The Trouble with Macroeconomics

The “Trouble with Macroeconomics,” according to a working paper by Paul Romer that is posted on his website, relates to dishonest identification assumptions, in particular in DSGE models used for policy analysis. Romer singles out calibration, assumptions about distribution functions and strong priors as culprits.

Romer argues that

[b]eing a Bayesian means that your software never barfs


I agree with the harsh judgment by Lucas and Sargent (1979) that the large Keynesian macro models of the day relied on identifying assumptions that were not credible. The situation now is worse. Macro models make assumptions that are no more credible and far more opaque.

Romer also offers a meta-model of himself as a critic of “post-real models” and “facts with unknown truth value.”

Karl Brunner

The SNB commemorated Karl Brunner’s 100th birthday with a Centenary Event and the first of a new lecture series, the Karl Brunner Distinguished Lecture Series. Allan Meltzer, Benjamin Friedman, Charlie Plosser, and Ernst Baltensperger reviewed Karl Brunner’s life and work at the event; Kenneth Rogoff delivered the lecture.

In the NZZ, Allan Meltzer writes about Karl Brunner. Ditto Kurt Schilknecht.


In the FAZ, Patrick Bernau und Manfred Schäfers report that the German Federal Ministry for Economic Affairs invited five research institutes to produce economic forecasts although the call for bids had stated that the Ministry would contract with at most four institutions. Legal experts agree that this procedure is illegal.

The report suggests that the institution that just made it (DIW) is led by Marcel Fratzscher who is politically close to the Minister.

Secular Stagnation Skepticism

I was asked to play devil’s advocate in a debate about “secular stagnation.” Here we go:

Alvin Hansen, the “American Keynes” predicted the end of US growth in the late 1930s—just before the economy started to boom because of America’s entry into WWII. Soon, nobody talked about “secular stagnation” any more.

75 years later, Larry Summers has revived the argument. Many academics have reacted skeptically; at the 2015 ASSA meetings, Greg Mankiw predicted that nobody would talk about secular stagnation any more a year later. But he was wrong; at least in policy circles, people still discuss and worry about secular stagnation. As we do tonight.

In his 2014 article, Summers does not offer a definition of “secular stagnation,” in fact the article barely mentions the term. But Summers tries to offer a unifying perspective on pressing policy questions. The precise elements of this perspective change from one piece in the secular stagnation debate to the other.

Summers (2014) emphasizes a conflict between growth and financial stability: He argues that before the crisis, growth was built on shaky foundations that resulted in financial instability; and after the crisis, projections of potential output were revised downwards.

Summers frames this conflict in terms of shifts in the supply of savings on the one hand and investment demand on the other, which are reflected in lower real interest rates.

He identifies multiple factors underlying these shifts:

  • The legacy of excessive leverage
  • Lower population growth
  • Redistribution to households with a higher propensity to save
  • Cheaper capital goods
  • Lower after tax returns due to low inflation
  • Global demand for CB reserves
  • Later added: Lower productivity growth
  • Risk aversion which creates a wedge between lending and borrowing rates

All this, Summers argues, is aggravated by the fact that nominal interest rates are constrained by the ZLB, and that low rate policies induce risk seeking and Ponzi games—that is, new financial instability—by investors.

I am not convinced by the diagnosis. First, I feel uncomfortable with “secular” theories of “lack of aggregate demand.” I guess I believe in some variant of Says’ law; I agree that the massive surge of CB reserves is relevant in this context but even this cannot rationalize “secular” demand failure (presumably, the surge will stop and may even be reversed or prices will adjust).

Second, I disagree on population growth. We have two workhorse models in dynamic macroeconomics, the Ramsey growth model and the overlapping generations model. In the former, population growth does not affect the long-term real interest rate (R = gamma^sigma / beta). In the latter, population growth can have an effect by changing factor prices; but in this model the real interest rate is unrelated to the economy’s growth rate.

Third, productivity growth clearly is relevant. Gordon would support the view that the outlook is bleak on that front, others would disagree and predict the opposite. We will know only in a few decades.

Fourth, domestic factors cannot be the dominant explanation. With open financial markets, global factors shape savings and interest rates.

Fifth, real interest rates have trended downward for thirty years, including in decades when no one worried about “demand shortfalls.” (Nominal rates trended downward too, but that is easy to explain.) But it is true that historically, low real rates tend to coincide with low labor productivity growth. Over the last years, low real rates have gone hand in hand with a stock market boom; this suggests financial frictions or increased risk aversion.

