Saturday, March 21, 2015

How should we study the economy?

Schumpeter's approach:

We shall proceed as the physical sciences do in those cases in which it is impossible actually to isolate a phenomenon by producing it in a laboratory: from our historic and everyday knowledge of economic behavior we shall construct a "model" of the economic process over time, see whether it is likely to work in a wave-like way, and compare the result with observed fact. Henceforth, therefore, we shall disregard not only wars, revolutions, natural catastrophes, institutional changes, but also changes in commercial policy, in banking and currency legislation and habits of payment, variations of crops as far as due to weather conditions or diseases, changes in gold production as far as due to chance discoveries, and so on. These we shall call outside factors. It will be seen that in some cases it is not easy to distinguish them from features of business behavior.

He goes on:

All we can do about this here is to recommend to the reader to hold tight to the common sense of the distinction and to consider that every business man knows quite well that he is doing one kind of thing when ordering a new machine and another kind of thing when lobbying for an increase of the import duty on his product. It will also be seen that many of the things we list as outside factors are, when considered on a higher plane and for a wider purpose, the direct outcome of the working of the capitalist machine and hence no independent agencies. This is surely so but does not reduce the practical value of the distinction on our plane and for our purposes,

Thursday, March 19, 2015

Straw man "economists"

"If Economists were Right, You Would Have a Raise by Now" is the title of an article by Peter Gosselin and Jennifer Oldham. I gather from the address bar that a previous title may have been "Your wallet isn't getting fatter as economics 101 comes unhinged."

What mistaken Econ 101 idea that economists embrace is to blame for this epic failure?

One of the fundamental axioms of labor economics, called the wage Phillips curve, says that, all else equal, lower unemployment leads to higher wages.

A lot of economists would be surprised to know that economists believe in the Phillips Curve (and that it's all about wages, but that's not my complaint). More broadly, on the first Friday of every month I see a flood of tweets about how puzzling it is that employment is growing while wages aren't rising (or are rising too slowly). I want $1 for every internet/press claim about Thing A violating Econ 101 when Thing A is perfectly consistent with Econ 101.

The article was published by a top economics news outlet! The Phillips Curve is a good example of what happens when you don't take economic theory seriously. The Bloomberg article is a good example of what happens when you write about what economists think without actually knowing what economists think.

Another event this week reminded me of this odd obsession some people have with criticizing bogus caricatures of economics. Look at this tweet:

Click for larger image

"Relentless insistence on the idea that . . . the economy will self organize into a state which has satisfactory welfare properties. . . . It has become an assumption." Anyone remotely familiar with mainstream economics knows this is, by any reasonable standard, misleading if not totally false. To the contrary, discovering and describing market failure accounts for a significant portion of economic research. Noah Smith has some nice thoughts on this.

I pointed this out to the tweeter, who responded:

2 approaches:
1. Assume benchmark state is perfect markets and distort your models until they resemble reality.
2. Assume economy is complex and adaptive and watch its history, derive analogies to disequilibrium systems.

Notice the sleight of hand: We started with the claim that the economics profession totally ignores market failure. When I pointed out that the claim is false, we moved to a different complaint: the Rethinkers don't like the way we study market failure. Why not say so in the first place? Click here for another example.

The sleight of hand leaves me with questions about motives. The problem with the critics of macroeconomics is not that macro is perfect as is. It's not. The problem is that they so often start with inaccurate portrayals of what people in the field actually believe and do. Progress in the discipline isn't going to be made this way. Note that this problem exists even within mainstream econ, see e.g. here and here.

Just as politics isn't about policy, perhaps demanding reforms to economics isn't about reforming economics.

Monday, March 16, 2015

Isaac Brock on research and teaching in economics

Well, he might actually be talking about songwriting, but it seems to apply reasonably well:

The method is this: Small ideas? Don’t hone in on them too much. If they seem too specific, too dead on, if your point is too on the nose, you’re going to lose the opportunity to have a lot of people get your point. Change it. Find a way to make what you’re saying matter to people without saying too much at all. Allow everyone enough imagination and ownership of coming to something themselves. They could come to something better, which would be great. They could come to something worse, which is dangerous.
So don't use too many of the big words you learned in college. The interview is here.

