“Economics can endanger your sanity”

This famous quote of Keynes:

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.

Needs to be amended. In times of crises, even living economists can be quite ‘dangerous’.

R&R 90% ‘tipping-point’ is a clear example. Less noticed is the ‘battle for fiscal supremacy’. That ‘battle’ is spearheaded by Paul Krugman and he never misses a chance to ‘disparage’ the views of others. So when Mike Konczal argued the market monetarist experiment had failed, Krugman quickly backed it up and Mark Thoma was also quick to second it.

One year ago, related to his Nobel win, Chris Sims was interviewed by the Gary Tapp at the Atlanta Fed:

Tapp: So, if I asked you to describe the main contribution of your work to the field of economic modeling and maybe relating back to the traditional model, how would you describe that?

Sims: I think that what the Noble Prize people were singling out was that my work helped sort out the dispute between the monetarists and Keynesians. They, in part by introducing new approaches to statistical modeling in the ’60s and early ’70s, monetarists were claiming that the main source of business cycle fluctuations was bad monetary policy. The monetary authority was making mistakes, making the growth rate of money vary a lot, and all those variations resulted in recessions and booms, and if only we could force the monetary authority to stop messing with the economy and just keep money growth steady, the business cycle would be greatly reduced or even vanish.

And then the Keynesians were saying that can’t be true, but they didn’t have statistical models in which they could each put forward their position and ask, well, what did the data say? There were lots of attempts to do that, but with very awkward statistical modeling.

Over the course of about 10 years, things that I did and other people followed up on managed to sort out what the effects of monetary policy changes are and distinguish those from co-movements in money and prices and income that didn’t have anything to do with policy. There’s now pretty much a consensus on how monetary policy affects the economy, and on what the size of that effect is. The general conclusion is that it accounts for maybe somewhere between zero and 20 or 25 percent of the fluctuations we see, but if you try to trace out historically, you can’t blame any recession on monetary policy.

That´s a pretty strong statement, especially if you remember Friedman and Schwartz´s Monetary History and the research that followed up on it. By 1985, even the great Keynesian Paul Samuelson wrote in his famous textbook:

“Money is the most powerful and useful tool that macroeconomic policymakers have, and the Fed is the most important factor in making policy.”

But Thoma liked what Sims said so much that he helped spread the idea:

Now we need Chris Sims, or someone like him, to lead the charge against the idea that the problem with the economy is bad fiscal policy. Even better would be if they could overcome the objections to the use of fiscal policy in severe recessions — i.e. the type of recession that monetary policy alone cannot cure even if the interest rate is lowered to zero and non-traditional policies are put into place. In this case though, the empirical evidence is already mounting, what is needed are strong, respected voices to counter the objections to fiscal policy coming from the right (particularly, though not exclusively, objections to infrastructure investment). The politics of fiscal policy will always be a problem, but it would be less so if economists had the same unity on fiscal policy, particularly its ability to help the economy is severe recessions that they have on monetary policy.

I really don´t know what Thoma means by ‘unity’. There´s the long standing joke that if you gather 7 economists you´ll likely hear 8 different opinions!

While Chris Sims may be a pretty competent econometrician/statistician with that statement he indicated his knowledge of economic history is nonexistent. Worse, if that was really the conclusion the application of his tools to history provided, maybe the problem lies with the tools.

Is he implying that a 50% drop in nominal spending (NGDP), something the Federal Reserve, through monetary policy, is able to closely control had nothing to do with the “Great Depression”?

Or that the ‘reversal of fortune’ engineered by Roosevelt’s monetary actions in early 1933 had nothing to do with the recovery that followed?

Or that the decades-long Japanese slump had nothing to do with the monetary policy practiced by the BoJ, despite a ‘war-like’ increase in government spending and debt?

7 thoughts on ““Economics can endanger your sanity”

  1. I get that Thoma and company want to “win” the battle and have it over and done with. But just when it seems battles such as this are won…they are inexplicably lost. One only need look at Keynesians in the EU right now, who find themselves dependent on handouts from those who despise them! For me that’s the worst part, I do not like to see their worst enemy win in such a way.

  2. In 1998 Sims wrote the following working paper that was later published (2006) in Macroeconomic Dynamics. The answer to the title’s provocative question is no in Sims’ view:

    Does Monetary Policy Generate Recessions?
    Christopher A. Sims and Tao A. Zha

    “The issue of uncovering the effects of monetary policy is far short of resolution. In the identified VAR literature, restrictions have been imposed to identify the effects of unpredictable monetary policy disturbances. We offer critical views on the unreasonable assumptions in the existing work and argue for careful economic argument about identifying assumptions. We display a structural stochastic equilibrium model in which our VAR identification would produce correct results while drawing attention to the serious lack of time series fit in most of the DSGE literature.”

