I got a pair of deuces, what you got?

... and what's the game we're playing, again?

Anyways. There comes a time when every macroeconomist needs to lay their cards on the table. Form their expectations, rational, adaptive or otherwise, but commit to something or other. Like a forecast.

And this time is obviously one of those times. All this crazy stuff happening, we should be able to say something about it. Something specific, in particular, to be precise, without qualifications. Most of the commentary so far has been on intermediate aspects, caveats, details, or theoretical nuances.

Yeah yeah yeah, credit crunch or not. Greenspan made some mistakes or maybe he was a Trotskyite saboteur. If only Friedman didn't advise the junta of Liechtenstein while Martin Luther was busy nailing his monetary thesis to the door of Wittenberg cathedral (i.e. on his "blog") Icelandics would've never settled Greenland. And then the Easter Island economy's money supply consisting of big statues of very important looking faces would've never collapsed, prompting a bailout of the Long Term Capital Management causing Cardinal Mazarin to scuttle the Bretton Woods system, Athos to become a drunk, Aramis to become a cynical advisor to McCain and Porthos wouldn't have died trying to hold up the whole edifice of the American financial system while Paulson cackled, Wasilla burned and Nemo fiddled. Rock the Vote against the Global Warming and for the Moderate Progress Within the Bounds of the Law!

But seriously. How much is GDP gonna fall? How high will unemployment get? When you say "worst since the Great Depression", do you mean like a 32.5% decline in output, .1% lower than that between 1929 and 1933? Or do you mean a 5% decline,.1% higher than the 1973-1975 recession? There's a lot of freakin' percentage points between 33% and 5%, which means there's worst and then there's worster, so let's get specific.

But of course I'm not gonna tell you. Well, I will but it should be immediately understood that the forecasts that follow are just based on half-monkey-butt guesses and quick algebra which I haven't double checked, but I think it's at least a way to clarify some of the issues and stop some of the crazy talk. Of course, we live in crazy times, so crazy talk might not be all that inappropriate. Hmm, I've already started with the qualifications.

Casey Mulligan has laid his cards on the table. Whatever you think of his estimates, at least he's estimating and doing what a macroeconomist should be doing in a situation like this. Predictin'. Forecastin'. Not evadin' the issue. Obviously he's new to blogging but I'm sure he'll learn soon (there's a lot more there).

My approach here is going to involve much more pulling stuff out of thin air, but it does have the potential misbenefit of being simpler.

So national income is composed of the financial sector and the non-financial sector. Here I take the financial sector to include the real estate sector, since it's more or less the same mess.



where Y is output at time t, F is the financial sector and NF is the non-financial sector.

Some data here. Better data around if you look.

In 2007, "Finance, insurance, real estate, rental, and leasing" (note that this does not include Construction which is a separate category. Real estate is people who buy and sell houses and other land for other people) was 20.68% of GDP. In 1998, it was 19.26% of GDP. Ok, here's the first problem. About 20% of the 'real economy' is 'unreal economy'. In other words, the financial sector + real estate are big enough in and of themselves that even if all negative effects from the present crisis are confined to that sector, it will still be big enough to show up as a decent recession. Suppose the financial sector shrinks by 10%. That's still a 2% drop in overall GDP which is larger than the last two recessions - basically, since Volcker.

10% shrinkage in the size of the financial sector is pretty huge actually. But anyway, we'll get to that soon enough. Ok, some simple accounting. Based on the equation above we have







or diving through by Y_t-1, re-arranging and all that, we get




where alpha_t=F_t/Y_t, or the share of the financial sector in GDP at time t. Factoring out the growth rate of the financial sector (or in this case, it's shrinkage) and letting g(.) denote growth rates ((dX/dt)/X) and dropping time subscripts on the alphas (which basically means going to continuous time - this doesn't matter significantly) we have




This is just accounting (true by definition) and it just means that the growth rate (or the fall in it) in output is a weighted average of the growth rate of the financial and non financial sectors where the weights are the shares of each in output. Like I said, it's just accounting. But here's where the economics come in - we can give an economic interpretation to the ratio




as the elasticity of the non-financial sector to the financial sector. In other words, this would be the effect that the trouble in the financial sector has on "mainstream", the "real economy" or whatever you want to call this. When you hear people talking about "how will this crisis affect main street?", they're really talking about that elasticity. Except so far it's not really an elasticity, I'm only pretending it is, so far it's only accounting. Still, at this point I can start putting some numbers on these variables and start figuring out how much of a decline in output can happen. Basically two variables got identified which will determine the recession, if any, that's gonna happen. And these are two variables that have been mentioned in a lot of the commentary directly or indirectly, but which here I am putting at the forefront, which I'm gonna slap some number on. Which allows me to put my pair of deuces on the table and look triumphantly at... well, nobody in particular. But it will be a really triumphant look. Because it's at least a forecast.


