Whither Macroeconomics?

Yesterday, I went to the Second Story Secondhand Bookshop warehouse. The front store is located at Dupont Circle, but the warehouse Maryland, about one mile away from Ujang's apartment -- and he unbelievably has not came to that place yet :-D. It was not so much like The Strand of New York to find new books -- although they have some review copies --, but it's the place to look for some standard/classic off-print -- important stuffs that have been published in, say, the 80s or 90s.

Moreover, if you are a macro person, that's the place where you can still find a copy of Sargent-Wallace, or Tobin, books.

Looking at the economic section's shelf, it strikes me that the Reagan period (the late 70s and early 80s crisis) has produced substantial books on macro discussing the business cycles. It was a war between Lucas/Sargent/Wallace versus Solow/Tobin/Modigliani -- all are the giants of the professions. But the puzzle is that in recent crisis of the 2000s, macro people have been strangely silent. No books come out yet, so do the published article.

I mean, look at a series of respectable books on current crisis by Raghuram Rajan, Gary Gorton, and the likes. Mostly micro - with an exception of, probably, Shiller and Akerlof's Animal Spirit, which is, to me, more a sketch of reminder that uncertainty matters than a neat macro explanation on what is really going on.

Maybe macro people are truly caught on (and complacent about) the Great Moderation period, in which they think they knew how to tame business cycle -- and by that, leave the once a lively discussion on equilibrium, expectation, and market clearing process.

Is it the end of macroeconomics we at the Cafe used to know it? I don't know. But surely some books from macroeconomics perspective dealing with the latest crisis would help to confirm that macro is still able to generate ingenious ways of seeing things. The magic that in the past had been amazingly spelled out by Keynes, Friedman, Lucas, Tobin, and the likes.

Take-Home Final Exam Question

Suppose you have these finding from Reinhart and Rogoff (AER: 2009) showing that a banking crisis on average causes:

a. Unemployment to rise for 4.8 years, with an increase in the unemployment rate of about 7 percentage point.
b. Real GDP to decline for 1.9 years, with a decline in real GDP of about 9.3 percent.
c. Cumulative public debt to rise 186.3 percent in the three years following the crisis.

Questions:

a. What is the probability (P) you are willing to assign that not bailing-out Bank Century will not lead to a banking crisis?
b. Multiply P with either a, b, or, c finding above-mentioned. Do you still let Bank Century collapse? Of course you can put the cost of moral-hazard into your equation.

Instruction:

Submit your answer to those Indonesian lawmakers in that special committee before they get confused.

On Banking Crisis

So if you like Kindleberger's Manias, Panics, and Crashes, chance is that you'll like this Reinhart and Rogoff's This Time Is Different.

One of the reasons is that the latter gives not only narrative, but also some simple numbers to ponder. My favorite chapters are on banking crisis, inflation, and currency crisis. The discussion on the Second Great Contraction (a.k.a current US financial crisis) is also worth for perusal.

Chapter 10 starts with these sentences:

"Although many now-advanced economies have graduated from a history of serial default on sovereign debt or very high inflation, so far graduation from banking crises has proven elusive. In effect, for the advanced economies during 1800-2008, the picture is one of serial banking crisis."

also,

"...there is indeed significant theoretical and empirical support for the view that a collapse in a country's banking system can have huge implication for its growth trajectory."

Moral of the story: dealing with potential banking crisis is bloody difficult and easier said than done.

Krugman on Macroeconomics

Bias toward old Keynesianism and against Chicago school aside, Krugman writes a useful summary on the state of macroeconomics here. It'd help anyone who wants to know the difference between saltwater and freshwater schools as well who's who in the discipline.

My take is here, and for sure I don't take hostile perspective to the freshwater school the way Krugman did. Nonetheless, one thing I agree with Krugman: his opinion on the use of math in the profession that prefers beauty over truth. But it just reinforces my intention to learn more (gasp!) math. A heroically tall order for me indeed, but I just see no other way.

Ben Again

Obama has re-nominated Ben Bernanke for the 2nd term of Fed Chairmanship. A good move. As any student of monetary economics knows, Bernanke is the leading scholar when it comes into monetary policy transmission and business cycle.