Thursday, March 5, 2015

My job market

This year I have been wrapping up my PhD at the University of Maryland, so I went on the infamous econ job market. I have a post about that experience that I'll put up later. For now I'll just announce that I accepted a job at the Federal Reserve Board, and I am ecstatic about it. I will join the Industrial Output section; they produce the monthly Industrial Production data that get covered in financial press. They also contribute to the FOMC forecast. I have a somewhat uncommon background for a macroeconomist due to having worked a lot in Census Bureau firm microdata while also doing standard macro modeling; I think the IO section is an excellent fit for that background. In fact, long before the job market started I had my eye on IO.

image source

Over the years I've received lots of questions from friends and family about what economists do when (if) they grow up. In particular, why do I want to work at the Federal Reserve Board? Working at the Board has been a dream of mine for many years. I will be helping with economic analysis and forecasting so that the people who make monetary policy have decent information about what's going on in the economy. Lots of businesses also rely on the Fed's analyses. The Board currently employs more than 300 economics PhDs. That density of economists and the Board's many high-quality visitors make it an unparalleled place to learn and become a better economist. There is nothing like it. Several years ago one of my mentors told me, "The Fed turns people into economists." When I talk to people at the Board or veterans of other similar central banks (eg, Claudia Sahm, Tony Yates), I can see the evidence for that claim. Moreover, while I've never known what "real-world experience" actually is, my best guess is that working on the forecast is a pretty good way to learn practical skills in macroeconomics. Finally, they have granted me a generous amount of time to keep doing economic research, which I find very valuable. The Fed is serious about having staff be on the knowledge frontier.

I think most people outside of the econ profession aren't aware of the unique space occupied by the Fed. A few days ago Justin Fox wrote:

[The Fed is] one of the last islands of technocratic, largely nonpartisan policy making in Washington. . . . The tone of discourse within the Federal Reserve System stands out as a refreshingly civil and thoughtful exception [to the standard partisan fights].

There are some ways in which the Board is in DC but not of DC. More broadly, probably few fields outside of economics have organizations with such a high density of PhDs working on immediate problems. It's an opportunity I couldn't pass up.

I am a pretty anxious person generally, and as my wife and I worked on my job market decisions I benefited immensely from discussions with my family and professional mentors (including some names you'd recognize from the econ blogosphere). I'll just say that there were many of them, that they put up with multiple emails or long phone calls that disrupted their busy schedules, and that I found their help invaluable. In some cases they had a stake in the outcome but gave me unbiased feedback regardless. You know who you are, and I won't forget it. Obviously, my adviser and committee members were particularly helpful. I must also mention the brilliant, hardworking people at the Center for Economic Studies who have played a huge role in my grad school experience.

I must also thank the people I interacted with on the job market. Lots of people gave me a chance, and for that I am grateful. I had great experiences presenting my research, receiving feedback, and getting to know people. I hope to interact with them again in the future.

It will be nice to stay around DC, which is a great city and a great place to do economics. I will be continuing my research agenda in microdata-based macro and firm dynamics, which I am just biased enough to believe is one of the most interesting things happening in macroeconomics these days.

Tuesday, March 3, 2015

Straightening deck chairs during the "retirement crisis"

Here's Eduardo Porter:

On average, a typical working family in the anteroom of retirement — headed by somebody 55 to 64 years old — has only about $104,000 in retirement savings, according to the Federal Reserve’s Survey of Consumer Finances. . . . 
The standard prescription is that Americans should put more money aside in investments. The recommendation, however, glosses over a critical driver of unpreparedness: Wall Street is bleeding savers dry. 
“Everybody’s big focus is that we have to save more,” said John C. Bogle, founder and former chief executive of Vanguard, the investment management colossus. “A greater part of the problem is the failure of investors to earn their fair share of market returns.”

So people are approaching retirement with $104,000, and "a greater part of the problem is the failure of investors to earn their fair share of market returns." What are we talking about? Bogle and Porter suggest that the real problem is about active vs. passive management.

I'm not kidding. That's what the article is about (despite its title).