So ok. First question, how much will the financial sector shrink? In other words, what's . Above I said -10% or -.1. That was just an example, using a round number and all that. The truth is that neither I nor nobody else has any good idea of what that's going to be. We live in crazy times, as I said. But I'll try being rational in non-rational times, which is of course very irrational. Anyway. According to the data above, between 1998 and 2007 the Financial sector of the economy grew by about 7% more than overall GDP. So let's pretend that 1998 was a "normal year" and that if none of this crazy stuff happened the financial sector + real estate would've grown at about the same rate as overall GDP (I'm picking 1998 because it's far enough and close enough to "normal times". The share of the financial sector in GDP was increasing before that but 1) at least some of that increase DOES represent genuine innovation in the financial markets and 2) I'm too lazy to look for data that goes back before 1998). So our first monkey-guess is that the "correction" that's going on is going to involve the financial sector shrinking by 7%, down to where it was if that sector had grown at the same rate as overall output. So



This is actually the easy one. The tougher question is, what is going to be the spillover from the financial sector into "main street" or the non-financial sector, or what is . So far it's only really the ratio of the growth of the non-financial sector to the growth rate of the financial sector but if we assume it's some kind of a behavioral/social elasticity (i.e. do economics rather than accounting) then we can get some estimates. And here they are...

Oh wait. This is still too accounting based. Ok, let the size of the non-financial sector be a function of the F sector (which provides credit to the NF sector, as well uses up resources which have alternative uses in the NF sector) and a whole bunch of other stuff that we'll call A:



We could include a lag here and let it be a function of F_(t-1) but that would just unnecessarily complicate things. Let's also assume that the "whole bunch of other stuff", whatever that is, grows at a constant rate, g. So growth of A is g. In that case, the growth of the non-financial sector's going to be



where now is the spillover of financial markets to non-financial markets (rather than just an accounting ratio), g is an exogenous growth rate of the non-financial sector due to productivity increases which have nothing to do with the financial markets (technological progress and the like) and is how much the non-financial sector grows due to these productivity increases. In fact, at this point it's not too crazy to assume which would be equivalent to assuming the functional form (even if one objects to this formulation, it's still that data-wise phi*g would be the actual estimated growth rate of the non-financial sector which is not due to changes in the financial sector, which is what we actually care about here. Yes. It is difficult to write economics in a non-confusing manner. That's why there was comedy at the beginning of this post. To soften you up). So now our equation for the size of the recession becomes:




or




which is very similar to what we had previously except for that now we have an extra term (1-a)g, which represent increases in output due to exogenous growth in the non-financial sector and, more importantly, our interpretation of epsilon has changed - now it is truly an elasticity which measures the effect of changes in the financial sector on the main street economy.

Ok, but we still need to know what that epsilon is. I don't know. I know "g" though. If your horizon is a year than I'd say it's between 1% and 2%. Let's not be too optimistic and say it's actually .5% but now that we have actual formulas we can calculate the recession for various levels. Hmmm,... epsilon.

The epsilon or the how the financial crisis will affect the size of the "real economy". Thinking about it there's couple heuristics we can use here. First, there's a lot of talk about how the financial sector is too big and too bloated. A lot of that is crazy talk from people who ascribe to the Thomas Aquinas view that interest rate should be zero, but in these particular times there's probably something to it. What this means is that epsilon cannot be THAT big. I'd say less than one, and significantly so. Second, note that it can be positive or negative.

If epsilon > 0 this means that when the financial sector contracts, the non-financial sector does as well. The straightforward interpretation here is that as the financial sector collapses, the non-financial sector gets denied credit. And I'm sure you've been hearing stories about that.

A more counter-intuitive case would be that epsilon < 0, which you don't hear as much about. But this has a natural interpretation too. As a particular sector of the economy contracts, it releases resources, in terms of workers, capital, knowledge and yes, even re-directed credit, which can than be used by the non-financial sector. In fact, for most industries, this is exactly what happens when one industry contracts and another expands (and it is at least partly what Casey Mulligan's talking about in his post). That means that as the financial sector shrinks, the non-financial sector is given more resources to grow. So the elasticity is negative (which is good news for us here).

Additionally, in the long run (yes yes yes, I know that in the long run "we're all dead" but if you never think about the long run then when it comes it's gonna suck, and so will the medium run which comes around while you're still alive. (Rock the Vote against the metempsychosis of good quotes into empty cliches!)) insolvent financial institutions will be replaced by new, solvent ones, or their business overtaken by old, solvent ones. And that means the credit will resume and the negative aspects of epsilon will be reduced.

