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Noah Smith catches the Demand-Denialist Bug

I like Noah Smith, but his scientific-skepticism meme-immune system appears to be very weak.  The latest case in point is Noah’s post defending the use of Search Theory in Macroeconomics against John Quiggin who is rightly pointing out that Search Theory is incapable of explaining cyclical unemployment.  I’m not really going to add to what Quiggin wrote, instead I’m only interested in Noah’s response.  Before I go on, I should link to Noah’s excellent critique of Kartik Arthreya’s Big Ideas in Macroeconomics to which Quiggin is responding.

Conceding that Search Theory doesn’t explain all the employment patterns, Noah goes on to criticize “demand” explanations:

This is a simple answer… Economists are used to thinking in terms of supply and demand, so the AD-AS model comes naturally to mind… 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.

…what causes aggregate demand curves to shift?…how does aggregate demand affect unemployment? The usual explanation for this isdownward-sticky nominal wages. But why are nominal wages downward-sticky? There are a number of explanations, and again, these differences will have practical consequences.

… is an AD-AS model really a good way of modeling the macroeconomy?… 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,..

… 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…

Wow is that a lot of BS jammed into a short space.   Noah is a strong proponent of a more empirical and predictive macroeconomics, which I agree with!  but this post suggests that Noah doesn’t understand the other side of the problem, model selection and Okkam’s razor.

How do you know which model is the correct one?  You can’t just say that it’s the model that survived empirical tests because there are an infinite number of possible models at any given time which have survived those tests.   All that data you’ve collected tells you exactly nothing until you figure out which of those continuum of possible models you should treat as the preferred one.   Okkam’s razor plays the keystone role in scientific methodology as the selection criterion.   (If you were a philosopher of science you’d spend a lot of time trying to justify Okkam’s razor…Karl Popper believed it gave the most easily falsified model among the alternative… but as a practical scientist you can just accept it.)

Now that we’ve all accepted that Okkam’s razor must be used to winnow our choice of models, we should spend some time thinking about how to use Okkam’s razor to do this in practice.   That would require a post in itself, so instead let me just mention one particular criterion I use:  At any given time, who is the claimant?   In science, the burden of proof is always on the claimant because the claimant’s model at any given time  is almost always less simple than the accepted model given the field’s accepted information set.

As a heuristic, the claimant’s model generally does not pass Okkam’s razor’s test until new information is found and added to the field’s information set.   It’s possible (and does happen) that a heretofore unknown or unnoticed model is simpler than the accepted one, but that’s rarer than you might think and not generally how science proceeds.

With all that out of the way, what’s my problem with Noah’s post?  Two things:

1)  Demand is not phlogiston

For those not in the know, phlogiston was an hypothetical substance which made up fire.  The theory was rendered obsolete by the discovery of combustion.

Basically what Noah is saying here is that maybe demand, like phlogiston, is a hypothetical piece of a theory and that piece may be unnecessary.   Now science certainly does produce phlogiston-like theories from time to time, these theories tend to be the result of trying to tweak systemic models:   you have a theory of elements (at the time of phlogiston a sort of proto-elemental atomic theory) and a substance (fire) which you can’t explain.  So add an element to you model to explain the substance.

The first thing to point out is that demand is a reductionist phenomenon in the strictest sense.   The smallest unit of a macroeconomy (the atom, if you will) is the transaction.  But a single transaction has a well-defined demand:  how much the buyer is willing to trade for the item being transacted.   So the neoclassicals are the claimants here:  they’re saying that there is an emergent phenomenon in which demand becomes irrelevant for the macroeconomy.   They are using an updated version of  Say’s Law to argue that demand goes away, not that it never existed–that would be crazy.

Show me the evidence that it doesn’t exist, then we can talk.   Yes, that’s hard.   Tough… you’re the one making an outlandish claim, now live with it.

The second thing to notice is that phlogiston isn’t even phlogiston as Noah means it… rather phlogiston is a perfectly reasonable and testable scientific hypothesis, the study of which led to our understanding of oxidation.

2)  You don’t need sticky prices to get demand curves

You don’t need sticky prices to get aggregate demand, rather sticky prices are the simplest (in modeling terms) way to get rid of Say’s law while otherwise keeping the market clearing assumption intact.  Now market clearing is not necessarily a good assumption, but even more than the sticky prices are, it is a standard one.

