Substitution and Allometry

Brad DeLong channels Milton Friedman:

Supply and demand curves are never horizontal. They are never vertical. If somebody says that quantities change without changing prices, or that prices change without changing quantities, hold tightly onto your wallet--there is something funny going on.

Yes, this is how economists think, or at least think they think. And there's more than a bit of truth in it. Certainly in the case at hand, DeLong-cum-Friedman is right, and Myron Scholes is wrong: It's neither plausible nor properly thinking like an economist to suppose that if unconventional monetary policy can substantially reduce the quantity of risky financial assets held by the public, the price of such assets -- the relevant interest rates -- will remain unchanged.

That's right. But it's not the only way to be right.

Consider the marginal propensity to consume, that workhorse of practical macroeconomic analysis. It's impossible to talk about the effects of changes in government spending or other demand-side shifts without it. What it says is that, in the short run at least there is a regular relationship between the level of income and the proportion of income spent on current consumption, both across households and over time. Now, of course, you can explain this relationship with a story about relative prices driving substitution between consumption now and consumption later, if you want. But this story is just tacked on, you don't need it to observe the empirical relationship and make predictions accordingly. And more restrictive versions of the substitution story, like the permanent income hypothesis, while they do add some positive content, tend not to survive confrontations with the data. The essential point is that whatever one thinks are the underlying social or psychological processes driving consumption decisions (it's unlikely they can be usefully described as maximizing anything) we reliably observe that when income rises, less of it goes to consumption; when it falls, more of it does.

In biology, a regular relationship between the size of an organism and the proportions of its body is called an allometry. A classic example is the skeleton of mammals, which becomes much more robust and massive relative to the size of the body as the body size increases. Economists are fond of importing concepts from harder sciences, so why not this one? After all, consumption is just one of a number of areas where we rely on stable relations between changes in aggregates and relative changes in their components. There's fixed-coefficient production functions (strictly, an isometry rather than allometry, but we can use the term more broadly than biologists do); the stylized fact, important to (inter alia) classical Marxists, that capital-output ratios rise as output grows; or composition effects in trade, which seem to play such a major role in explaining the collapse in trade volumes during the Great Recession.

This is a way of thinking about economic shifts that doesn't require the price-quantity links that Friedman-DeLong think are the mark of honest economics, even if you can come up with some price-signal based microfoundation for any observed allometry. It's more the spirit of the old institutionalists, or traditional development or industrial-organization economics, which tend to take a natural historian's view of the economy. Of course, not every change in proportion can be explained in terms of regular responses to a change in the aggregate they're part of. Plenty of times, we should still think in terms of prices and substitution; the hard question is exactly when. But it would be an easier question to answer, if we were clearer about the alternatives.

Does the Level of the Dollar Matter?

Mike Konczal has kindly reposted my back-of-the-envelope estimate of how much a dollar devaluation would boost US demand. (Spoiler: Not much.)

I am far from an expert on international trade and exchange rates. (Or on anything else.) Maybe some real economist will see the post and explain why it's all wrong. But until then, I'm going to continue asking why Krugman and others who claim that exchange rates are an important cause of unemployment in this country, never provide any quantitative analysis to back that opinion up.

More abstractly, one might ask: Is the time it takes for demand to respond to changes in relative prices, minus the time it takes for exchange rate changes to move relative prices, greater than the time it takes for exchange rates changes to move relative costs (or to be reversed)? Just because freshwater economists say No for a bad reason (because relative costs adjust instantly) doesn't mean the answer isn't actually No for a good reason.

Abject Patience

Aldous Huxley says, "The abject patience of the oppressed is perhaps the most inexplicable, as it is also the most important, fact in all history."

I thought of that today when I came across this story, which really must be read to be believed. And if you read the fantastic work that Mike Konczal and a few other left bloggers are doing on the foreclosure crisis, it's clear that what happened here is shocking and horrifying but not especially unusual. All over the country, people's homes are quite simply being stolen from them by banks and other creatures from the financial sector.

But the most disturbing part isn't the mortgage servicers evicting people from their homes with no clear title or other legal basis. It is the homeowners themselves. The "good" ones most of all.

Tina Kimmel was told by Citi, her lender, that she qualified for a trial loan modification under HAMP. Then after seven months of paying the lower amount as instructed, she was told without explanation she did not qualify and would be considered in default if she didn't make all the back payments with interest and penalties. She paid them. Then Citi said they wouldn't accept her money, she was being foreclosed. She kept paying. Without informing her they sold her mortgage to Carrington Mortgage Services, which told her that all they knew was she was in foreclosure and it was up to her, not Citi, to give them documentation on anything else regarding her loan. She gave it. And that while they were deciding whether to evict her, she'd have to keep paying. She paid. Next thing she heard was a sheriff's notice on her door, announcing the house would be auctioned in three weeks. At the last minute, she paid the $13,000 -- borrowed from family and friends -- that Carrington was demanding for her nonexistent missed payments, and was allowed to keep her house.