There's another aspect that should keep epsilon down in absolute terms ...

Oh.

The forecasts. Where are they? Hold up, hold up. Would anyone try to bluff by telling you they got a pair of deuces? They're coming.

... and that's the fact that by many accounts banks are withholding credit for two reasons. One, they wanna hoard because they're worried that they might go insolvent themselves. Two, they wanna hoard because they're worried that whoever they lend to will go insolvent and won't pay back. The first one applies generally. The second one though should not be a problem in terms of lending to non-financial institutions - provided that most "main street" firms are fine. Which if they're not, then we're in big trouble, but then, why are we worrying about the financial crisis in particular anyway? So while the supply side of credit may be a problem here, there shouldn't be much of a problem on the "effective" demand side - i.e. banks should be able to find non-financial firms to lend to.

Note that this DOES NOT apply to the trouble that's currently starting in many emerging markets, as noted in some places, where many firms are potentially insolvent. In that case, both the number of potential supply of lenders and decent borrowers are low so ... well, this post is getting long and you probably want your forecasts, but yeah, much bigger trouble.

Anyways. I pick:

In the short run; epsilon = .3, in other words, if the financial system shrinks by 10%, the non-financial system shrinks by 3% due to lack of credit. I also pick g (exogenous growth in non-financial sector) g=0, reflecting, well, the short run.

In the medium run; epsilon = 0. I'm just gonna assume that the positive and negative effects described above offset each other. I'll let g=.005 in this case.

In the long run; epsilon = -.2. For symmetry I wanna go with -.3 but I also want to be a bit pessimistic. So if the financial system initially shrinks by 10%, it releases enough resources (I do wish I had some input/output tables here. It's true, people don't do that enough anymore) for the non-financial sector to increase by 2%. Going along with the pessimist I'll keep g at .5%.

What does that gives us?
Well, here's the values based on all this stuff above:
g_F - exogenous shrinkage in the financial system due to the present crisis = -.07
alpha - share of the financial sector in gdp, rounding it up = .2
g - exogenous improvements in the non financial sector = 0 in short run, .005 in medium and long run.
epsilon - .3 in short run, 0 in medium run, -.2 in long run.

Which means:
In short run



In other words a drop, peak to trough, in GDP of slightly more than 3%. How bad is this? Well, it's basically the second part of the Volcker recession. So not as bad as all of the Volcker recession of the early 80's (the whole thing was 5%+). But worse than the last two recessions we've had. If you want some good news, then there's the schadenfreude that the drop in the "main street" economy this implies is only about 2.1%

In the medium run:



Or something that looks like the 2000's recession if it looks like anything at all. You'll be able to see it if you squint really hard, but it will be there.

In the long run:



which means a slight gain due to the fact that the over bloated financial sector gets rid of some excess weight and due to the fact there's some productivity increases in the non-financial sector. Note that the productivity increases in the non-financial sector are assumed to be 1/2 of a percent, which would normally show up as .4% growth in GDP so this still represents some drag on the increases in incomes that would otherwise happen.

So there you go. There's my pair of dueces. They may not be much but they're spades.

But wait! We're not done actually.

One more thing we can do, since we're totally into the monkey-guess-ad-hoc-macro-make-up-elasticity-values territory (BTW. An empirical question related to a previous post. Did any of the efforts in macroeconomics to try and deal with the Lucas Critique and estimate the "deep" parameters actually lead to better forecasts? Or did they just lead to changes in the assumed utility functions/adjustment costs of capital/pushed back the ad-hociness another level? In other words, did they deal with Friedman?). It's called Okun's Law, which relates changes in output to changes in unemployment:



Usually u* is taken to be "natural rate" of unemployment but here we can just take it to be the present rate of unemployment. And xi is usually estimated to be between 2 and 3. And current unemployment rate is 6.1. Then the relevant unemployment rates we'll see according to the estimates above are:

Short run: Lower 6.1+(3.08)/3=7.13, Upper 6.1+(3.08)/2=7.64
Medium run: Lower 6.1+1/3=6.43, Upper 6.1+1/2=6.6
Long run: Lower 6.1-.12/3=6.06, Upper 6.1-.12/2=6.04

Alright, almost over. But obviously in these circumstances Bob's your uncle and the guesses above are just guesses although based on some assumptions. So here are some tables which allow you to question me (remember that this is all based on accounting and the behavioral assumptions are free) - maybe you think the crisis will cause a much greater fall in the size of the financial sector or maybe you think that epsilon's greater/smaller/insane. Here's some tables which do the calculations for you. I highlighted some values which I thought were relevant (click to enlarge).

