if you hear the words “IS curve,” “Phillips curve,” “aggregate demand,” and “central bank,” and think you’ve got NK, you’re way off.

Way off? How? In this post, I wrote about a simplified NK model, and its implications. Some people seem to think that NK models with rational expectations tell us that, if a central bank increases its nominal interest rate target, then inflation will go down. But, in my post, I showed that there are several ways in which that is false. NK models in fact have Fisherian properties – or Neo-Fisherian properties, if you like. Fortunately, there are some people who agree with me, including John Cochrane and Rupert and Sustek. But, in spite of the fact that you can demonstrate how conventional macroeconomic models have Neo-Fisherian properties – analytically and quantitatively – and cite empirical evidence to back it up, the majority of people who work in the NK tradition don’t believe it, and neither do most policymakers. Part of this has to do with the fact that there indeed exists a model from which one could conclude that an increase in the central bank’s nominal interest rate target will decrease inflation. That model is a static IS-LM model with a Phillips curve and fixed (i.e. exogenous) inflation expectations. That’s the model that many (indeed likely the majority) of central bankers understand. And you can forgive them for thinking that’s roughly the same thing as a full-blown NK model, because that’s what they were told by the NK people. Now you can see the danger of non-confrontation – the policymakers with the power may not get it, though they are under the illusion that they do.

I know I’m taking a circuitous route to discussing Roger’s new paper, but we’re getting there. A few years ago, when Roger started thinking about these ideas and putting the ideas in blog posts, I wrote down a little model to help me understand what he was doing. Not wanting to let that effort go to waste, I expanded on it to the point where I could argue I was doing something new, and submitted it to a journal. AEJ-Macro rejected it (an unjust decision, as I’m sure all your rejections are too), but I managed to convince the JMCB to take it. [And now I'm recognizing some of my errors - note that "Keynesian" is in the title.] Here’s the idea. In his earlier work Roger had studied a type of macroeconomic indeterminacy that is very different from the multiple equilibrium models most of us are used to. In search and matching models we typically have to deal with situations in which two economic agents have to divide the surplus from exchange. There is abundant theory to bring to bear here - generalized Nash bargaining, Kalai bargaining, Rubinstein bargaining, etc. - but if we're to be honest with ourselves, we have to admit that we really don't know much about how people will divide the surplus in exchange. That idea has been exploited in monetary theory - for example by Hu, Kennan, and Wallace. Once we accept the idea that there is indeterminacy in how the surplus from exchange is split, we can think about artificial worlds with multiple equilibria. In my paper, I first showed a simple version of Roger's idea. Output is produced by workers and producers, and there is a population of people who can choose to be either, but not both. Each individual in this world chooses an occupation (worker or producer), they go through a matching process where workers are matched with producers (there's a matching function). Some get matched, some do not, and when there is a match output gets produced and the worker and producer split the proceeds and consume. In equilibrium there are always some unmatched workers (unemployment) and unmatched producers (unfilled vacancies). There is a continuum of equilibria indexed by the wage in a match. A high wage is associated with a high unemployment rate. That's because, in equilibrium, everyone has to be indifferent between becoming a producer and becoming a worker. If the wage is high, an individual receives high surplus as a worker and low surplus as a producer. Therefore, it must be easier in equilibrium to find a match as a producer than as a worker - the unemployment rate must be high and the vacancy rate low.

What I did was to extend the idea by working this out in a monetary economy - for me, a Lagos-Wright economy where money was necessary to purchase goods. Then, I could think about monetary (and fiscal) policy, and how policymakers could achieve optimality. As in the indeterminacy literature, this required thinking about how policy rules could kill off bad equilibria.

On to Roger's new paper. He also wants to flesh out his ideas in a monetary economy, and there's a lot in there, including quantitative work. As in Roger's previous work, and my interpretation of it, there are multiple steady states, with high wage/high unemployment steady states. As it's a monetary economy (overlapping generations), there are also multiple dynamic equilibria, and Roger explores that. So, that all seems interesting. But I'm having trouble with two things. The first is Roger's "belief function." In Roger's words:
To close our model, we assume that equilibrium is selected by ‘animal spirits’ and we model that idea by introducing a belief function as in Farmer (1993, 2002, 2012b). We treat the belief function as a fundamental with the same methodological status as preferences and endowments and we study the implications of that assumption for the ability of monetary policy to influence inflation, output and unemployment.
So, a lot of people have done work on indeterminacy, and I have never run across a "belief function," that someone wants me to think is going to deliver beliefs exogenously. In Roger's model, the belief function is actually an equilibrium selection device, imposed by the modeler. The model tells us there are multiple equilibria, and that's all it has to say. "Beliefs" as we typically understand them, are in fact endogenous in Roger's model. And calling them exogenous does not accomplish anything, as far as I can tell, other than to get people confused, or cause them to raise objections, as I'm doing now.

