Sunday, August 3, 2014

Strange Defeat: An Exchange

My EPW article with Arjun prompted an interesting exchange with Parag Waknis. Since the letters, like the article, are behind a paywall, I'm reposting them here, below the fold. Waknis' letter is first, followed by our response.

Austerity or Fiscal Stimulus? On Modern Macroeconomics and the Importance of Context

Parag Waknis, Assistant Professor of Economics, UMass Dartmouth.

This discussion refers to the article titled, “Strange Defeat” by J W Mason and Arjun Jayadev in the Economic and Political Weekly, August 10, 2013 Vol. 48 No. 32. Though in general, the paper rightly points out the similarities in the New Keynesian and New Classical macroeconomics and the prescriptions that follow from them concerning austerity vs. fiscal stimulus, it fails to highlight the importance of context in resolution of such debates. According to me the austerity issue in the European Union (EU) has to be treated differently than in the US and certainly different in countries like India and there is a good amount of literature in modern macroeconomics itself that provides justification for this approach.

Also, it should be noted that the tendency to immediately dismiss the idea of dynamic optimizing agents as absurd, however tempting, only comes at the cost of clarity and rigor. If plausibility of such assumptions is to be questioned, then why not question the analysis based simply on macroeconomic aggregates with no regard to the process of their emergence! I think, as a social scientist, one has to have some faith in people’s ability of making choices and that they have some agency. However, once we do that policy prescriptions cannot be made without considering how people would react to it- a point, which simplistic analysis based on Hicks-Hansen IS-LM or AS-AD framework seems to so often miss[1]

Austerity vs. Fiscal Stimulus- Importance of Context:

Let us take the example of the EU debt crisis. The fact that EU is a monetary union but not a fiscal union creates inherent instability in the system and I think that the EU debt crisis is just its logical consequence. Ideally, Greece should not have been able to borrow at the interest rate Germany is able to borrow. However, in the pre housing crisis world, creditors treated the debt issued by these countries at the same level and corrected their perceptions only after the crisis (Martin & Waller 2011). Without a fiscal union such free riding by members, otherwise not having creditworthiness to borrow at a lower rate, is bound to happen. Hence, the question of an appropriate policy in this context becomes important.  Should we allow such free riding or take away each member’s individual right to issue bonds and just float Eurobonds? The answer I guess depends on how far do the EU members want to take the idea of a union.  As argued by Sargent (2012) for a monetary union to be successful it also needs to be a fiscal union.  In fact, I think that is an economic definition of a country- a fiscal and a monetary union.

Does that make austerity good for every country? Let us first talk about the US. In a couple of influential papers, Valerie Ramey addresses this issue. Based on theoretical work, aggregate empirical estimates from the United States, and cross-locality estimates, Ramey (2011a) shows that for a temporary, deficit-financed increase in government purchases, the expenditure multiplier estimates are between 0.80- 1.5 and based on a narrative methodology of identifying government spending shocks, Ramey (2011b) shows them to be between 0.6-1.2. These estimates mean that not much can be expected through stimulus spending, at least in the US, because a dollar spent by the US government either crowds out private consumption and investment or at best adds 50 cents to the real GDP.

What about the monetary policy? There is not much hope from this front either. The fact that the Federal Reserve currently pays a positive interest on reserves and has kept the federal funds rate (the US counterpart to call money rate in India) hovering at zero means that any swap of debt through quantitative easing is not going to do much in terms of increasing the spending in the economy (Williamson 2012). Most of the funds that the Fed is releasing in the system just stay put as reserves because short term lending is not profitable. So as a plausible alternative, it might be a good idea to look at some tax or other supply side incentives to create jobs or to stimulate investment spending. There is also the issue of fixing the financial system that still needs to be effectively addressed despite the passing of Dodd-Frank Act.