The recession:



The effect on main street:



And the resulting unemployment rate:



Oh yeah. These were calculated under the assumption that g=0. Which means that if g=.005 - there's a 1/2 % improvement in productivity of the non financial sector - add .004 to the estimated growth rates of output. And then use Okun's Rule again. Basically this makes things a little bit, but not much, better.

Additional stuff:
* Ugh, now I gotta look for the links to anything that's relevant in all that crap I wrote above.
* This is also a useful framework to use when thinking about the bailout plan. What is it trying to achieve? Is it trying to contain the shrinkage of the financial sector? Well, that means less recession in short run, but less positive adjustment in the long run. Sure, it may be worth it. Or is trying to target the epsilon, the spillover from the financial sector to the non-financial sector? This also has some short run vs. long run implications (even if one's not a liquidationist - see previous post). Or is it just throwing money around hoping that it will hit something somewhere?
* I'm actually very much in favor of "moderate progress within the bounds of the law". In fact, I think that's my political bliss point. I still think that's pretty funny though. There's a difference between aesthetics/humor and ethics/politics.
* This stuff's peak to trough. If someone forces me to forecast the time frames as well I'd say; short run = 1 year, medium run = 1.5 years, long run = 2 years+
* I kept the Visigoths out of this

Minsky, Austrians and the MMT

In the discussion of the present crisis two kinds of theories are generally being invoked as applicable or as "having foreseen it", by two different groups of people. Interestingly enough they lie on opposite ends of the political spectrum. Minsky's "Financial Instability Hypothesis" is generally associated with a pretty left wing version of "radical Keynesianism", while the "Fed driven malinvestment" story comes courtesy of the Austrian school. There is of course a fundamental difference between the two - the Keynesian view sees fluctuations and bubbles as inherent to the capitalist system, while the Austrians think it's all created by sloppy government/Fed policy - but, aside from that, both of these stories can be reconciled with the present events. (And here is a bit of a synthesis though done from the Austrian side)

At this point I should probably say that my knowledge of both of these approaches is pretty superficial and I'm perfectly happy to be corrected.

To make both stories make sense we need to add in the role of monetary policy in the present crisis. Daniel Davies (among others) has argued (somewhat along the Austrian view, surprisingly) that it was Fed policy to "engineer" the housing bubble as part of its 2000/2001 recession fighting strategy.

So let's accept for the moment that monetary policy was bad. How does the Minsky view contrast with the Austrian view?

In Minsky, as I understand it, waves of euphoria in good times lead to speculative bubbles which then crash resulting in a credit crunch and ensuing bad times. Now, it's partly the job of the Central Bank to step in and try to smooth this "slow movement" by cooling down the euphoria with high interest rates in the good times and expanding credit with low interest rates once the bubble pops (plus regulation and the like). Assuming the above view of monetary policy, the Fed did not do its job in this regard, letting the euphoria and the bubble grow until we got into the present mess. On the face of it, this view roughly fits.

So, to sum up, Minsky:
Naturally occurring speculative bubbles + Fed fails at its role = crisis.

How is the Austrian view different? Well basically it is:
Fed naturally screws up -> artificial speculative bubble = crisis.

You can sort of see why both stories can plausibly fit the present scenario here. In the Austrian view the Central Bank keeps interest rates artificially low, which causes "malinvestment" or in this context the real estate bubble, eventually this policy induced bubble collapses and all those bad investments have to be "liquidated" with a resulting recession.

One significant difference between the two views is how to deal with the situation. In the Minsky view, since these bubbles are inherent to the market, the role of the Fed once the crisis is under way is to provide liquidity. So even though the Fed failed at stopping the bubble in the first place, now that the bubble popped the Fed's job is to continue with the policy of cheap credit until good times return. The same policy that caused the bubble in the first place is the one necessary to get out of the crisis.

In the Austrian view the "liquidation" of "malinvestment" is necessary and even desirable, if the economy is to get back on its track. Hence, the Fed should not provide cheap credit but keep it at its normal level and let the thing sort itself out. Otherwise the "malinvestments" will continue leading to an even bigger necessary "correction" later on.

So while both these theories can offer a somewhat convincing story of how we got here, their fundamental assumptions imply completely different policy actions. And at that point it's basically a confused look and a "who knows".

