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SNB Profit Distributions

The Federal Department of Finance and the SNB have agreed on a new scheme for the distribution of SNB profits. Agreement for the period 2020-2025, Explanations. Some comments in German (also available as PDF):

Profitieren Bund und Kantone finanziell von den höheren SNB-Ausschüttungen?

  • Höhere Gewinnausschüttungen in der Gegenwart bedingen tiefere in der Zukunft.
  • In erster Näherung bleibt das Nettovermögen von Bund und Kantonen unverändert, denn es berücksichtigt auch den Wert der zukünftigen Ansprüche gegenüber der SNB.
  • Siehe z.B. „Die Volkswirtschaft“ 8-9 2020, HTML.

Warum dann die positiven Reaktionen bei Vertretern von Bund und Kantonen?

  • Politiker/Wähler orientieren sich an den ausgewiesenen Schulden des Staates. Höhere Ausschüttungen ermöglichen eine tiefere Schuldenaufnahme. Daher die Reaktionen.
  • Relevanter als ausgewiesene Schulden ist das Nettovermögen. Dieses wird von Ausschüttungen (in erster Näherung) nicht beeinflusst.

Was ist die primäre Wirkung höherer Ausschüttungen?

  • Die Schuldenbremse wird in der Gegenwart gelockert und in der Zukunft angezogen.
  • Falls die Schuldenbremse bindet, erhöhen frühere, höhere Ausschüttungen den Spielraum für staatliche Ausgaben in der Gegenwart, aber nicht in der Zukunft.
  • Hohe Ausschüttungen könnten über ihre Wirkung auf das Eigenkapital der SNB auch deren geldpolitische Entscheide beeinflussen.

Wie ist die neue Gewinnausschüttungsformel ökonomisch zu bewerten?

  • Ausschüttungen sollten die Geldpolitik nicht konterkarieren.
  • Die Geldpolitik setzt Bilanzlänge und -struktur der SNB als Instrumente ein. Ihre Glaubwürdigkeit kann vom Eigenkapital der SNB abhängen.
  • Demnach müssten Ausschüttungen von Bilanzlänge, -struktur und Eigenkapital der SNB abhängen. Nicht vom Gewinn des Vorjahres.

Wie ist die neue Gewinnausschüttungsformel politökonomisch zu bewerten?

  • Problematisch ist, dass der Eindruck entstehen kann, alle paar Jahre würde unter politischem Druck um eine neue Formel gefeilscht. Die Bindung an eine sinnvolle Regel würde diesem Eindruck entgegenwirken.
  • Gleichzeitig reduziert die neue Formel den politischen Druck. Sie signalisiert die Bereitschaft der SNB zur Diskussion.

Wie könnte ein alternatives Ausschüttungsmodell aussehen?

  • Die SNB erklärt periodisch, welche Bilanzlänge und -struktur sie zur Erfüllung ihrer Aufgaben benötigt. Sie stellt sich der Kritik, entscheidet aber eigenverantwortlich.
  • Ausschüttungen sind nicht zweckgebunden. Dadurch wird vermieden, dass sich Interessengruppen bilden, die systematisch auf höhere Ausschüttungen drängen.

Welches Grundproblem bliebe bestehen?

  • Eine ökonomisch begründete Ausschüttungspolitik führt zu fluktuierenden Ausschüttungen. Diese können die Schuldenbremse konterkarieren.
  • Glättet die SNB hingegen ohne geldpolitische Notwendigkeit ihre Ausschüttungen, masst sie sich eine Kontrolle der Fiskalpolitik an, die ausserhalb ihres Aufgabenbereichs liegt.

Reading List on ‘Free’ or ‘Not-so-free’ Public Debt

Risk, Discounting, and Dynamic Efficiency

In the presence of risk, a comparison of the risk-free interest rate and the expected growth rate is insufficient to assess whether an economy is dynamically efficient or inefficient. Stochastic discount factors—not risk-free interest rates—enter the government’s budget constraint, even if debt is safe.

These points are made, for example, by Andrew Abel, N. Gregory Mankiw, Lawrence Summers, and Richard Zeckhauser (Assessing Dynamic Efficiency: Theory and Evidence, REStud 56(1), 1989),

the issue of dynamic efficiency can be resolved by comparing the level of investment with the cash flows generated by production after the payment of wages … dynamic efficiency cannot be assessed by comparing the safe rate of interest and the average growth rate of the capital stock, output, or any other accounting aggregate,

or Henning Bohn (The Sustainability of Budget Deficits in a Stochastic Economy, JMCB 27(1), 1995),

discounting at the safe interest rate is usually incorrect. … popular fiscal policy “indicators” like deficit levels or debt-GNP ratios may provide very little information about sustainability. … the intertemporal budget constraint imposes very few restrictions on the average primary balance.

Recent work in which these themes appear include papers by Zhengyang Jiang, Hanno Lustig, Stijn Van Nieuwerburgh, and Mindy Xiaolan (Manufacturing Risk-free Government Debt, NBER wp 27786, 2020), Robert Barro (r Minus g, NBER wp 28002, 2020), or Stan Olijslagers, Nander de Vette, and Sweder van Wijnbergen (Debt Sustainability when r−g<0: No Free Lunch after All, CEPR dp 15478, 2020).

Intergenerational Risk Sharing

With overlapping generations the way the government manages its debt has implications for intergenerational risk sharing, see for example Henning Bohn (Risk Sharing in a Stochastic Overlapping Generations Economy, mimeo, 1998), Robert Shiller (Social Security and Institutions for Intergenerational, Intragenerational, and International Risk Sharing, Carnegie-Rochester Conference on Public Policy 50, 1999), or Gabrielle Demange (On Optimality of Intergenerational Risk Sharing, Economic Theory 20(1), 2002).

