Germany leaves the Euro?

The idea, crazy as it sounds, makes a lot of sense. The current hope -- in discussion today in Brussels -- is to consider ways for some central European finance minister to exert veto power over national budgets. That sounds to me like a recipe for disaster and ultimately real vicious conflict between European nations. Do we really want to experiment with that? As an alternative, consider a unilateral German exit from the Euro:

A better, bolder and, until now, almost inconceivable solution is for Germany to reintroduce the mark, which would cause the euro to immediately decline in value. Such a devaluation would give troubled economies, especially those of Greece, Italy and Spain, the financial flexibility they need to stabilize themselves.

Although repeated currency devaluations are not the path to prosperity, a weaker euro would give a boost in competitiveness to all members of the monetary union, including France and the Netherlands, which is why they might very well choose to remain in it even if Germany were to gradually leave. A resurgence of manufacturing would also allow the vast unemployment rolls of Spain, Portugal, Greece and other countries to begin to decline. The tremendous loss of human capital and human dignity we are witnessing would ease.

Reintroducing the mark would not solve the debt burdens of southern European countries, but it would give them needed breathing room to restructure their economies, reform labor markets, collect more taxes and reassure investors. The ability of the southern European countries to service their sovereign debt would immediately improve, helping to end the slow-burning debt and banking crises that have engulfed the Continent since 2008.

Read the whole proposal here. Sadly I suspect this is a little too bold and creative to actually be considered seriously. 

John Lanchester on Marx

I know very little about Karl Marx, but this beautiful essay by John Lanchester convinces me that his analysis of capitalist economics was indeed profound to the core, right, wrong, sometimes short-sighted, but penetrating and still relevant to our situation today. Very much worth 20 minutes of your time:

Consider these passages from The Communist Manifesto, which Marx wrote with Engels in 1848, after being kicked out of both France and Germany for his political writings:

Capitalism has subjected the country to the rule of the towns. It has created enormous cities. Capitalism has agglomerated population, centralised means of production, and has concentrated property in a few hands.

Capitalism has left remaining no other nexus between man and man than naked self-interest, than callous ‘cash payment’.

Capitalism has been the first to show what man’s activity can bring about. It has accomplished wonders far surpassing Egyptian pyramids, Roman aqueducts and Gothic cathedrals; it has conducted expeditions that put in the shade all former Exoduses of nations and crusades. Capitalism has created more massive and more colossal productive forces than have all preceding generations together.

Capitalism cannot exist without constantly revolutionising the instruments of production, and thereby the means of production, and with them the whole relations of society. Constant revolutionising of production, uninterrupted disturbance of all social conditions, everlasting uncertainty and agitation distinguish the capitalist epoch from all earlier ones. All old-established national industries have been destroyed or are daily being destroyed.

In place of the old wants, satisfied by the productions of the country, we find new wants, requiring for their satisfaction the products of distant lands and climes.

Commercial crises put on trial, each time more threateningly, the existence of the entire capitalist society. In these crises a great part not only of the existing products, but also of the previously created productive forces, are periodically destroyed.

It’s hard not to conclude from these selected sentences that Marx was extraordinarily prescient. He really did have the most astonishing insight into the nature and trajectory and direction of capitalism. Three aspects which particularly stand out here are the tribute he pays to the productive capacity of capitalism, which far exceeds that of any other political-economic system we’ve ever seen; the remaking of social order which accompanies that; and capitalism’s inherent tendency for crisis, for cycles of boom and bust.

Read it all here.

Physics proof of innocence

In the category of unimportant but highly amusing, I think many will enjoy this very short paper written by a physicist in California. It was apparently offered, successfully, as proof of his innocence in a traffic case in which he was accused of running a red light. Based on three simple and plausible assumptions, he demonstrates that the perceiving officer must have been deceived. As the author describes the work:

A way to fight your traffic tickets. The paper was awarded a special prize of $400 that the author did not have to pay to the state of California.

Still here everyone...

