Josh Hendrickson has a new post that defends the use of models that might in some respects be viewed as “unrealistic”. I agree with his general point about models, and also his specific defense of models that assume perfect competition. But I have a few reservations about some of his examples:
Ricardian Equivalence holds that governments should be indifferent between generating revenue from taxes or new debt issuances. This is a benchmark. The Modigliani-Miller Theorem states that the value of the firm does not depend on whether it is financing with debt or equity. Again, this is a benchmark. Regardless of what one thinks about the empirical validity of these claims, they provide useful benchmarks in the sense that they give us an understanding of when these claims are true and how to test them. By providing a benchmark for comparison, they help us to better understand the world.
With all that being said, a world without “frictions” is not always the correct counterfactual.
Taken as a whole, this statement is quite reasonable. But I would slightly take issue with the first sentence, which is likely to mislead some readers. Ricardian Equivalence doesn’t actually tell the government how it “should” feel about the issue of debt vs. taxes, even if Ricardian Equivalence is true. Rather it says something like the following:
If the government believes that debt issuance is less efficient than tax financed spending because people don’t account for future tax liabilities, that belief will not be accurate if people do account for future tax liabilities.
But even if people do anticipate the future tax burden created by the national debt, heavy public borrowing may still be less efficient than tax-financed spending because taxes are distortionary, and hence tax rates should be smoothed over time.
I happen to believe Ricardian Equivalence is roughly true, but I still don’t believe the government should be indifferent between taxes and borrowing. Similarly, I believe that rational expectations is roughly true, and yet also believe that monetary shocks have real effects due to sticky wages. I believe that the Coase Theorem is true, but also believe that the allocation of resources depends on how legal liability is assigned (due to transactions costs). Models generally don’t tell us what we should believe about a given issue; rather they address one aspect of highly complex problems.
Here’s Hendrickson on real business cycle theory:
Since the RBC model has competitive and complete markets, the inefficiency of business cycles can be measured by using the RBC as a benchmark. In addition, if your model does not add much insight relative to the RBC model, how valuable can it be?
[As an aside, I agree with Bennett McCallum that either the term ‘real business cycle model’ means a model where business cycles are not caused by nominal shocks interacting with sticky wages/prices, or else the term is meaningless. There is nothing “real” about a model where nominal shocks cause business cycles.]
Do RBC models provide a useful benchmark for judging inefficiency? Consider the following analogy: “A model where there is no gravity provides a useful benchmark for airline industry inefficiency in a world with gravity.” It is certainly true that airlines could be more fuel efficient in a world with no gravity, but it’s equally true that they have no way to make that happen. I don’t believe that gravity-free models tell us much of value about airline industry efficiency.
In my view, the concept of efficiency is most useful at a policy counterfactual. Thus monetary policy A is inefficient if monetary policy B or C produces a better outcome in terms of some plausible metric such as utility or GDP or consumption. (I do understand that macro outcomes are hard to measure (especially utility), but unless we have some ability to measure outcomes then no one could claim that South Korea is more successful than North Korea. I’m not that pessimistic about our knowledge of the world.)
In my view, you don’t measure inefficiency by comparing a sticky price model featuring nominal shocks against a flexible price RBC model, rather you measure efficiency by comparing two different types of monetary policies in a realistic model with sticky prices.
That’s not to say that there are not aspects of RBC models that are useful, and indeed some of those innovations might provide insights into thinking about what sort of fluctuation in GDP would be optimal. But I don’t believe you can say anything about policy efficiency unless you first embed those RBC insights (on things like productivity shocks) into a sticky wage/price model, and then compare policy alternatives with that model. I view sticky prices as 90% a given, much like gravity. (The other 10% is things like minimum wage laws, which can be impacted by policy.)
PS. Just to be clear, I agree with Hendrickson on the more important issues in his post. My support for University of Chicago-style perfect competition models definitely puts me on “team Hendrickson”, especially when I consider the direction the broader profession is moving.
