Yearly Archives: 2014

On Models

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Ryan Decker has a blog post on DSGE models. Although I don’t like DSGE models, I think he has something nice to say about modeling:

We must get econ pundits to understand that we’re all using models, including non-economist bloggers, even if they’re not written down as mathematical expressions. Writing a model down in its entirety so that its assumptions are made explicit and its internal workings can be examined by anyone is an act of intellectual humility. It is baffling to me that people who write down their models formally so we can all argue about them are supposedly worse and more arrogant than those who think they can identify a narrative model’s assumptions and keep it internally consistent.

James Tobin had something similar to say in his 1982 Nobel lecture Money and Finance in the Macroeconomic Process (alternative link):

Theoretical macroeconomic models of one brand or another are very influential. They guide the architects of econometric forecasting models. They shape the thinking of policymakers and their advisers about “the way the world works.” They color the views of journalists, managers, teachers, housewives, politicians, and voters. Almost everyone thinks about the economy, tries to understand it, and has opinions on how to improve its performance. Anyone who does so uses a model, even if it is vague and informal.

[emphasis added]

In his 1999 paper Money And Credit In A Keynesian Model Of Income Determination, Wynne Godley says:

This paper takes a step in the right direction by incorporating EM [endogenous money] ideas into a complete, if very much simplified model of the whole economy. Writings on monetary theory commonly rely solely on a narrative method which puts a strain on the reader’s imagination and makes disagreements difficult to resolve. The narratives in this paper will all describe simulations which are grounded in a rigorous model, which will make it possible to pin down exactly why the results come out as they do.

Personally I find stock-flow consistent models extremely useful to think about the working of the world as a whole. It is when you sit down and work through the models, that you realize how complicated the whole thing is and how naive intuition isn’t good enough. Of course models aren’t the only way to study, so one needs a mix of models and a non-mathematical narrative and some empirical analysis to add colour to the story. It is true models have disadvantages but beware of people who just highlight the disadvantages and don’t know the advantages because their intuition is also a naive model of the world.

Interest Rates And Investment

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There is a new interesting Federal Reserve paper The insensitivity of investment to interest rates: Evidence from a survey of CFOs.

Abstract:

A fundamental tenet of investment theory and the traditional theory of monetary policy transmission is that investment expenditures by businesses are negatively affected by interest rates. Yet, a large body of empirical research offer mixed evidence, at best, for a substantial interest-rate effect on investment. In this paper, we examine the sensitivity of investment plans to interest rates using a set of special questions asked of CFOs in the Global Business Outlook Survey conducted in the third quarter of 2012. Among the more than 500 responses to the special questions, we find that most firms claim to be quite insensitive to decreases in interest rates, and only mildly more responsive to interest rate increases. Most CFOs cited ample cash or the low level of interest rates, as explanations for their own insensitivity. We also find that sensitivity to interest rate changes tends to be lower among firms that do not report being concerned about working capital management as well as those that do not expect to borrow over the coming year. Perhaps more surprisingly, we find that investment is also less interest sensitive among firms expecting greater revenue growth. These findings seem to be corroborated by a cursory meta-analysis of average hurdle rates drawn from firm-level surveys at different times over the past 30 years, which exhibit no apparent relation to market interest rates.

The survey makes sense on a cursory look and lot of economists – especially Post-Keynesians assume away the interest sensitivity of interest rates on business investment in models many times. This is because demand for their goods and services is far more important than interest payments.

There are many complications however. Inventory building can have sensitivities to interest rates – although this may not be too significant. I am not sure the same can be said for house purchases. People’s knowledge of movements of mortgage rates can sometimes be surprising. If interest rates are dropped, households can purchase more houses on credit and this leads to a higher output and higher national income and more demand for firms’ products and services inducing more business investment – a multiplier effect. So indirectly interest rates can be said to have an effect on business investment. A resultant stock market rise – if there is one – can lead to wealth effects i.e., rise in output caused by rise in consumption due to capital gains and rise in household wealth.

One can think of international effects as well. If other central banks do not change interest rates, the domestic currency can depreciate against foreign currencies and this may slightly improve price-competitiveness of firms compared to foreign firms and improve exports and lead to some amount of imports substitution. This will have its own multiplier effect.