Where does this leave the developing countries on the question of appropriate fiscal and monetary policy? To answer this question we should look at the unique features of developing countries that separate them from developed countries. I think these features provide a sufficient rationale for running government deficits in developing countries like India. One such factor is presence and size of the informal sector. If the informal sector is substantial then the ability to raise tax revenues from it is limited and then a viable alternative is an inflation tax. This public finance motive has been shown to account for cross-country dispersion of inflation rates quite well (Koreshkova 2006).

According to GhatePandey & Patnaik (2013), private consumption expenditure in India is more variable than the real GDP at business cycle frequencies. This is in contrast to the US and other developed countries where consumption is bit less volatile than real GDP. These differences imply that unlike consumers in the US, consumers in India seem to be less able to smooth consumption suggesting a lack or substantial inequity in access to credit markets. In such situations, government expenditure might provide an opportunity to smooth consumption. Expenditure on employment support schemes like the Mahatma Gandhi National Rural Employment Guarantee Scheme (MNREGA), which has been argued to be influential in reducing poverty from 2004 to 2013 (Kotwal & Sen2013), are a case in point.

These intellectual justifications come with some caveats though. It has been highlighted time and again that a large part of inflation in countries like India is a supply side phenomenon putting a limitation on the ability to control or alleviate inflation through just monetary policy or reduced government spending. Add to these the pressures of maintaining stability in the foreign exchange market and policy conundrum just worsens because of the exchange rate pass through (Bhattacharya, Patnaik and Shah, 2011). Also, government’s intertemporal budget constraint is not merely a figment of imagination of New Classical macroeconomists. It does bind at some point as clearly shown by the case of Zimbabwe recently.  The only way to give some incentives to the creditors for a debt rollover is robust economic growth. So what should be the optimal policy given these benefits and costs of government spending or should the fiscal and monetary authorities continue relying on discretionary responses only to address pertinent issues at a given point in time? I think that answer to this question will only come from rigorous research followed by a substantial debate on the appropriate or optimal fiscal and monetary policy mix in the Indian context.

Unemployment in Western Europe vs. US:

The authors claim that, “These core intellectual commitments of modern economics have contributed to the weakness of efforts to reduce unemployment in the US and Europe.”  I am not sure if that is true either. It is by now common knowledge that many countries in Western Europe offer extremely generous unemployment benefits and higher minimum wages than the United States. This in itself is one of the reasons why many west European countries have much higher unemployment rate than the US. This outcome is well predicted by modern macroeconomics where agents choose how much to work depending on the opportunity cost of not working. Generous unemployment support systems reduce incentives to look for work (Kreuger & Muller 2009). How would this insight into people’s behavior contribute to weakness in effort to reduce unemployment? In fact it tells you exactly what needs to be done to increase employment. I think the political costs of reducing unemployment benefits are the ones that are keeping these economies back, not modern macroeconomics.
The similar seems to be the story of unemployment in the US during the Great Recession.  Mulligan (2012) argues that many changes in the labor market policies that have been enacted after the 2007 recession have actually ended changing the incentives for people to work and firms to hire making this recession deepest and longest to recover. Again most of this analysis has come from a macroeconomic framework that emphasizes microfoundations.

Concluding Comments:

While it is true that certain research gains primacy as intellectual justification for policy choices, albeit even without explicit support from the authors themselves (for example Rogoff and Reinhart paper pointed by the authors), the crisis and the recession that followed have brought diverse perspectives to contribute to the debate[2]. I have tried to point out some of such research in this write up. Also, availability of large scale data sets on prices of various goods and services have helped to situate the debate on price and wage stickiness in a firm empirical ground (Klenow and Malin, 2010).  Given this and the rich possibilities of improved data collection and computing power, I sincerely hope that economists keep on researching and debating theories in the light of current macroeconomic problems. I certainly do not see any defeat in it.  