Long-Run Debt Dynamics and Fiscal Space

Dmitriy Sergeyev and Neil Mehrotra (Debt Sustainability in a Low Interest World, CEPR dp 15282, 2020) offer an analysis of long-run debt dynamics under the assumption that the primary surplus systematically, and strongly responds to the debt-to-GDP ratio such that the government’s intertemporal budget constraint is necessarily satisfied:

Population growth and productivity growth have opposing effects on the debt-to-GDP ratio due to their opposing effects on the real interest rate. Lower population growth leaves the borrowing rate unchanged while directly lowering output growth, shifting the average debt-to-GDP ratio higher. By contrast, when the elasticity of intertemporal substitution is less than one, a decline in productivity growth has a more than a one-for-one effect on the real interest rate, lowering the cost of servicing the debt and thereby reducing the average debt-to-GDP ratio. To the extent that higher uncertainty accounts for low real interest rates, we find that
the variance of the log debt-to-GDP ratio unambiguously increases with higher output
uncertainty. However, uncertainty also has an effect on the mean debt-to-GDP ratio that
depends on the coefficient of relative risk aversion. Higher uncertainty lowers the real
interest rate but this effect may be outweighed by an Ito’s lemma term due to Jensen’s
inequality that works in the opposite direction.

Sergeyev and Mehrotra also consider the effects of rare disasters as well as of a maximum primary surplus which implies that debt becomes defaultable and the interest rate on debt features an endogenous risk premium, generating the possibility of a “tipping point” with a slow moving debt crises as in Guido Lorenzoni and Ivan Werning (Slow Moving Debt Crises, AER 109(9), 2019).

Ricardo Reis (The Constraint on Public Debt when r<g But g<m, mimeo, 2020) analyzes a non-stochastic framework under the assumption that the marginal product of capital, m, exceeds the growth rate, g, which in turn exceeds the risk-free interest rate, r. Reis considers the case where m is the relevant discount rate, for example because r features a liquidity premium:

there is still a meaningful government budget constraint once future surpluses and debt are discounted by the marginal product of capital.

He shows the following:

  • The debt due to a one-time primary deficit can be rolled over indefinitely and disappears asymptotically as long as r<g.
  • With permanent primary deficits that grow at the same rate as debt and output, the government’s intertemporal budget constraint features a bubble component due to r<m. This corresponds to the usual seignorage revenue measure (see p. 173 in Niepelt, Macroeconomic Analysis, 2019).
  • Suppose that from tomorrow on, the primary deficit and debt quotas are given by d and b, respectively. Then, the present value of total net revenues in the government’s budget constraint equals [- d + (m – r)*b] / (m-g). Both m>g and g>r relax the constraint, as does a lower r.
  • Along a balanced growth path, b = [- d + (m – r)*b] / (m-g) and thus, d = (g-r)*b where d is assumed to be positive. Reis argues that b cannot be larger than total assets relative to GDP. Accordingly, the deficit cannot exceed total assets times (g-r).

Reis concludes that most of the bubble component “has already been used.” In addition to developing a model that yields m>g>r in equilibrium he also discusses the role of inflation (stable inflation generates fiscal space because it renders debt safer and thus increases demand for debt) and inequality (more inequality increases fiscal space).

Blanchard’s Presidential Address

In his presidential address, Olivier Blanchard (Public Debt and Low Interest Rates, AER 109(4), 2019) argues that the risk-free interest rate has fallen short of average US growth rate (and similarly, in other countries). Importantly—and implicitly addressing Abel, Mankiw, Summers, Zeckhauser, and Bohn (see above)—he also argues that risk is not that much of an issue as far as the sustainability of public debt is concerned:

Jensen’s inequality is thus not an issue here. In short, if we assume that the future will be like the past (admittedly a big if), debt rollovers appear feasible. While the debt ratio may increase for some time due to adverse shocks to growth or positive shocks to the interest rate, it will eventually decrease over time. In other words, higher debt may not imply a higher fiscal cost.

Most of his formal analysis doesn’t focus on debt though. Instead he analyzes the effects of risk-free social security transfers from young to old in a stochastic OLG economy. (There are close parallels between debt and such transfers to the old that are financed by contemporaneous taxes on the young.) In a steady-state with very low interest rates higher transfers have two effects on welfare, by (i) providing an attractive substitute for savings and by (ii) reducing capital accumulation and thereby lowering wages and raising the interest rate. If the economy initially is dynamically inefficient both effects are welfare improving because (i) capital accumulation with a low return is replaced by higher yielding intergenerational transfers and (ii) lower wages and higher interest rates are attractive, starting from a situation with a low interest rate. In a stochastic economy the first channel yields welfare gains as long as the growth rate exceeds the risk-free rate, and the second channel yields welfare gains (approximately) when the growth rate exceeds the marginal product of capital. Blanchard argues

[b]e this as it may, the analysis suggests that the welfare effects of a transfer may not necessarily be adverse, or, if adverse, may not be very large.

In the corresponding case with debt there is another effect because the intergenerational transfer is not risk-free; the size of this additional effect depends on the path of the risk-free interest rates (Blanchard assumes that the debt level is stabilized which requires net tax payments by the young to reflect the contemporaneous risk-free rate). In the slightly different case where debt is increased once and then rolled over, without adjusting taxes in the future, the sustainability and welfare implications are ambiguous and critically depend on the production function:

In the linear case, debt rollovers typically do not fail [my emphasis] and welfare is increased throughout. For the generation receiving the initial transfer associated with debt issuance, the effect is clearly positive and large. For later generations, while they are, at the margin, indifferent between holding safe debt or risky capital, the inframarginal gains (from a less risky portfolio) imply slightly larger utility. But the welfare gain is small … . In the Cobb-Douglas case however, this positive effect is more than offset by the price effect, and while welfare still goes up for the first generation (by 2 percent), it is typically negative thereafter. In the case of successful debt rollovers, the average adverse welfare cost decreases as debt decreases over time. In the case of unsuccessful rollovers, the adjustment implies a larger welfare loss when it happens. If we take the Cobb-Douglas example to be more representative, are these Ponzi gambles, as Ball, Elmendorf, and Mankiw (1998) have called them, worth it from a welfare viewpoint? This clearly depends on the relative weight the policymaker puts on the utility of different generations [my emphasis].

Blanchard argues that the marginal product of capital may be smaller than commonly assumed, implying that it is more likely that the welfare effects working through (ii) are positive (those working through (i) are very likely positive). Finally, he also presents some additional potential arguments pro and con higher public debt.