Let's step back though and think about a "what if" scenario? What if the Fed had raised the interest rates and 'smoothed the euphoria' in the Minsky view or not lowered the interest rates and not caused the bubble in the Austrian view? Well, the most apt reference point here is that of Japan in the early 90's, which also had a real estate bubble (whether naturally occurring or caused by previous lax monetary policy on the part of BoJ). The Japanese Central Bank DID pop that one. And the result was ten years of economic stagnation. We've yet to see how the present situation unfolds and how it compares to that particular outcome.

Anyways. Where does this leave Mainstream Macroeconomic Theory (MMT), which is neither Austrian nor Radically Keynesian? Not applicable, irrelevant, out of touch? After all, in your basic MMT, too lax of a monetary policy just leads to higher inflation which then puts a drag on long term growth (Austrians also have this part). But bubbles and crises aren't a part of it. And inflation hasn't been a problem (yet). So yeah, for present purposes MMT doesn't seem to do us any good in understanding this crisis.

Is that a damning failure? Umm, yes and no. The 'yes' side seems pretty straight forward and basically that's what all the stuff written above is about. On the 'no' side, I think it's important to realize two things about MMT. First, it seeks to describe how the economy operates during "normal times", is in fact pretty good at that aspect (which is where it gets that first 'M' in its acronym), and it just happens that we aren't living in "normal times". Second, and relatedly, the MMT developed in particular historical circumstances and in response to particular historical events. And almost by definition, first-M-in-the-acronym kind of theories are going to change much more slowly than events on the ground. Theory builds on what came before it, it changes slowly, it is "sticky". It evolves rather than jumps. When the world goes out of wack that affects the direction in which the theory evolves but very rarely will it cause a complete overhaul of the theory (a possible exception: General Theory, the Great Depression, and the development of Macro itself). New ideas, new hypothesis, radical new explanations occasioned by crises and unforeseen events even when they seem plausible need to be tested by real life experience, filtered by repeated natural experiments and thoroughly examined on the basis of their yet unexplored assumptions. All this takes time and expecting MMT to be able to explain something unprecedented is like expecting your (fixed) capital stock to instantaneously adjust to its long run level in your basic growth model.

And this of course is what opens up the door for more radical theories like the two mentioned above. The thing is that even though both of them may be able to offer plausible stories about the current events, overall... well, overall, they're wrong. The Minsky "movements" of euphoria driven bubbles seem to be rare. Between 1987 and 2000 too be generous, and 1982 and the present to not be, the theory seemed to have next to no applicability. That's between 13 and 26 years where these kind of fluctuations just weren't there. Similarly, in the same time period, despite very widely different Central Bank monetary policies (or maybe because of it) the 'malinvestment' cycles don't really seem to be either.

When the crisis hits, yeah, you're gonna reach for the shelf and pull down the first bottle labeled "crisis theory" since that's what you need. But when there is no crisis you'll hardly notice that shelf and those bottles are there, and with good reason. Part of the difficulty here is that 'normal times' are, well, normal, while crises only come around once in awhile. This means that you will have a lot more data to test the 'normal times' theory and only a few observations which can be used to sort among possible crisis theories. So the MMT, which is, which needs to be, based on a thorough empirical footing is going to be based on all the data available for normal times and that is what it is going to explain well. But once a crisis hits it will be irrelevant since the observations of crises, within the context of that theory are pretty much bound up to be considered "outliers", being few, in between, and extreme. And being few, in between, and extreme these outliers are not even going to be particularly useful in figuring out which crisis theory is correct. And that's how both the Minsky view and the Austrian view can both wind up providing plausible explanations for what's happening now, even though fundamentally they are very different.

But like I said, when the world goes out of wack that can, and should, influence the direction in which MMT is evolving, even if it cannot make it instantaneously adjust to offer a good explanation. So here's my suggestion. Traditionally Macroeconomics is divided into two branches - Long Run Growth and Short Run Fluctuations. Perhaps the impact of this crisis on Macroeconomics-as-she-is-done is that it really should have three branches; Long Run Growth, Short Run Fluctuations and Crisis Managment. As it is currently, crises, of whatever kind, don't really have much of a place in either LRG or SRF though there is some exceptions/precedents (Krugman's (and others) currency crisis theory for example. Or the whole 'coordination game' approach. All in all, the point is that these approaches probably could use a greater emphasis within the general Macro framework ). This is why MMT doesn't have much of an explanation for all this mess, and why you got to reach for the shelf with the 'extreme' (though not necessarily wrong) theories. Given that I don't think Macroeconomics is really capable of integrating 'crisis theory' into either LRG or SRF - particularly since it is not really capable of integrating these two approaches themselves, whether out of the inherent difficulty or just plain ol' unwillingness to try, something I've complained about before - the next best scenario might be that crises get their own sub-branch within Macro.