Bhattacharya Rudrani, Ila Patnaik & Ajay Shah &, 2011. "Monetary policy transmission in an emerging market setting," IMF Working Papers 11/5, International Monetary Fund.
Ghate, Chetan & Pandey, Radhika & Patnaik, Ila, 2013. "Has India emerged? Business cycle stylized facts from a transitioning economy," Structural Change and Economic Dynamics, Elsevier, vol. 24(C), pages 157-172.
Klenow, Peter J. & Malin, Benjamin A., 2010. "Microeconomic Evidence on Price-Setting," Handbook of Monetary Economics, in: Benjamin M. Friedman & Michael Woodford (ed.), Handbook of Monetary Economics, edition 1, volume 3, chapter 6, pages 231-284 Elsevier.
Koreshkova, Tatyana A., 2006. "A quantitative analysis of inflation as a tax on the underground economy," Journal of Monetary Economics, Elsevier, vol. 53(4), pages 773-796, May.

Kotwal Ashok and Pranob Sen, 2013, What explains the steep poverty decline in India from 2004 to 2011? accessed on August 12, 2013.
Krueger Alan B.  & Andreas Mueller, Job search and unemployment insurance: New evidence from time use data, Journal of Public Economics, Volume 94, Issues 3–4, April 2010, Pages 298-307

Martin Fernando M.  & Christopher J. Waller, 2011. "Sovereign debt: a Modern Greek tragedy," Annual Report, Federal Reserve Bank of St. Louis, pages 4-19.

Mulligan, Casey, 2012, “The Redistribution Recession- How Labor Market Distortions Contracted the Economy” Oxford University Press, New York.
Ramey Valerie A., 2011b. "Identifying Government Spending Shocks: It's all in the Timing," The Quarterly Journal of Economics, Oxford University Press, vol. 126(1), pages 1-50.
Ramey Valerie A., 2011a. "Can Government Purchases Stimulate the Economy?," Journal of Economic Literature, American Economic Association, vol. 49(3), pages 673-85, September.
Sargent Thomas J., 2012. "Nobel Lecture: United States Then, Europe Now," Journal of Political Economy, University of Chicago Press, vol. 120(1), pages 1 - 40.

Williamson Stephen D., 2012. "New Monetarist Economics: Understanding Unconventional Monetary Policy," The Economic Record, The Economic Society of Australia, vol. 88(s1), pages 10-21, 06.

[1] Paul Krugman has been dabbling in Kalecki’s approach along with IS-LM. However, he does not follow through to get to the implications. See Stephen Williamson’s post “Deconstructing Krugman” at for an illuminating analysis.
[2] Carmen Reinhart and Kenneth Rogoff have responded to the criticism of their “Growth in the time of Debt” paper.  Readers should take a look at it to get a balanced perspective.

We thank Parag Waknis for his comment. If nothing else, it succeeds  -albeit unintentionally -in providing a fine illustration of the problems with contemporary economics that our article described.

In our article, we suggested that the methodology that has dominated economics for the last generation leaves economists unequipped to make arguments for active macroeconomic policy. Since agents know the true parameters of the distribution of future outcomes and intertemporally optimize at all points based on that, the link between current income and current expenditure, and the consequent centrality of aggregate demand, are broken. The result of this approach is that recessions and periods of high unemployment are simply assumed to be the result of optimizing choices on the part of agents. Waknis does not challenge the accuracy of this description of current economic practice; he just doesn’t see anything wrong with it.

Waknis employs a common rhetorical sleight of hand, conflating the undisputed importance of expectations and profit-seeking behavior, with one specific approach to them. Economists have always been interested in how people make choices, and analysis of aggregates has always incorporated stories about the individual behavior underlying them. What is new to the modern consensus is the idea that the only legitimate way to handle expectations, is to assume that all economic actors know the true probability distribution of all possible future events. When people like Waknis say that we must think about expectations, what they really mean is that we must not think about what happens when expectations are distorted or differ between actors, or about the concrete process through which expectations are formed.

However much this approach monopolizes the textbooks, it is not useful for describing real-world booms, cycles and crises, as Waknis himself inadvertently demonstrates. In the paragraph immediately following his lecture urging “faith in people’s ability to make choices,” he announces that investors in Europe made consistently wrong choices about the riskiness of public debt! Waknis may be right that Southern European public debt was systematically mispriced, but it is logically incompatible with the models economists use to think about government budgets, which assume that financial market participants know the true expected values of government spending and taxing across all future time.