READER COMMENTS
Dylan
Sep 18 2020 at 1:49pm
Scott,
How much of your model depends on sticky wages and prices? How sticky do wages have to be for the model to remain valid? Does the recent empirical work of Vigdor and others showing that wages have been less sticky over time than previously assumed cause any change in your thinking?
Scott Sumner
Sep 18 2020 at 6:08pm
Dylan, First of all, I don’t think we are very good at measuring wage stickiness empirically. You need a model, and I’m not sure we have the right one. What kind of wage stickiness matters?
I do not believe that wages need to be very sticky in order for wage stickiness to be a major problem at the aggregate level. I’d cite the severe recession of 1921, which occurred in an economy where wages were not very sticky. Even then, real wages rose sharply.
Michael Sandifer
Sep 18 2020 at 5:41pm
Scott,
Speaking of monetary models, what if I gave you the following facts:
1. The difference in average annual NGDP growth and the average annual S&P 500 earnings yield(e/p) since 1948 is ~.002, or .2%.
2. The correlation between NGDP growth and the S&P 500 earnings yield is striking since Volker. Prior divergences were due to higher RGDP growth in the ’48-’60 time frame, and due to higher inflation in the 60s and 70s.
3. A sustained greater average divergence between these rates began in the late 90s, continuing to this day.
4. Cotemporal with the divergence in point 3 above, risk spreads between Treasuries and AAA bonds widened by a little over 1%, continuing to this day. https://fred.stlouisfed.org/graph/fredgraph.png?g=vVK7
5. Since 1948, one year T-bill rates were ~1% lower than NGDP growth and earnings yield rates, on average.
6. Since 1997, the average difference between NGDP growth and the earnings yield has grown by a bit more than 1.3%.
7. Also, since 1997, the average difference between NGDP growth and T-bill rates has grown by ~1%.
The hypthothesis that NGDP growth = the S&P 500 earnings yield in monetary equilibrium explains these facts well.
Do you agree, and if so, can the Fed target NGDP, at least in part, by targeting the S&P 500 earnings yield?
Scott Sumner
Sep 18 2020 at 6:11pm
I agree there is a correlation, but I don’t believe it’s strong enough to justify targeting stock yields. I’m not saying that would definitely not work, but it seems risky to me, especially when there are alternatives available.
Michael Sandifer
Sep 18 2020 at 7:57pm
It’s fair to say I only have a circumstantial case, and I can imagine alternative explanations for the changes since the 90s, such as population growth decline, and a savings influx from overseas, but population growth fell throughout the 90s and didn’t prevent the productivity boom of the latter half of the decade. That said, working age population grew in the 90s, though actually fell in the 80s, so that wouldn’t seem to be determinitive.
https://fred.stlouisfed.org/series/LFWA64TTUSM647S#0
https://fred.stlouisfed.org/graph/?g=vW0X
Also, population growth does seem to depend on productivity growth to a degree, so there’s some confounding there.
If I’m right though, the implications are obviously huge for macro. It becomes a much more exact science, and it means index P/E’s are nominal variables, which is very counter to what is taught in finance and economics. Imagine that the market-based NGDP forecast is so explicit…
I’m considering beginning a master’s degree program in economics soon, and this might make for a good master’s thesis.
Michael Sandifer
Sep 21 2020 at 7:55pm
I’m curious, does it make you feel better that average S&P 500 earnings growth is just a few tenths of a percent away from that of average GDP growth and the earnings yield? This is what one would expect if the S&P 500 was representative of the stock market as a whole(80% of the US market cap), and in fact, the return on US capital investment generally.
This also greatly strengthens the case that variations between the earnings yield and GDP growth are caused by monetary policy, especially given that the patterns of deviations are exactly what this hypothesis predicts.
If I were on the FOMC, I’d at least engage with the research staff to begin having a close look at this.
nobody.really
Sep 18 2020 at 8:55pm
What do models tell us? Nothing. They just saunter close, flash their eyeslashes with a pouty look, pivot, and walk the other way.