Friedman vs. Microfoundations

MACROECONOMIST! Stand up, lend your ear, and listen! The very reason for your existence is under question once again (last link, only in the comments). It is said that you are no more than a subspecies of a superior form (can we please have a Google or some other search engine that is "net" of Wiki pages?), one which you should aspire too but have not yet achieved. Your discipline, your raison d’etre (well, I am going to use it as long as it's here), is called ethereal and treated like some aboriginal culture which needs to be civilized by those who claim superior status. This process has been well underway by well meaning but clueless colonizers for some time. And it is time. It is time you rejected their do-gooder inroads, their insistence on assimilation, and the patronizing misunderstandings they carry before their Gods as offerings. Their temptations of Maximization (seriously, if maximization was all there was to 'microfoundations' shouldn't we all be studying evolutionary models anyway. That's a critique of both btw). Their phony Dynamics which were always implicit in your own dogmas. Their substitution of ritual for true hermeneutics.

What have they brought us? It is true that our texts were fallible. And it is true that, in the beginning, their critiques shone light upon our misunderstandings. But we mistook a lighting of a candle for a conflagration of divine knowledge. And ecstatic with a small dose of illumination we threw our books upon Savoranola’s fire. Even Michelangelo himself threw his Madonnas onto the pyre (find a relevant link yourself. All I get is wiki).

Yet in end, their promises fizzled once the glow of the ambers died. Having abandoned our faith we were left with trying to build a house out of ashes – micro founded ashes – rather than ad-hoc oaken beams. It is time. It is time we returned to the practical knowledge which had allowed us to built a shelter, no matter how shabby, but which could stand up well in the hail storms, even if we did not understand the engineering principles involved. A good pool player knows how to sink the final ball in its pocket at the end of the game, avoiding the eight ball. The knowledge of the laws of physics is immaterial. Perhaps if the game was played on a table with no friction our detractors would have had something useful to say.

But we have been in the wilderness for a long time. We are weak. It is the truth and let us admit it, our spirits have been starved of intellectual substance for some time. And they may be for some time yet. But our path is righteous. And if we are going to ever get back upon it we need to first assert our own existence. We are MACROECONOMISTS! We have insights which cannot be derived from the cult of Some-kind-of-Maximization-somewhere-by-somebody-for-some-reason (and who knows who or what) = Microfoundations.

MACROECONOMIST! Stand up and listen because you need a weapon. A holy weapon! Or an unholy one perhaps! One forged in the fires of battles of yore’. One, which even the detractors fear. One, which they claim to worship as much as we do. Only the cold steel which is mutually respected can shatter their sanctimonious presumptions. Too many times, too many battles, have the detractors fought against faux foes with their faux epees. Yet, those easy skirmishes have dulled their senses. Since we both have arisen from the same Promethean fire, in order to strike at our brothers’ usurpation we need that which contains our mutual essence.

And here I will give it to you, that sacred weapon which can turn the tide. The task will not be easy, but if we are to persevere it is necessary. You, each one of you, will need a printer. An ink jet or a laser jet, it matters not which. Some stock of paper, the heavier the better. Turn on your printer, oh MACROECONOMIST! Let the incantations begin.

First, you will need to download this file, although it is quite possible that you may have this ancient text in your archives already. If so, retrieve it! Next, comes the mystical part of forging words into weapons. Take the essay, convert it into a text file through whatever magic you are suited to best. Once it is in a text format, the hardest, most tedious, most excruciating part begins. What you need to do, OH MACROECONMIST, is to format the text so that each letter of the mystical incantation corresponds to only one page. That is, one page = one letter of Friedman’s “Essay in Positive Economics”. All in all it seems there are about 10,135 words in that essay. Assuming average word length to be about 5 letters that amounts to 50,675 pages. I know, I know, it’s gonna cost you a lot of printer ink, but come on, this is a mystical weapon we’re talking about. Print that sucker out. And then wield it.

Your next task, OH MACROECONOMIST, is to seek out your foes. Attend a conference and purposefully present a paper which is just pure Macro. If need be, put a Phillips Curve in it. And then wait for your adversary, your prey, your would be patron, to ask you about … microfoundations.

Raise your ancient mystical weapon! 50,675 pages of Friedman. They will cower upon its revelation. Do not be afraid of your own wrath, let not mercy enter into your heart!. If need be, think of Charleston Heston smashing the Tablets of the Covenant in 10 Commandments or of William Jennings Bryan being crucified upon the cross of gold in that cartoon Macro Principles books always include! But strike down hard. Slap that faux-macroeconomist who insists upon microfoundations with your fury.