Of course, no microeconomist worth half his or her salt would ever think market clearing is necessary because market clearing doesn’t always happen in the real world (look around).  Store shelves are rarely bare, there are usually tables empty (or people waiting in line) at restaurants and some people pay outlandish prices for tickets to sporting events from scalpers even as some seats go unfilled.   You can talk all you want about how sticky prices are a bad assumption, but the real problem here is that it’s silly that macroeconomists insist on market clearing.

This is a long winded way of saying that anything which breaks Say’s Law can substitute for the sticky-price assumption: 1) nominal debt not indexed to inflation, 2) demand for financial assests, or 3) non-stantionarity and knightian uncertainties.   I’m sure I’m missing some other possibilities.

These are all “reductionist” explanations and once again, that’s my point.   It is the neoclassicist demand-deniers who are flipping the script here and insisting on a systemic explanation for why demand should disappear in the aggregate.

I can go on, but this post is already getting too long.  For my take on AS/AD in particular, see this.  I think that answers Noah’s implicit objection.

The Problem with the Money Multiplier

March 28, 2014 6 comments

There’s an interesting back-and-forth between the ever ingenious Nick Rowe and David Glasner about the money multiplier.   I don’t have a lot to add to it, really… I do have certain monetarist sympathies, but I don’t tend to view a money-centric view as particularly useful (as opposed to “true” in some metaphysical sense).   And since I’m a microeconomist, I don’t really need to have a strong opinion.

Still, I think this particular debate might be illuminated by just a tad of data.  Here is M3 (broad money) and the monetary base for the US.  Notice the pattern?

fredgraph

 

Neither do I.  The two weakly track each other (not surprising), but M3 moves with MB in starts and stops, even to the point where on occasion M3 is falling while MB is rising!   Think about that….

You start off with a money multiplier, which means that the two should increase in proportion with one another… that doesn’t quite work.  So then you tell yourself “well, as long as M3 weakly increases in MB” (this is something like, but not identical to what Rowe is arguing)… but then you notice that from mid-2009 to mid-2010 M3 is falling (or at least stagnant as MB rises, then from mid-2011 to 2013 MB falls a bit while M3 shoots upward.   So, that doesn’t work either.    Hmmm.

For me, it’s simple.   The relationship between the Fed’s actions (creating monetary base) and the actual private creation of money is not a predictable relationship.   Oh, maybe over time there is some tendency for the two series to converge.  Fine, that seems reasonable.  In fact, that seems like a good reason to keep teaching the money multiplier to early undergrads.

Doesn’t seem like it’s helping us understand what’s going on though.

Categories: macro, monetarism, Money

AS-AD Day for Economics Theory

June 7, 2013 1 comment

Since I’m currently a little sick (and hence I don’t really want to do much real work, like trying to graduate), I think I might just take a brief hiatus from my blogging hiatus to push back a bit on all the AS-AD hate out there in the econo-blogosphere. To put it briefly, I don’t think that AS-AD is research quality, obviously, but I don’t understand why (almost) everyone seems to agree that it isn’t fit to be taught (presumably to first or second year undergrads; if we’re arguing about teaching it to advanced students, I have to ask, who’s teaching it to advanced students?).  Frankly, I think AS-AD is a great teaching tool and I’m rather fond of it.

The proximate cause of this post is this, via Peter Dorman, lengthy take-down of AS-AD from Fred Moseley.   I am sympathetic to some of the hate out there (like this from Krugman), but not this.   Not to be rude, but Moseley–who I have nothing against, personally or professionally–is just wrong. Let me go through the argument point by point.

Criticizing AS-AD as a Broader attack on Equilibrium Economics

1. It is logically inconsistent outside of equilibrium. The AS and AD curves do not refer to separate economic agents making separate decisions about S and D (as consumers and firms in microeconomics), but instead refers to different theories of the relation between output and the price level in the same economy. Outside of equilibrium, these two different theories predict two different levels of output for the same price level; but the same economy cannot produce two different levels of output at the same time.

This isn’t just wrong; it doesn’t even make sense–although in fairness to Moseley the problem is rather technical.   To understand why, I need to back for a moment and explain something about AS-AD; at least, how I understand AS-AD.