There are competing narratives of what is going on. For example, Kenneth Rogoff argues that we are experiencing the usual deleveraging process of a debt supercycle; in Rogoff’s view, the secular stagnation hypothesis does not attribute sufficient importance to the financial crisis. Bob Hall has identified an interesting structural break: Since 2000, households and in particular, the teenagers and young adults in those households supply less labor (they play video games instead).

Summers discusses three policy strategies in his 2014 article:

  • Wait and see (he associates this with Japan)
  • Policies that lower nominal interest rates to stimulate demand; Summers mentions various risks associated with this strategy, related to bubbles, redistribution, or zombie banks
  • Fiscal and other stimulus policies: Fiscal austerity only if it strongly fosters confidence; regulatory and tax reform; export promotion, trade agreements, and beggar thy neighbor policies; and public investment

I am not convinced by the medicine either. In general, I miss a clear argument for why policy needs to respond. We might be very disappointed about slower future growth. But this does not imply that governments should intervene. The relevant questions are whether we identify market failures; whether governments can improve the outcome (or whether they introduce additional failures); and whether it’s worth it. And this must be asked against the background that some of the trends described before may reverse sooner than later. For example, aggregate savings propensities are likely to fall when baby boomers start to dis-save, and Chinese savings have started to ebb.

More specifically, the Japanese approach over the last decades strikes me as following the third, stimulus strategy favored by Summers rather than the first, wait and see strategy that he dislikes. So we should discount this argument. (In any case, Japan might be a bad example since its per capita growth is not that low.) I agree that I don’t see much scope on the monetary policy side. Monetary policy also has the problem that interest rate changes have income in addition to substitution effects, and that it has lost effectiveness, both fundamentally and in terms of public perceptions. I believe that our views on monetary policy transmission will dramatically change in the next ten years (think for example about the discussion on Neo-Fisherianism). The interesting thing about Summers’ third, stimulus strategy is that it is much less demand focused than conventional wisdom would have it (think of regulation and taxes and confidence to some extent as well).

Finally, the argument for public investment as the instrument of choice is much weaker than Summers suggests. One can think of a situation where private investment is held back for various reasons and as a consequence, interest rates are low and public investment is “cheap.” Nevertheless, the optimal policy response need not be to invest; it could be preferable to eliminate the friction on private investment. For example, with excessively tight borrowing constraints, tax cuts for private investors could be appropriate. If we believe that demographics is the problem then investment could be counter productive as well (dynamic inefficiency in the OLG context). And public investment as an instrument for stimulus is problematic for politico-economic reasons. Low interest rates do not imply that debt is “for free.” It indicates that the supply of risk-free savings is ample, for example because markets are very concerned about tail risks.


Lawrence H. Summers (2014), “U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound,” Business Economics 49(2), 65—73.


Young Men in the US Work Fewer Hours

More discussion about falling employment of young men in the US:

  • John Rust publicizes the facts in a speech: Unskilled young men spend more time playing video games and less time in the labor market. “In 2015, 22 percent of lower-skilled men aged 21–30 had not worked at all during the prior 12 months.” They live in the basement of their parents’ houses and are not married. (And on his 12-year old son: “If we didn’t ration video games, I am not sure he would ever eat. I am positive he wouldn’t shower.)
  • Jason Richwine argues that the trend is restricted to natives as opposed to immigrants.
  • A critical assessment on We the Pleeple.

One of the first to point to the phenomenon was Bob Hall, for example at the 2015 ASSA meetings in Boston.

Have Banks Become Less Risky?

In BPEA, Natasha Sarin and Larry Summers argue that bank stock has not:

… we find that financial market information provides little support for the view that major institutions are significantly safer than they were before the crisis and some support for the notion that risks have actually increased. …

… financial markets may have underestimated risk prior to the crisis … Yet we believe that the main reason for our findings is that regulatory measures that have increased safety have been offset by a dramatic decline in the franchise value of major financial institutions, caused at least in part by these new regulations.

This table is taken from their paper:


However, their finding need not be as bad as it sounds. After all, bank regulators intended to insulate taxpayers against bank failure and to render the financial system more shock proof, not bank equity.

