Thursday, May 29, 2014

"Not mere extrapolations"

From Krusell and Smith:

We emphasize, first, that Piketty's predictions are not mere extrapolations from past data but, instead, rest importantly on the use of economic theory. This is important, since for the predictions to be reliable, one would want to feel some comfort in the particular theory that is used.

There has been some confusion on this point. The K&S note is worth reading in its entirety (it's short).

Monday, May 12, 2014

Public Service Announcement: There is an inequality literature in macro

Here is a claim by Atif Mian and Amir Sufi:
Macroeconomists have traditionally ignored distributional issues, grouping all households into a a single “representative agent.”
This is misleading (unless Mian and Sufi define "traditional" as "representative agent," in which case it's a tautology). Here's an excerpt from Big Ideas in Macroeconomics (review here), which is already proving useful as a reference:
Starting in the late 1980s, a clutch of papers arrived that would open the floodgates for macroeconomic research into inequality. . . . A few of these papers deserve special mention. These are Ayse Imrohoroglu's 1989 paper on the pain inflicted by business cycles on households, John Laitner's 1992 paper on how luck in earnings and inequality are related in general equilibrium, Mark Huggett's 1993 paper on the "Risk-Free Rate in Heterogenous-Agent Incomplete-Market Economies," and the late Rao Aiyagari's seminal paper on "Uninsured Idiosyncratic Risk and Aggregate Saving" (1994). These papers taught an entire generation of macroeconomists like me how to frame questions in which uninsurable risks were likely to be important for decision making and for the implications of policy. . . . Twenty years on, we are still learning from this model. For instance, Guerrieri and Lorenzoni (2011), a quite standard [incomplete markets] setting, is at present the leading model helping macroeconomists understand the implications of credit crunches for real interest rates and aggregate consumption.
Of all the advances made by macroeconomists over the past two decades, these models have been at the top. . . . For thorough reviews of the models I refer readers to Heathcote, Storesletten, and Violante (2009) and Guvenen (2012). (291)
There is much more in following pages. I was taught these models in multiple classes in the macro sequence of my PhD program. If I had to define "traditional" macroeconomics, I would probably define it as the stuff they teach in grad school. Here is another compilation of relevant literature, yet some people seem to be unaware of it or refuse to acknowledge its existence. Inequality is an old topic in macroeconomics. The literature has considered policy, and it has shown that a variety of causal forces can produce observationally equivalent patterns in wealth and income distributions--a result that should inform the policy discussion! [Update: Note that I'm not claiming this literature is totally complete or conclusive; just that it exists and is active.]

Suppose, instead, Profs. Mian and Sufi said:
Many macroeconomists work primarily with representative agent models that abstract from distributional issues. We believe this focus to be misguided and hope that the data we have assembled will lead to greater emphasis on heterogeneous agent models.

Broadly speaking, I would agree with that. I've complained about rep agent before (1, 23, 4), and the data I regularly discuss on this blog suggest a need to focus less on rep agent. Some macroeconomists might disagree, pointing out ways that representative agent models have provided other useful insights and noting the high costs of doing policy analysis with het agent models (which are often very computationally intensive). But the point is that asking for a change in focus at the margin is reasonable, while suggesting that macroeconomists have been ignoring distributions this whole time is not.

Economists do their readers a disservice by saying that the field has until now totally ignored hugely important economic concepts (Piketty tried this too). To insiders, it may seem like the usual attempt to distinguish new research from the literature, but outsiders may take it seriously and be misled. Mian and Sufi have a new book; I hope it does not ignore the work others have done.

Update, 5/13: Kartik Athreya emails me the following helpful addendum:

Thanks for drawing attention to this huge branch of macro.  One point I'd stress to outsiders to the literature is that the models you note can be used to assess the distributional effects of policy when wealth inequality arises specifically from uninsurable fortune and misfortune to labor earnings. Discussions often had in the public sphere reveal that inequality is bothersome to many, and in these models, inequality is primarily reflective of insurance and/or labor market dysfunction, rather than being due to character "defects" or differences in future-orientedness or preferences for leisure. It is not the only way to generate inequality, but it seems a good starting place.