AS-AD is the only example in Economics that I can think of which can be understood as what physicist call an adiabatic approximation–what I like to call “equilibrium disequilibrium” (which I think is more descriptive).   Think of it this way: there are “equilibrating” processes and “disequilibrating” processes which evolve the system through time.  If the equilibrating process is “fast” compared to the disequilibrating process, then the system can be approximated as a series of equilibria.   If the system is in equilibrium {P(t),Y(t)} at time t, then at time t + dt, the system is in a new equilibrium, {P(t + dt),Y(t+ dt)}, and the change {dP,dY} depends only on the disequilibrating process (approximately).   In AS-AD, the equilibrating process are “plans and expectations” of individual agents and the disequilibrating processes are the goods and factor markets.   Since it is the goods/factors markets which are out of equilibrium, AS-AD is specifically an adiabatic approximation to the classical Spending Allocation model of Econ 101 in which these markets ARE in equilibrium.

So here’s the problem with what Moseley is trying to say: it doesn’t make a lick of sense to talk about disequilibrium dynamics of an (approximate) disequilibrium model.   He is of course correct in saying that the model would “predict” two distinct levels for output, but that is because output is already out of equilibrium!   Anyway, moving on.

2. Because of the logical inconsistency between AS and AD, the model cannot explain the adjustment process to equilibrium. For example, in the case of excess supply, the AD curves implies that output should increase in order to restore equilibrium and the neo-classical AS curve implies that output shoulddecrease in order to restore equilibrium. But the output of the same economy cannot both increase and decrease at the same time.  In the “sticky price” model, AS > AD has no meaning, because AD is a quantity and AS is a price.

Most of this I just covered, but there are some additional claims here.   The issue, I think, is whether AS and AD can exist separately.   If not, then the period-by-period equilibrium condition makes no sense, and so neither would the adiabatic approximation.  I think they can, and the issue here is really important to understanding the model.

So, what is AS?  Broadly it is the schedule of price adjustments to observed sales (and observed sales to price adjustments) for the firms and individuals in the economy.   For example, if the economy is populated by, say, my favorite (admittedly intractable) model of ignorant monopolists facing idiosyncratic demand curves against competitors selling highly substitutable output (fortunately, this model ought to look on average a bit like monopolisticly competitive firms subject to Calvo pricing).   That should give us a nice upward convex shape for AS in {P,Y} space.

And what is AD?  It’s the convolution of the loci of IS-LM equilibria (so it is the spending/income response to interest rates) with the Fed’s response to economic data (Fed reaction function/Taylor rule/whatever).   You can think of the IS/LM relationship as a constraint the Fed faces (there is, of course, no economic actor who decides where the IS curve or LM curve should be–they are both the results of the general equilibrium condition) and hence AD can be thought of as the output/inflation trade-off that the Fed will accept.

The key point I want to make is that each of these curves involve separate decision makers (businesses and consumers for AS and the Fed for AD) forming plans.   This is the “fast” process in our adiabatic approximation and so it is a perfectly valid, and each decision maker will wait to see what happens (goods sell/competitors raise prices for AS and inflation/output too high for AD) before adjusting those plans–the goods/factors markets are out of equilibrium.   This is exactly what I described as the adiabatic approximation above.   Next point:

3. The AS-AD model is empirically unrealistic. The model predicts that AS > AD causes prices to fall, but prices have not fallen since the 1930s (more than a percent or two once or twice). And it is a very good thing that prices no longer fall! Because significant deflation would be a disaster for such a heavily indebted economy as the US. And yet the AS-AD models in the textbooks still present deflation as an unproblematic solution to excess supply. Ben Bernanke, in his real-world job as Chairman of the Fed, is doing everything he can possibly think of in order to avoid deflation. And yet his intermediate macro textbook (co-authored) still presents the AS-AD model and deflation as a solution to excess supply.

This seems to me to be a critique of some exceptionally naive versions of AS-AD: so I’ll have to chalk this up as straw man punching and leave it at that.   Yes, if your particular version of AS-AD implies deflation every time growth falls below trend, then its probably wrong.   It probably doesn’t have production or realistic investment either–because AS-AD doesn’t really attempt to model any of these things.