Sorry I haven't managed to post anything now for quite some time. All the result of lots of travel to various scientific meetings -- including one fascinating event on non-equilibrium economics -- and a MAD effort to get my book done on time. Deadline is effectively NOW!!!!!

So I haven't been able to afford any time to blog. But I will be posting more soon. And I have Bloomberg pieces appearing once a month (with one due out now in the next couple of days).

Meanwhile, Satajit Das has an excellent deconstruction of a recent article in The Economist that could (may?) have been written by the financial industry itself, arguing why financial innovation is indeed such a wonderful thing, making the world more prosperous, stable, etc (have you heard that before?).

"Unemployment is an illusion and recessions are voluntary"

An illuminating speech by Paul Krugman:

... I assume that most of those hearing or reading this speech at all closely are aware of the great divide that emerged in macroeconomics in the 1970s. For those who aren’t familiar with the story: in the 1930s Keynesian economics emerged as a response to depression, and by the 1950s it had come to dominate the field. There was, however, an undercurrent of dissatisfaction with that style of modeling, not so much because it fell short empirically as because it seemed intellectually incomplete. In “normal” economics we assume that prices rise or fall to match supply with demand. In Keynesian macroeconomics, however, one simply assumes that wages and perhaps prices too don’t fall in the face of high unemployment, or at least fall only slowly.

Why make this assumption? Well, because it’s what we see in reality – as confirmed once again by the experience of peripheral European countries, Portugal included, where wage declines have so far been modest even in the face of very high unemployment. But that’s an unsatisfying answer, and it was only natural that economists would try to find some deeper explanation.

The trouble is that finding that deeper explanation is hard. Keynes offered some plausible speculations that were as much sociological and psychological as purely economic – which is not to say that there’s anything wrong with invoking such factors. Modern “New Keynesians” have come up with stories in terms of the cost of changing prices, the desire of many firms to attract quality workers by paying a premium, and more. But one has to admit that it’s all pretty ad hoc; it’s more a matter of offering excuses, or if you prefer, possible rationales, for an empirical observation that we probably wouldn’t have predicted if we didn’t know it was there.

This, understandably, wasn’t satisfying to many economists. So there developed an alternative school of thought, which basically argued that the apparent “stickiness” of wages and prices in the face of unemployment was an optical illusion. Initially the story ran in terms of imperfect information; later it became a story about “real” shocks, in which unemployment was actually voluntary; that was the real business cycle approach.

And so we got the division of macroeconomics. On one side there was “saltwater” economics – people, who in America tended to be in coastal universities, who continued to view Keynes as broadly right, even though they couldn’t offer a rigorous justification for some of their assumptions. On the other side was “freshwater” – people who tended to be in inland US universities, and who went for logically complete models even if they seemed very much at odds with lived experience.

Obviously I don’t believe any of the freshwater stories, and indeed find them wildly implausible. But economists will have different ideas, and it’s OK if some of them are ones I or others dislike.

What’s not OK is what actually happened, which is that freshwater economics became a kind of cult, ignoring and ridiculing any ideas that didn’t fit its paradigm. This started very early; by 1980 Robert Lucas, one of the founders of the school, wrote approvingly of how people would giggle and whisper when facing a Keynesian. What’s remarkable about that is that this was all based on the presumption that freshwater logic would provide a plausible, workable alternative to Keynes – a presumption that was not borne out by anything that had happened in the 1970s. And in fact it never happened: over time, freshwater economics kept failing the test of empirical validity, and responded by downgrading the importance of evidence.

Read the whole thing.

Microfoundations -- fact and fiction

UPDATE AT THE END

I generally try not to write about things I know almost nothing about, but here goes. Take everything that follows here as a kind of "thinking out loud" -- a struggle to put into words my thoughts about some apparently odd ideas in macroeconomics. I say "apparently" because I don't know enough to be sure. Maybe they are all very sensible. I would greatly appreciate any further insight from anyone out there who knows.