This is what I'm talking about when I say that the early retirement people have shown that the emperor has no clothes. Do Porter and Bogle really want us to believe that the main reason people are trying to retire on $100 grand is that they haven't made sufficient use of passive funds?

Really? Really?!

I'm as big a fan of passive management as anybody, but this is totally absurd. This sort of logic is straightening the deck chairs on the Titanic. What would the average nest egg be if everyone had chosen the right fee structure and asset allocation? Whatever it is, it's not going to get anyone very far in retirement, particularly if they're accustomed to spending money at the kind of rates that lead to having such a small stash at that age. Porter and Bogle even reveal the real problem with their own example:

Assuming an annual market return of 7 percent, he says, a 30-year-old worker who made $30,000 a year and received a 3 percent annual raise could retire at age 70 with $927,000 in the pot by saving 10 percent of her wages every year in a passive index fund. (Such a nest egg, at the standard withdrawal rate of 4 percent, would generate an inflation-adjusted $37,000 a year more or less indefinitely.) If she put it in a typical actively managed fund, she would end up with only $561,000.

But even $561,000 would be a massive improvement on the status quo, and we're talking about someone who started at $30,000/year. Where's the example where active management reduces a $927,000 nest egg to $104,000?

By all means, don't throw your money away on active management, and don't waste your time trying to pick stocks. That stuff matters at the margin. But that particular margin is insignificant compared to the problem of low savings rates. And the early retirement people have shown that almost everyone could easily hit a higher savings rate. The journalists who tell people that the problem is the banks, or the government, or stagnating incomes, or anything other than savings rates are doing people a huge disservice (see MMM on this topic).

I understand the urge to do something about Wall Street misleading savers. I understand the role that journalists can play in showing people that they're getting duped; I even understand why some people want the President of the United States to do something about this. But if Porter's readers are relying on changes in banking or policy to save their retirement, they are totally screwed.

UPDATE: First, check out the comment by "ed" in my comments section. Second, Noah Smith responds:

Ryan is wrong to say that this makes Bogle and Porter's argument invalid. Actually, Bogle and Porter have a good argument.

Noah then proceeds to explain how switching from active to passive management is basically a free lunch, allowing people to have higher total lifetime consumption without having to save an extra dime. I agree! But Noah isn't reading me--or Porter--very carefully.

I'm not saying that switching from active to passive management isn't worthwhile. Do it! I'm a huge fan of Bogle, and all of my retirement savings is in Vanguard passive funds. I'm also not saying that people should want to have larger nest eggs. Rather, I'm responding to Bogle and Porter's actual argument. Porter's piece isn't just telling people to switch from active to passive. Porter and Bogle are selling passive management as the solution to huge shortfalls in retirement saving. Let's see what they actually say:

That’s not nearly enough [meaning, the average nest egg of $104,000 isn't "enough"]. And the situation will only grow worse. . . . 
The Center for Retirement Research at Boston College estimates that more than half of all American households will not have enough retirement income to maintain the living standards they were accustomed to before retirement [this seems to be Porter's definition of "enough"]. . . . 
The standard prescription is that Americans should put more money aside in investments. The recommendation, however, glosses over a critical driver of unpreparedness: Wall Street is bleeding savers dry.

The context suggests that "prescription" here refers to the remedy for massive shortfalls in retirement savings. Noah is annoyed because it looks like I'm telling people that they should want to save more, when maybe they're actually happy with their current rate of savings. But I'm not doing that. Porter is starting with the assumption that nest eggs are far too small. I'm taking his premise as given and simply pointing out the obvious: if people want to "have enough retirement income to maintain the living standards they were accustomed to before retirement," switching from active to passive isn't going to do it for them. Porter isn't just saying that passive management is a good idea; he's portraying it as an alternative to saving more if people want to have his definition of "enough" retirement money.

It's a pretty simple point. I'm not moralizing about whether people should have a huge nest egg. I'm just saying that if they want a huge nest egg--which Porter and Bogle are clearly taking as given--then the only prescription that can get them there (compared with the current average) is more cowbell, I mean saving. If you're happy being poor in retirement, by all means don't change your savings habits--and keep your stuff in passive since it's basically a free lunch compared to active. But if you want a lot of retirement money, you need to save more. That's a much higher priority than getting the fee structure or asset allocation just right.