With the AS-AD models the rest of us are using, inflation falls, not prices when there is sufficient slack in the economy.   Even that is not necessary: an inflation targeting CB will be successful in keeping inflation fixed right where it is–although, in the spirit of my adiabatic approximation rant, it’s only right that I point out that inflation targeting will cause inflation to meander a bit around target; tightly around target if the CB is viewed to be competent (so that expectations of excess inflation are low) and more wildly if not.

Why all the Hate

Moseley writes

We should not be teaching such a logically contradictory and empirically unrealistic to our students. It encourages sloppy thinking and memorization, rather than rigorous and critical and creative thinking.

I don’t see it.   As I’ve just been arguing, the logical contradictions are really just his discomfort with what I think is a perfectly reasonable approximation.   The model is plenty consistent.   If you are confusing your students so much then, perhaps, the problem is with you.   I would argue that there is no simpler way to teach inflation/output dynamics to freshmen (which I think is what Krugman was getting at).

Now, I can see why would might argue that AS-AD is not ideal, but it is still useful to know, even for researchers.   If for no other reason than as a quick gut check for fancier models.

Frankly, I’m a bit mystified by all the vitriol flung it’s way in this latest blog spat.   If you can explain to me what harm it is actually doing to students, please, leave a reply in comments because I truly don’t understand.   As I see it, the alternative to teaching AS-AD is to stop at IS-LM, which doesn’t include inflation or dynamics (your students–the better ones–I’m sure, would notice).   You could, of course, try to teach more modern models, say DSGE… except I’m not actually sure that in terms of “logical consistency” that DSGE actually beats AS-AD (I actually would have some critiques of my own to add, but that’s a subject for another time).   And don’t tell me you’re going to teach your students some heterodox theory; if they come away from your class speaking a different language than mainstream economists, you’ve done them a real disservice.

Bursting the Bubble-Bubble

The word “bubble” must be in some kind of bubble.   I’m serious.   A few months ago, oil (according to some) was supposed to be in a bubble (it wasn’t) while at the same time, government bonds were supposed to be in a ‘bubble’ as well (see here and especially here). Today Matt Yglesias points out (citing this)  that Norway is in a property bubble.   Of these, this last example is likely to the only bubble.

We need to think more seriously about what it means to be in a bubble.

What is a “Bubble”?

I think the problem here starts with the fact that no one seems to agree, precisely, what a bubble is.  For Karl Smith an asset is apparently in a ‘bubble’ if it has high liquidity value (it can be sold quickly and without loss).   On the one hand, every bubble that has ever existed has had this property.  On the other hand, what about this definition wouldn’t apply to the run-up in oil prices?

So, I would argue that this definition is far too broad and it obscures more than it illuminates.   In particular, adopting this definition of bubble would gives us absolutely no idea when a bubble would be considered dangerous and when not.   If government bonds are “in a bubble” (like oil prices were last year), it is not a dangerous bubble.

For the Fed note that Matt Yglesias points to, the definition of bubble is a falling risk premium.   The problem, of course, with this idea is actually buried in the note iteself.   On the one hand, there is a clear expectational channel necessary for bubbles to form;

One way that a bubble might be distinguished from a situation with rationally low risk premiums is to examine investor expectations about returns. Rational investors with low risk premiums would expect low returns after a sustained price run-up. By contrast, irrationally exuberant bubble investors would expect high returns because they simply extrapolate recent price movements into the future

But on the other hand,  this is the case far too often to be called a ‘bubble’ every time it appears;

Shiller (2000) developed a questionnaire to study investor expectations about future stock market returns in Japan and the United States during the 1990s. From the data, he constructed an index of “bubble expectations,” that is, the belief that stock prices would continue to rise despite being high relative to fundamentals. He found that the index moved roughly in line with movements in the stock market itself, suggesting that investors tend to extrapolate recent market trends when making predictions about future returns.

In other words, this definition is also too broad.   The typical ups and downs of the stock market should not be lumped in with the real deal (the US housing bubble circa 2005, the Norwegian housing bubble).