Redistribution From Unexpected Deflation in the Euro Area

In the JEEA 14(4) (August 2016) Klaus Adam and Junyi Zhu argue that

unexpected price-level movements generate sizable wealth redistribution in the Euro Area (EA) … The EA as a whole is a net loser of unexpected price-level decreases, with Italy, Greece, Portugal, and Spain losing most in per capita terms, and Belgium and Malta being net winners. Governments are net losers of deflation, while the household (HH) sector is a net winner … HHs in Belgium, Ireland, Malta, and Germany experience the biggest per capita gains, while HHs in Finland and Spain turn out to be net losers. … relatively young middle class HHs are net losers of deflation, while older and richer HHs are winners. … wealth inequality in the EA increases with unexpected deflation, although in some countries (Austria, Germany, and Malta) inequality decreases due to the presence of relatively few young borrowing HHs. … HHs in high-inflation EA countries hold… systematically lower nominal exposures.

The table reports the estimated effects of a one-time unexpected change in the general price level by 10% (expressed either in thousand EUR per capita, or as a share of GDP); a positive sign indicates a gain from deflation.

(1000 EUR p.c.)
(1000 EUR p.c.)
(1000 EUR p.c.)
(share of GDP)
(share of GDP)
(share of GDP)
Euro Area−18.67.810.8−0.730.300.42

Dynamics of the World Income Distribution

In a Resolution Foundation report, Adam Corlett examines the “Elephant Curve.” The curve shows that between 1988 and 2008 income growth in the 70th to 95th percentile range of the world income distribution was much lower than for almost all other percentiles. Since the lower middle class of rich countries is situated around the 80th percentile of the distribution the Elephant curve has been interpreted as evidence for stagnating middle class incomes in the rich countries.

Corlett emphasizes that

  • the country composition in 1988 and 2008 is not the same. Holding it constant the Elephant curve is less pronounced.
  • “Population changes, rather than just income changes, have driven the income growth distribution in the elephant curve.” Holding the relative population size across countries constant the Elephant curve is less pronounced.
  • There is lots of variation across developed economies. “[T]he weak figures for the mature economies as a whole are driven by Japan (reflecting in part its two ‘lost decades’ of growth post-bubble, but primarily due to likely flawed data) and by Eastern European states (with large falls in incomes following the collapse of the Soviet Union after 1988). Looking only at the remaining mature economies, far from stagnation we find average real income growth of 52 per cent with strong growth across the distribution, though slightly higher at the top. [But] there are great differences between these nations. US growth of 41 per cent was notably unequally shared, with low (but not zero) growth for poorer deciles meaning that the US comes closest to matching the stagnation and inequality narrative – despite international trade being much less important on a national level there than elsewhere [my emphasis]. But most people in most other rich countries experienced stronger growth.”

Negative Interest Rates vs. Higher Inflation

On his blog, Ben Bernanke weighs the pros and cons of negative (nominal) interest rates vs. a higher inflation target to create monetary “policy space.” His main points are:

  • Lower rates work immediately. In contrast, a higher inflation target only works once agents’ expectations adjust. A higher target may not be politically tenable a thus, not be credible. In contrast, “institutional changes … [such] as eliminating or restricting the issuance of large-denomination currency, could expand the scope for negative rates.”
  • Both negative rates and higher inflation have negative side effects. But the side effects of negative rates would materialize only during bad recessions.
  • There are reasons to expect that higher inflation would impose a relatively larger burden on the “poor” while negative interest rates would impose a relatively larger burden on the “rich.”
  • The political risks for the Fed associated with a higher inflation target may be substantial.

Monetary Policy When Interest Rates are Near Zero

In the 18th Geneva Report on the World Economy, Laurence Ball, Joseph Gagnon, Patrick Honohan and Signe Krogstrup ask whether “central banks can do [more] to provide stimulus when rates are near zero; and … whether policies exist that would lessen future constraints from the lower bound.”

They are optimistic and argue that the unconventional policies of recent years can be extended: “[I]t is likely that rates could go somewhat further than what has been done so far without adverse consequences” and “[m]ore stimulus can be provided if policymakers increase the scale of quantitative easing, and if they expand the range of assets they purchase to include risky assets such as equity.” While the authors concede that QE might have negative side effects they argue that the benefits are worth the costs.

To relax the zero lower bound constraint in the future, Ball, Gagnon, Honohan and Krogstrup argue in favor of a higher inflation target. They view cashless societies as not imminent but possible.