His work on agency cost, net worth, and business fluctuation is important. For those who want to force Indonesian banks' lending rate down (by regulation or any non market mechanism), that article should be on the top of their reading list.

Waiting for a Keynes-like Macroeconomist

The Economist published an interesting article on the crisis of macroeconomics. If you happen taking, have had taken, or are about to take the subject, you may want to read that article too.

My personal take on that piece is this: one of the reasons on why I find macroeconomics fascinating is precisely the fact that the subject is still very much evolving. This is the branch of economics where the fight between schools of thought is still kicking, alive, and relevant, particularly after the recent crisis. And it's is a good sign, unless you just want things that already well-settled a.k.a boring.

True, as The Economist states, that for many economists the Great Moderation period from mid 80s to just before current crisis means the end of debates in macroeconomics as the business cycle was then tamed. But I was, and am, not convinced. Ten years ago, the Asia Crisis in 1998 got me thinking that there should be a new way to see the macro economy where economic activities and markets are now much more internationally linked at much speedier pace. I was expecting a new approach out of then the debates between market fundamentalists and panic approach on Asia crisis. Alas it never was.

Up to now, when it comes into macro, I can not really make up my mind and pick between (new) Keynesian or neoclassical school. Both are equally theoretically plausible and empirically defendable. I also am not fully convinced whether micro-foundation of macroeconomics is really the only way to progress, or more pragmatic positive methodology a-la Friedman and Keynes might be more useful.

But make no mistake, I very much enjoy every bit of this my state of not-knowing. It keeps me thinking and rethinking my position. It is good that the crisis of the subject forces macroeconomists back to the drawing board. Hopefully a Keynes-like figure would emerge and come up with a macroeconomics we never knew before.

And to those aspiring macroeconomists, I do not think the current state of macroeconomics should discourage you. If anything, this is the best time to study macroeconomics and join the game. Perhaps you are the Keynes-like we are waiting for.

Advice # 876: Take A Longer Perspective

I look at a graph showing Indonesia per capita GDP level and annual growth from 1970 to 2007 and could not stop to marvel (if it is the right word) that the depth of our 1997 crisis actually makes the US zero growth this year look like a one lazy Sunday afternoon.

It takes a mere two years from around 15 percent GDP per capita contraction to regain positive growth, as Reinhart and Rogoff (in pdf) rightly point out; but around 7 years to get back to pre-crisis income per capita level. Even more daunting, after the crisis, the average annual growth has been substantially lower than before, despite its accelerated upward trend.

And today we have global recession. I just hope that we don't take a wrong lesson by taking short-sighted economic populist policy and dramatically departing from market-based reform that has been responsible for much of the longer-run pre crisis growth and post crisis recovery.

Getting off the track is too expensive. Although the temptation is high, especially if you want to run for President/House members/funny pundit.

Keynes The Optimist

Keynes, I think before he said that in the long term we're all dead, in Economic Possibilities for our Grandchildren, a short paper presented before students of, according to Bob Solow, a less-snotty-than-Eton public school, Winchester, wrote:

We are suffering just now from a bad attack of economic pessimism. It is common to hear people say that the epoch of enormous economic progress which characterised the nineteenth cen­tury is over; that the rapid improvement in the standard of life is now going to slow down ‑-at any rate in Great Britain; that a decline in prosperity is more likely than an improve­ment in the decade which lies ahead of us.

I believe that this is a wildly mistaken inter­pretation of what is happening to us. We are suffering, not from the rheumatics of old age, but from the growing‑pains of over‑rapid changes, from the painfulness of readjustment between one economic period and another

I think this is relevant to current world economic affair, as well as to Indonesia.

Animal Spirits Explained (Not Yet)

I still find the New Keynesian approach for short term output fluctuation is one of the finest theoretical explanation. You can find the summary of their research in chapter 6 of the standard Romer's Advanced Macroeconomics. Their models are so cool in explaining the seemingly irrational behavior that was not yet elaborated in the old Keynesian school.

But against the backdrop of current crisis, Akerlof and Shiller in their latest book Animal Spirits, want to move further. They argue that New Keynesian approach is good to explain the small fluctuations, but not a deep crisis. Instead they believe that animal spirits --Keynes' phrase for irrational behavior- is responsible for such exuberance, booms, and eventually bust.