A better definition

To get a useful definition for bubble, we need that definition to capture;

  1. that a “bubble” should be dangerous–a bubble represents a true instability in the economy
  2. that prices no longer reflect market “fundamentals”
  3. that this is an unusual situation

To capture all three at the same time, I would start by (only partly) agreeing with Karl Smith–a high value for the liquidity premium is necessary, but not sufficient.   I can think of at least two reasons; a) a bubble occurs for goods with significant resale value or equivalently in markets for particularly long-lived goods–this means asset markets primarily, or possibly durable goods markets if the rate of depreciation is slow enough, b) a bubble occurs when the expected resale price of the asset rises; or equivalently the implied yield rises, ceteris paribus

Both a) and b) imply that liquidity premia are critical for bubbles to form.   But are these enough?  If a market is simply in backwardation, then the price would rise in the future and it would be expected to rise.    Moreover, the asset would almost certainly be liquid in this kind of scenario, since the reason a commodity market might be in backwardation is that there is an expected future shortage, i.e. you will expect to be sell the asset without taking a loss (storing the commodity may be difficult).

Relatedly, liquidity premia are a kind of insurance–a liquid asset is one that could be sold quickly in the event that you need cash for an emergency.   But, at what point is liquidity premium so high that it can’t be explained by the insurance value of liquidity?

Liquidity and leverage

I think liquidity premia capture much of the bubble dynamic, but I think I’ve argued sufficiently that it doesn’t capture everything.   So what’s missing?   As a first thought, I think we really need to seperate out price and income effects.   So, let me try the following definition;

An asset is in a Bubble if it is behaving as both a giffen good (demand increases as its price rises) and a normal good (demand increases as buyer income increases).

[For the rest of this post, don’t think an “income effect” with regard to current income, but rather “wealth effect”, since purchases of the asset are funded–for a particular buyer–out of wealth, not necessarily income, so that the budget constraint shifts outward with rising wealth. ]

This definition is completely descriptive.   Still, thinking through the dynamics of a good that is both giffen and normal suggests a circular feedback process where demand for the asset rises, bounded only by funds available for purchase.   Prices rise, so that demand rises (giffen) so that the wealth of asset holders rises (the asset itself is a part of one’s portfolio) and so demand rises (normal) and so price rises (scarcity).   Basically, the supply and demand curves are shifting outward together, and the demand curve, in particular, is upward sloping.

This unstable situation suggests (but doesn’t require) the use of leverage–if the process is limited by the supply of funds available, then funds will be drawn from elsewhere.   This is the missing ingredient.   Asset purchases in the context of rising prices are being funded in part from those same asset price increases, but also from increased borrowing.   If that is the case, then this “bubble” as I’ve defined it is also very dangerous.

And that covers every requirement I set out.   It’s a dangerous (combined with leverage), unusual market in which the price of the asset does not reflect fundamentals in the sense that the pattern of supply/demand cannot possibly continue in the same way indefinitely.

Categories: Finance, macro, Micro

Nick Rowe and the inflation fairy

June 22, 2012 3 comments

Nick Rowe is one of my favorite bloggers.   On most days, my only complaint about Nick Rowe is that he’s not posting.   Every time Nick Rowe sends his thoughts into the aether, I feel as though I’ve learned something.

So you can imagine my disappointment in this post from Nick.    This post is wrong, I’m quite sure.    At issue is the post from Yglesias that I linked to yesterday (here).  Not only doesn’t Nick seem to think through Matt’s case, but his response is pure AS-AD model.   I find it unlikely that Matt doesn’t understand AS-AD.   In fairness, Nick is trying to push a pet idea about how we teach economics (the thought being that economics the “non-linear”–not in the mathematical sense, but in the “artistic” sense as in a story that doesn’t follow a linear plot).   “Artsie-nonlinear” you should, of course, read as “equilibrium”.

In addition to agreeing with Matt on this one, I’ve a couple specific problems with this.

  1. It ignores disequilibrium dynamics:   when I say that “signals require realizations”, I am talking about a disequilibrium phenomenon.   In models everyone is on “equilibrium path”, no one deviates.   In the real world, real economic actors need to observe a deviation–or at least observe enough information to predict the costs of deviation–before they know to avoid doing it.    Since Nick has harped on this himself, I would think that he would see it straight off.
  2. Inflation from where?   Macro types like to assume either a Phillips curve, or at least a central  bank reaction function which implies some inflation rate, keeping all other variables constant.   The CB waves its magic wand and inflation appears, it has no other cause.   As a theoretical matter, AS-AD is consistent with all inflation and no RGDP growth,  all RGDP growth and no inflation or anything in between.   In the real world, inflation is the sum of many individual decisions to a) raise prices b) raise wages and each of those decisions has a cause.