Turning to questions of policy, it appears that Waknis does not understand what a multiplier is. He notes a range of multiplier estimates around one, and takes this to mean that increased public borrowing crowds out an equal quantity of private spending. But as anyone who has sat through an undergraduate macroeconomics course should know, what the multiplier measures is the ratio of the change in total output to the change in government output. So with a multiplier of one, there is no crowding out; government spending increases real output dollar for dollar. Under today’s conditions, most empirical economists prefer estimates at the high end of Waknis’ range; the chief economist of the IMF recently suggested a typical value “substantially greater than one.” (Blanchard and Leigh, 2013) But even lower values still mean that higher government spending will raise output and reduce unemployment. Waknis thinks he is bringing these estimates up as arguments for austerity, but he is really offering testimony for the other side. His confusion on this elementary point suggests a harsher judgment on the state of economics than anything in our original article.

Waknis’ inability to grasp the role of aggregate demand is striking, but sadly not unusual. It leads naturally to the claim that high unemployment, especially in Europe, is due to over-generous benefits to those out of work. There is an immense empirical literature on this claim, which finds the evidence for it somewhere between weak and nonexistent. (Howell et al., 2007) Indeed, the countries with the highest and most comprehensive unemployment benefits (Norway and Denmark) have substantially lower unemployment than the US (OECD, 2013). The argument also fails the test of common sense. Today, unemployment in the European Union is about five points higher than in the US. But as recently as the fall of 2009, US and EU unemployment rates were identical. Surely the European welfare state is not a fresh creation of the past four years? More fundamentally, if the rise in unemployment is due to declining “incentives to work,” it follows that newly unemployed prefer their current state of leisure to the jobs they had before.  Professor Waknis ends his letter with a call for continued research. One useful contribution he might make is interviewing unemployed workers, and asking them how they are enjoying the vacations they’ve chosen. We expect he will find the answers most stimulating.

Arjun Jayadev and J. W. Mason

Works cited:

Howell, David R., Dean Baker, Andrew Glyn, and John Schmitt. "Are protective labor market institutions at the root of unemployment? A critical review of the evidence." Capitalism and Society 2, no. 1 (2007).

Blanchard, Olivier J., and Daniel Leigh. Growth forecast errors and fiscal multipliers. No. w18779National Bureau of Economic Research, 2013.

OECD (2013). Organisation for Economic Cooperation and Development Short-Term Labour Market Statistics Description: etaData : Harmonised Unemployment Rates (HURs). Available at


  1. Textbooks and teachers should lean against the idea that government spending is bad. Waknis writes "because a dollar spent by the US government either crowds out private consumption and investment or at best adds 50 cents to the real GDP." And as you point out "In the paragraph immediately following his lecture urging “faith in people’s ability to make choices,” he announces that investors in Europe made consistently wrong choices about the riskiness of public debt! "

    Private choices are often wrong. Just look at the epic, overleveraged housing bubble. So who cares if they are "crowded out?" At the very least government spending can maintain full employment and be the job creator of last resort. It seems these conclusions can be reached within the NK conceptual framework, it's just possible for a Waknis not to reach them. But it seems like the consensus represented by Blanchard and the recent Chicago survey on the stimulus consider government spending as worthwhile.

  2. I pretty much agree with your take. Leaving demand management to the central bank leads to problems of inequality and financial instability.

    You discuss the central banks' antipathy towards and concern over the UPS strike and European governments' finances in the piece. Recently, there have been counter examples as economies face deflation. Time magazine: ""I'd like to see real wages going up," Yellen says, adding that the average American male worker's inflation-adjusted wages have been flat or down for the past 20 years.""

    And from the Financial Times:

    "The Bundesbank has backed the push by Germany’s trade unions for inflation-busting wage settlements, in a remarkable shift in stance from a central bank famed for its tough approach to keeping prices in check.