Saturday, May 10, 2014

Noah Smith on declining dynamism

Should we be worried about [the trend toward large firms]? Many people over the years have bemoaned the death of the mom-and-pop store or the local restaurant, but I'm not sure we should be too concerned. Go visit a poor country, and you'll see that every other family has a food stand or little clothing stall, etc. That kind of "entrepreneurship" takes guts and ingenuity, but it's born out of hardship, not opportunity. The birth and death of small family businesses is one kind of "economic dynamism", but not really the kind that leads to increasing living standards or technological progress. In the U.S., it's not clear from Brookings' data how much high-growth entrepreneurship has changed. 

Read the whole thing, and links therein. See also my comment here.

Thursday, May 8, 2014

Modern macro, without the math



Review: Kartik B. Athreya, Big Ideas in Macroeconomics: A Nontechnical View

Athreya is an economist at the Richmond Fed. The primary contribution of the book is to describe the workhorse analytical framework of mainstream macroeconomics without the use of any technical apparatus (math). This book does not have a single equation. Two types of people can reap large benefits from Athreya's efforts: (1) people considering or already pursuing graduate school in macroeconomics, and (2) outsiders to economics proper who want to read and respond to academic work in macroeconomics, like journalists or policy observers.

When I was studying for comprehensive exams I read Hal Varian's undergrad micro text. I had never really learned micro without the calculus (my undergrad econ program really liked math). Varian helped me develop intuition that gave me a better grasp of the math (which gave me better intuition). I think Athreya can serve a similar purpose for macro (and even parts of micro). I find math really useful, but the critics are right that it can sometimes cause us to miss the forest for the trees. Athreya can help you keep the big picture in mind by putting most macro models into the perspective of a single framework, and it can help you get more intuition out of the math itself. I will recommend it to undergrads preparing for grad school and those cramming for comps.

The second audience I mention--journalists and other observers who like to read and comment on economic research--are sometimes inclined to be critical of how macroeconomists do things. In some cases this may be driven by honest ignorance; modern macro isn't always very accessible. Athreya eliminates that problem. The book isn't an easy, casual read by any means, but anyone who wants to learn the material can do it. Athreya provides a lot of perspective on the tradeoffs faced by macroeconomists, including popular targets of ridicule like rational expectations, DSGE, and microfoundations generally. It would be refreshing if critics had a better grasp of the methods they criticize (though a few do); the tradeoffs faced by practitioners are steep. Athreya won't convince everyone, but at the very least I think it will dissuade any honest observer from acting as if macroeconomists are stupid and stubbornly obtuse. Macro analysis is harder than it looks (or, it only looks easy to the absurdly overconfident).

You could build a serious independent study of macroeconomics on this book and the many references Athreya suggests.

***

Athreya describes modern macro by building from the foundations of preferences and trading arrangements. He focuses on Walrasian equilibrium and the Arrow-Debreu (and later Radner) models. This proceeds to discussion of Pareto efficiency and the Fundamental Welfare Theorems. Along the way, he provides literature and insight into whether key assumptions are useful. He defends the use of math, which clarifies causal linkages and makes it so that our arguments are "over the relevance of preconditions, not over the conclusions given those preconditions" (195). As I've said before, we're all using models; some of us use transparent ones.

Athreya makes it clear that the caricature of macroeconomists as worshipers of Laissez-faire is misguided, but he also provides intuition for why many economists respect decentralized markets along many dimensions:

The "market" is acting as if it has solved a system of nonlinear equations with as many equations and unknowns as there are consumers and producers (as well as one more equation for prices). . . . These equations arise from the optimization problems of consumers and producers who take prices as given but know nothing about any more than prices and the equations describing what is optimal for them alone! (91)

This is basically the I, Pencil insight, or the insight we get from that guy who tried to build a toaster. It's very profound.