Blanchard’s work has attracted substantial criticism, for instance at the January 2020 ASSA meetings (see this previous post). In a short paper presented at the meetings, Johannes Brumm, Laurence Kotlikoff, and Felix Kubler (Leveraging Posterity’s Prosperity?) point out that a negative difference between average interest and growth rates is not necessarily indicative of dynamic inefficiency (see the discussion above) and that Blanchard’s analysis disregards tax distortions as well as the welfare effects from intergenerational risk sharing (again, see above):

To see the distinction between risk-sharing and a Ponzi scheme, modify B’s two-period model to include agents working when old if they don’t randomly become disabled. Now workers face second-period asset income and labor earnings risk. The government has no safe asset in which to invest. If it borrows, invests in capital, and taxes bond holders its excess return, “safe” debt is identical to risky capital. But if the net taxes are only levied on the non-disabled, bonds become a valued risk-mitigating asset and their return can be driven far below zero. This scheme could be, and to some extend it is, implemented through progressive taxation. If, observing this gap between growth and safe rates, the government decides to institute an “efficient” Ponzi scheme with a fixed pension benefit financed on a pay-go basis by taxes on workers, net wages when young will be more variable, raising generation-specific risk and potentially producing an outcome in which no generation is better off and at least one is worse off.

Brumm, Kotlikoff, and Kubler also note that the effective interest rate at which US households are borrowing is much higher than the borrowing rate of the government; this undermines Blanchard’s approach to gauge the welfare implications. And they point out that the scheme suggested by Blanchard could harm other countries by reducing global investment.

Jasmina Hasanhodzic (Simulating the Blanchard Conjecture in a Multi-Period Life-Cycle Model) simulates a richer OLG model and rejects the Blanchard conjecture of Pareto gains due to higher transfers:

It shows that the safe rate on government debt can, on average, be far less than the economy’s growth rate without its implying that ongoing redistribution from the young to the old is Pareto improving. Indeed, in a 10-period, OLG, CGE model, whose average safe rate averages negative 2 percent on an annual basis, welfare losses to future generations resulting from the introduction of pay-go Social Security, financed with a 15 percent payroll tax, are enormous—roughly 20 percent measured as a compensating variation relative to no policy.

Relative to Blanchard’s simulations, her model implies more negative consequences of crowding out on wages, a higher tax burden from the transfer scheme, and more induced old-age consumption risk.

Michael Boskin (How, When and Why Deficits Are Dangerous) offers a broad discussion of potential weaknesses of Blanchard’s analysis. Richard Evens (Public Debt, Interest Rates, and Negative Shocks) questions Blanchard’s simulations on calibration grounds and notes that he couldn’t replicate some of Blanchard’s findings.

On his blog, John Cochrane argues along similar lines as Ricardo Reis: Even if r<g, expected primary deficits are so large that debt quotas will explode nevertheless.

Note: This post was updated several times.

Robert Pirsig’s “Zen and the Art of Motorcycle Maintenance: An Inquiry Into Values”

Quality, not subject or object, as the elementary fabric. ἀρετή. A rehabilitation of the sophists.

Some quotes:

If the purpose of scientific method is to select from among a multitude of hypotheses, and if the number of hypotheses grows faster than experimental method can handle, then it is clear that all hypotheses can never be tested. If all hypotheses cannot be tested, then the results of any experiment are inconclusive and the entire scientific method falls short of its goal of establishing proven knowledge. …

God, I don’t want to have any more enthusiasm for big programs full of social planning for big masses of people that leave individual Quality out. These can be left alone for a while. There’s a place for them but they’ve got to be built on a foundation of Quality within the individuals involved. We’ve had that individual quality in the past, exploited as a natural resource without knowing it, and now it’s just about depleted. Everyone’s just about out if gumption. And I think it’s about time to return the rebuilding of this American resource – individual worth. There are political reactionaries who’ve been saying something close to this for years. I’m not one of them, but to the extent they’re talking about real individual worth and not just an excuse for giving more money to the rich, they’re right. We do need a return to individual integrity, self-reliance and old-fashioned gumption. We really do. …

What is good, Phaedrus, and what is not good – need we ask anyone to tell us these things?

Anthony McWatt’s discussion of Pirsig’s philosophy in Philosophy Now:

In Zen & the Art of Motorcycle Maintenance, Pirsig first explored the history of the term ‘Quality’, or what the Ancient Greeks called arête, tracing it all the way back to Plato (428-348 BCE). He concluded that the strange position of Quality in today’s West originated with Plato’s division of the human soul into its reason and emotion aspects, in his dialogue the Phaedrus. In this dialogue, Plato gave primary place to reason over emotion. Soon afterwards Aristotle was similarily emphasizing analysis over rhetoric. And as Hugh Lawson-Tancred confirms in the Introduction to his 1991 translation of Aristotle’s Rhetoric: “There are few things that are more to be deplored in Greek culture, and notably in the legacy of Plato, than the wholly forced and unnatural division between… [the] two sister studies” of rhetoric and philosophy (p.57). Eventually this division grew into the ‘subjective versus objective’ way of thinking now largely dominant in the West. So now in the West we have objectivity, reason, logic, and dialectic on the one hand; and subjectivity, emotion, imagination, intuition, and rhetoric on the other. The former terms suggest scientific respectability, while the latter are often assumed to be artistic terms, having little place in science or rationality. It is this Platonic conception of rationality that Pirsig sought to challenge by reconciling the spiritual (for example, Zen), artistic (for example, art) and scientific (for example, motorcycle maintenance) realms within the unifying paradigm of the Metaphysics of Quality. …

Plato was perhaps a little too over-confident in how usable his theory of Forms is in practice. I wonder if it ever crossed his mind that his mentor, Socrates, might have been hinting to him and the other young philosophy students in Athens that the Good and Beauty are actually indefinable? The idea of Forms was, of course, invented by Plato, not Socrates. Unfortunately, as a consequence of Plato’s thinking that reality can be basically defined, Western philosophy is in the state that it is in today: more a handmaiden of science rather than its master. Assuming that words can capture all aspects of reality is an understandable error to make at the very beginning of the Western philosophical tradition… but having said that, it was a metaphysical error avoided by East Asian philosophy. Think about Plato’s allegory of the Cave of Ignorance and escaping from it to see the Sun of the Good, then compare it with the following quote:

“Not by its rising is there light,
Not by its sinking is there darkness
Unceasing, continuous
It cannot be defined…
The image of no-thingness…
Meet it and you do not see its face
Follow it and you do not see its back.”

