What Is This "We," Kemosabe?
He has smart things to say--like that, contra Lucas's claim, it was not a victory for the Efficient Market Hypothesis that economists (except for Mussa, Krugman, Baker, and their posse) did not worry about the housing bubble and the size of the lower tail of asset price changes:
Lucas roundtable: Some successes, some failures: Let me focus on some areas where I disagree with Mr Lucas.... I think he is too quick to cite the Efficient Markets Hypothesis (EMH) to dismiss criticism that economists should have predicted the collapse. To be sure, Lucas is correct that we should not expect economists to predict the timing of changes in security markets prices. That said, I do still think that economists—myself included—missed the boat in a fundamental way. Too many economists thought that a collapse of the recent magnitude was unthinkable, especially since financial institution CEOs generally had their own money on the line. To put the point into EMH lingo, we miscalculated systematic risk very badly. We underestimated financial fragility and we underestimated the extent to which common expectational errors, across many entrepreneurs and indeed many nations, were possible. Citing EMH does not in my view excuse this error or account for it.
Second, one can believe in EMH and still think it is possible to identify bubbles in the housing market ex ante. It is difficult to sell houses short and so the bubble can last for some time, even if it has been identified by informed observers. One group of economists, including Ben Bernanke, significantly underestimated the potential for large and systemic risk in the housing market. This was a simple, flat out error. We don’t have to toss out modern macroeconomics, but we do need to ask why it happened.
Third, Mr Bernanke and many others, again including myself, failed to appreciate how much the Lehman failure would cause some credit flows to shut down. It was surprising to see the interbank repo market collapsing so radically, as has been analysed since by Gary Gorton. There is something fundamental about financial intermediation that we did not understand and probably still do not understand. Why should those markets have dried up so thoroughly and so quickly? Why wasn’t a price adjustment sufficient to restore equilibrium? Why is the continued operation of these markets so important for the real economy?
Fourth, the recent debates over fiscal policy and stimulus have not enhanced my confidence in macroeconomics. Analytic conclusions in this area seem to line up too tightly with the political views of the researchers. If we can’t understand fiscal policy, I suggest something broader is amiss...
I do however, find myself puzzled by Tyler's last paragraph.
Who is this "we" he speaks of?
Tyler Cowen understands fiscal policy very well. If you ask him how it is that expansionary fiscal policy can increase the flow of nominal demand, he can identify all four parts of the elephant blindfolded:
In a Quantity Theory of Money System: If a collapse in market risk tolerance leads to a sharp fall in the short-term nominal interest rate on Treasury securities, that will diminish the opportunity cost of holding money balances and so reduce monetary velocity and thus the flow of nominal demand. Expansionary fiscal policy increases the stock of government bonds outstanding, lowers their price by supply and demand, and thus raises the opportunity cost of holding money balances and puts upward pressure on velocity...
In a Neo-Wicksellian Flow-of-Funds System: If a collapse in market risk tolerance pushes the natural rate of interest negative--to a place where the market interest rate cannot go--and so creates an deflationary gap where planned investment is less than actual national net saving, government deficits--dissaving--that reduce national net saving eliminate this deflationary gap between investment and saving, and relieve what would otherwise be downward pressure on the flow of nominal spending...
In a Keynesian Income-Expenditure System: If a collapse in market risk tolerance leads to a sharp rise in inventories that causes firms to start firing people, boosting government spending without boosting taxes soaks up those excess inventories, and then there is no signal to private companies adjusting quantities rather than prices that they should fire more workers, which would lower incomes, which would lower consumption spending, which sets off the multiplier process...
In a Credit-Channel System: If a collapse in banking-sector capitalization leads to an intensification of moral hazard and adverse selection problems in capital markets, private financial intermediaries will no longer be able to strike contracts to intermediate flows between saver sources and users of funds. But the government--as long as the government's debt remains the safe asset in the economy, that is--is not subject to these moral hazard and adverse selection problems, and expansionary fiscal policy is a way for the government to serve as financial intermediary of last resort...
(My standard references for these four ways of thinking about fiscal policy are Hicks (1937), Krugman (2009) (quoting Jan Hatzius: where is a longer version?), Keynes (1936), and Gertler (2009). Note that these are not, in any sense, contradictory or inconsistent--just different ways of touching the elephant.)
I agree with Tyler that there is something very wrong with those who "cannot understand fiscal policy." I just don't understand why he puts himself in the "we" there--I wish his language were less Aesopian.
And when Tyler says that "analytic conclusions in [macroeconomics] seem to line up too tightly with the political views [of researchers]," I think that is wrong too. Republicans like Glenn Hubbard, Greg Mankiw, Mark Zandi, and Ben Bernanke have no problem advocating fiscal expansions as a tool for fighting recessions (tax cut-heavy fiscal expansions, admittedly). Democrats like Alice Rivlin have no problem saying that it is time to stop thinking deficits are an aid to fighting recession and start worrying again about the long-run fiscal sustainability of the American government. Republicans like Kevin Murphy have no problem saying that even though fiscal policy would be somewhat effective its costs would outweigh its benefits. Democrats like me have no trouble saying that banking-sector policy should be carried out not through the U.S. Treasury but through a bipartisan technocratic institution like the RTC or the RFC.
The divide that worries me isn't sensible Democrat-sensible Republican. The divide that worries me is between economists who understand that the nominal money stock is not a sufficient statistic for the flow of nominal demand--especially when interest rates on short-term Treasuries are very low--and those who don't know enough to have figured that out, and who think that the nominal money stock is a sufficient statistic for the flow of nominal demand--even when interest rates on short-term Treasuries are very low.