She did everything the banks told her to. She's proud of that. Shouldn't she be ashamed?

I don't know that much about mortgages or mortgage fraud. But one thing I do know is that the Citis and the Carringtons will keep stealing houses as long as the victims think it's their duty to do whatever it takes to satisfy them, and to peacefully move out if they fail.

One can't help wondering how many houses would have to end up mysteriously burned a few days after an eviction, to make the banks find loan modifications suddenly quite attractive. But instead we get Tina Kimmel, stakhanovite bill-payer.

From Obscure Blog to Slightly Less Obscure Blog

A revised version of my stuff on the dollar and trade is now up at the Roosevelt Institute's blog, New Deal 2.0.

People are liable to actually read it now. Let's hope I didn't get anything too egregiously wrong.

A Bit More on China

Mike Konczal points me to this interesting piece by Walker Frost in The American Scene, on the Chinese currency peg. I asked earlier how much Chinese appreciation would boost US demand (more on that below). But there's a prior question, which is whether an end to Chinese currency intervention would lead to appreciation at all. As Frost points out, the dollar purchases by the central bank coexist with restrictions on private investment abroad and strong incentives for FDI by foreign firms. These policies increase net capital inflows and therefore tend to raise the value of the Chinese currency; the Chinese central bank then pushes it back down with its dollar purchases. It's far from clear which of these effects is stronger, and therefore, whether an across-the-board liberalization would lead the Chinese currency to rise against the dollar, or to fall. In short, we should see Chinese currency interventions not as part of an export-led growth strategy that requires a current-account surplus, but as part of an investment-led growth strategy that would otherwise tend to produce a current-account deficit. [1]

This is a point Anwar Shaikh has also made, when I've discussed this stuff with him. Don't talk about undervaluation, he says, that implies some known free-market equilibrium exchange rate, and there isn't one; talk about stabilization instead.

Another interesting discussion of the Chinese currency peg is in this Deutsche Bank report, which tends to confirm my skepticism about the effect of currency adjustment on US-China trade flows. They note that "RMB appreciation tends to ... reduce nominal wages in the export sector," confirming my sense that exchange rate changes don't reliably move relative costs. And they use an estimate of -0.6 for exchange rate elasticity of Chinese exports. I don't want to put too much weight on this number -- I'm not sure how it's derived -- and they don't give any estiamtes for US-China flows specifically; but given the well-established empirical fact that exchange-rate elasticity is unsually low for US imports, we have to conclude that the number for Chinese exports to the US is substantially lower. So if you believe the Deutsche Bank number for Chinese exports as a whole, my estimate of -0.17 for Chinese exports to the US is probably in the right ballpark. Which, again, means that even a very large Chinese appreciation would have only a trivial impact on US aggregate demand.


[1] The same goes for tariffs and other trade restrictions imposed by Latin American countries as part of import-substitution industrialization.

... and How About a Higher Yuan?

Another day, another Paul Krugman post blaming China for US unemployment. And maybe he's right. But it would be nice to see some numbers.

On the same lines as my earlier post about the effect of dollar devaluation on aggregate demand, we can make a rough estimate of trade elasticities to calculate the effect of a Chinese revaluation.

Unfortunately, there aren't many recent estimates of bilateral trade elasticities between the US and China. But common sense can get us quite a ways here. In recent years, US imports from China have run around 2 percent of GDP, and US exports to China a bit under 0.5 percent. So even if we assume that (1) a change in the nominal exchange rate is reflected one for one in the real exchange rate, i.e. that it doesn't affect Chinese prices or wages at all; (2) a change in the real exchange rate is passed one for one into prices of Chinese imports in the US; (3) Chinese goods compete only with American-made goods, and not with those of other exporters; and (4) the price elasticity of US imports from China is a very high 4.0; then a 20 percent appreciation of the Chinese currency still boosts US demand by less than 1 percent of GDP.

And of course, those are all wildly optimistic assumptions. My own simple error-correction model, using 1993-2010 data on US imports from China and the relative CPI-deflated bilateral exchange rate, gives an import elasticity of just 0.17. [1] If the real figure is in that range, then a Chinese appreciation of 20 percent will reduce our imports from China by just 0.03 percent of GDP -- and of course much of even that tiny demand shift will be to goods from other low-wage exporters.

I don't claim my estimate is correct. But is it too much to ask that Krugman tell us what estimates he is using, that have convinced him that the best way to help US workers is to foment a trade war with China?


[1] This is a real exchange-rate elasticity, not a price elasticity, so it accounts for incomplete passthrough and offsetting movements in Chinese real wages. It assumes, however, that changes in the nominal exchange rate don't affect inflation in either country; to that extent, it's more likely an overestimate than an underestimate