Of course like other channels mentioned above, this is not guaranteed to work and to the extent needed. A drop in the short term interest rate by the central bank can induce portfolio investment from abroad into equities and the exchange rate may not fall and instead rise. Also if households incomes have dropped due to a recent recession, they may not buy homes just because interest rates have dropped.

What about the reverse? A rise in interest rates – in addition to a reduced demand for house purchases – can lead to a higher interest burden of households on existing loans for house purchases, reduce domestic demand due to a drop in consumption and cause a fall in firms’ investment.

This post of course just touches these things and isn’t a claim to be anything like a full analysis. Models can be helpful in bringing these things more clearly. But models themselves have limitations so one needs a mix of empirical analysis to study such things.

Even empirical studies may be difficult.  Nicholas Kaldor’s in his 1958 article Monetary Policy, Economic Stability And Growth (republished in Collected Essays, Vol. 3, page 133) points out:

It must be remembered that in times of full employment, or even of approximately full employment, the capacity of the investment goods industries may exert a far more important limitation on the level of capital expenditure than the cost of borrowing or the availability of particular forms of finance. Thus the rate of building and constructional activity may be confined by the availability of building and constructional labour; expenditure on plant and equipment may be limited by lengthening delivery periods on new contracts. In such situations, the range of projects whose execution would be influenced by changes in the cost of borrowing or in the availability of loans might be unusually narrow …

So if we have some empirical data, how do we decide whether the slowdown of output in whichever period in the data the output slowed down was caused due to an increase in short term interest rate by the central bank or because of capacity constraints? The answer in my opinion is more empirical research and more model building.

It is also worth mentioning that despite so many complications, the economics profession pretends that fiscal policy is somewhat less important and ignores it as compared to monetary policy. Things have changed a little during after the crisis but one never knows when they take a U-turn on such issues.

Augusto Graziani And The Theory Of The Monetary Circuit

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One of Augusto Graziani’s best papers was The Theory Of The Monetary Circuit, Économies et Sociétés, 24 (6) (June), pp. 7–36. The paper is available at the UMKC course site here.

One description of money is looking at payments as triangular transactions. Graziani says that for money to exist, three conditions have to be met:

  1. since money cannot be a commodity, it can only be a token money;
  2. the use of money must give rise to an immediate and final payment and not a simple commitment to make a payment in the future; and
  3. the use of money must be so regulated as to give no privilege of seignoriage to any agent

The phrase “money circuit” was actually first used by Morris Copeland – the discover of flow of funds in his book A Study of Moneyflows in the United States

A Study Of Moneyflows In The United States - Morris Copeland

(image credit: Xerxes Books, from whom I obtained the copy)

In his book, he actually draws a diagram of a circuit – on the inside covers and on page 245:

The Main Money Circuit

The circuitists’ motivation for using the phrase “circuit” was a circular flow starting with credit but Copeland was in total opposition of the usage of the phrase “hyrdraulic/s” and the misleading notions that this latter phrase conveys about money. Hence he proposed the phrase money circuit. Check his book on why this is so for details. I will at some point write about Copeland’s arguments.

Augusto Graziani, R.I.P.

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Augusto Graziani has died.

One of Graziani’s main themes runs as follows. In order to finance production, the entrepreneur must obtain the funds necessary to pay his workforce in advance of sales taking place. Starting from scratch, he must borrow from banks, at the beginning of each production cycle, the sum which is needed in order to pay wages, creating a debt for the entrepreneur and, thereby, an equivalent amount of credit money, which sits initially in the hands of the labour force. Production now takes place and the produced good is sold at a price which enables the debt to be repaid inclusive of interest, while hopefully generating a surplus – that is, a profit – for the entrepreneur. When the debt is repaid, the money originally created is extinguished. An entire monetary circuit is now complete.