    Jens Ulbrich, the Bundesbank’s chief economist, told Spiegel, a German weekly, that recently agreed pay rises of more than 3 per cent were welcome, despite being above the European Central Bank’s inflation target of below but close to 2 per cent.

    In an article published on Sunday, Mr Ulbrich said that recent wage trends were “moderate” given Germany’s relative economic strength and low levels of unemployment. His comments echo the views of Jens Weidmann, Bundesbank president, according to a senior central bank official.
    Ursula Engelen-Kefer, a lecturer at Hochschule der Bundesagentur für Arbeit university and former deputy chair of DGB, Germany’s confederation of trade unions, said she was “flabbergasted” by Mr Ulbrich’s remarks.

    “It goes to prove that even the central bank recognises that we can’t improve internal economic growth without wages,” she added. "

    1. The thing is, central bank economics and academic economics are very different animals. There is certainly plenty to criticize central bankers for, but it's important to acknowledge that they operate with a model of the economy that is very different from the academic consensus we are attacking here. In fact, it's striking how little communication there has been between the new consensus in macroeconomics and modern central bankers.

      Here's Michael Woodford:

      "The conceptual frameworks proposed by central banks ... developed without much guidance from the academic literature... The central questions of practical interest for the conduct of policy ... had in recent decades ceased to be considered suitable topics for academic study."

      The most dramatic illustration of the divide between academic and central-bank macroeconomics in recent years that I can think of Narayana Kocherlakota's road-to-Damascus moment, which led -- among other things -- to him firing the whole research staff at the Minneapolis Fed.

      The ECB case is complicated, but in the US the quality of economic analysis at the Fed is higher than that of the "best" academics, Krugman included, IMO.

  3. Last comment (thanks for the though provoking article). Here in 2010, DeLong says Krugman is wrong about Ricardian equivalence:

    "[Krugman writes]:And at that point further open-market operations do nothing — they just swap one zero-interest asset for another, with no effect on anything.

    So why not forget about open-market operations, and just drop the stuff from helicopters? Well, remember that at this point cash and short-term bonds are equivalent. So a helicopter drop is just like a temporary lump-sum tax cut. And we would expect people to save much or most of such a tax cut — all of it, if you believe in full Ricardian equivalence."

    But we don't believe in full Ricardian equivalence. Maybe we would if this year's helicopter drop was to be followed by next year's great helicopter vacuuming, but it isn't. So printing money now--and promising never to buy it back--is a way of having some impact on future inflation, and thus of getting some traction. Moreover, "much or most" is not all.

    The "much or most" is, I think, reason to go for money-financed government spending as a preferable policy to a helicopter drop--which is a money-financed tax cut. And it is reason to go for an explicit raising of the Federal Reserve's long-term inflation rate target from 2% to 3%.

    But if we are not going to do either of those things--and it looks like we are not--it's time to rev up the helicopters..."

  4. I think DeLong has a much more realistic vision of the economy than Krugman. I prefer Krugman's politics, though.

    Thanks for the comments -- more replies in a bit.

  5. This comment is perhaps just half on topic, however, this sentence of P. Waknis caught my eye:

    " Without a fiscal union such free riding by members, otherwise not having creditworthiness to borrow at a lower rate, is bound to happen."

    As a citizien of one of the "PIIGS" countries, at first this sentence just was slightly offensive: free riding? Who is free riding?
    However thinking more about it, i think that this concept of "free riding countries" should be analysed nore in dept, as IMHO explains the logical problem of the approach that Waknis is defending here.

    First of all, how does one know that the interest rates that Greece (or others) had to pay were "too low"? It could well be that the error is that, at a certain point, the rate asked to these "debtor countries" [1] was "too high", and this caused the crisis. If we just think in terms of market perceptions of value, there is no reason to think that those people who tought that Greece (or others) were risky were smarter than the people who tought that Greece was not risky a few years before (often they were the same people); J.W. Mason and A. Jayadev also point out this in their answer. So why is Waknis so confident that Greece's interst payments were "too low"? Well, first of all, we know that Greece did in fact default; however this too could be a consequence of an irrational behaviour of investors later, when they rised the interest that they expected Greece to pay. I think that the real reason that Waknis thinks that Greece interests were too low is that Greece's interst ended up increasing Greece's debt, because those interests were higer than the increase in tax revenues that they caused; in shord Greece ended up enacting a sort of "Ponzi scheme" where new debt is required both to rollover past debt AND to pay for interest on past debt.