The idea puzzling me is "microfoundations." As I understand it, the rational expectations revolution in macroeconomics, linked to the names Robert Lucas, Edward Prescott, Thomas Sargent and others, demanded that macroeconomic theories shouldn't just be built as coarse-grained effective theories operating at the macroscale and written in terms of macroscopic variables such as inflation, unemployment, etc. Rather, a good theory henceforth was to link macroeconomic outcomes back to the behaviour of the individual agents in an economy, i.e. to their microeconomics behaviour. Such as theory would have "microfoundations."

To my physicist mind, this seems entirely sensible, so far. A difficult project, no doubt but sensible. By analogy, of course, this just seems like the effort to derive thermodynamics (a macroscopic theory) from the underlying behaviours of individual particles, which is the project of statistical mechanics. Deriving theories at higher levels from behaviours at lower levels is, when possible, a natural scientific project -- it offers unification or, if it can't be carried through, points to problem areas from which new ideas are likely to come.

Now, I have also read that much of the impetus for the rational expectations movement was the famous Lucas Critique which, if I understand it correctly, says that you can't reliably base policy interventions on simple regularities observed in macroeconomic data (a historically observed tradeoff between unemployment and inflation, for example). That regularity existed, after all, in the context of the policies prevailing in the past. Change the policies and those changes, by influencing the way people act and anticipate the future, may well strongly change or destroy the regularity on which you had based your plans. Again, plausible and sensible, it seems to me.

So, I can see the attraction of theories with microfoundations -- theories, that is, giving a plausible account of how macroeconomic reality emerges out of the micro reality and actual behaviour of millions of people and firms in interaction.

Now my puzzlement. As far as can tell, the idea of "microfoundations" as actually used in macroeconomics isn't quite how I described it above, i.e. seeking to base macro theory on a plausible account of the behaviour of individuals. Rather, in economics (through the work of Lucas) it has come to mean theories in which individuals and firms are hyperrational optimizers of their utility over a span of time (they solve a complicated optimization problem over their lifetime). This no longer seems so plausible, and on this point, a commenter from Mark Thoma's blog captures my feelings on this quite clearly:

hrsaccount said...

Microfoundations would be important if there were clear evidence that they represented the truth. For example, if there had been a series of experiments demonstrating that individuals are rational and make decisions so as to maximize some measurable quantity called utility, it would be important that macro models were consistent with this and the most direct way of ensuring that would be to incorporate rational utility-maximizing households into the model.

The fact is that there is no such evidence. Microeconomics is not based on empirical evidence, and the approach used in microeconomics has no special claim to the truth. So, leaving aside the fact that the way macroeconomics uses micro (i.e., in a way that many microeconomists don't approve, ignoring aggregation issues) there's no logical reason why macro needs to even be consistent with micro.

His point seems to me very well put -- if "microfoundations" as currently interpreted don't give foundations to anything, then a theory having them has no advantage. Theories with microfoundations (as interpreted in this odd sense) have no more claim to relevance than anything else. Indeed, we might say they are even worse as they are almost certainly demonstrably inconsistent with real behaviour at the micro level.

Again, I'm not an expert on this. But I see this kind of argument breaking out over and over among economists. I often think I must have it wrong, so please if I do, someone let me know.

UPDATE

While writing the above, I happened to find and read a couple of things that clarified matters quite a bit for me. My take seems to be shared by economists as well, although I'm not sure the few things I read are representative. First, Maarten Janssen of the Tinbergen Institute published an excellent short review of the idea of microfoundations in 2008. He describes the history, but notes that key criticisms of the idea do center in the "plausibility" of the rational expectations approach. That is, including expectations in macromodels is sensible, but everything depends on how you include them:

The approaches discussed so far... all postulate rational behavior on the part of economic agents and some notion of equilibrium. If expectations are important, it is postulated that agents’ expectations concerning important variables coincide with the model’s predicted values concerning these same variables.

