Economists' Models: Analysis Pumps or Filing Systems? And Do Countries with Reserve Currencies Need to Fear Solvency Crises?
I believe that there are four issues in this Summers-Krugman-Rogoff-Blanchard et al.-DeLong internet discussion of three years ago:
As far as we economists are concerned, are our models analysis pumps, or are they merely filing systems to remind us of experiential wisdom? In other words: Are our models to be taken seriously when they lead us to a conclusion that the great and good believe is unserious?
Do economies with exorbitant privilege in which the key leveraged financial institutions have little foreign-currency debt need to fear banking and government solvency crises?
Can economies with exorbitant privilege in which the key leveraged financial institutions have little foreign-currency debt rely on their abilty to print their way to liquidity in an emergency and on market participants' recognition of that ability?
Can economists build models and conduct analyses assuming that business expectations are reasonable things, and will not push the economy to a position that is not close to a self-consistent near rational expectations equilibrium?
As near as I can see:
- Larry Summers says: filing systems, yes, no, no.
- Paul Krugman says: analysis pumps, no, yes, yes.
- I say" both, no, yes, no.
I think I should, sometime over the past three years, have written a really good piece about these questions based on the ten items below. But I regret that I have not:
Lawrence Summers (2015): My Views and the Fed’s Views on Secular Stagnation: "Why is the Fed making these mistakes if indeed they are mistakes? It is not because its leaders are not thoughtful or open minded or concerned with growth and employment. Rather I suspect it is because of an excessive commitment to existing models and modes of thought. Usually it takes disaster to shatter orthodoxy. We can all hope that either my worries prove misplaced or the Fed shows itself to be less in the thrall of orthodoxy than it has been of late...
Brad DeLong (2015): Musings on the Current Episteme of the Federal Reserve...: "The... errors that the Federal Reserve is currently making... are the result of an excessive commitment to some current modes of thought-.... But... are models properly idea-generating machines... or merely filing systems?... If you give even minor weight to the first... the line of work into the economics of the liquidity trap that I see as well-represented by Krugman's (1999) "Thinking About the Liquidity Trap" tells us, very strongly, that the Federal Reserve is on the wrong track intellectually right now...
Paul Krugman (2015): Respectable Radicalism: "Brad DeLong... argues... Larry has it wrong, that the Fed’s problem is not an 'excessive commitment to existing models'.... The case that the risks of hiking too soon and too late are deeply asymmetric comes right out of IS-LM with a zero lower bound.... I think I understand how being an official, surrounded by men (and some but not many women) who seem knowledgeable in the ways of the world, can create a conviction that you and your colleagues know more than is in the textbooks.... But in a world of zero-lower-bound macroeconomics... theory and history are much more important than market savvy...
Lawrence Summers (2016): Thoughts on Delong and Krugman Blogs: "Delong and... Krugman... disagree with my assertion that it reflects an excessive attachment to existing models and modes of thought.... On the supply side... if I believed strongly in the vertical long run Phillips curve with a NAIRU around five percent and in inflation expectations responsiveness to a heated up labor market, I would see a reasonable case for the monetary tightening that has taken place.... The disagreement does, it seems to me , come down to the Fed’s attachment to the standard Phillips curve mode of thought...
Lawrence Summers (2016): Thoughts on Delong and Krugman Blogs: "A desire to be “sound” also influences policy. I am not nearly as hostile to this as Paul. I think... market thought is I think right and simple model based thought is I think dangerously wrong is Paul’s own Mundell-Fleming lecture on confidence crises in countries that have their own currencies. Paul asserts that a damaging confidence crisis in a liquidity trap country without large foreign debts is impossible because if one developed the currency would depreciate generating an export surge...
Brad DeLong (2016): MOAR Musings on Whether We Consciously Know More or Less than What Is in Our Models...: "Summers presents as an example of his contention that we know more than is in our models—that our models are more a filing system, and more a way of efficiently conveying part of what we know, than they are an idea-generating mechanism—Paul Krugman's... contention that floating exchange-rate countries that can borrow in their own currency should not fear capital flight in a liquidity trap. Summers points to Olivier Blanchard et al.'s empirical finding that capital outflows do indeed appear to be not expansionary but contractionary...
Paul Krugman (2013): Currency Régimes, Capital Flows, and Crises: "Several commentators... have suggested that a sudden stop of capital inflows provoked by concerns over sovereign debt would inevitably lead to a banking crisis.... If correct, this would certainly undermine the optimism I have expressed about how such a scenario would play out. The question we need to ask here is why, exactly, we should believe that a sudden stop leads to a banking crisis. The argument seems to be that banks would take large losses on their holdings of government bonds. But why, exactly? A country that borrows in its own currency can’t be forced into default, and we’ve just seen that it can’t even be forced to raise interest rates. So there is no reason the domestic-currency value of the country’s bonds should plunge. The foreign-currency value of those bonds may indeed fall sharply thanks to currency depreciation, but this is only a problem for the banks if they have large liabilities denominated in foreign currency.... The historical example that comes nearest to the kind of crisis so widely envisaged–France in the 1920s–involved a very steep currency depreciation, but did not involve a banking crisis...
Ken Rogoff (2013): Britain Should Not Take Its Credit Status for Granted: "Debt panglossians are far too confident that the UK’s credit status is bulletproof, and too dismissive of the risks... about pension liabilities or existential threats to the banking system that could require massive injections of cash to fix.... Last but not least, what about the UK’s serial dependence on International Monetary Fund bailouts from the mid-1950s until the mid-1970s? This is hardly a country with an indestructible credit status...
Olivier Blanchard, Jonathan D. Ostry, Atish R. Ghosh, and Marcos Chamon (2015): Macro Effects of Capital Inflows: Capital Type Matters: "Some scholars view capital inflows as contractionary, but many policymakers view them as expansionary. Evidence supports the policymakers. This column introduces an analytic framework that knits together the two views. For a given policy rate, bond inflows lead to currency appreciation and are contractionary, while non-bond inflows lead to an appreciation but also to a decrease in the cost of borrowing, and thus may be expansionary...
*John Maynard Keynes * (1936): The General Theory of Employment, Interest and Money: Chapter 12. The State of Long-Term Expectation: "Enterprise.... Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come. Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die.... This means... that economic prosperity is excessively dependent on a political and social atmosphere which is congenial to the average business man. If the fear of a Labour Government or a New Deal depresses enterprise, this need not be the result either of a reasonable calculation or of a plot with political intent;—it is the mere consequence of upsetting the delicate balance of spontaneous optimism. In estimating the prospects of investment, we must have regard, therefore, to the nerves and hysteria and even the digestions and reactions to the weather of those upon whose spontaneous activity it largely depends...
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