They offer some working proposition by describing five aspects of animal spirits: confidence, fairness, money, illusion, corruption and anti social behavior, and stories (or narrative).

Alas, until the end of the book, I fail to grab a coherent theoretical construct, or even its prospect. They, less fruitfully, go back to old battle by bashing new classical approach and, this is rather disconcerting, relying too much on anecdotal evidence. Plus some I-told-you-so tone.

Akerlof's paper on the market of 'lemon' is one of my favorite model. And I certainly expect more with his credential, including winning the Nobel. But maybe winning Nobel is a bad signal nowadays (think of Stiglitz and Krugman).

I am still looking forward from them, though, that eventually, a neat theory of animal spirits in macroeconomics come up and stands up for academic test. And they can take their time to do this, without hurrying to publish a book just to catch up with daily conversation topic at the moment.

My (tentative) Take on Our Fiscal Stimulus

Do we, Indonesia, after all, need a fiscal stimulus?
I am not sure, probably no.

Will our current stimulus plan give the bang for the buck?
I don't think so.

What do you think?

Where's the Beef? (2)

As predicted by The Economist, the recent G20 meeting, despite

several have talked grandly of a sequel to the 1944 Bretton Woods conference, which created the post-war system of fixed exchange rates and established the International Monetary Fund and World Bank. That is nonsense. The original Bretton Woods lasted three weeks and was preceded by more than two years of technical preparation. Today’s crisis may be the gravest since the Depression, but global finance will not be remade in a five-hour powwow hosted by a lame-duck president after less preparation than many corporate board meetings.

The meeting turned out to have just a little beef, especially when it comes into the ambitious plan for a new global financial architecture. But was it really a waste for Indonesia to join the group?

Maybe not. We have two concerns regarding the current crisis: to maintain sensible balance of payment (and exchange rate) and to secure financial sources for the state budget --you know, to fund basic infrastructure, pay salaries, and poverty reduction related actions. The former might not be solved by, predictably, the inability of the meeting to agree on above new global financial structure, but there is an opportunity to ease the latter. And here is how.

It is now widely argued by key policy makers and some prominent economists that a world fiscal stimulus (tax cutting or more government spending) and, some say, higher liquidity through lower interest rate are needed to boost the otherwise slowing world economy. But we don't have the money to do so, because the market sources for state budget financing, the government bonds, is now becoming very expensive. We need different sources.

If Indonesia went alone in asking this to the developed countries, it is likely that we'd meet with no response for two reasons: we're too small (yes, contrary to some of you believe, we're a small open economy) and those big boys don't have lots of money either. The best option available is to join forces, mainly with developing countries, to tap the money -by the way, China and Saudi Arabia now has the money - and to elevate the bargaining position before those big boys to give more money to either bilateral scheme or multilateral agencies like the IMF and the World Bank. At the same time, it'd be also the right time to ask IMF to be less strict on their conditionalities, the sources of domestic discontent and political unpopularity in many countries, including Indonesia.

Of course, it is now more international politics than economics.

Where's The Beef?

In relation to G20 Summit here, WSJ reports that:

Dominique Strauss-Kahn, managing director of the International Monetary Fund, said coordinated stimulus amounting to at least 2% of global gross domestic product is required. That should provide a similar boost of 2% of GDP, if it's correctly coordinated, he said.

Stimulus, you said? If truly so, where is Keynes the multiplier, please?

And What Happens to Indonesian Economy

So you want to know what the impact of current global financial meltdown on Indonesian economy is? Dede Basri of Diskusi Ekonomi gives you some of the answers in this readable economic (mind you, economic) writing.

To get a better grasp for the center of his argument, you need to understand at least the straightforward national income accounting and balance of payment identities (ask your economist friend to tell you this concept over a coffee, if you don't).

On what makes BI raise interest rates, he wrote that the step is justifiable as an attempt to stem the domestic demand for import (while export declining) at the time of low capital inflow. The failure to do so might deplete the foreign reserves and lead to deeper Rupiah depreciation.