And he mentions several branches of research criticizing this view and testing it, in particular, testing whether in a decentralized economy economic agents may learn over time to have expectations that are consistent with those that are assumed by the rational expectations hypothesis:

The general conclusion of this literature is that due to the feedback from expectations to economic behavior, the outcomes of an economic model with learning agents do not converge to the rational expectations solution. It then follows that the microfoundations literature mentioned so far has not really succeeded in deriving all macroeconomic propositions from fundamental hypotheses on the behavior of individual agents. The requirements of methodological individualism have thus not been satisfied by the microfoundations literature that has pre-dominantly presumed that individuals behave rationally...

I cannot say I'm surprised. So we're left with theories that only go one short step toward the idea of microfoundations, and, in my view, can't claim they have given microfoundations to anything -- the use of the word in these models is totally unwarranted, and I think way overstates what they achieve.

I think much the same point of view is expressed by Michael Woodford, himself a big name in macro modelling. In a response to an essay by John Kay critical of modern macroeconomics and its unrealistic assumptions, Woodford in a roundabout way eventually says, well, yes, I agree:

 

It has been standard for at least the past three decades to use models in which not only does the model give a complete description of a hypothetical world, and not only is this description one in which outcomes follow from rational behavior on the part of the decision makers in the model, but the decision makers in the model are assumed to understand the world in exactly the way it is represented in the model. More precisely, in making predictions about the consequences of their actions (a necessary component of an accounting for their behavior in terms of rational choice), they are assumed to make exactly the predictions that the model implies are correct (conditional on the information available to them in their personal situation).

This postulate of “rational expectations,” as it is commonly though rather misleadingly known, is the crucial theoretical assumption behind such doctrines as “efficient markets” in asset pricing theory and “Ricardian equivalence” in macroeconomics. It is often presented as if it were a simple consequence of an aspiration to internal consistency in one’s model and/or explanation of people’s choices in terms of individual rationality, but in fact it is not a necessary implication of these methodological commitments. It does not follow from the fact that one believes in the validity of one’s own model and that one believes that people can be assumed to make rational choices that they must be assumed to make the choices that would be seen to be correct by someone who (like the economist) believes in the validity of the predictions of that model. Still less would it follow, if the economist herself accepts the necessity of entertaining the possibility of a variety of possible models, that the only models that she should consider are ones in each of which everyone in the economy is assumed to understand the correctness of that particular model, rather than entertaining beliefs that might (for example) be consistent with one of the other models in the set that she herself regards as possibly correct.

So I feel that my suspicions and objections aren't misplaced, despite my vast ignorance. One other excellent article I recommend is this one from 2011 in which Woodford details the history of modern macroeconomics over the past century. Nothing I've read has given such a complete and clearly explained exposition, while it seems being balanced along the way (or so it seems, to my physicist's eyes).

UPDATE

Ole Rogeberg kindly let pointed me to this post by economist Noah Smith who makes some of the same points -- but from the position of someone with far economics domain knowledge than myself.

How markets become efficient (answer: they don't)

A staggering amount of effort has been spent -- and wasted -- exploring the idea of market efficiency. The notoriously malleable efficient markets hypothesis (EMH) claims (in its weakest form) that markets are "information efficient" -- market movements are unpredictable because smart investors keep them that way. They should quickly -- even, "instantaneously" in some statements -- pounce on any predictable pattern in the market, and by profiting will act to wipe out that pattern.

I've written too many times (here, here, here, for example) about the masses of evidence against this idea. It's not that predictable patterns don't attract investors who often act in ways that tend to wipe out those patterns through arbitrage. Part of the problem is that investors often act in ways that amplify the pattern (following trends, for example). Moreover, there are fundamental limits to arbitrage -- "the markets can stay irrational longer than you can stay solvent." Still, the EMH stumbles onward like a zombie -- dead, proven incorrect and misleading, yet still taking center place in the way many people think of markets.