How Does the Blockchain Transform Central Banking?

The blockchain technology opens up new possibilities for financial market participants. It allows to get rid of middle men and thus, to save cost, speed up clearing and settlement (possibly lowering capital requirements), protect privacy, avoid operational risks and improve the bargaining position of customers.

Internet based technologies have rendered it cheap to collect information and to network. This lies at the foundation of business models in the “sharing economy.” It also lets fintech companies seize intermediation business from banks and degrade them to utilities, now that the financial crisis has severely damaged banks’ reputation. But both fintech and sharing-economy companies continue to manage information centrally.

The blockchain technology undermines the middle-men business model. It renders cheating in transactions much harder and thereby reduces the value of credibility lent by middle men. The fact that counter parties do not know and trust each other becomes less of an impediment to trade.

The blockchain may lend credibility to a plethora of transactions, including payments denominated in traditional fiat monies like the US dollar or virtual krypto currencies like Bitcoin. An advantage of krypto currencies over traditional currencies concerns the commitment power lent by “smart contracts.” Unlike the money supply of fiat monies that hinges on discretionary decisions by monetary policy makers, the supply of krypto currencies can in principle be insulated against human interference ex post and at the same time conditioned on arbitrary verifiable outcomes (if done properly). This opens the way for resolving commitment problems in monetary economics. (Currently, however, most krypto currencies do not exploit this opportunity; they allow ex post interference by a “monetary policy committee.”) A disadvantage of krypto currencies concerns their limited liquidity and thus, exchange rate variability relative to traditional currencies if only few transactions are conducted using the krypto currency.

Whether blockchain payments are denominated in traditional fiat monies or krypto currencies, they are always of relevance for central banks. Transactions denominated in a krypto currency affect the central bank in similar ways as US dollar transactions, say, affect the monetary authority in a dollarized economy: The central bank looses control over the money supply, and its power to intervene as lender of last resort may be diminished as well. The underlying causes for the crowding out of the legal tender also are familiar from dollarization episodes: Loss of trust in the central bank and the stability of the legal tender, or a desire of the transacting parties to hide their identity if the central bank can monitor payments in the domestic currency but not otherwise.

Blockchain facilitated transactions denominated in domestic currency have the potential to affect central bank operations much more directly. To leverage the efficiency of domestic currency denominated blockchain transactions between financial institutions it is in the interest of banks to have the central bank on board: The domestic currency denominated krypto currency should ideally be base money or a perfect substitute to it, directly exchangeable against central bank reserves. For when perfect substitutability is not guaranteed then the payment associated with the transaction eventually requires clearing through the traditional central bank managed clearing mechanism and as a consequence, the gain in speed and efficiency is relinquished. Of course, building an interface between the blockchain and the central bank’s clearing system could constitute a first step towards completely dismantling the latter and shifting all central bank managed clearing to the former.

Why would central banks want to join forces? If they don’t, they risk being cut out from transactions denominated in domestic currency and to end up monitoring only a fraction of the clearing between market participants. Central banks are under pressure to keep “their” currencies attractive. For the same reason (as well as for others), I propose “Reserves for All”—letting the general public and not only banks access central bank reserves (here, here, here, and here).

Banking on the Blockchain

In the NZZ, Axel Lehmann offers his views on the prospects of blockchain technologies in banking. Lehmann is Group Chief Operating Officer of UBS Group AG.

New possibilities:

  • Higher efficiency; lower cost; more robustness and simpler processes; real-time clearing;
  • no need for intermediaries; information exchange without risk of interference
  • automated “smart contracts;” automated wealth management;
  • more control over transactions; better data protection;
  • improved possibilities for macro prudential monitoring.


  • Speed; scalability; security;
  • privacy;
  • smart contracts require new contract law;
  • interface between traditional payments system and blockchain payment system.

Lehmann favors common standards and he points out that this is what is happening (R3-consortium with UBS, Hyperledger project with Linux foundation).

Related, Martin Arnold reported in the FT in late August that UBS, Deutsche Bank, Santander, BNY Mellon as well as the broker ICAP pursue the project of a “utility settlement coin.” Here is my reading of what this is:

  • The aim seems to be to have central banks on board; so USCs might be a form of reserves (base money). The difference to traditional reserves would be that USCs facilitate transactions using distributed ledgers rather than traditional clearing and settlement mechanisms. (This leads to the question of the appropriate interface between the two systems posed by Lehmann.)