This account of the monetary circuit has a number of extremely important and distinctive features. It emphasises, in particular, that a) there is a gap in (historical) time between production and sales which generates a systemic need for finance; b) bank money is endogenously determined by the flow of credit and c) total real income must be considered to be divided into three parts – that received by entrepreneurs, that received by labour and that received by banks. We have already travelled an infinite distance from the (yes, silly) neo-classical world where production is (must be) instantaneous, where money must be exogenous and fixed and has no counterpart liability, and where the distribution of income is determined by the marginal products of labour and capital – a construction which depends entirely on the assumption that all firms sit perennially on a single aggregate neoclassical production function frontier.

− Wynne Godley, Weaving Cloth From Graziani’s Thread in Money, Credit And The Role Of The State: Essays In Honour Of Augusto Graziani

Ben Bernanke On Effects Of Federal Reserve LSAP

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In a speech at the Annual Meeting of the American Economic Association, Philadelphia, Pennsylvania, Ben Bernanke defended the large-scale asset purchase program of the Federal Reserve (“QE”).

The text is available here and the video is here

Bernanke’s argument is that fiscal policy was tight but yet the U.S. had an economic recovery and unconventional monetary policy helped.

First he talks of headwinds:

Have these unconventional tools been effective? Skeptics have pointed out that the pace of recovery has been disappointingly slow, with inflation-adjusted GDP growth averaging only slightly higher than a 2 percent annual rate over the past few years and inflation below the Committee’s 2 percent longer-term target. However, as I will discuss, the recovery has faced powerful headwinds, suggesting that economic growth might well have been considerably weaker, or even negative, without substantial monetary policy support.

and then identifies tight fiscal policy by both the federal government and state and local governments as one of the headwinds.

I have discussed the factors that have held back the recovery, not only to better understand the recent past but also to think about the economy’s prospects. The encouraging news is that the headwinds I have mentioned may now be abating. Near-term fiscal policy at the federal level remains restrictive, but the degree of restraint on economic growth seems likely to lessen somewhat in 2014 and even more so in 2015; meanwhile, the budgetary situations of state and local governments have improved, reducing the need for further sharp cuts …

It is not easy to see if this is true but it is true that fiscal policy had been tight and Bernanke’s argument is interesting for further analysis.

Happy New Year 2014

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Here’s wishing the readers a happy new year. May you (and I) have a prosperous year ahead and learn more about the shell game of economists!

Good time to talk briefly about time.

Joan Robinson was perhaps the best critic of neoclassical economics and she did this by attacking the very basic concepts of mainstream theory. In her essay Time In Economic Theory (1980, Ch 7 in What Are The Questions?: And Other Essays), page 87 in Section 1: ‘Logical Time’ she says:

In a properly specified stationary state, there is no distinction between any one day and any other. On a properly specified growth path, such as a von Neumann ray, exhibiting a particular pace of expansion of employment and of a specified stock of means of production, there is no movement forward and upward or backward and downward, except the movement of the reader’s eye along the curve.

Unfortunately, the great majority of models in the textbooks are not properly specified. Take, for instance, the familiar Marshallian cross of supply and demand curves showing an equilibrium point in the middle. At a price above the equilibrium level, offer exceeds demand, and below, demand exceeds offer.

Now we are told, if price at any moment is not at the equilibrium level, it will tend toward it. This means that historical events are introduced into a timeless picture. As Professor Samuelson kindly explained to me, ‘When a mathematician says “y rises as  x falls”, he is implying nothing about temporal sequences or anything different from “When x is low, y is high”.’ 

To move implies a temporal sequence. To fill in the story of a movement towards equilibrium, a complicated dynamic process must be specified and to specify a process that will actually reach equilibrium is by no means a simple matter.

[emphasis added]

A footnote refers to page 138 of the book – another essay quoting Samuelson:

[Samuelson]: I do not think that the real stumbling block has been the failure of a literary writer to understand that when a mathematician says, ‘y rises as x falls’, he is implying nothing about temporal sequences or anything different from ‘when x is low, y is high’.

Robinson’s response is:

My dear sir! That is my point. I really cannot allow you to get away with that.

Unfortunately, economists keep getting away from this.

Joan Robinson - What Are The Questions And Other Essays Back CoverBack cover of What Are The Questions? …  And Other Essays