Noah's other argument is that telling people to save more is assuming we know better than they do what they want. If they don't want to save more, stop moralizing! It's ok to tell them to switch from active to passive because they may have been making that choice based on limited information or behavioral blinders. That's fine. Again, I'm taking preferences as given--Porter is the one assuming that people want larger nest eggs, and I'm just pointing out the unpleasant fact that if we think $104k is several hundred thousand dollars too little, reducing fees isn't going to suddenly give us enough.

Moreover, we can just as easily justify the save-more moralizing in terms of limited information: Maybe people are making their current savings decisions because they actually think they are on track for a big nest egg. Maybe part of the reason for this misconception is that people like Porter keep writing articles telling everyone that it's not their fault their nest egg is tiny--if only they'd used Vanguard they'd be sitting on a million bucks! Showing up for retirement with $100k in the bank then complaining that fees kept you from having your pre-retirement living standard in retirement is like losing a basketball game by 60 points then blaming the loss on the referee because he called one too many fouls on you. The ref should make accurate calls, but you just needed to make more shots.

I'm also responding to a broader sentiment suggesting that it's impossible for the middle class to have enough money for the retirement they want. It's all doom and gloom about how the middle class is totally screwed by forces beyond their control. But Bogle's own numbers in the Porter article reveal that even people on low income can accumulate a large amount of savings in time for retirement by putting away just 10 percent of their income. Maybe Noah is right and people are happy with tiny nest eggs. Or maybe Porter and Bogle are right that people want more. I don't care who is right: either way, the doom and gloom stories are misguided.

The bottom line is that it's hugely misleading for Porter and Bogle to start from the assumption that people want enough retirement savings to preserve their pre-retirement standard of living, then to suggest that the main thing standing between having $104k and having the appropriate amount for the goal is active management. That's what they're suggesting (Bogle: "A greater part of the problem is the failure of investors to earn their fair share of market returns"), and that's what annoyed me about the article. Bogle isn't doing his job as an investment guru, and Porter isn't doing his job as a journalist.

Wednesday, February 25, 2015

Articulating my confusion: Shareholders vs. the real economy

Here's an article by Lydia DePillis based on a study by J.W. Mason. Excerpt:

The years since the recession have given firms even more of an incentive to dispense cash rather than invest in growth: The Fed’s policy of keeping interest rates low has made credit cheap, and with weak consumer demand, high-yield investment opportunities have been scarce. So instead, companies have been borrowing in order to buy back stock, which boosts their share price and keeps investors happy — but doesn’t give anything back to the world of job listings and salary freezes, where most of us still exist.

DePillis (and/or Mason) blames the rise of a "shareholder-above-all philosophy" for the more-cash-to-shareholders trend. The article's headline (which was probably not written by DePillis) is blunt: "Why companies are rewarding shareholders instead of investing in the real economy."

We might call this partial equilibrium reasoning. Shareholders are not modeled explicitly. Firms can use their earnings in one of two ways: hire people, or make payouts to shareholders. Since shareholders are not modeled, the latter means throwing money outside of the economy. We might as well be setting it on fire. Regular folks like you and me will never see that money--all those corporate profits just disappear.

In general equilibrium, those shareholder payouts go somewhere. If the shareholders invest the money in companies (or loan the money to someone else who invests in companies), then this is just a roundabout way of doing what DePillis wants. The money might not be staying inside the firm that earned it, but it will find its way into some other firm. The fact that the reallocation happened suggests that the funds are more productive in the second firm than they would have been in the first firm, unless some sort of policy is distorting things.

Another alternative is that the shareholders spend the money. That boosts aggregate demand, right? Maybe DePillis and the other people who don't like what's happening here don't think more demand is good for regular workers.

But maybe the shareholders don't invest or spend the money. They put the cash under their mattress and it does nothing. That may be the case, but it would be very odd in light of the argument that all this flow of cash is happening because shareholders have become so powerful. Dictatorial shareholders demand that firms give them the cash, so that said shareholders can... do nothing with it.