It is also to give signal that in the medium term, the BI still concerns with and runs its main job -keeping the inflation low. In this respect, Ross McLeod of ANU's Indonesia Project wrote why monetary expansionary policies, including lower interest rate, might not be desirable:

(But) base money has already been growing far too rapidly to be consistent with the current target level of about 5% inflation, which has risen from about 6% in the middle of 2007 to more than 12% in September this year.

Growing Up in Wrong Times

In her work in progress, Growing Up in Bad Times: Macroeconomic Volatility and the Formation of Beliefs, Paola Giuliano of Harvard shows that individuals who are subject to macroeconomic volatility when he/she is 18-25 years old support more government redistribution but less confident on government institutions --and these beliefs will stay over his/her lifetime.

If it's true, then it partly tells me why our public discussion, which is now dominated by people aged 18-25 at the time the crisis hit in 1998-2000, is hostile to market based reform while at the same time, paradoxically, not confident with the government. And it will remain so until they are too old for public discussion, or the subsequent cohort coming up with differing views wins the debate.

It reminds me of an old joke: if you are below 30 and you are not marxist, you don't have a heart; but if you are above 30 and still marxist, you don't have a head.

Apparently, you are what you were at 18-25.

And the US now is Keynesian

Something odd is going on here in the US. As you know, the country suffers from the excessive borrowing and lending, on sub-prime mortgage, the bubble went bust and seemingly dragged the economy down to recession.

I feel a kind of dejavu. Apparently the US does not learn the very same lesson from the series of Asia and Latin America crisis. And even more surprising, US administration took different set of policies than what they had suggested to the rest of the world on how to overcome recession, that is, tighter monetary and fiscal policies.

Instead they go for relaxing policies and launch an aggressive economic stimulus plan. In this package, the Fed cut of key interest rate (monetary) and tax rebate plan (fiscal).

Whether you agree with this Keynesian counter-cyclical policy or not is a matter of not only empirical, but also difference in school of thought. Some argue that economy needs a bail out (from government) to get out from the mess, the others prefer to let the (market) economy pays for its mistake.

The debate aside, apart from the positive response from stock market index, we do not know yet the impact of such stimulus scheme on output. Nevertheless as Krugman, Hausmann, and Landsburg point out, the tax rebate plan is likely doomed to failure by design. The bulk of rebate would go to relatively financially OK household, so it would not be spent, hence little multiplier effect (Krugman); or it is less likely to put American into work, and enhance domestic investment (Hausmann and Landsburg).

If US economy were truly resilient, dynamic, and strong --as many of us would like to believe--, I think it's time for them to be tough in this difficult time, the way we, East Asians, stood up and recovered, following their very own prescription.

Ben, The Decider

I like this Godfather-like picture of Ben Bernanke in the front cover of this week's New York Times Magazine. So cool, as if the whole US economy depends on his words.

The article is also very educating. It gives you a glimpse on how a central banker has to deal with unemployment-inflation tradeoff, and beat the market expectation. Hopefully, amidst the now enormous pressure from US public and media, he would not get mental breakdown like Britney Spears --a very sorry of her.

Holiday's Coming

And it's time to look more closely into, well, sub prime mortgage crisis. Especially when Larry Summers (in pdf, but short) said that even with recent bail-out policy measures, up to one million foreclosures are expected to come in the next two years. 

That's a lot. 

Ben Bernanke also gave his insight. If you're the one to decide, would it be a bail out, or not?

The sequel: The Good, The Bad, and The Unpleasant Arithmetic, Part 2

Let's carry on the game. Get your cup of Kenyan now, and I'll play Miles Davis' Freddie Freeloader.

You remember Alesina and Summers, right? Those guys said that independent central bank is good for the economy. Now let me introduce you to another guys, who are more or less in the same camp in favor of central bank's virtue, Kydland and Prescott (1977). With their work on time inconsistency, they lean toward something called rules based over discretion policies and make the idea of inflation targeting popular. The two, independency and inflation targeting, are now becoming the norm for central banking.

But Greg Mankiw, 2006, disagrees. He said that independency is loosely connected with rule based inflation targeting. Alan Greenspan is the most notorious example for his flexibility and somewhat discretionary approach, yet his policy works. Moreover, citing the work of Ball and Sheridan (2005), for the larger sample. inflation targeting doesn't explain recent trend of low, stable inflation rate. Bluntly, independency is not the prerequisite for good monetary policy.