Dao De Jing, Laozi, Quoted in ZMM, p.253-54

If you think about it long enough, then you’ll see that there was no ‘Cave of Ignorance’ until Plato put Western culture inside its metaphysical darkness for 2,400 years!

Obituary by Paul Vitello in the New York Times:

One of Mr. Pirsig’s central ideas is that so-called ordinary experience and so-called transcendent experience are actually one and the same — and that Westerners only imagine them as separate realms because Plato, Aristotle and other early philosophers came to believe that they were.

But Plato and Aristotle were wrong, Mr. Pirsig said. Worse, the mind-body dualism, soldered into Western consciousness by the Greeks, fomented a kind of civil war of the mind — stripping rationality of its spiritual underpinnings and spirituality of its reason, and casting each into false conflict with the other.

Obituary by Michael Carlson in The Guardian.

Edward Snowden’s “Permanent Record”

An intriguing description of America’s intelligence community and the industry surrounding it; the slippery slopes; and Snowden’s motivation for following his conscience rather than the money. From the book, how we got here:

[After 9/11] [n]early a hundred thousand spies returned to work at the agencies with the knowledge that they’d failed at their primary job, which was protecting America. …

In retrospect, my country … could have used this rare moment of solidarity to reinforce democratic values and cultivate resilience in the now-connected global public. Instead, it went to war. The greatest regret of my life is my reflexive, unquestioning support for that decision. I was outraged, yes, but that was only the beginning of a process in which my heart completely defeated my rational judgment. I accepted all the claims retailed by the media as facts, and I repeated them as if I were being paid for it. … I embraced the truth constructed for the good of the state, which in my passion I confused with the good of the country.

And what to make of it:

Ultimately, saying that you don’t care about privacy because you have nothing to hide is no different from saying you don’t care about freedom of speech because you have nothing to say. Or that you don’t care about freedom of the press because you don’t like to read. … Just because this or that freedom might not have meaning to you today doesn’t mean that it doesn’t or won’t have meaning tomorrow, to you, or to your neighbor – or to the crowds of principled dissidents I was following on my phone who were protesting halfway across the planet, hoping to gain just a fraction of the freedom that my country was busily dismantling. …

Any elected government that relies on surveillance to maintain control of a citizenry that regards surveillance as anathema to democracy has effectively ceased to be a democracy.

Buy the book from a key contractor of the intelligence community. Reviews on goodreads. Youtube video of the 2013 presentation by CIA CTO Gus Hunt which Snowden discusses in the book.

Jack Kerouac’s “On the Road”

280 pages of frantic search for an end. New York, Denver, San Francisco, New Orleans, Mexico City, and the miles in between. Music, drugs, talk, sex.


Inspired by a 10000-word rambling letter from his friend Neal Cassady, Kerouac in 1950 outlined the “Essentials of Spontaneous Prose” and decided to tell the story of his years on the road with Cassady as if writing a letter to a friend in a form that reflected the improvisational fluidity of jazz. In a letter to a student in 1961, Kerouac wrote: “Dean and I were embarked on a journey through post-Whitman America to find that America and to find the inherent goodness in American man. It was really a story about 2 Catholic buddies roaming the country in search of God. And we found him.”

Arnold Kling’s “Specialization and Trade, A Re-Introduction to Economics”

Arnold Kling (2016), Specialization and Trade, A Re-Introduction to Economics, Washington, DC, Cato Institute.

Kling’s central theme in this short book of nine main chapters is that specialization, trade, and the coordination of individual plans by means of the price system and the profit motive play fundamental roles in modern economies. Most mainstream economists would agree with this assessment. Their models of trade, growth, and innovation certainly include the four elements, with varying emphasis.

But Kling criticizes the methodological approach adopted by post-world-war-II economics, which he associates with “MIT economics.” An MIT PhD himself, he argues that economics, and specifically macroeconomics, should adopt less of a mechanistic and more of an evolutionary perspective to gain relevance. In the second chapter, entitled “Machine as Metaphor,” Kling asserts that under the leadership of Paul Samuelson post-war (macro)economics framed economic issues as programming problems that resemble resource allocation problems in a wartime economy. Even as the discipline evolved, Kling contends, the methodology remained the same, pretending controllability by economist-engineers; in the process, the role of specialization was sidelined in the analysis.

I think that Kling is too harsh in his assessment. Economics and macroeconomics, in particular, has changed dramatically since the times of Paul Samuelson. The notion that, given enough instruments, any economic problem can be solved as easily as a system of equations, has lost attraction. Modern macroeconomic models are based on microeconomic primitives; they take gains from trade seriously; they involve expectations and frictions; and they do not suggest easy answers. The task of modern macroeconomics is not to spit out a roadmap for the economist-engineer but to understand mechanisms and identify problems that arise from misaligned incentives.

Kling is right, of course, when he argues that many theoretical models are too simplistic to be taken at face value. But this is not a critique against economic research which must focus and abstract in order to clarify. It rather is a critique against professional policy advisors and forecasters, “economic experts” say. These “experts” face the difficult task of surveying the vast variety of mechanisms identified by academic research and to apply judgement when weighing their relevance for a particular real-world setting. To be useful, “experts” must not rely on a single framework and extrapolation. Instead, they must base their analysis on a wide set of frameworks to gain independent perspectives on a question of interest.

In chapters three to five, Kling discusses in more detail the interplay of myriads of specialized trading partners in a market economy and how prices and the profit motive orchestrate it. In the chapter entitled “Instructions and Incentives,” Kling emphasizes that prices signal scarcity and opportunity costs are subjective. In the chapter entitled “Choices and Commands,” he discusses that command-and-control approaches to organizing a society face information, incentive, and innovation problems, unlike approaches that rely on a functioning price mechanism. And in the chapter “Specialization and Sustainability,” Kling makes the point that well-defined property rights and a functioning price mechanism offer the best possible protection for scarce resources and a guarantee for their efficient use. Sustainability additionally requires mechanisms to secure intergenerational equity.

I agree with Kling’s point that we should be humble when assessing whether market prices, which reflect the interplay of countless actors, are “right” or “wrong.” However, I would probably be prepared more often than Kling to acknowledge market failures of the type that call for corrective taxes. The general point is that Kling’s views expressed in the three chapters seem entirely mainstream. While we may debate how often and strongly market prices fail to account for social costs and benefits, the economics profession widely agrees that for a price system to function well this precondition must be satisfied.