For point one, I might add a more general point.   It is not strictly the concept of “equilibrium” that is the problem here.   I would argue, instead, that the problem boils down to the form the equilibrium concept takes–almost trivially, there will be a “correct” equilibrium concept which approximates the real world… although that’s a subject for another post.

In macro, there is an implicit use of the “Bayesian Nash Equilibrium” (really perfect bayesian… but I digress) concept which means, in a nutshell, that everyone’s beliefs are formed through the same process.   In words, I could have the same beliefs as you… to the extent that I don’t, it is because it was not worth my time to look up information in your possession.    There is classic uncertainty, but only classical uncertainty.  We all make optimal use of the information available to the world.

In the real world, we form our beliefs through history, seeing things.   We know the bad guy for the bad guy when the bad guy busts some kneecaps.  We are not certain, until it happens, how the bad-y will act.   The signal badness requires the realization of bad actions.

There is another concept that better matches the real world process of expectations formation including “model” uncertainty:  “Self-Confirming Equilibrium“.   The idea for SCEs is that one’s beliefs on path only have to be consistent with one’s own information (see here, for how this relates to model uncertainty).   In short, signals require realizations.

Do the prices of European bonds reflect default chances?

I have a tendency to reject the conventional wisdom without thinking.   So much so that I more than half suspect that this knee-jerk skepticism of mine works on the level of what Kahneman would call “System 1”–effortless thinking– rather than on “System 2” which is supposed to be the skeptical part of your mind.   One reason I say this, is that I come across essays like this from Krugman or this from Yglesias both of which reflect my thinking right back at me.   Both have argued in the past that Greece was the “exception” in the Euro-mess, while I see no important differences on the macro-level (as opposed to the, largely irrelevent, micro-level inefficiencies of the Greek system).    I would almost think that Yglesias/Krugman read me, except that, to a good approximation, no one reads me (hi mom!–j/k… she doesn’t read me, either).

Well, let’s see if we really are on the same page after all.   I have another anti-CW thought rolling around my brain.   It seems to be taken as given that bond spreads in the Euro-periphery reflect the risk of sovereign default.   I call BS.   There’s a much bigger effect on bond yields: Euro-breakup.

So what do you think is more likely: the periphery nations stay on the Euro, but default on debts, or the periphery nations drop the Euro?   If you think the latter, than we are on the same page.   Consider: If the periphery drops the Euro, what happens to the real value of bonds?   What happens to default probability?

On the second question, the answer is easy.   Once the Euro is dropped, all domestic debts would be re-denominated in the local currency–this includes bonds.   Debtors in these countries will demand the option to repay in the new currency (drachmas).  Creditors will demand repayment in their new currency (marks).   It is debtors who hold the purse-strings.   It will be messy, but debts will be inflated away.   The chances of default would fall dramatically–although perhaps Greece might still find it be in its interests to default anyway.

The first question is more interesting.   Exit for the peripheral nations means large devaluations of their currencies.   Breakup for Germany means a revaluation of its currency.

Suppose that you are an investor in Europe right now.   You can buy a Greek bond or a German bond.  It will be practically impossible to pay only Greek citizens drachmas and German citizens marks.   You know this, so you would want to purchase the bond with the highest real value after a Euro-breakup.   In particular, a German bond will be worth more than its face value if it is converted one for one from Euro-denominated to mark-denominated.   On the other hand, the Greek bond will be worth less if it is converted one for one to drachmas.

Then, you as a bond investor will buy the Greek bond only if there is a discount roughly equal to the probability of exit times the expected exchange rate of drachmas in terms of marks, since the mark would be expected to rise considerably and the drachma to fall even more dramatically.   Let’s put some numbers to this.   If the new exchange rate is expected to be 2-1 and the probability of exit is about 50-50, than a Greek bond is worth (in PDV) about 25% less than the equivalent German bond.   That’s huge.   I’m too lazy to turn that into a yield for the sole purpose of this post, but that could easily explain the majority of the German/Greek spread.