Rajat
Sep 18 2020 at 10:17pm
I think wage and price stickiness are a bit bit different to gravity. No one needs any convincing that aeroplanes would perform very differently in a world without gravity. But I think there are a lot of people who don’t realise that 99% of business cycles are due to the interaction of nominal shocks with nominal stickiness. So many people still blame things like debt accumulation and poor structural policies, or growing inequality. Not serious economists perhaps, but many people going into graduate studies. Also, while you’re mostly interested on measuring the efficiency of policy alternatives, I read Hendrickson as referring to inefficiency relative to a simple theoretical extreme, like perfect competition. Just like no feasible policy option would eliminate all nominal rigidities (and in fact, we may not want to eliminate all of them), no feasible policy option will lead us to a world of perfect competition and complete markets – but we can judge their relative performance but how close they are likely to get us to those outcomes (allowing for real-world things that may be beneficial like economies of scale & scope, etc). As I think you’ve previously suggested, you support NGDPLT and MM so that we can effectively live in a supply-side, or an RBC, world.
Scott Sumner
Sep 19 2020 at 11:17am
You may be right. But the question is whether the prefect competition model is a useful benchmark for macro policy analysis. You could argue that when comparing policies A and B in a real world setting, the better policy is the one that makes the economy look more like a frictionless economy. But I wonder if we know enough about macro where these RBC models would actually be useful. There’s so much simplification, so much guesswork about what is important, that the models seem more like metaphors than useful analytical tools.
I prefer Milton Friedman’s partial equilibrium approach in many cases (not all.)
In any case, I still say that “inefficiency” is not the difference between reality and a frictionless economy, it’s the difference between current policy and a superior policy.
Jose Pablo
Sep 21 2020 at 11:16am
“I happen to believe Ricardian Equivalence is roughly true”,
how can it be so? What is the mechanism in the real world?
Ricardian equivalence requires people changing their expending habits today depending on the debt level of the government. They will expend less today and increase their savings, in order to be prepared for the tax increases of tomorrow.
In order for this to happen people should, in Tetlock terms (1) to “get it right” (meaning having adequate information of the fiscal situation) and (2) “thinking it the right way” (meaning translating this information into the right course of action to be financially prepared for the tax increase of tomorrow)
* Regarding (1):
– Most people are not even aware of the debt level of the government (we are awfully bad at grasping this kind of figure with so many zeros on it). Not even in a “per person basis”. This fact can be very easily verified thru polls.
– Almost nobody has any idea of how the “tax burden” is distributed among people depending on their tax bracket. Even if they know the debt per person, they are unable to answer the question, how much of this debt would a person like you be in the hook for, considering your income level? more than 50% of all federal taxes came from the top 10% of taxpayers and the poorest 20% pay less than 1%. It is a guess, but I think that less than 1% of the taxpayers are aware of how the tax progressivity affect their share of the government liabilities.
– The relevant tax bracket is not my tax bracket today but my tax bracket “in the future”. So, in order to get it right I need to have an idea of how my income (and so my fiscal co-responsibility) is going to evolved over time
– The relevant tax code for this is not today’s but tomorrows. So, I would have to figure out the last part according to a future tax code I can only guess (ie if the “tax code of tomorrow” penalize “wealth” instead of “income” maybe saving to face your future liabilities is a horrible idea after all)
* Regarding (2): Given the situation after getting all the information right, I have to decide how much to save in order to face the tax increase of tomorrow. Having to save today for a payment tomorrow, I have to place different amounts of money at different investment periods for my future income to match my future liabilities. Not an easy task considering that not even the professionals get this right all the time (i.e. AIG)
No, I do not see how the Ricardian equivalence can work in the real world. Trump tax reform was a clear example that it does not. Many people I know were extremely happy with the tax reduction they could see in their payrolls and they could not care less about the fact that their net payroll increases are being financed with more debt. The usual answer (and they were, for the most part, financially savvy) when I pointed out that they will have to pay back the debt at some point, was “Well, we will see”. And they were right: “we will see”.
Pierre Lemieux
Sep 21 2020 at 11:50am
Scott, you write:
I would propose a different formulation
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