Friday, August 26, 2011

The Mind Reels

From Stephen Cecchetti's paper at the Jackson Hole conference.
For a macroeconomist working to construct a theoretical structure for understanding the economy as a whole, debt is either trivial or intractable. Trivial because (in a closed economy) it is net zero – the liabilities of all borrowers always exactly match the assets of all lenders. Intractable because a full understanding of debt means grappling with a world in which the choice between debt and equity matters in some fundamental way. That means confronting, among other things, the intrinsic differences between borrowers and lenders; non-linearities, discontinuities, and constraints in which bankruptcy and limits on borrowing are key; taxes, where interest paid to lenders is treated differently from dividends paid to shareholders; differences between types of borrowers, so household, corporate and government debt are treated separately; and externalities, since there are times when financial actors do not bear (or are able to avoid) the full costs of their actions.

As modern macroeconomics developed over the last half-century, most people either ignored or finessed the issue of debt. With few exceptions, the focus was on a real economic system in which nominal variables – prices or wages, and sometimes both – were costly to adjust. The result, brought together brilliantly by Michael Woodford in his 2003 book, is a logical framework where economic welfare depends on the ability of a central bank to stabilise inflation using its short-term nominal interest rate tool. Money, both in the form of the monetary base controlled by the central bank and as the liabilities of the banking system, is a passive by-product. With no active role for money, integrating credit in the mainstream framework has proven to be difficult.

Yet, as the mainstream was building and embracing the New Keynesian orthodoxy, there was a nagging concern that something had been missing. On the fringe were theoretical papers in which debt played a key role, and empirical papers concluding that the quantity of debt makes a difference.

The latest crisis has revealed the deficiencies of the mainstream approach and the value of joining those once seen as inhabiting the margin.
The mind reels - they are just starting to think about how to include debt in their models now?


dr2chase said...

There was an article years ago in SIAM Review, 1990, Lazer and McKenna, where the authors observed that modeling bridge suspension wires (or concrete piers) as if they obeyed Hookes' law made the math much easier, but also required the assumption that ropes can be pushed.

And that's just bridge construction, untainted by crazy ideas about what "should" happen when economies get out of whack, and who "should" pay the costs. Little wonder that they're just now getting to it.

Skeptical Economist said...

"The mind reels - they are just starting to think about how to include debt in their models now?"

No. See the work of Fisher (after the 1929 crash) and Hyman Minsky.

Of course, debt becomes a much more interesting issue after a debt bubble and subsequent crash.

Gary said...

Tackling the issue of borrowers and lenders has the unfortunate effect of introducing class into economics. It's a concept many elite Americans would rather avoid. Can't help wondering if that's part of the problem.

bmerson said...

Wow! Debt! Who would have thought?

What next? Energy!? Resources!? Biosphere!?

Oh wait. That's right. Those things are externalities and/or completely and instantly substitutable at the right price point.

Well, I guess there's no need to think about those then, huh?

Rob said...

Economics as practiced today is an embarrassment. They do not understand and ignore both the relationship between wealth and energy, and the relationship between sustainability and debt. In other words they ignore pretty much the only things that matter today. Idiots.

Greg said...

Yes and no: Irving Fisher studied "debt deflation" in the 1930s, but little work has been done since, and it's certainly not a core topic. Eggertsson and Krugman wrote a paper last year to try to re-ignite interest, with, as yet, no visible result.

Cecchetti highlights the cowardice of macroeconomists: faced with a difficult problem, they scurry off, pretending it does not exist. I'd like to think that engineers would do much, much better.

Seth said...

According to the Modigliani-Miller theorem, capital structure of firms is irrelevant. For economists who are in it for the shallow but flashy math, that's a perfectly adequate rationalization for ignoring debt.

But as Cecchetti pointed out, debt is difficult. There are a few brave Hyman Minsky types out there who attempt to model debt (Steve Keen is one such hardy soul working today) but they have to use different kinds of math. And economists are considerably less open to new mathematical methods than physicists are. So these would-be debt-theorists are marginalized.

Stuart, you would make a fine econophysicist (eg Doyne Farmer) if you ever make so much money from your software work that you stop needing/wanting your day job ;)

Greg said...

Seth: using the Modigliani-Miller theorem in macro is a classic fallacy of composition.

kjmclark said...

It requires a bit of behavioral economics to properly understand too. Debt is more painful than savings are pleasant. The wealthy don't get as much security out of their savings, and are never quite satisfied that they've saved enough. The lower middle class feels their debt like a lead weight wrapped around their necks. It's probably an effect similar to the loss/gain feelings that have been documented - people feel losses much more acutely than gains.

Economics has some really useful insights, but it has a long way to go as well. Not as far along as physics, but physics mostly doesn't have politicians and oligarchs constantly trying to manipulate it. Imagine the Koch brothers paying for an institute to throw out quantum physics or have lasers banned.

Ron Broberg said...

Spent some time at the Schneider climate symposium in Boulder on Thursday. Got to ask some questions about modeling fossil fuel constraints, food production, and demographics. Now it may be that the questions were naive and not properly framed, but the answers that I did get seemed to indicate that neither food nor energy constraints are commonly modeled at a physical level in the type of economic models used in integrated assessments. I'm quite confident that debt doesn't show anywhere near such models. So the kind of constraints on growth that we expect are probably not reflected in climate impact assessments. They appear to be BAU models.

dcomerf said...

Some of the comments here are a bit unfair: Modigliani and Miller is a theorem that says that, given some assumptions including no taxes, financing of a company makes no difference to company's economic value. Since we know that many of these assumptions don't hold, I don't think anyone claims that capital structure of a firm makes no difference.

Whilst many economists are politically motivated to the extent that it directs their work in an unscientific manner, it would be a mistake to claim that they are idiots.

As for just getting round to credit, debt and financial frictions, that's just not true. Obviously outside of the mainstream, the Minskyite work's been around for ages. Within the mainstream, Bernanke-Gertler (1990?) and Kyotaki-Moore (1997) shows that many mainstream economists (though definitely a minority) have been thinking about how to include debt in their models for the best part of 2 decades.

James said...

The excellent documentary Inside Job seeks to explain the causes of the 2007 financial crisis ... and it raises some interesting questions about whether economics research in the west is being exposed to undue influence by those who might profit from influencing it.