Athreya outlines conditions under which the models tell us to worry about the efficiency of decentralized outcomes: intertemporal issues (what he often calls IOU markets), monopoly, irrationality, public goods, insurance, and externalities. While things like rationality and monopoly attract a lot of attention, Athreya makes a compelling argument that these issues are far less problematic than market incompleteness (70). He argues that assumptions like rationality are good for protecting the public from economists, as departure from such assumptions can make room for a lot of arbitrariness. He also outlines the methodological tradeoffs associated with various modeling assumptions; these should be carefully considered by the critics (185). More broadly, he tries to give readers a feel for a central tradeoff in the study of macroeconomics, which requires researchers to reach "a compromise. . . between expanding the 'reach' of a model and retaining its internal consistency" (159).

Much of the book, like much of modern macroeconomics, highlights market failure. "A huge amount of work in modern macroeconomics is about studying the size of departures from efficiency" (334). Athreya focuses on search models, incomplete market models, and overlapping generations models as the main classes of models that fail to deliver optimal allocations from decentralized trading (276). Note that the topic of economic inequality fits well within the framework of some of these models, particularly the incomplete markets model, and Athreya discusses some of the relevant literature and the broad policy ideas implied by the main models. Incomplete markets models typically require some heterogeneity (a reminder that representative agent isn't the only game in town), and Athreya discusses how that can be modeled and what it can teach us.

Athreya also briefly describes the debate about calibration and estimation (263). "Calibration is thus not new, nor is it the preserve of one 'kind' of macroeconomist, nor is it politically stilted" (265). I could have used even more discussion of this debate. I don't have a dog in that fight, but in my main work I calibrate for computational feasibility reasons.

The book ends with a discussion of the Great Recession. By this point in the book, readers will already have an idea for how the standard tools can be used to study the crisis. Athreya gets more explicit, breaking the study of the crisis into three key questions: (1) Why did asset prices rise so much? (2) Why did initial changes get amplified? and (3) Why has the recovery been so slow? Broadly speaking, modern macro fared better than its critics allow when approaching these questions. However, Athreya does note some issues on which it failed (358): We know far too little about the rich structure of credit markets and instruments, the role of underwriting standards, the magnitude of the collapse of asset prices, the role of mass mortgage renegotiation, and others. Athreya concludes that we have plenty of work to do, but "these failures do not make a wholesale revamping of macroeconomics a bright idea" (359). Economists have plenty of incentives to develop empirically disciplined, persuasive responses to recent events, and this can be accommodated by the dominant framework. If you are dissatisfied with the macro field, Athreya may ask you to first consider how the changes you would like to see can be implemented on the existing, flexible framework. Note, though, that one need not agree with these conclusions to enjoy the book.

Being partial to firm dynamics, I would have liked to see more about how heterogeneous firm models can help us think about growth and business cycles. Entrepreneurship and firm dynamics generally may have a lot to say about inequality, the response of the job market to business cycle shocks, and the forces of creative destruction that we see clearly in the data but not in most macro models. The composition of the firm distribution is changing over time, and we need to know what that means and whether we should worry. The book is full enough already, so I don't blame Athreya for leaving this out, but it is my hobby so I had to mention it. I also think I could add a more specific item to the "how macro failed" list. Matteo Iacoviello describes having a paper rejected in 2001 with the following explanation:

This paper focuses on a small niche--the housing market--with limited evidence that this market has the significance that is implied for real economic activity.

I think we missed the boat on that one, though there were certainly a few people writing down models with housing, land, or durable goods. An asset with its own investment category and unique collateral and consumption roles deserves attention by macroeconomics. It's getting that attention now, and the methodological framework Athreya describes is perfectly capable of handling it.

***

Athreya has written a useful book. There was a need for a nontechnical explanation of the macroeconomics discipline. Even people with undergrad economics degrees sometimes don't know what macroeconomists do. It's too easy for outsiders to dismiss these tools without understanding why we use them. And for insiders, this is an excellent way to build intuition and refresh memory. You can think of it as a resource for grad students, or you can think of it as a thorough, constructive response to macro's critics. In any case, it's a nice addition to a bookshelf.