Micro vs Macro

...the fallacy of composition separates micro from macro...

As I struggle with teaching senior majors a bit of macroeconomics, I am trying to think of ways in which I can distinguish the mindset of micro (the majority of our curriculm) from macro.

(Aside: for the present, I'm posting primarily on the course site on the publicly-accessible W&L WordPress server, at http://econ398.academic.wlu.edu (and similar sites for Japan at econ272.academic.wlu.edu and Industrial Organization at econ243.academic.wlu.edu)

One issue is data: if you take a skeptical view, that structural change in the US since 1980 is substantial -- look at changes in "openness" (trade shares, international financial flows), financial sector reforms (the nature of "money", the rise of multistate banks, and "shadow" banks), labor markets (education levels, mobility, less weight in unionized sectors, more in services) and demographics (more and older retirees hence greater transfers) -- then you may be reluctant to think that there is much to be garnered, indeed you may believe that much will be muddied, from using data older than 20 years. Since key macro measures are only available on a quarterly basis, you're thus stuck with 80 observations, which doesn't provide for much statistical power, particularly given the infrequency of shocks and major policy changes. Using multi-country panel data requires even stronger assumptions than (say) using data from 1962 on for the US. Those doing micro work tend to use datasets with hundreds, if not many thousands, of observations.

Then there are aggregation issues. The more disaggregated the model, the more convincing are microfoundations (though ironically those who use that term are often using models so aggregate that they are reduced to assuming representative agents with identical and unchanging preferences for labor vs leisure and today vs the future). These are present as well in micro markets, but are either more obvious or less severe, and typically both.

Most central, in my mind, is that the fallacy of composition separates micro from macro. A nice post on the Vox EU blog, "Micro success does not guarantee macro success," provides an illustration. They look at job search assistance programs, for which in the Danish case there are not only good data, but a randomized base that helps control for extraneous factors. Such programs do indeed improve the speed at which workers find new jobs, by about 10% over 3 months. Since such individuals then stop collecting unemployment and start paying taxes, it is extremely cost-effective.

However...such experiments are hard to replicate, because unless the demand for workers is adequate, the primary effect is to speed up who gets jobs -- those fortunate enough to be enrolled in the program -- but not to create extra jobs.

Basically, the normal statistical design takes those in a city who were chosen (randomly) for the program with those who were not. Most (though not all) of the effects disappear when those not chosen for the program are compared with those newly unemployed elsewhere. At first glance that's less clean because it's harder to control for various in geography and attendant local industry effects. However, it misses the point that the difference in the more typical control case doesn't preclude that it takes those (randomly) not chosen for the program longer to find a job. Furthermore, when extended to a wider share of those unemployed, employers are flooded with applications, while the ability of the employment office to taylor their help goes down. Indeed, past the point of including about 30% of those unemployed, the spillovers dominate, and the program ceases to be cost-effective.

Macroeconomics if full of similar examples. One household can increase their saving to provide for retirement; that won't shift asset prices, it won't shift the amount of consumption. So they can effectively transfer resources across time. We have that built in (fallaciously) into our economy, in the form of the Social Security Trust Fund. Unfortunately, we can't put doctors in deep freeze: medical services have to come out of contemporaneous production. So in order for retirees to consume medical services (and in the aggregate, other consumption goods), we who are working have to consume less. All retirement is fundamentally pay-as-you-go. The Trust Fund is meaningless; when the future comes, the idea is that it sells off assets. But it's not small in the economy. To do so requires us to save more (to buy those bonds) or to be taxed more (so the government can buy them on our behalf) or (but only in the short term) rolled over into general government debt.

I won't pretend this is simple to understand. But I don't pretend that macroeconomics is easy, either. It requires us to deal with aggregation and spillovers, which is not what we do in our day-to-day decision making. That requires abstraction and building models to check that we've aggregated consistently; it turns out to be very easy to play with ideas only to discover that they don't add up, that they are internally inconsistent (and not in a small way).

And then there remains the challenge of testing these abstractions against our scanty set of real-world data.

...signature...

Was Tobin Right? – "the" Tobin Tax, that is?

...foreshortening the bubble by 6 months would have helped...

I'd headed from Wall Street to grad school in the fall of 1980 because of the eurodollar bubble I saw poised to implode around my bank and others. Lots of liquidity, regulation carried out with a wink and a nod – where I worked, the Bank of Tokyo, continued lending quietly despite a formal prohibition, a "quiet period", imposed by the Ministry of Finance on Japanese banks. How did BOT get around it? – well, they had two subsidiaries, one in California, one in New York, that were (legally) US banks. So regulations from Tokyo didn't apply. We didn't tell regulators what we were doing, and it seems they didn't ask.

In college I'd done math, history, languages but not a single course in economics. It was thus Jim Tobin – the late Nobel laureate who spent most of his career at Yale – who introduced me to macroeconomics. At that point the rational expectations revolution was just beginning, while many of today's standard econometric techniques were just being developed, so I had a foot in both schools. Tobin saw that we were exposed to as much as he could cram into a year, including finance and other areas that are now separate fields. It was a good grounding, full of wisdom, and an attempt to get us to think through stories, to learn the weaknesses of narrative and the weaknesses of formal models. He was suspicious of what he called "new classical" macroeconomics. Formal general equilibrium models were not robust – John Taylor showed that one simple tweak undid the initial "policy neutrality" models of last year's Nobel laureate Thomas Sargent (who, by the way, Tobin tried unsuccessfully to recruit to Yale). Of course "Jumpin" Joe Stiglitz was showing the same thing held true for a variety of simple equilibrium models, but that's for a footnote.*

But all of this is an aside, and ultimately I didn't stay on the macro side, partly because that seemed less central to understanding Japan, and partly because a whole group of students were doing the money-macro thing. In addition, I'd done some grad work in math, and deliberately gave it up. So I wondered whether I'd be any happier doing it a second time around. Too bad, perhaps, because I think my sense of the dynamics of bubbles turned out to be pretty sound – the bubble I saw clearly as an insider didn't actually "break" until the Latin American debt crisis erupted in 1984. In any case, I was iconoclastic enough to avoid the crowd, ultimately doing a dissertation with another future nobel laureate as chair, but those stories are for later.

Back to Tobin and macro. Over time the gist of macro gradually sank in, in all its variety; I only remember one thing as puzzling me, the "Tobin tax" on financial transactions. He foresaw financial markets as able to move money into individuals niches (say, an Iceland) in such volume as to sway the structure of the real economy, and able to move more quickly than real economies could respond. Except that it wasn't just tiny economies that were at risk, but subsets such as US real estate or (within the still inchoate EU) Spain. Putting a tax on transactions could shift traders away from short-term arbitrage (in today's markets, of potentially under a second's duration) and into assets that offered higher real returns over a longer time horizon. (Of course Tobin was a developer of CAPM, and so preached on the risk-return tradeoff and balanced portfolios, more poignant at Yale because in the go-go years of the 1970s endowment managers lost so much money as to put the institution at risk.)

Anyway, at the time I saw no benefit from a "Tobin tax"; I thought he was wrong, overstating the dangers, understating the costs of his tax. But he really did see the direction the world was moving – perhaps because, unlike economists of the past 30 years, as a grad student he had had to study economic history, including the era of global markets that started unravelling in 1914. Would a "Tobin tax" have prevented our current meltdown? Perhaps not. Leaning on central bankers to provide easy money wasn't even necessary, Greenspan and counterparts elsewhere needed little urging. But it would have slowed the rise, would have forced managers in financial institutions to step back and ask whether speculation should be allowed to develop into a core source of profits. And it would have generated much more information.

That lack of information should not be treated lightly. People really didn't know what was going on.

Let me illustrate that with a story from my banking days. Sometime in 1980 it fell to me to sound out peer institutions on their Brazil exposure. To do that I needed to offer information from my end, and so asked for and was given (in considerable detail) our own exposure: local lending, short-term trade finance ("letters of credit"), foreign exchange positions, cross-border "eurodollar" loans in various currencies. At that point BOT's position was on the order of $1 billion, not quite enough to bring down the bank, but enough to make a serious dent in its capitalization. We were reaching the point where we were reluctant to hold more Brazil paper directly, and if others were in a similar position … well, that would be it for Brazil.

So I called around to the then-reigning banks, Citi and Morgan and a few others most active in Latin America, where Brazil was perceived as the most successful and the best managed economy. Some banks gave me more info, some less, but to me the bottom line was clear: Brazil could still borrow, but at its then-current rate of burning through foreign exchange reserves, it wouldn't be able to do so for long. That was bad news: their economy was running on debt, fueled by a plethora of "big push" investment projects financed with international loans that weren't (yet) generating exports and hence the dollar revenue needed to "service" dollar-denominated debt. Needless to say, that big push also generated lots of jobs, and so was popular with the military dictatorship of the day, who (with hindsight justly) feared the impact on their hold on power should the economy slow. [Homework: trace analogs with German banks and Spanish resort property developers.]

The bottom line, however, is that banks were flying blind, unable to aggregate information in much detail. No one talked about private loans or foreign exchange business, which was quite profitable (we "scored" with VW in Brazil and used that to gain business with VW in Germany, all hush-hush). And even if we (and the Brazilian government) kept pretty good track of eurodollar originations, we (and we assumed others) tried to sell on paper to smaller, correspondent banks and get it off our own books so that we could keep lending. Foisting Brazil paper took time, and those in the making the loans to Brazil weren't necessarily kept in the loop by our own correspondent banking people. We had no idea about others; the borrower – Brazil – only knew who originally lent the money, not who currently held the "paper", the loan. Well, it turned out that other banks too were finding it harder to unload their eurodollar assets to smaller banks. By the time everyone knew that, however, it was too late: by the fall of 1980 the overwhelming majority of the loans that underlay the crisis of 1984 had been "booked".

Again, this time around many market participants were surely starting to have their suspicions. A Tobin tax would have forced greater clarity. Oh, not much. With real estate prices rising at 20+% per annum in places such as Arizona (to use US as an example), however, even foreshortening the bubble by 6 months would have helped.

...Mike Smitka...

* Note: to the best of my knowledge – I have not scanned the literature for a number of years – the uncomfortable truth is that this lack of robustness in small models is true for large models, too. There is simply no "law of large numbers" for general equilibria, where a simple model of an economy that is fragile to minor changes in assumptions gets things "almost right" when hundreds more markets are added.
In addition, the "dynamic" (forward-looking) general equilibrium models in current use rely upon convergence to a steady state as a solution technique. That assumption distinctly limits the ability to use such models to "test" whether fiscal policy works since it makes it hard to force the model to deviate from the equilibrium path.

Mea culpa: my apologies for weaving too many threads in one short post. I intend to gradually expand this into multiple posts. But not tonight.

… what do I do when data demonstrate I've been wrong? I hope I change my mind …