So now, Central Bank got their point cut. Central Bank 0 - MoF 0.

The Good, The Bad, and The Unpleasant Arithmetic

I can't find a good metaphor for what I'd like to blog here, so let us be a little bit more serious. But not too serious as you can still think about it, while sipping your espresso and listening to Dave Brubeck's Take Five, -the way we in this cafe make money out of you.

In macroeconomics, there are two great enemies an economy, a country, always wants to get rid of: low growth and (too) high inflation --and the other is high unemployment. Low growth is like having your pie getting bigger, yet at lower rate than your neighbourhood has. Inflation is that your money in your pocket now can not buy you a pie as big as before.

To handle a normal economy, we have two important offices: Ministry of Finance (MoF) and Central Bank. The former is more to stabilize the output (the pie) against its ups and downs, keeping it on track for an upward path. The Central Bank is responsible for money supply, maintaining the inflation rate sensible, hence, your money purchasing power.

And in standard macroeconomic model, both are well linked.

Now, enter favorite words that you may often hear as a cocktail conversation or read in newspaper: the central bank independency. The argument goes that in managing the economy, central bank's policy (on money supply and inflation rate) needs to be independent from MoF's (output stabilization). Why?

MoF policies oftentimes, due its proximity to political pressures, go for higher budget deficits (government spends more, say, on big projects or subsidies than what it gets from taxes), rely on pushing central bank to print more money --a politically induced inflation, that is. And in a corrupt country, it spurs a big business on monetary policy misuses. In this part one of this story, MoF is the bad guy. (See Alesina and Gatti, 1995)

In part two, meet the unpleasant monetary arithmetic (Sargent and Wallace, 1981). Now suppose Central Bank thinks that current inflation is higher than targeted rate, because, say, MoF carelessly raises the budget deficit. The Bank dispatches then a tight money policy (reduce the money supply). But while lowering current inflation rate, it is at the cost of future inflation rate. The catch is here: higher expected inflation rate in the future tends to raise current price level, a.k.a current inflation, as the current price level depends not only to current but also all anticipated money supply. Feel dizzy already? Don't worry, just recall: There is a good chance that the Bank's effort to curb current inflation is ineffective.

If you want, you can order another cup of Colombia supremo now, before we move on.

Now, let's get into another easier-to-imagine situation. If the Bank always want to tame inflation independently, it will react every ups and downs of price shocks. And as the latter is usually volatile, so is the money supply set by the Bank for keeping it steady. As money supply affecs the size of our pie (output) and employment, these two will be more volatile accordingly. This is bad and, here, Central Bank is the bad guy. (Rogoff, 1985)

But you may ask that earlier the bad guy is MoF. So which is which? When you are in this situation, play Sherlock Holmes with Google Scholar finding the empirical evidences. The most famous one (Alesina and Summers, 1993) says that for OECD (meaning the rich countries), central bank independency brings lower inflation and no effect in output and employment. So, the Bank is the good guy for the economy, let him be independent. Central Bank 1 - MoF 0.

OK, time out. But before you go, let me give you a question to think about: Is it really the Kebon Sirih gang better than the Lapangan Banteng's? Next time you drop by at our cafe, tell me

Economics is not a Rocket Science

This is from an interesting book, with an unimpressive title: The Knowledge and The Wealth of Nations: A Story of Economic Discovery, page 169

(Lucas) sought a 1957 book by Richard Bellman, Dynamic Programming. Bellman was a mathematician working at RAND Corporation, quite literally a rocket scientist. He had invented a set of techniques designed to optimize decisions in which long chains of choices had to be made amid changing circumstances -if for example, you wanted to fire a missile into the upper atmosphere and hit a target halfway around the globe, or even travel to the moon".

and

"Lucas hoped the same methods could also be applied equally to calculate a point at which to spend or save, to decide when to draw down inventory, or to switch from stocks to bonds. Anything that required a formal statement of the links between present and future was a candidate be improved by rocket science".

Now I know why I had so much trouble preparing for Macro mid exam. (grin)

OK, let's just play jazz.