I found an illuminating new perspective on the matter in this recent paper by Doyne Farmer and Spyros Skouras, which explore analogies between finance and ecology. This analogy is itself deeply suggestive. They note, for example, how the interactions between hedge funds can be useful viewed in ecological terms -- funds sometimes act as direct competitors (the profits of one reducing opportunities for another), and in other cases as predator and prey or as symbiotic partners. But I want to look specifically at an effort they make to give a rough estimate of the timescale over which the actions of sophisticated arbitragers might reasonably be expected to wipe out a new predictable pattern in the market. That is, if the market for whatever reason is temporarily inefficient -- showing a predictable pattern -- how quickly should it be returned to efficiency? How long is the time to relaxation that the EMH claims is "instantaneous" or close to it?

The gist of their idea is very simple. Before you can exploit a predictable pattern, you first have to identify it. If you're going to invest money trading against it, you need to be fairly sure you've identified a real pattern, not just a statistical fluke. If you're going to invest somebody else's money, you have to convince them. This takes some time. The stronger the pattern, the more it stands out and the less time it should take to be sure. Weaker signals will be hidden by more noise, and reliable identification will take longer. Looking at how much time it should take to get good statistics should give an order of magnitude of how long a pattern should persist before any smart investor can begin reliably trading against it and (perhaps) erasing it.

Here's the specific argument, expressed using the Sharpe ratio (ratio of expected return to standard deviation of a strategy exploiting the pattern):

This makes obvious intuitive sense. If S is very large, making the pattern obvious, more deterministic and easier to exploit, then the time over which it might be expected to vanish is smaller. Truly obvious patterns can be expected to vanish quickly. But if S is small, the timescale for identification and exploitation grows.

As Farmer and Skouras note, successful investment strategies often have Sharpe ratios of about S = 1, so this gives a result of about 10 years. [This is the result if one makes the analysis on an annual timescale, with the Sharpe ratio calculated on a yearly basis. If we're talking about fast algorithmic trading, then the analysis takes place on a shorter timescale.]

So, 10 years is the order of magnitude estimate -- which is a rather peculiar interpretation of the word "instantaneous." Perhaps that word should be replaced in the EMH with "very slowly," although that somewhat dampens the appeal of the idea: "The EMH asserts that sophisticated investors will very slowly identify and exploit any inefficiencies in the market, tending the erase those inefficiencies over a few decades or so." Given that new inefficiencies can be expected the arise in the mean time, you might as well call this more plausible hypothesis the PIMH: the perpetually inefficient markets hypothesis.

And their estimate, Farmer and Skouras point out, is actually optimistic:

We should stress that this estimate is based on idealized assumptions, such as log-normal returns – heavy tails, autocorrelations, and other effects will tend to make the timescale even longer.... As a given inefficiency is exploited, it will become weaker and the Sharpe ratio of investment strategies associated with it drops. As the Sharpe ratio becomes smaller the fluctuations in its returns become bigger, which can generate uncertainty about whether or not the strategy is still viable. This slows down the approach to inefficiency even more.

Of course, as I mentioned above, this analysis depends on timescale. Take t in years and we're thinking about predictable patterns emerging on the usual investment horizon of a year or longer, patterns exploited by hedge funds and mutual funds of the more traditional (not high frequency) kind.  Here we see that the time to expect predictable patterns to be wiped out is very long indeed. If 10 years is the order of magnitude, then it's likely some of these patterns persist for several decades -- getting up to the time of a typical investing career. Hardcore supporters of the EMH should learn to speak more honestly: "We have every reason to expect that predictable market inefficiencies should be wiped out fairly quickly, at least on the timescale of a human investment career."

All in all, this way of estimating the time for relaxation back to the "efficient equilibrium" suggests that the relaxation is anything but fast, and often very slow. The EMH may be right that there likely aren't any obvious patterns, but more subtle predictable patterns will likely persist for long periods of time, even while they present real profit opportunities. The market is not in equilibrium. And with no mechanism to prevent them, new predictable patterns and "inefficiencies" should be emerging all the time.