    I think that this idea is also the so called "austrian" theory [2], that is, that the increase in debt levels is only justified as long as debt is the counterpart of some real capital, so that the profits from the real capital can pay for the interest on debt.

    However, this idea (that is quite reasonable) implies that the profit rate can't be substantially higer than the growth rate, and the interest rate cannot be higer than the growth rate (otherwise, debt would baloon indefinitely and ultimately interest would eat all income, the definition of a Ponzi scheme; the interest rate cannot be much lower than the profit rate because this would give too much incentives to lend).

  6. [continues from previous comment]

    But, we know from the now famous "Capital in the 21st Century" (by T. Piketty) that the rate of profit was higer than the rate of growth basically for all known history of capitalism. While Piketty doesn't make this argument, it is obvious IMHO that this can be the case only if there is some Ponziness going on, as the rate of interest is always higer than the rate of growth, that necessariously causes this sort of Ponzi situation.

    How can we explain this in terms of rational actors? The only possible explanation is that those actors want to "save" [accumulate wealth] faster than the economy is growing, so that this wealth necessariously cannot end up in "real" capital but necessariously ends up in some "bubble wealth", such as greece debt but also housing in the USA and Spain, etc.

    But this is a kind of rational actor totally different, on the long term, to the rational actors of current theories (who just smooth consumption on an indefinitely long time), and more similar to Marx's capitalists, who have a drive to accumulation for accumulation's sake.

    If we change the consumption smoothing rational actors in an army of Scrooge McDucks, this clearly explain why we have crises of demand, and also why someone is bound to end up racking up all the debt (that is just the counterpart of McDuck's wealth) and will be ultimately found as running a sort of Ponzi scheme.

    So here the problem is not really wether actors are "rational" or not, but rather how do we define this "rationality".
    [1] In fact, almost all countries are "debtor countries", as states are generally in the red and most of the wealth is owned by private citiziens.
    [2] Incidentially, could someone point to me a simple, not crazy sounding introduction to austrian theories? The few stuff I found on the net makes sense up to a certain point but then I lose the logic to it, as apparently it seems that they don't think that there can be a situation where savings can exceed "productive investiment", so they literally can't think of a reason for the interest rate to fall.

  7. I'm curious if you think the new hetrodox agent macro models are an imporvement. I suspect not, but I havn't been able to really grok them yet.

    1. I just don't think these kinds of models are useful. There are two many adjustable parameters, too little clarity about what drives the results, and most important, they aren't efficient ways of summarizing stable economic relationships -- which is all that a model is. What we want --in my opinion -- is simple aggregative models, plus the broad social and historical background to judge what domain those models apply to. As my new friend Servaas Storm says, agent-based modeling is just one more example of how cheap computing power gets substituted for critical thought.

    2. I like the idea of adding up how many cars and houses (and food and clothing) people are buying, and making guesses about how and under what circumstances people buy those things, and making guesses about how and under what circumstances people go to the doctor a lot, or pay a lot for school, and when the government buys a bunch of planes or roads or school psychologists or nurses. I think each of those types of decisions are possibly susceptible to modeling, but they are all pretty different (even if, yeah, they are all mutually affected by broader credit markets, monetary policy, "aggregate demand," and so on.)

      I mean, the economy is complicated, but it is finite, just like our individual personal and economic lives are complicated but finite.

  8. Simcity is fun. (Well, not the new version. But the original and Simcity 2000, yes.) But you can't build a useful economic theory from the ground up this way.

  9. Thanks Mason for making the exchange generally accessible. I did have a response to your response, which the EPW did not care to publish. I have uploaded it here: