Category Archives: Macroeconomics and the crisis

Strange Defeat: An Exchange

Since EPW decided not to publish any further correspondence between Jaydev and Mason & me, I am giving the link to Mason’s blogpost on the subject below:

Of course, I had a response to their response, which EPW decided not to publish! So for those who are interested here it is:

On Modern Macro: A Response to Jaydev and Mason
Parag Waknis

In what follows, I try to address the concerns raised by Jaydev and Mason in their extremely civilized and professional criticism, “A Response to Waknis” in November 2, 2013 issue of this journal!

Optimizing agents and the EU debt:
Financial markets not being able to price the EU debt correctly prior to the crisis does not contradict the rational optimizing framework really. It only reflects the ambiguity that comes with a monetary union that is not a fiscal union. Hence, even though the default probability might not have been same across members, absence of a severe shock, investors may have perceived it as so. Despite the significantly different fiscal situations of member countries, convergence of inflation across the EU members might have supported such valuation. But a shock as severe as the US financial crisis can force investors to reevaluate their portfolio positions in order to minimize risk and that is what seems to have happened. Given that asset prices are conditional variables and that pricing being a discovery process, this response of investors actually seems reasonable and not so off the mark from the optimizing benchmark.

I am not arguing for only one kind of microfundaions. A rational optimizing agent is a useful benchmark in macroeconomic modeling but may not be appropriate for answering all the questions macroeconomists ask. Several alternative avenues of modeling expectations have been explored in the literature and sometimes confrontations with data have helped explain the disagreement between reality and the theoretical benchmark (See Sargent (1999)). Macroeconomists face special problems in terms of evaluating a policy as they only have model economies at their disposal. Then search has to be for policies that are robust to several different model environments. Hansen and Sargent (2008) develop an agenda along these lines.

In short, there is substantial heterogeneity in macroeconomics and there are enough examples of how macroeconomists have pushed forward the research agenda to address basic methodological issues and limitations. Concentrating ones critique on certain frameworks that gain primacy and generalizing it to the whole field at best betrays ignorance or at worst belies an ideologically motivated critique!

Unemployment in the US and Europe:
The difference between European and US unemployment is not a new phenomenon. European unemployment on an average has been consistently higher than the US for past 30 years. Prior to 1970, EU countries had similar unemployment durations as the US but lower inflows to unemployment keeping their unemployment rate low. After 1970 this changes, though. The inflows to unemployment remain the same but the typical duration of unemployment is much longer in EU countries than in the US making EU unemployment rate higher. So how do we account for this reversal in the comparative unemployment regimes despite the persistency of institutions in both the continents? Ljunqvist and Sargent (2008) provide an answer. They show that the unemployment effects of higher unemployment insurance and employment protection depend on the amount of economic turbulence represented as skill depreciation at moments of involuntary separation.

At any given point of time in their economy, there are two types of job separations. One is voluntary- people who quit their current job to look for another and possibly a better one. These people are secure in their skills and do not experience a skill depreciation when they quit a job. In contrast to these workers are those who are laid off. These contribute to involuntary separations and imply skill obsolescence. Economic turbulence is defined as negative shocks to laid of workers’ earning potentials. Given this description of the economy, which pretty much sums up the economic environment that workers in the EU and the US faced after 1980, it is not hard to see how generous and long lasting unemployment benefits would provide a higher incentive to the unlucky workers for staying unemployed keeping the unemployment rate in the EU higher than the US up until recently.

The recent change in employment benefits in the US seems to have altered this situation bringing unemployment rate in the EU and the US closer. So the authors should not be surprised that in 2009 US and EU rates are identical. The US workers are staying unemployed longer like those in EU there by pushing up the unemployment rate even though the inflows to unemployment pool have not changed substantially. As I mention in my response, Mulligan (2012) confirms that increases in unemployment benefits has been one of the reason for increasing the unemployment duration. In a similar vein but highlighting a different mechanism, Hagedorn (2013) show that the increased unemployment benefit eligibility during the great recession affected the rate of job creation contributing to the higher unemployment in recent periods.

The example of Denmark and Norway that the authors provide only highlights that there is substantial heterogeneity within Europe but most of the numbers seem to be on the higher side pulling the average well above that in US. Taking a survey of the literature on this issue, Blanchard, Bean and Mucnhu (2006) argue that most of the theories that have been put forward regarding the labor market institutions explain the persistently higher unemployment rate in EU quite well, with a caveat that differences in labor market institutions within the EU countries might explain the differences within the EU countries.

While ridiculing the suggestion that unemployment has increased in the US because of increased unemployment benefits during the Great Recession, the authors suggest that “One useful contribution that I might make is interviewing unemployed workers, and asking them how they are enjoying the vacations they have chosen. We expect he will find the answers most stimulating (Italics are mine)”. As an answer let me give this graph from an “undergraduate macroeconomics’’ text:

Source: Cowen and Tabarrok (2013), Modern Principles: Macroeconomics, Worth Publishers, 2nd Edition, pp. 5.

So the unemployed seem to be vacationing in the several thousand universities across the US! To be fair to the academic bent of this article and journal, research shows a differential impact of unemployment on graduate school enrollment rates according to gender and GPA (see Johnson 2013 as an example). As far as ability is function of economic conditions, I do not think that life of an unemployed is an easy one.

Government Expenditure Multiplier:
I said in my response that if the expenditure multiplier is 1.5, then a dollar of government spending adds at best 50 cents to the GDP. I was hoping that the authors would be careful enough to read that as net addition to the GDP. So just to clarify, I do not regard this situation as crowding out. However, an estimate below 1 does mean crowding out. Also, many of these estimates are based on defense spending in the US and entail an increase in distortionary taxation. A government expenditure increase on some different category of spending or financed in a different way may have different impact. For example, infrastructure spending might have a positive impact on productivity of the private sector (Ramey 2011). This may not provide a sufficient rationale for increasing government spending in a developed country like the US that already has a huge stock of infrastructure but definitely does so for a developing country like India that falls short on that front.

However, by saying, “most empirical economists prefer estimates on the higher end”, the authors seem to suggest that most government spending either is financed in a non-distortionary way and/or it is spent on commodities that affect the private sector productivity. I am not quite sure if that is true. If government spending rises through changing unemployment benefits eligibility, would it have similar incentive effects as funding defense research projects?

About Aggregate Demand:
What role does aggregate demand play in causing business cycles? According to Old/New Keynesians the answer is possibly shortage in aggregate demand, most of which comes through reductions in autonomous investment. I don’t necessarily disagree with this, even though I do not agree with their reasoning behind such shortage* . The important question however, is whether government spending can plug this shortfall in spending and prop up the economy out of recession or would the effect of government spending depend on what might be the cause behind decline in spending? For example, if consumers have already built up a lot of debt and hence are holding spending back in economic downtimes, then would giving them additional money make them actually spend it? There is ample evidence from the analysis of the 2008 tax rebate to suggest that it does not. Most of the extra money was used by households to repay back some of the accumulated debt. So the immediate impact of a tax rebate was increased savings. According to Sahm, Shapiro and Slemrod (2010), the distribution of survey answers to questions about the use of tax rebates in 2001 and 2008 corresponds to an aggregate MPC after one year of about one-third.

Another aspect of recessions, especially after a severe crisis, is destruction of match capital or relationship capital as argued by Andolfatto (2010). Relationships like firm/worker, creditor/debtor, supplier/retailer, etc. are destroyed by the crisis and rebuilding them might take time. This would be especially true if these matches looked good ex ante but not ex post. How does government spending help in this case? May be instead a permanent tax cut might help!

The point is that we should know why aggregate spending is falling short, if at all, in order to see what government policy might work. If the national income was just an identity, then it might have worked to spend and plug the hole. However, there are actual people taking economic decisions and hence the effect of a policy on structure of incentives in the economy matters. Otherwise why not argue for infinite government spending?


*It is typical of the Keynesian school to assume nominal stickiness in wages or product prices. However, note that the failure of markets to clear as implied by price or wage stickiness is not enough to generate stickiness in the aggregate price level required to cause a shortage of aggregate demand. See Barro (1977) for an example of early theoretical work showing this.


Andolfatto D, 2010, Deficient Demand: The Deflated Balloon Hypothesis. Link accessed on November 5, 2013.

Barro, Robert J., 1977. “Long-term contracting, sticky prices, and monetary policy,” Journal of Monetary Economics, Elsevier, vol. 3(3), pages 305-316, July.

Blanchard, Bean and Munchau, 2006, European Unemployment: The Evolution of Facts and Ideas, Economic Policy, Vol. 21, No. 45.

Mulligan, Casey, 2012, “The Redistribution Recession- How Labor Market Distortions Contracted the Economy” Oxford University Press, New York.

Ramey Valerie A., 2011b. “Identifying Government Spending Shocks: It’s all in the Timing,” The Quarterly Journal of Economics, Oxford University Press, vol. 126(1), pages 1-50.

Hagedorn M, 2013, Unemployment Benefits and Unemployment in the GreatRecession: The Role of Macro Effects, NBER Working Paper 19499, October.

Ljungqvist L and T Sargent, 2008, Two Questions about European Unemployment, Econometrica, Vol. 76, No. 1, pp. 1-29.

Johnson M, 2013, The impact of business cycle fluctuations on graduate school
Enrollment, Economics of Education Review 34 (2013) 122–134

Sahm Claudia R., Matthew D. Shapiro and Joel Slemrod Household Response to the 2008 Tax Rebate: Survey Evidence and Aggregate Implications, , in Tax Policy and the Economy, Volume 24 (2010), The University of Chicago Press

Sargent T, 1999, The Conquest of American Inflation, Princeton University Press, Princeton and Oxford.
Hansen L P and T Sargent, 2008, Robustness, Princeton University Press, Princeton and Oxford.

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NBER Summer Institute

An interesting and informative summary by John Cochranne of NBER summer institutes on Economic Fluctuations and Growth and Asset Pricing.

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Unconventional Monetary Policy in an Interconnected World

I came across this news item from CNBC about Bernanke and Rajan face-off and that was enough to break the long blogging hiatus!  Rajan raises an important question that should be addressed given today’s closely connected economic systems. In the context of unconventional monetary policies, he asks “If the policy hurts the rest of the world more than it helps the United States, should this policy be pursued?”  This question is important because there has been a lot of debate about the domestic impact of Fed’s QE policies , but not much has been said about the effects of such policies on emerging market economies. In fact, Rajan puts it quite bluntly when he criticizes “the Fed for failing to mention turmoil in emerging economies in its January 2014 policy statement, sending “the probably unintended message that those markets were on their own,” a sentiment reinforced by public comments by regional Fed bank presidents.” (Source)

While some macroeconomists and even the new Fed Chairman continue to argue about the favorable effects of QE and the eventual low interest rate regime, there has been a convincing argument against it made by New Monetarists like Stephen Williamson here and more informally here.  The infromal argument in short goes somewhat like this: if money competes as means of payments with other assets playing similar role (shadow banking) and if QE is increasing their prices, then the only way money can retain value is if inflation goes down. So we have an imminent danger of Japaneese style stagnation as the lowering of interest rates and increase in value of money creates a liquidity trap.  This is quite apparent in the data and hence quite surprising that Fed continues to neglect it when it comes to policy making. Thus, given that the benefits of QE for the US itself are circumspect or unclear at best, Rajan’s criticism seems valid and timely. Of course, Bernanke did not take it well- he does not want any blemish on his legacy! Not sure what to think of his argument about QE being demand augmenting as suggested by required exchange rate intervention.

Notwithstanding this face-off between two first rate scholar central bankers, something definitely needs to be thought about policy making in an interconnected world economy-especially in case of the US who supplies the world’s most prominent reserve currency and the general shortage of safe assets as argued by Caballero. It looks like there was some talk about this in Kansas City Fed in 2012, the Jackson Hole symposium in 2013, and very recently at the IMF. Rajan’s proposal in this regard seems interesting and worth researching. He sees “merit in assigning the International Monetary Fund or a similar institution the responsibility of assessing the spillover effects of major central banks policies – much as the World Trade Organization does with trade rules – but acknowledged this isn’t politically viable.” 

Whether, such a solution is possible or not, the argument against activist monetary policy favoring low interest rates has never been stronger than now. As James Bullard suggests here, there is a strong evidence that low interest rates may have prolonged the recession that started in August 2007, when firms speculated in the international oil markets using the abundantly available cheap funds and literally engineered an oil price shock! Of course, real data available to Fed at that time did not reflect this and significantly understated the extent of actual recession. Talk about lags in policy making eh!


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Austerity or Fiscal Stimulus?

Here is the link to my response to an article in the Economic and Political Weekly. You can also read the not so civil response by the original authors to my response.  I thank them for putting a layer of thick skin on me 😉

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Kalecki-Krugman Deconstructed!

Michael Kalecki is/was one of the favorite authors in Center for Economic Studies and Planning, JNU, India. But frankly speaking I did not understand what he said much while I was a student there. However, recently Steve Williamson has done a very good job of putting Kalecki’s ideas in a very accessible way. Of course, the whole thing began as usual with Krugman trudging up Kalecki’s ghost!

You can read Steve’s analysis here and here.

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Must be right- Krugman says it!

A couple of students from UMass Amherst find a fault in the results by Ken Rogoff and Carmen Reinhart weakening their claim about the proportion of debt to GDP and its deleterious effects. It seems, now that this link appears to be tenuous, the case for austerity in case of many debt ridden EU countries is significantly weakened and finally the Keynesians of the world win the intellectual battle. Certainly, Paul Krugman seems to think that in successive blogposts on the Rogoff affair!

So is the case for austerity for these debt ridden EU countries really that tenuous? Should they be allowed to continue to inflate their way out? I do not think so. A clear picture of what plagues EU can be found here. The theoretical and empirical evidence against government spending as a way out of economic problems is overwhelmingly in support of austerity. Empirical work by Barro clearly shows that even with huge government spending shocks, the expenditure multiplier tends to just a little over or equal to 1. Moreover, theory tells us that polices that alter the incentives people face will tend to work far better in stimulating the economy in the desired direction. Even if there is deficient private demand, just filling in the gap will just do that- plug the hole. It does not affect the behavior of private sector in the long run. For example we know that the 2008 tax rebate did not move current consumption at all. Savings went up and people paid down the debt that was accumulated in the past. Sometimes even seemingly well intentioned policies can have opposite effects. Casey Mulligan makes an interesting case for this in his latest book, “The Redistribution Recession”.

There might be some case for government spending or inflation tax in developing countries. The presence of a substantial informal sector and significant positive returns on investment in public infrastructure are the cases in point. But you cannot have the same prescription for every country, and hence the Keynesians or Left thinkers especially in developing countries should not take shortcomings in Rogoff and Reinhart’s work as their victory.  Increased government expenditure on employee salaries is still unproductive and deficient private demand (if present at all) may still not be corrected with it. And that replication of results should be still taken seriously before we base policy prescriptions on them.

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Krugman and Layard’s Economic Nonsense

What would Keynes say about the way his ideas are being used and abused to figure out what should policy makers do in the wake of recent financial crisis? I would like to believe he would not repeat his general theory. But leaving the speculation on this question for some other time, I would like to focus on Krugman and Layard’s manifesto for economic sense in today’s Financial Times. Interestingly, while arguing for differences in the European and US financial crisis, Krugman and Layard seem to have a single policy response as a panacea. This according to me actually seems to be a first step towards economic nonsense.

My reasoning is as follows: Among many other things related to how the ECB should function and whether Greece should stay or go, the European crisis is indeed a crisis of excessive public borrowing in countries like Greece, Ireland, Portugal, Italy and Spain. Contrary to this, K and L suggest that excessive public borrowing is a problem only in the case of Greece. To refresh on the EU situation, both of them might do good by reading or watching the work by Fernando Martin and Chris Waller of the St. Louis Fed. Fortunately, K and L get at least part of the US crisis right.  They say it was caused by “excessive private borrowing” but leave out the counterpart that this appetite was whetted by the financial system’s need for collateral to settle debts between themselves. While K and L somewhat agree with these differences, their blanket prescription for government spending in both the cases makes little sense. Looking at the level of public debt that the above mentioned countries have,  austerity does seem like the only way to go! On the other hand, considering the ‘paucity of good collateral argument’, at least in the long run US government  should borrow and spend more.

Now as K and L suggest, is there no evidence for deleterious effects of government deficits and the resulting borrowing on interest rates? The  rising yield curves on government debt for countries in EU,  (See this interesting  chart on Andolfatto’s blog), seem to suggest otherwise. It is probably only US that can still borrow at a lower interest rate without risking an immediate rise in the future interest rate. This is primarily because the US dollar still remains a strong international currency and the ability of the US government to honor its debt is not yet in doubt.  So as much one could argue for government spending in the US, especially on retraining programs or on Universities where the unemployed tend to flock, not all countries have the capacity to roll over their debt indefinitely and sustain such expenditure.

So what should be the manifesto for economic sense? Thinking carefully about the nature of the two crises and suggesting policy prescriptions based on such analysis or lumping both these crises together and somehow arguing that government spending is a panacea in both the cases? I pick the former while practical men seem to gobbling down the later keeping with the Keynesian adage of falling for a defunct economist!

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