None of this is to say that default isn’t reflected in the price of bonds, rather my point is that exit/devaluation likely dominate the German/periphery spread.   This means that a simple (yet binding) commitment to keep these nations in the Eurozone  would in itself bring down spreads considerably.   On the other hand, a small increase in the probability of exit increases refinancing costs and hence the probability of exit, and hence refi costs, etc.

Categories: Finance, macro, politics

Labor markets are financial markets

June 17, 2012 1 comment

In support of my last post, there was another point that I wanted to make.   One thing that I’ve found helpful when thinking about labor markets is specifically not to think of hiring/firing workers (i.e. economic agents with a mind of their own).   Instead, and I always worry that this isn’t very PC, we should think of labor markets as the buying and selling of an asset–employment contracts–which just happen to be backed by the real productive capacity (human capital) of human beings.

For example, I don’t believe in profit maximization.   When it comes right down to it, maximizing anything in the real world is an extraordinarily complex task which requires an immense amount of information (relatedly, if you have time you should read this).  What people do, though, is they exploit opportunities for arbitrage.

This is an important distinction.   An arbitrage is a decision problem that is “local”, while maximization is “global”.   It also explains how and why an economy can appear to be very classical even when it is anything but.   For example, if you recognize that as an empirical matter, marginal product of labor equals the real wage (it does, or at least it is close) than you might be tempted to think that labor markets must clear.   This is not the case, you’re thinking too “global”, there’s no reason that total output must equal the potential total output at any given time.

Consider a firm trying to decide whether or not to hire a new employee–i.e. buy another labor contract.   There is a going (nominal) price for that labor contract (W) on the open market as well as a (nominal) price of goods (P) on the market.   The ratio of these two things is the real wage (W/P).   For a labor force (current) of size L, the firm could in theory (sustainably) produce f(L) units of output at price p (standard concave production function).   Operating at full output, the firm then has an arbitrage opportunity if:

  • p[f(L) – f(L-1)]/P < W/P  ==>  MPL < Real Wage  ==>  sell labor contracts to increase profits (a.k.a. layoffs)
  • p[f(L) – f(L-1)]/P > W/P  ==>  MPL > Real Wage  ==>  buy labor contracts to increase profits (a.k.a. hiring)

In other words, we recover profit maximization in the limit that all arbitrage opportunities are exhausted.   But there’s an advantage to this approach, it is not identical to profit maximization.   I’ve assumed that the firm is operating at capacity and selling its output.   I’ve assumed Say’s law is true.

Instead, I can replace the LHS of the above conditions with the real value of marginal sales.   The arbitrage condition still holds, and at full employment of the firm’s capacity the real value of  marginal sales (RVMS) must equal the marginal product of labor.   However, this need not be the case since the only decision the firm makes (in the presence of competitive labor markets) is the hire/fire decision.   Wages and sales involve the entire market.   Without going into details, RVMS is the firm’s “contribution” to aggregate demand–adjusted for prices–while the MPL is the firm’s contribution to aggregate supply.  Why there is a wedge between RVMS and MPL is an interesting question, but from the firm’s perspective there’s just no there there.  From the firm’s perspective sales as just given, since finding the “correct” market price is hard.

When I taught Macro Principles last year, I made sure to explain “MPL = W/P” as an arbitrage condition which I think is a more natural explanation for new students than “profit maximization”.   On the other hand, RVMS might be too much for most students, but for the rest of us, I think it might help us get our minds around the microfoundations of macro.

Another useful application is CEO pay.   From the firm’s perspective, at full employment, MPL is driven towards W/P because the firm purchases/sells many “copies” of similar wage contracts.   It does so until the condition is met.   A CEO is different, in this perspective, because leadership/management positions in general are not replicate-able for the firm–they are unique.

The firm has neither the use for buying more CEO contracts nor would selling make sense, as the firm certainly needs some kind of leadership, without a (near) simultaneous buy..   If there is to be efficient pricing of CEOs, then, the market has to be well-served on the “supply” side; i.e. there must be free entry of potential CEOs.   This also has profound implications, but I think that’s a story for another post.