    Click to access wp9812.pdf

    On page 24 they note:

    “We were inspired by Ball and Mankiw [1992] to consider more disaggregated data on prices in modeling business cycle behavior. They showed that measures of asymmetry in price changes across sectors have predictive power for inflation. Our own experiments with a measure like theirs suggest that the extra predictive power they find is entirely captured by the conventional breakdown of the producers’ price index into crude, intermediate, and finished components. Our model, then, uses quarterly data over 1964-1994 on the following variables:”

    [List of Variables]

    “These variables correspond to those used elsewhere in this literature, except for the disaggregated price variables, for which the motivation was discussed above, and the bankruptcy variable. The bankruptcy variable was introduced on the basis of theoretical reasoning by one of
    us (Zha [1995]), and it appears to sharpen estimates of dynamics.”

    So the “bankruptcy variable” is totally new and is denoted Tbk. He explains in greater detail on page 30:

    “The Tbk shock that accounts for much of output, price and interest rate movements might be interpreted as a supply shock. Interest rates, commodity prices, and intermediate goods prices drop immediately after one of these shocks, followed by deflation in the general price level, output increases, a decline in bankruptcy, and a rise in the money supply. This is all what one would expect from an anticipated reduction in scarcity of inputs, resulting in deflationary pressure offset partly by expansionary monetary policy. It is clear that these shocks are sharply distinguished from monetary policy shocks by their different effects on subsequent inflation.”

    So a Tbk shock can be interpreted as an aggregate supply (AS) shock. His discussion of its effects and of monetary policy’s response is in the case of a positive AS shock leading to increased real GDP and reduced inflation. Monetary policy responds by loosening up in order to increase the rate of inflation but in doing so should raise real GDP still further. This is right if one views monetary policy’s main function as inflation targeting. But if stabilizing either real GDP or nominal GDP is the goal this is the exact opposite of what monetary policy should be doing.

    And on pages 31-32:

    “As can be seen from Figure 7b, output did decline in response to money supply shocks alone after the 1969 date, but the recessions around the 1974 and 1978-79 dates are attributed almost entirely to Tbk shocks. Both MS and Tbk shocks contributed to output decline subsequent to the 1988 date. A comparison of the MS line of Figure 7b with the Tbk line of Figure 7c shows that the latter is more important source of output fluctuation.”

    An examination of Figure 7 reveals that the Tbk variable contributed more to real GDP variability than any other variable. And based on their description of monetary policy’s response to Tbk shocks this should come as no surprise.

  3. Sims wrote an earlier paper that is very similar in methodology and conclusions:

    What Does Monetary Policy Do?
    By Eric M. Leeper, Christopher A. Sims and Tao Zha

    Click to access 1996b_bpea_leeper_sims_zha_hall_bernanke.pdf

    What’s most interesting about this paper is not the paper itself but the Comments by Ben Bernanke and Robert Hall and the Discussion which included Greg Mankiw and Milton Friedman. All have praise and criticism but allow me to turn to a portion of Bernanke’s criticism which I found most interesting:

    “And even if one agrees that monetary policy shocks explain a small portion of the variance in output and prices over the past thirty years, this is only one of several interesting questions that might be asked about postwar U.S. monetary policy. First, the within-sample variance decompositions say nothing about the potential real effects of monetary policy which experiences like the Great Depression and the Volcker disinflation suggest are large. To use a perhaps strained analogy, nuclear explosions account for approximately 0 percent of output variation in the U.S. economy over the past thirty years, but that fact is not informative about what would happen if nuclear weapons were actually used. To assess the potential of monetary policy to move output, one should focus on impulse response functions rather than variance decompositions (and perhaps consider the effects of “large” rather than “typical” innovations in monetary policy). Second, the result that monetary policy shocks have played a small role in output variation does not prove that policy was conducted well during the sample period (al-though a small degree of unpredictability is a feature of good monetary policy). In particular, as is well known, this exercise says nothing about the effects of anticipated monetary policy-or, equivalently, of the monetary policy rule-on the economy. Figuring out how to analyze policy rules in a framework of this sort remains an important unsolved problem.”

    So the “nuclear bomb,” that Bernanke seemingly so prophetically forecast, ironically fell on his watch. And given Bernanke’s addiction to Inflation Targeting as a policy goal, he naturally passively tightened monetary policy in the face of a supply side shock, which reading between the lines in Sims’ more recent paper which totally exonerates the Fed’s past conduct of monetary policy, has actually been a major contributing factor in every single recession he examined. Amazing.

  4. Mark. In a 1997 paper Bernake (and Gerler) conclude:
    Substantively, our results suggest that an important part of the effect of oil price shocks on the economy results not from the change in oil prices per se, but from the resulting tightening of monetary policy. This finding may help explain the apparently large effects of oil price changes found by Hamilton (1983) and many others.

    Click to access RR97-25.PDF

    There´s been no greater divergence between ‘words and deeds’ than in Bernanke!

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