Second complaint: This goes back to my lengthy discussion above. Roger's paper has "animal spirits" in the title, it cites the General Theory, and the words "aggregate demand" show up 7 times in the paper. Roger also sometimes comes up with passages like this:
Our model provides a microfoundation for the textbook Keynesian cross, in which the equilibrium level of output is determined by aggregate demand. Our labor market structure explains why firms are willing to produce any quantity of goods demanded, and our assumption that beliefs are fundamental determines aggregate demand.
And this:
Although our work is superficially similar to the IS-LM model and its modern New Keynesian variants; there are significant differences. By grounding the aggregate supply function in the theory of search and, more importantly, by dropping the Nash bargaining assumption, we arrive at a theory where preferences, technology and endowments are not sufficient to uniquely select an equilibrium.
In how many ways are these silly statements? This model is related to the Keynesian Cross and IS-LM as chickens are related to bears. The genesis of Roger's framework is Paul Samuelson's overlapping generations model, work on indeterminacy in monetary versions of that model (some of which you can find in the Minneapolis conference volume), and the search and matching literature. NK models are not "variants" of IS-LM models - they are entirely different beasts. It's not "aggregate demand" that is determining anything in Roger's model - there are multiple equilibria, and that's all.

Maybe you think this is all harmless, but it gets in the way of understanding, and I think Roger's goal is to be understood. Describe a bear as if it's a chicken, and you're going to confuse and mislead people. And they may make bad policy decisions as a result. Better to get in our faces with your ideas, and bear the consequences.

22 comments:

  1. You lost me here: " "Beliefs" as we typically understand them, are in fact endogenous in Roger's model."

    Can't Roger just *assert* that a particular belief (or belief function) is exogenous in his model? There is nothing in that assertion that would be contradicted by the rest of his model. It's just an assumption, that we can agree or disagree with.

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  2. BTW, I think (unless I missed it) you forgot the link to Roger's new paper. Did you mean this one, with Konstantin Platanov? http://www.rogerfarmer.com/s/Animal_Spirits_in_a_Monetary_Model-2.pdf

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    1. Fixed. I did part of this on a plane without wifi, and put the links in later. Missed the most important one.

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  3. You may be unable to distinguish between bears and chickens Steve. I'm not and nor are the readers of our blogs. And to argue that my goal is to deliberately mislead policy makers into making bad choices is Insulting. But you knew that.

    "Better to get in our faces with your ideas, and bear the consequences". Quite.

    I argue that beliefs are fundamental. That is a clear statement. Yes it is "Farmerian" rather than Keynesian. But I have always been clear in my writing that, while I draw on the best ideas of my predecessors, I am not a parrot.

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    1. no, I never thought you were intentionally misleading anyone. I think this is your honest attempt to make yourself understood. Just trying to be helpful by letting you know what may or may not be working for you. I would gladly insult a parrot (or a dead parrot), but you're definitely not one of those.

      But, sorry, beliefs are not "fundamental" in your model, in the sense that economists agree on. There is some set of assumptions and interpretations that we have to agree on to make progress.

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    2. I see the confusion. Bad wording in the last paragraph. Corrected.

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  4. Great post. I think one could read this post as critiquing Farmer for "mathiness", in the way Romer used the term (whether he was doing so accurately or inaccurately!): showing one thing with math in formal models, but then using the English language to say another thing.

    I hope Farmer responds -- I think everyone could benefit from a back-and-forth!

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    1. No, see my reply to Roger's comment above. Romer was accusing people of using math to hide their dishonesty, which is not Roger's game at all. He has good intentions.

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  5. "there indeed exists a model from which one could conclude that an increase in the central bank’s nominal interest rate target will increase inflation. That model is a static IS-LM model with a Phillips curve and fixed (i.e. exogenous) inflation expectations."

    Shouldn't that be "decrease inflation".

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  6. Two thumbs up for an excellent post. I really hope that you and Roger clear up the misunderstanding. I know that you have great respect for his work as your textbook is one of very few (maybe the only one?) undergraduate Macroeconomics textbook that has a section devoted to Roger's work with increasing returns and multiple equilibria. Hope Roger can see that.

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    1. Don't worry. Roger doesn't like some of what I do, and he's not shy about telling me so. This is just about science.

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  7. Stephen, I agree with you about the benefits of controversy.

    You write, “But, Roger falls into a habit common to others who call themselves Keynesians, which is to describe what he does in terms of some older paradigm.” Didn’t Lucas and Sargent, in their 1979 polemic, “After Keynesian Macroeconomics,” describe their programmatic alternative “in terms of some older paradigm,” i.e., “classical economics” and its presumptions of rational, self-interested agents and markets that clear?

    You complain about Roger’s use of Keynes’s phrase, “animal spirits,” because (if I may read between the lines), Roger’s mathematical machinery is much more powerful, from a scientific point of view, than Keynes’s “mere words,” to invoke another insult from Lucas.