In the sixth chapter, entitled “Trade and Trust,” Kling argues that specialization rests on cultural evolution and learning and more broadly, that modern economic systems require institutions that promote trust. Independently of the norms a particular society adopts, it must implement the basic social rule,

[r]eward cooperators and punish defectors.

How this is achieved (even if it is against the short-run interest of an individual) varies. Incentive mechanisms may be built on the rule of law, religion, or reputation. And as Kling points out societies almost always rely on some form of government to implement the basic social rule. In turn, this creates problems of abuse of power as well as “deception” and “demonization.” Mainstream economists would agree. In fact, incentive and participation constraints, lack of commitment, enforcement, and self-enforcement are at center stage in many of their models of partial or general equilibrium. Similarly, the role of government, whether benevolent or representing the interests of lobby groups and elites, is a key theme in modern economics.

Chapter seven, entitled “Finance and Fluctuations,” deals with the role of the financial sector. Kling argues that finance is a key prerequisite for specialization and since trust is a prerequisite for finance, swings in trust—waves of optimism and pessimism—affect the economy. No mainstream macroeconomist will object to the notion that the financial sector can amplify shocks. Seminal articles (which all were published well before the most recent financial crisis) exactly make that point. But Kling is probably right that the profession’s workhorse models have not yet been able to incorporate moods, fads, and manias, the reputation of intermediaries, and the confidence of their clients in satisfactory and tractable ways, in spite of recent path-breaking work on the role of heterogenous beliefs.

In chapter eight, Kling focuses on “Policy in Practice.” He explains why identifying market failure in a model is not the same as convincingly arguing for government intervention, simply because first, the model may be wrong and second, there is no reason to expect government intervention to be frictionless. I don’t know any well-trained academic economist who would disagree with this assessment (but many “experts” who are very frighteningly confident about their level of understanding). The profession is well aware of the insights from Public Choice and Political Economics, although these insights might not be as widely taught as they deserve. And Kling is right that economists could explain better why real-world policy selection and implementation can give rise to new problems rather than solely focusing on the issue of how an ideal policy might improve outcomes.

To me, the most interesting chapters of the book are the first and the last, entitled “Filling in Frameworks” and “Macroeconomics and Misgivings,” respectively. In the first chapter, Kling discusses the difference between the natural sciences and economics. He distinguishes between scientific propositions, which a logical flaw or a contradictory experiment falsifies, and “interpretive frameworks” a.k.a. Kuhn’s paradigms, which cannot easily be falsified. Kling argues that

[i]n natural science, there are relatively many falsifiable propositions and relatively few attractive interpretive frameworks. In the social sciences, there are relatively many attractive interpretive frameworks and relatively few falsifiable propositions.

According to Kling, economic models are interpretative frameworks, not scientific propositions, because they incorporate a plethora of auxiliary assumptions and since experiments of the type run in the natural sciences are beyond reach in the social sciences. Anomalies or puzzles do not lead economists to reject their models right away as long as the latter remain useful paradigms to work with. And rightly so, according to Kling: For an interpretative framework with all its anomalies is less flawed than intuition which is uninformed by a framework. At the same time, economists should remain humble, acknowledge the risk of confirmation bias, and remain open to competing interpretative frameworks.

In the chapter entitled “Macroeconomics and Misgivings,” Kling criticizes macroeconomists’ reliance on models with a representative agent. I agree that representative agent models are irrelevant for applied questions when the model implications strongly depend on the assumption that households are literally alike, or that markets are complete such that heterogeneous agents can perfectly insure each other. When “experts” forecast macroeconomic outcomes based on models with a homogeneous household sector then these forecasts rest on very heroic assumptions, as any well-trained economist will readily acknowledge. Is this a problem for macroeconomics which, by the way, has made a lot of progress in modeling economies with heterogeneous agents and incomplete markets? I don’t think so. But it is a problem when “experts” use such inadequate models for policy advice.

Kling argues that the dynamic process of creative destruction that characterizes modern economies requires ongoing change in the patterns of specialization and trade and that this generates unemployment. Mainstream models of innovation and growth capture this process, at least partially; they explain how investment in new types of capital and “ideas” can generate growth and structural change. And the standard framework for modeling labor markets features churn and unemployment (as well as search and matching) although, admittedly, it does not contain a detailed description of the sources of churn. The difference between the mainstream’s and Kling’s view of how the macroeconomy operates thus appears to be a difference of degree rather than substance. And the difference between these views and existing models clearly also reflects the fact that modeling creative destruction and its consequences is difficult.

Kling is a sharp observer when he talks about the difference between “popular Keynesianism” and “rigor-seeking Keynesianism.” The former is what underlies the thinking of many policy makers, central bankers, or journalists: a blend of the aggregate-demand logic taught to undergraduates and some supply side elements. The latter is a tractable simplification of a micro-founded dynamic general equilibrium model with frictions whose properties resemble some key intuitions from popular Keynesianism.

The two forms of Keynesianism help support each other. Popular Keynesianism is useful for trying to convince the public that macroeconomists understand macroeconomic fluctuations and how to control them. Rigor-seeking Keynesianism is used to beat back objections raised by economists who are concerned with the ways in which Keynesianism deviates from standard economics, even though the internal obsessions of rigor-seeking Keynesianism have no traction with those making economic policy.

There is truth to this. But in my view, this critique does not undermine the academic, rigor-seeking type of Keynesianism while it should undermine our trust in “experts” who work with the popular sort which, as Kling explains, mostly is confusing for a trained economist.

In the end, Kling concludes that it is the basics that matter most:

[B]etter economic outcomes arise when patterns of sustainable specialization and trade are formed. … It requires the creative, decentralized, trial-and-error efforts of thousands of entrepreneurs and millions of households … Probably the best thing that the government can do to encourage new forms of specialization is to rethink existing policies that restrict competition, discourage innovation, and retard mobility.

This is a reasonable conclusion. But it is neither a falsifiable proposition nor an interpretive framework. It is the synthesis of many interpretive frameworks, weighed by Kling. In my own view, the weighting is based on too harsh an assessment according to which many modern macroeconomic models are irrelevant.

Kling’s criticism of contemporaneous macroeconomics reads like a criticism of the kind of macroeconomics still taught at the undergraduate level. But modern macroeconomics has moved on—it is general equilibrium microeconomics. Its primary objective is not to produce the one and only model for economist-engineers or “experts” to use, but rather to help us understand mechanisms. A good expert knows many models, is informed about institutions, and has the courage to judge which of the models (or mechanisms they identify) are the most relevant in a specific context. We don’t need a new macroeconomics. But maybe we need better “experts.”

The IMF “In Principle” Approves Funding For Greece

In the FT, Mehreen Khan reports about the IMF’s conditional acceptance to lend to Greece.

The IMF’s “agreement in principle” (AIP) tool draws on a practice where the fund is able to greenlight its involvement in a debtor country, conditional on the government and its creditors agreeing to future debt relief measures.

Of course, the dispute about the merits of debt relief is unresolved. The IMF thinks Greek debt is ‘unsustainable’ and the European creditors should bear more losses, earlier on while some Euro area countries disagree. (For the numbers, see here).

Earlier in July, the European Stability Mechanism had approved a new cash injection (FT). This followed a dodgy compromise in June, as reported by Jim Brunsden in the FT:

Euro area ministers and the International Monetary Fund unveiled a deal … that will … sav[e Greece] … from default this summer. The IMF will join the bailout as a partner but withhold any money until euro area finance ministers give more detail on what debt relief they might offer Athens. …

Euro-area policymakers have been trying to reconcile competing EU and IMF visions of the €86bn programme and, crucially, whether it will make Greece’s debts sustainable.

Programme conditions set by euro area governments in 2015 included budget surplus targets that the IMF said were punishingly ambitious and unlikely to be met. The fund set out a different vision: lower primary surplus targets for Athens, coupled with comprehensive pension and tax reform and, crucially, far-reaching debt relief.

At the centre of the puzzle was Germany’s finance minister, Wolfgang Schäuble, who has insisted that the IMF must join if Greece is going to continue receiving tranches of bailout aid — but has also resisted significant debt relief commitments.

Given that the fund could not join up unless convinced that Greece’s debts were being put on to a sustainable path, the euro area and IMF had to find another solution — and it came in the form of asking Athens to do more.

To give the IMF confidence that Greece could hit budget surplus targets set by the euro area, Athens was asked to widen its income tax base and cut pensions. The measures, adopted in May, are estimated to be worth about 2 percentage points of gross domestic product.

In the meantime, Greece plans to regain market access by 2018 (FT).

Sources of Low Real Interest Rates

In a (December 2015) Bank of England Staff Working Paper, Lukasz Rachel and Thomas Smith dissect the global decline in long-term real interest rates over the last thirty years.

A summary of their executive summary:

  • Market measures of long-term risk-free real interest rates have declined by around 450bps.
  • Absent signs of overheating this suggests that the global neutral rate fell.
  • Expected trend growth as well as other factors affecting desired savings and investment determine the neutral rate.
  • Global growth was fairly steady before the crisis but may (be expected to) fall after the financial crisis. Recently, slower labor supply (demographics) and productivity growth may account for a 100bps decline in the real rate.
  • Desired savings rose, due to demographics (90bps), higher within country inequality (45bps), and higher savings rates in emerging markets following the Asian crisis (25bps).
  • Desired investment fell, due to a lower relative price of capital goods (50bps) and less public investment (20bps).
  • The spread between the return on capital and the risk-free rate rose (70bps).
  • These trends look likely to persist and the “global neutral real rate may settle at or slightly below 1% over the medium- to long-run”.

From page 2 of the paper:

See also the summary by James Hamilton; the White House CEA report; and the 17th Geneva report.

Does Greece Need Official Debt Relief?

In a Peterson Institute working paper, Jeromin Zettelmeyer, Eike Kreplin, and Ugo Panizza conclude that the answer to that question depends on your assumptions.

The authors compare several scenarios, including

  • scenarios A–C, the baseline scenario of the European institutions and two more pessimistic variants;
  • scenario I which underlies the IMF reasoning and which assumes that “Greece will not undertake the structural reforms needed to achieve higher potential growth”;
  • and scenario D, which corresponds to what Greece committed to when the third program was agreed, and which represents the German position.

They assume that interest rates on privately held debt rise with the debt-to-GDP ratio, and they use two “sustainability” metrics: The debt-to-GDP ratio (should fall), and gross financing needs as a share of GDP (should be smaller than 20%).

When running Monte Carlos simulations, the authors find that for each scenario, the assumptions about growth and primary surpluses are consistent with the conclusions drawn by the different institutions:

  • In A (borderline) and D, debt is “sustainable.”
  • Not so in B, C, and I, due to “accelerating substitution of official debt by more expensive borrowing from private sources”.

The authors then evaluate the plausibility of the scenario assumptions. They conclude that “international evidence does not support an adjustment path that envisages a primary surplus of above 3.5 percent for more than three to four years on a continuous basis and for more than seven years on an average basis” rendering B and C the most plausible scenarios, and suggesting that the debt is “unsustainable.”

In reaching their conclusions, the authors assume that primary surpluses in Greece will react to debt, inflation, and growth in line with the experience in other (developed) economies. (This means, for example, that surpluses rise as the debt burden increases, which seems to contradict the notion of debt overhang.) This is unconvincing, of course, if one takes the view underlying scenario D which presumes that feasible promises are kept. Or stated differently: Greece might well be able but not willing to pay—after all, in this very case official creditor intervention could have made sense in the first place although private lenders charged high interest rates. (With Harris Dellas, we make this argument precise in a paper in the Journal of International Economics.) Related, one can think of many reasons why the historical experience in other countries may be uninformative for the Greek case. The authors address one concern: They focus on episodes with very high debt-to-GDP ratios and find that in these cases, primary surpluses are maintained for longer. Moreover, there is the important question of measurement: The Greek debt-to-GDP ratio is not easily comparable with the ratio in other countries, see here and here, and most likely overstated.

Zettelmeyer, Kreplin, and Panizza make the case for a delay of Greece’s return to capital markets. In the conclusions, they write that

the debt relief measures put on the table by the Eurogroup in May 2016 could be sufficient to restore debt sustainability, but only if these measures are taken to an extreme. This means accepting an extremely long maturity extension of EFSF debts. In addition, it requires either substantial additional interest rate deferrals, or locking in significantly lower funding costs and hence lower interest rates than the EFSF currently expects, or a combination of both. While these measures are feasible within the red lines described by the Eurogroup, they are likely to be politically and/or technically difficult. Unless the EFSF manages to eke out substantial extra interest relief through creative long-term funding operations, its exposure to Greece will likely have to rise, possibly for decades, before it starts falling. A private sector creditor would not accept this type of restructuring because it gives the debtor country a strong incentive to default (or at least renegotiate) when the debt is at its peak.

… one way out of this dilemma would be to delay Greece’s return to capital markets, continuing to finance Greece through ESM programs until its private sector spreads are much lower than they are now. … this approach would lower the total need for debt relief and/or fiscal effort required to restore Greece to debt sustainability. While it would lead to a significant increase in official creditor exposure to Greece—requiring perhaps €100 billion of extra ESM financing—this is less than the rise in EFSF exposure that would be required in the Eurogroup’s approach, which aims to return Greece to private capital markets in 2018 while relying mainly on EFSF maturity extensions and interest rate deferrals … total official exposure to Greece would decline faster if ESM financing were to continue than if it were to end in 2018.

Importantly, they also point to the incentive effects of debt restructuring:

If [the threat of Grexit is essential to maintain incentives for reform] keeping the sword of Grexit … would help reduce debt levels only so long as Greece is being financed with cheap official funds. If, however, Greece returns to capital markets, any beneficial incentives of this approach would likely be offset by the risk premiums that private lenders would charge to a country whose euro membership remains at risk.

The official creditors will have to make up their minds: Not only the return on their lending is at stake, but also reform in Greece.

Kenneth Arrow’s Work

On VoxEU, Steven Durlauf offers an excellent overview over Kenneth Arrow’s work. Durlauf emphasizes five areas of research:

  • The impossibility theorem, in the tradition of Condorcet.
  • General equilibrium theory and the welfare theorems, in the tradition of Walras.
  • Decision-making under uncertainty, the Arrow-Pratt measures of risk aversion and contingent commodities.
  • Imperfect information, in the context of medical care and as a source of statistical discrimination.
  • Economics of knowledge, anticipating the endogenous growth literature.

Durlauf closes:

Like Faust, limitless curiosity and passion for knowledge meant that Arrow strove without relenting; but unlike Faust, Arrow needed no redemption. His intellectual integrity was pristine and unparalleled at every stage of his life. His character was as admirable and admired as his intellect. Arrow’s personal and scholarly example continues to inspire, nurture, and challenge.

Models Make Economics A Science

In the Journal of Economic Literature, Ariel Rubinstein discusses Dani Rodrik’s “superb” book “Economics Rules.” The article nicely articulates what economics and specifically, economic modeling is about. Some quotes (emphasis my own) …

… on the nature of economics:

[A] quote … by John Maynard Keynes to Roy Harrod in 1938: “It seems to me that economics is a branch of logic, a way of thinking”; “Economics is a science of thinking in terms of models joined to the art of choosing models which are relevant to the contemporary world.”

[Rodrik] … declares: “Models make economics a science” … He rejects … the … common justification given by economists for calling economics a science: “It’s a science because we work with the scientific method: we build hypotheses and then test them. When a theory fails the test, we discard it and either replace it or come up with an improved version.” Dani’s response: “This is a nice story, but it bears little relationship to what economists do in practice …”

… on models, forecasts, and tests:

A good model is, for me, a good story about an interaction between human beings …

A story is not a tool for making predictions. At best, it can help us realize that a particular outcome is possible or that some element might be critical in obtaining a particular result. … Personally, I don’t have any urge to predict anything. I dread the moment (which will hopefully never arrive) when academics, and therefore also governments and corporations, will be able to predict human behavior with any accuracy.

A story is not meant to be “useful” in the sense that most people use the word. I view economics as useful in the sense that Chekhov’s stories are useful—it inspires new ideas and clarifies situations and concepts. … [Rodrik] is aware … “Mischief occurs when economists begin to treat a model as the model. Then the narrative takes on a life of its own and becomes dislodged from the setting that produced it. It turns into an all-purpose explanation that obscures alternative, and potentially more useful, story lines”.

A story is not testable. But when we read a story, we ask ourselves whether it has any connection to reality. In doing so, we are essentially trying to assess whether the basic scenario of the story is a reasonable one, rather than whether the end of the story rings true. … Similarly, … testing an economic model should be focused on its assumptions, rather than its predictions. On this point, I am in agreement with Economics Rules: “. . . what matters to the empirical relevance of a model is the realism of its critical assumptions”.

… on facts:

The big “problem” with interpreting data collected from experiments, whether in the field or in the lab, is that the researchers themselves are subject to the profession’s incentive system. The standard statistical tests capture some aspects of randomness in the results, but not the uncertainty regarding such things as the purity of the experiment, the procedure used to collect the data, the reliability of the researchers, and the differences in how the experiment was perceived between the researcher and the subjects. These problems, whether they are the result of intentional sleight of hand or the natural tendency of researchers to ignore inconvenient data, make me somewhat skeptical about “economic facts.”

Money, Banking, and Dreams

In another excellent post on Moneyness, J P Koning likens the monetary system to the plot in the movie Inception, featuring

a dream piled on a dream piled on a dream piled on a dream.

Koning explains that

[l]ike Inception, our monetary system is a layer upon a layer upon a layer. Anyone who withdraws cash at an ATM is ‘kicking’ back into the underlying central bank layer from the banking layer; depositing cash is like sedating oneself back into the overlying banking layer.

Monetary history a story of how these layers have evolved over time. The original bottom layer was comprised of gold and silver coins. On top this base, banks erected the banknote layer; bits of paper which could be redeemed with gold coin. The next layer to develop was the deposit layer; non-tangible book entries that could be transferred by order from one person to another.

The foundation layer has changed over time:

One of the defining themes of modern monetary history has been the death of the original foundation layer; precious metals. … as central banks chased private banks from the banknote layer … and then gradually severed the banknote layer from the gold layer. By 1971, … [b]anknotes issued by the central bank had become the foundation layer. The trend towards a cashless world is a repeat of this script, except instead of the gold layer being slowly removed it is the banknote layer.

Fintech improves the efficiency of the layer arrangement and its connections. It also adds new layers: For instance, some payments made via mobile phone effectively transfer claims on deposits. And it may circumvent layers:

In U.K., the Bank of England is considering allowing fintech companies to bypass the banking layer by offering them direct access to the bottom-most central banking layer.

In contrast, a krypto currency like bitcoin establishes a new foundation layer, on which new layers may be built:

Even now there is talk of a new layer being developed on top of the original bitcoin foundation, the Lightning network. The idea here is that the majority of payments will occur in the Lightning layer with final settlement occurring some time later in the slower Bitcoin layer.

I fully agree with this characterization. In addition to the theme emphasized by Koning—adding layers—I would also stress the theme of untying higher-level layers from lower ones: Central bank money typically is no longer backed by gold; deposits typically are not fully backed by notes; and mobile phone credits may no longer be backed by deposits. The process of untying layers relies on social conventions and trust, and it is fragile. Important questions concern the cost of such fragility, and its necessity. Fragility is not necessary when the social cost of liquidity provision at the foundation layer is negligible.


In the FAZ, molecular biologist and Tibetan monk Matthieu Ricard advises to find “happiness” (“Glück, innere Zufriedenheit”) by acquiring certain attitudes:

Wir Buddhisten, aber auch Psychologen, verstehen unter Glücklichsein keinen für sich alleinstehenden Gefühlszustand, sondern eine Gruppe von menschlichen Eigenschaften. Dazu zählen innere Freiheit, emotionale Ausgeglichenheit, altruistische Liebe, Mitgefühl. Für mich kann Glück nicht eigennützig sein. Wer sich selbst die ganze Zeit ins Zentrum stellt, fühlt sich mit der Zeit elend und ist obendrein verwundbar. Denn auch ich-zentrierte Personen kommen nicht ohne andere Menschen aus.

Um zu innerer Zufriedenheit zu gelangen, muss man den entgegengesetzten Weg gehen, und zwar die anderen Menschen ins Zentrum stellen, indem man diesen mit Wohlwollen, Großzügigkeit, Mitgefühl und Altruismus begegnet. Großzügig und freundlich zu sein, erzeugt ein Gefühl von innerer Harmonie. Diese Form von Glücklichsein nutzt sich zudem nicht ab, wie das bei den hedonistischen Freuden der Fall ist, sondern wird mit der Zeit immer stärker und verringert außerdem die Verletzlichkeit.

Daniel Quinn’s “Ishmael”

In Daniel Quinn’s “Ishmael,” a gorilla offers his perspective on human civilization and the narratives surrounding it.

Ishmael—the gorilla—characterizes the early agricultural revolution as the takeoff of the nowadays-dominant “Takers’” culture, a culture that does not only reject the hunter-gatherer and herder life of “Leaver” tribes but also finds it acceptable to eradicate the latter. The Takers reject the notion that man is part of a balanced, competitive and evolving natural system; but this rejection places humanity on a trajectory ultimately leading to self-destruction.

The gods realized that “of all the trees in the garden, only the Tree of the Knowledge of Good and Evil could destroy Adam.” (9, 6) And so they forbid Adam to taste the fruit of that tree. (He tasted anyway.) The ban constitutes a mystery for Takers. For they think of themselves as destined to rule the world, and “knowledge of good and evil is fundamentally the knowledge the rulers of the world must exercise, because every single thing they do is good for some but evil for others.” (9, 7)

According to Ishmael, the mystery is solved by noting that Genesis reflects a narrative of the Semites, a Leaver people, who experienced the expansion of the Taker culture as Cain slaughtering his brother Abel. The Hebrew later adopted the tale but could no longer make sense of it because they had adopted the Taker culture.

Ishmael makes some other points: “The Takers accumulate knowledge about what works well for things. The Leavers accumulate knowledge about what works well for people.” (10, 8) “The Takers are those who know good and evil, and the Leavers are … those who live in the hands of the gods.” (11, 6) The Leavers are in a position to evolve; they are part of the general community of life, while Takers believe that creation came to an end with man. (12, 3) “The Takers’ story is, ‘The gods made the world for man, but they botched the job, so we had to take matters into our own, more competent hand.’ The Leavers’ story is, ‘The gods made man for the world …; this seems to have worked pretty well so far, so we can take it easy and leave the running of the world to the gods.’” (12, 6)

Determinism and Free Will

In the Stanford Encyclopedia of Philosophy entry on Causal Determinism, Carl Hoefer suggests in the concluding section (Determinism and Human Action) that there is hope for those who want to believe in free will:

There is a long tradition of compatibilists arguing that freedom is fully compatible with physical determinism; a prominent recent defender is John Fischer (1994, 2012). Hume went so far as to argue that determinism is a necessary condition for freedom—or at least, he argued that some causality principle along the lines of “same cause, same effect” is required. …

Physics, particularly 20th century physics, does have one lesson to impart to the free will debate; a lesson about the relationship between time and determinism. Recall that … the fundamental theories … if they are deterministic at all, are time-symmetrically deterministic. That is, earlier states of the world can be seen as fixing all later states; but equally, later states can be seen as fixing all earlier states. …

Nor does 20th (21st) -century physics countenance the idea that there is anything ontologically special about the past, as opposed to the present and the future. In fact, it fails to use these categories in any respect, and teaches that in some senses they are probably illusory. So there is no support in physics for the idea that the past is “fixed” in some way that the present and future are not, or that it has some ontological power to constrain our actions that the present and future do not have. It is not hard to uncover the reasons why we naturally do tend to think of the past as special, and assume that both physical causation and physical explanation work only in the past present/future direction (see the entry on thermodynamic asymmetry in time). But these pragmatic matters have nothing to do with fundamental determinism. If we shake loose from the tendency to see the past as special, when it comes to the relationships of determination, it may prove possible to think of a deterministic world as one in which each part bears a determining—or partial-determining—relation to other parts, but in which no particular part (region of space-time, event or set of events, …) has a special, privileged determining role that undercuts the others. Hoefer (2002a) and Ismael (2016) use such considerations to argue in a novel way for the compatiblity of determinism with human free agency.