Smite!

Smite!

Smite the microeconomists who say that macro is but a sub field of micro. Smite them with your 50,675 pages of Friedman, which say:

Misunderstanding about this apparently straightforward process centers on the phrase "the class of phenomena the hypothesis is designed to explain." The difficulty in the social sciences of getting new evidence for this class of phenomena and of judging its conformity with the implications of the hypothesis makes it tempting to suppose that other, more readily available, evidence is equally relevant to the validity of the hypothesis-to suppose that hypotheses have not only "implications" but also "assumptions" and that the conformity of these "assumptions" to "reality" is a test of the validity of the hypothesis different from or additional to the test by implications. This widely held view is fundamentally wrong and productive of much mischief. Far from, providing an easier means for sifting valid from invalid hypotheses, it only confuses the issue, promotes misunderstanding about the significance of empirical evidence for economic theory, produces a misdirection of much intellectual effort devoted to the development of positive economics, and impedes the attainment of consensus on tentative hypotheses in positive economics.

Now, just substitute "microfoundations" for "assumptions" and your weapon of great power is ready. It is not the assumptions of a model that matter. And THAT, you freakin’ monkeys (this is spoken in an ominous Friedman voice, not my voice, I’m just channeling here you know), applies to macro or micro assumptions. It is how good the model is at actually describing and predicting reality. One can have a macro model founded on good micro foundations predicting crap. Like all these “puzzles” that generate papers in present day macroeconmics without ever wondering “hey! Maybe it’s the assumption of complete markets that screws everything up!”. Or one can have a perfectly good macro model, reduced form and all of that, no worry about microfoundations, which predicts stuff that actually happens. Why have you forgotten? Why? Why? Why?”

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All I’m saying, 50,675 pages of Friedman outta be enough to convince any neoclassical economist.

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In trying to link to relevant stuff in this post, it occurs to me that the whole freakin' problem with Wikipedia is not enough supply (or substitutes) rather than too much demand. That and deviation from median person's preferences. Really, detailed info on Savoranola just really ain't there on the internets just like it's he/it's not something/someone you can just bring up in a normal conversation. Wiki gets criticized for having too many goofy articles on whether Skeletor had ears or not but honestly, that's what people wanna read about. Nothing wrong with that, though personally I'd rather read about Savoranola. But you gotta take the good of the capitaleesm with the bad of the capitaleesm. Same thing for democracy.

Obligatory Post on Krugman's Nobel

In Econ Grad Student Lore (which is as often false as true) it is said that when Maurice Allais got his Nobel prize he said "About freakin' time!", or at least something close to that, maybe in French. Paul Krugman actually seems genuinely surprised to have gotten one, but I'm with Maurice on this one.

Oh yeah, I've never met Krugman (though I've met some other laureates. George Akerlof in particular seems like a very nice person) but I did pass him in the hallway at the AEA meetings when I was on the job market. "Hey that guy's Paul Krugman!" I thought to myself. And then; "Wow, he's sort of short".

Additional thought (added later): And yeah, Krugman was the economist that got me first interested in economics with his popular books. But I expect a lot of people are going to be saying that now (and some of it may be true).

You know those charts which graph your political ideologies in a two dimensional space?

I was trying really hard to write a post on how Macroeconomics should, should not, has, and has not been done. It got long. But in the process of trying to organize my thoughts I drew this graph to help me think. In the end the graph was better than the long winded rant, so I dumped the post and kept the graph. Not as good as XKCD but the self reflection did illuminate some surprising things I never realized about myself before. I am really, really, really bothered by Platypusai.

Click to enlarge and all that.



Please note that if you were try to draw some indifference curves through that creepy/cheesy space, you'd get to the problem of non convex preferences, and possibly satiation point, very quickly (I'm not sure of what I'd like more of; Uriah Heep or Alaric the Visigoth).

UPDATE: This one's updated to be more about economics:

The "Sweeteners"

So after voting "no" before, enough lawmakers might now vote "yes" on the new bailout plan because:

1. Mental health provisions in insurance plans.
2. State and local sales tax deductions.
3. Subsidies to rural counties
4. Relief for victims of natural disasters
5. Business tax breaks
6. Energy subsidies

and all that for a measly 120 billion on top of the 700 billion already in there.

So, ok, raising the FDIC limit to 250,000 may be a good idea in the present circumstances. But other than that, what 1-6 above have in common is that

THEY HAVE NOTHING IN COMMON WITH THE FINANCIAL CRISIS!!!!!!!

(and did anyone notice how in the debates McCain kept referring to this situation as a "Fiscal Crisis"? No John, a "Fiscal Crisis" is when the government's broke and can't borrow. What we have is a "Financial Crisis". Two different things, buddy. I know, I know, he's not the only one confusing things.)