So I don't understand the story, but the notion that money going to shareholders is money lost from the economy is fairly popular. I would like to see that modeled. In any case, the recommendation at the end is that politicians should have more power over credit allocation, which would not surprise Arnold Kling.

Monday, February 23, 2015

The early retirement movement

Many times on Twitter I have revealed that I am a huge fan of Mr. Money Mustache, profiled here and a million other places. For the unfamiliar, MMM is part of a movement ("early retirement extreme," or ERE) that basically says: most people in developed countries are rich by any reasonable standard; we can live a materially abundant, happy life on a tiny portion of what we are actually spending; as a result, it's possible to retire after only a few years of full-time work (depending on your wage, of course). Keynes was right, or at least he should have been: we can do the 15-hour work week but choose not to. A lot of people on the internet hate this movement because it runs counter to some popular political and economic talking points. My assessment of the debate is that MMM is winning handily, but that's not what this post is about.

I was reminded of this recently when Josh Brown tweeted about it ("Not sure how it's a badge of honor to substitute shampoo with baking soda so you can retire at 30. What are we trying to win here?"). I think Brown is missing the point. One need not make such substitutions to live a life that approximates what MMM has pulled off. Most of us are spending far more than necessary on cars, housing, restaurants, cable TV, the latest gadgets, clothes, and so on. We're riding the hedonic treadmill; MMM gets a lot of flack for suggesting that we might be just as happy--and far wealthier--if we step off of it. Learning to distinguish between wants and needs can be extremely valuable, even if you are happy with working until 60 or 70 or 80. But more generally, the MMM people aren't trying to "win" anything. Apparently Brown values the time he spends at work more than he would value more leisure, so clearly ERE isn't relevant for him. That's fine. MMM is just pointing out that some people have a different preference, and the growth of developed economies over the last century or so has allowed those people to get the leisure time they really want.

Price and quality dispersion

Following the ERE movement has made me think a lot about the relationship between price dispersion and quality dispersion. Here's Steve Jobs:

Most things in life, the dynamic range between average and the best is at most 2:1. If you go to New York City and you get an average taxi cab driver versus the best taxi cab driver, you’ll probably get to your destination with the best taxi cab maybe 30 percent faster. And an automobile; what’s the difference between an average and the best? Maybe 20 percent? The best CD player and an average CD player? I don't know, 20 percent? So 2:1 is a big, big dynamic range in most of life.*

This is a concept I think about a lot. I think Jobs is right; but the prices of various goods might suggest otherwise. Call it the Camry Concept. You can buy a car for $200,000, but in automobile functionality terms there is no way it is 10 times as good as a $20,000 Toyota. In my utility function, there is no car worth $200,000; once a car gets me from A to B safely, comfortably, and reasonably quickly, additional improvements to the machine won't be worth a lot of money to me, even though I would find them enjoyable. Watches are even more striking. You can buy a watch for $500,000. It will basically do the same things that a $100 watch does. The extra $499,900 is the price of prestige or some other benefit that is largely orthogonal to the ostensible function of the watch.

I don't judge preferences--all of this price dispersion is fine. I get utility from lots of things that others would find pointless. But one of the things ERE people do is focus relentlessly on functionality. This is not a lifestyle for the type of person who gets a lot of utility from high price/quality ratios. The concept can be generalized some. Does a $75 cable TV package provide fives times better entertainment than getting subscriptions to Netflix and Hulu Plus? Maybe, if you watch sports. Otherwise, probably not. The ERE people ditch the cable.

The "retirement crisis"

The ERE people have basically shown that a large portion of Americans should have no problem being ready for retirement. We can all think of obvious exceptions--things happen. But MMM has shown that a 30-year working life should be plenty of time to accumulate a lot of savings, even on below-median incomes. ERE is the solution to the retirement crisis, the student loan crisis, and probably a bunch of other crises--at least at the individual level. It's the Garett Jones approach to inequality:

So let's start training ourselves and our children to delay gratification, to forego that great sound system on the new car, to eat at home a little more often.

This approach might not be of much help to policymakers, but it's a pretty good solution at the individual level. It might prevent some of this sort of thing.