    Of course, Keynes had reasons for using “mere words,” one of which is that “facts and expectations are not given in a definite and calculable form.” What will the European Union look like ten years from now? The Republican Party? The state of macroeconomics? Was Keynes wrong to point out that constrained maximization only works if we have a clear understanding of our circumstances and their possible lines of development? Lucas was only half right when he said we need better theories, not better verbal descriptions.

    You write, “Now you can see the danger of non-confrontation – the policymakers with the power may not get it, though they are under the illusion that they do.” Imagine this discussion: Economist with hard-to-understand theory says to central bank policymaker, “I’ve got a model which shows that if you raise the interest rate, prices will also rise.” Policymaker says, “Yes, I can see the logic leading to your conclusion, but if most of the public thinks higher interest rates are deflationary, will we get the same result?”

    Do you see “a danger of non-confrontation” with Mordecai Kurz’s claim that “belief diversity is not only a well-established empirical fact, but forecast data also reveal no tendency for persistent merging of opinions about any important variable”? (“Symposium: on the role of market beliefs in economic dynamics, an introduction,” Econ Theory [2007]).

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    1. "Didn’t Lucas and Sargent, in their 1979 polemic, “After Keynesian Macroeconomics,” describe their programmatic alternative “in terms of some older paradigm,” i.e., “classical economics” and its presumptions of rational, self-interested agents and markets that clear?"

      Here's a key sentence from Lucas and Sargent's paper: "In recent years, the meaning of the term equilibrium has changed so dramatically that a theorist of the 1930s would not recognize it." So, Lucas and Sargent weren't saying, "oh, we found a microfoundation for classical economics," or some such.

      "if most of the public thinks higher interest rates are deflationary, will we get the same result"

      Question is, why would they think that, and what happens if people have been confused by economists and central bankers who have a faulty view - perhaps of their own models?

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  8. “Question is, why would [most of the public think higher interest rates are deflationary], and what happens if people have been confused by economists and central bankers who have a faulty view - perhaps of their own models?”

    Before attempting a reply, it’s worth taking stock of the general terrain by which I mean the presence of the Bulls the Bears in every speculative market, the diversity of economic models used by central banks, corporations, labor organizations, state governments, university endowments, and, of course, the Nobel prize awarded to Fama and Shiller in the same year. Whatever its origin, and reasons for persistence, it’s hard to overlook the brute fact that people are guided by a diversity of views about the way the economy works and hold conflicting beliefs about future prices among many other things. Mordecai Kurz has pursued the reasons for, and consequences of, diverse beliefs.

    Even if your model shows that, on plausible assumptions, a higher interest rate goes hand-in-hand with higher prices, most of the public could still believe (and probably does believe) the opposite simply because it’s the conventional view, and doesn’t confront, I think, anything close to unanimous opposition from the economics profession. If the Booth School of Business had asked its panel of first-class economists whether a four-fold increase in the Fed’s balance sheet would bring deflation or inflation, what do you think the result would have been?

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    1. I understand that, from your viewpoint, the economics profession looks pretty confused, without any firm conclusions on anything. But, I see my job as distilling all of that stuff, using what I know, and then giving you the best advice I can. I think economists do know things that are useful to society, and I'm sorry the stream of information coming from the profession is so noisy. On the Booth School project, that's one of the silliest exercises I've ever seen. It consists of asking people questions which, for any given question, most of them have spent no time thinking about. For example, here's one on banking regulation:

      http://www.igmchicago.org/igm-economic-experts-panel/poll-results?SurveyID=SV_dbCps0eT0oB32E5

      There are only a handful of people on that panel who have ever had any contact with research on banking regulation in their lives. Autor is a labor economist, Judd does taxation and computational economics, Samuelson is a theorist, Thaler is a behavioralist. But they're all happy to answer the question. And if we actually implemented policy based on their advice, it could have very large repercussions. Maybe that's part of our problem - too many economists with inflated ideas about what they know about work in subfields outside their own.

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    2. More simply: We don't do science by taking a poll.

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    3. I don't think the economics profession is confused, or that scientific questions should be decided by taking a poll. I was trying to stress the point that the decisions of private agents and public policymakers are guided by many different, often conflicting, beliefs. This is not to say that all of these viewpoints should be assigned an equal value as scientific theories or models, but rather that this diversity of views makes a difference in how the economy actually works and what the consequences of alternative policies will be. There's bit more explication and justification here (http://www.the-human-predicament.com/2015/09/rational-expectations-and.html), but I know you're busy.

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    4. Easier said than done. What you're talking about is extremely difficult. Hansen and Sargent tried something related - summarized in their book:

      http://press.princeton.edu/titles/8535.html

      That's highly technical, and it hasn't been influential. But, contrary to how you're thinking about this, we're not so diverse when acting in groups. People have a remarkable tendency to converge to similar ways of thinking, which is interesting. There are plenty of paths that may be productive, and that's what research is all about. But, for the time being, RE is productive, and a very helpful way to structure how we think about the world. I wouldn't throw it out for anything else I've seen.

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  9. Thank you for this very informative post.

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