Alright, so maybe you gotta cut some deals to pass the darned thing and that's where we get the above. But the list also reflects how seriously our lawmakers are taking this plan - basically, who cares about the plan itself, let's see how many pet projects we can coat tail on it. If you want those things, fine, but try to get'em passed when there isn't a big crisis going on. If the plan sucked before it sucks worse now.

And of course there's this whole thing about how the taxpayers will not actually have to pay the 700 billion (I'm assuming that no one's been brazen enough to argue the same for the additional 120 billion but who knows), and hey, maybe they'll even make a profit. Whoa! Government makes profit for the taxpayers! Hey, why didn't we do this before? Why not in fact, do it all the time, crisis or no crisis. I mean, Profit's good! With a bailout plan every year, pretty soon the government will be able to close that deficit and pay off the debt. I know, I know, I'm being uncharitable, but the amount of crap that we're being told on this whole thing is overwhelming and it's almost enough by itself to oppose it.

Economic Logic is also mad. (via Gabriel)

Here's Casey Mulligan on the lack of the link between Wall Street and Main Street.

UPDATE: Here's Ken Rogoff, via Mark Thoma:

"Does such nitpicking fail to recognize the urgency of fixing the financial system? Isn’t any plan better than none? I, for one, am not convinced. Efficient financial systems are supposed to promote growth in the real economy, not impose a huge tax burden. And the US financial sector, in greasing the wheels of the real economy, has been soaking up an astounding 30% of corporate profits and 10% of wages. ... Isn’t it possible, then, that rather than causing a Great Depression, significant shrinkage of the financial sector, particularly if facilitated by an improved regulatory structure, might actually enhance efficiency and growth?"

Free Clay Davis!

I know, I know, Economics.

Anyways, the DVD of the 5th season of the Wire arrived and I've been re-watching it (and apparently it just ended airing in the UK - this one's a ping back). One scene/development struck out which I haven't noticed before.

So you know how Herc 'steals' Marlo's cell phone number from Levy's Rolodex which he then passes on to Carver making the (illegal) wiretapping of Marlo by Lester possible (with some sketchy help from McNulty). If you read the boards (like at Television Without Pity - is there such a thing as a Wire-nerd?) while the show was airing, that one act on Herc's part was lauded as a single redeeming feature of an otherwise useless and incompetent existence (though possibly just coming up with the fake informer name "Fuzzy Dunlop" might also qualify).

Watching it again though, I got the impression that actually Levy purposefully set Herc up. So redeeming it might have been, but here Herc was also a pawn in a larger plan (i.e. as dumb as ever). Levy obviously knew that Herc lost his police job because of Marlo, Marlo rubbed it in when he saw Herc working for Levy ("ever find that camera?", "cost me the job", evil chuckle), and Levy could've realistically expected that Herc would try to get back at Marlo.

What's in it for Levy? Well, what suggests that it's a setup is that when Levy puts Marlo's number in his Rolodex he does so with great flourish, eyes Herc and then pronounces "I have a feeling Marlo's going to bring us a lot of business" and then explains that the fact that Marlo's using a cell phone means that sooner or later it's going to get wire tapped and that means a lot of extra work and pay for the law firm. He almost suggests to Herc that he steal and pass the number along so that it gets wire tapped.

Additional evidence: Marlo and Snoop and that third guy are first seen talking to Levy about that third guy taking a charge for someone else. Once they're done discussing the details Marlo tells Levy "take me off your clock". Levy looks annoyed and then, after Marlo leaves proceeds to set Herc up as described above.

Also noteworthy is that Clay Davis implies to Lester in the next to last episode that Levy knew about the scam he, Clay, pulled on Stringer Bell (with greasing the approval for Stringer's developments) and was in fact part of the con. So him setting up one of his clients, in this case Marlo, is not unprecedented. Principal-agent problem and all that.

Of course this show's so good that you sort of want to look for stuff that's not really there and read too much into it.

And I know that I should post something on the bailout and all but in fact I think this Wire t-shirt might sum it up perfectly.
There's also the one in the title of this post.

More Wire economics: when Michael suspects that Snoop is setting him up he goes to the meeting place early to observe the situation - just as Chris and Snoop taught him. Being young and car-less but not careless, he's watching Snoop from a taxi. After seeing what he needs to see he asks the taxi driver to take him somewhere else. The driver replies:
"I see no Medium of Exchange", after which Michael slips him a few bills.
Hey, that guy took a Principles of Macro class and remembered one of the functions of money!