What if everybody did it?

A popular rebuttal to the ERE arguments is something like this: That's fine for you, but if everyone did it, the economy would collapse since nobody is buying anything. One of the founders of the movement (he goes by Jacob) has a note in response:

It is important to realize that a consumer economy in which people go to work in order to buy stuff is not the only form of economy. It is just the current one. 
Money can also be spent on productive assets, art, preserving nature, space exploration, eliminating hunger, maybe even eliminating war. It’s just that we've collectively chosen to spend it on cell phone upgrades, furniture replacements, fashionable vehicles, shoe collections, throwaway electronics, and so on.

I don't have a problem with the ERE people responding to the consumption question in this way. There is no economic law saying that two thirds of output must be spent on consumption (though some of the secular stagnationists seem to agree with the ERE critics...). But they're ignoring other important channels. ERE isn't just about less consumption; it's about less labor. Labor is a production input! Less labor means capital is less productive in the short run; in the long run, this means less capital as well.

When we do economic analysis of big economic changes, we have to think carefully about feedback mechanisms. We can sometimes leave everything constant when we ask what happens if a few people change their lifestyle preferences. We don't have that luxury when we want everyone to change. A useful way to think this question through is to use a model in which the relevant prices and quantities are allowed to adjust.

Suppose I take a little economic model off the shelf (for those who care, this is from page 40 of the McCandless RBC book, see description here; set depreciation=0 and set theta=0.33). This isn't the right model for the job, but I think it will illustrate the point. We produce stuff with capital (machines, buildings, whatever) and labor. We get utility (happiness) from consumption and leisure time. Think of two ways we can model the shift to ERE: people become more patient, or people increase their preference for leisure. Each concept maps directly to a parameter of the model (beta and B, respectively. Higher beta means more patient; higher B means more leisure preference).

Let's look at model steady state (long-run) outcomes for various levels of impatience and leisure preference. In the figure below, the X axis shows time spent working. The Y axis measures GDP. I plot lines for several different levels of patience, with higher beta meaning more patient (click for a larger image).

First, let's suppose the shift to ERE is all about an increase in patience. Then things look pretty good: increasing beta means more output for a given amount of labor. But ERE isn't about patience. It is explicitly about leisure time. We want to move along a given curve in the graph, not shift between curves.

Focus first on the black line. Reducing labor time from about one quarter to one tenth reduces GDP by about 60 percent (note: in this setup, all GDP is consumption in the steady state). We can even be generous: suppose we reduce labor to 10 percent while also raising beta to 0.99. GDP still falls by about 14 percent. That might be fine: in this model, all outcomes are optimal given households' preferences, so a change in output caused by a change in leisure taste doesn't bother anyone. But reason beyond the model a bit. Here's Jacob:

Money can also be spent on productive assets, art, preserving nature, space exploration, eliminating hunger, maybe even eliminating war. 

The space exploration and hunger elimination, at least, will require output. The chart shows a pretty reliable tradeoff between labor time and output--after allowing the economy to adjust thoroughly. We can somewhat mitigate the output loss through increased patience. But to keep output high, we need a really big increase in patience and/or a smaller reduction in labor supply. This is just a simple model, and the specific numbers aren't that important. What's important is that the ERE world is a world where a key input to production--labor--is supplied in lower quantities. The ERE strategy is to own productive assets--but those assets are less productive without workers, and in the long run that means fewer productive assets.

ERE works great in partial equilibrium. Mr. Money Mustache is very enthusiastic about how technology and general wealth have made his lifestyle possible. But if everyone did it, who would build the gadgets? Who would build and operate the machines that build the gadgets? Who would work for the companies in which MMM owns stock? The key point is this: the ERE world isn't just about people saving more. It's about people working less, and that's what kills it.

ERE works if we're willing to accept lower aggregate output than the counterfactual. I don't get the impression that the ERE people accept that. The robots can make it possible. Until then, it's not in the feasible set.

But that doesn't matter! Because not everyone is trying to do it. You and I can still do it, or at least get as close to it as we want.

UPDATE: Here is a model description

*This is from The Lost Interview; an abridged version is in Steve Jobs, page 363.