But what’s in for central banks? Would this be a test before the whole clearing and settlement system is revamped, based on new blockchain technology? Don’t central banks fear that transactions on distributed ledgers might foster anonymity?

Chile’s Fully Funded Pension System

On Project Syndicate, Andres Velasco argues that one of the sources of the current problems with the Chilean pension system are the high fees charged by fund managers:

A government-appointed commission recently concluded that managers have generated high gross real returns on investments: from 1981 to 2013, the annual average was 8.6%; but high fees cut net returns to savers to around 3% per year over that period.

The commission’s report.

Should the Fed Reduce the Size of its Balance Sheet?

On his blog, Ben Bernanke discusses the merits of the Fed’s strategy to slowly reduce the size of its balance sheet to pre crisis levels. Bernanke (with reference to a paper by Robin Greenwood, Samuel Hanson and Jeremy Stein) suggests that this strategy should be reconsidered:

First, the large balance sheet provides lots of safe and liquid assets for financial markets. This might strengthen financial stability. (DN: In my view, there are also reasons to expect the opposite.)

Second, a larger balance sheet can help improve the workings of the monetary transmission mechanism, in particular if non-banks can deposit funds at the Fed. Currently, the Fed accepts funds from private-sector institutional lenders such as money market funds, through the overnight reverse repurchase program (RRP). (DN: I agree. As I have argued elsewhere, access to central bank balance sheets should be broadened.)

Third, with a large balance sheet and thus, large bank reserve holdings to start with, it could be easier to avoid “stigma” in the next financial crisis when banks need to borrow cash from the Fed but prefer not to in order not to signal weakness. (DN: Like the first, this third argument emphasizes banks’ needs. In my view, monetary policy should not emphasize these needs too much because it is far from clear whether bank incentives are sufficiently aligned with the interests of society at large.)

Bernanke also discusses the reasons why the Fed does want to reduce the balance sheet size.

First, in a financial panic, programs like the RRP could result in market participants depositing more and more funds at the Fed until the interbank market would be drained of liquidity. But these programs could be capped.

Second, a large balance sheet increases the risk of large fiscal losses for the Fed and thus, the public sector. Losses could trigger a legislative response and undermine the Fed’s policy independence. But these risks could be kept in check if the Fed invested in government paper that constitutes a close substitute to cash, such as three year government debt. (DN: But why, then, shouldn’t financial market participants hold three year government debt rather than reserves at the Fed? Because cash is much more liquid than government debt … But what does this mean?)

Investment Lessons

In the FT, looking back at ten years of The Long View, John Authers offers investment lessons that may be summarized in five points:

  • Always worry about costs and don’t try to outsmart the market. That is, hold index funds.
  • Rebalancing pays off.
  • Since getting the timing right is very hard, being out of the market is as risky as being in it.
  • To beat the market, buying at low prices is key. But know what you know and what you don’t. Public markets are efficient.
  • Money isn’t everything; in fact it’s not among the things that really matter.

Developing Countries Issue Sovereign Debt (Lots of)

In the FT, Elaine Moore reports that “[d]eveloping economies are on course to raise a record sum on global debt markets this year, as ultra-low rates in the developed world cheapen borrowing costs for countries from Asia to South America.” By the end of the year, hard currency debt sales by countries such as Mexico, Quatar, Saudi Arabia and Argentina are expected to reach USD 125 billion.

“Fiscal Federalism, Taxation and Grants,” CEPR, 2016

CEPR Discussion Paper 11482, August 2016, with Martin Gonzalez-Eiras. PDF. Also published as CESifo Working Paper 6062, Study Center Gerzensee Working Paper 16-05. PDFPDF.

We propose a theory of tax centralization and inter governmental grants in politico-economic equilibrium. The cost of taxation differs across levels of government because voters internalize general equilibrium effects at the central but not at the local level. This renders the degree of tax centralization and the tax burden determinate even if none of the traditional, expenditure-related motives for centralization considered in the fiscal federalism literature is present. If central and local spending are complements and the trade-off between the cost of taxation and the benefit of spending is perceived differently across levels of government, inter governmental grants become relevant. Calibrated to U.S. data, our model helps to explain the introduction of federal grants at the time of the New Deal, and their increase up to the turn of the twenty-first century. Grants are predicted to increase to approximately 5.5% of GDP by 2060.