Random thoughts on economics

  1. I think most people understand the supply and demand less than we think. That’s because supply and demand are more confusing and complex than what is taught in mainstream EC101 lectures today. Maybe you don’t think so, but I do. Suppose we asked students who have already taken EC101&102:

“Oil prices fell. For this reason, people will probably buy more gas(as if something is cheaper, people will likely buy more.) (True/False).”

What do you think will be the response of many students? Most students would say “true” because “The demand curve slopes downwards; so the quantity demanded increases as the price falls.” But is it so? When I took EC101, I had the opportunity to observe many students. Almost all of them pass the course at the end of the semester without knowing more than they knew before. That’s why student essays consist of an endless cycle like “prices fall, demand increases; prices increase, supply increases.”

To be honest, I think economics is taught the wrong way. Have you looked at the introductory chapters of the best-selling textbooks? In the textbook next to me, all I see are meaningless examples such as “After an unexpected hail squall, the supply of crops decreases and prices increase,” “Unexpected high interest in Dean Martin concert driving up prices.” Students knew this even before taking the EC101. Do you know someone who has never studied economics and has never heard of the phrase “supply and demand sets the price”? And what most of the students know exactly at the end of the semester is nothing more than that. Basic econ courses should teach students intuition and interpretation, instead, they learn nothing but memorizing things like the “5 factors that shift the demand curve.” “If price increases, supply increases; when demand decreases, price increases; when X happens, the supply curve shifts to the left/right.” And it goes on like this.

This is an example of “reasoning from a price change,” and it’s the first thing many students learn in the intro to economics. Heck, it’s not surprising if you consider that even most professors make this fallacy all the time.

Let’s go back to the first example and take a closer look. Oil prices plunged, and oil consumption fell too. So low oil prices may also reduce oil consumption. How? Draw a supply and demand curve. What happens if the demand curve shifts to the left? When the price falls(if we only know that), there is the same chance that the quantity will increase or decrease.

Scott Sumner makes the same point in one of his posts: 

I often ask the following question to upper level econ or MBA students who have already taken principles:

Question: A survey shows that on average 100 people go to the movies when the price is $6 and 300 people go when the price is $9. Does this violate the laws of supply and demand?

Very, very few can answer this question, especially if you ask for an explanation. Even worse, I think there is a perception that there is something ‘tricky’ about this question, something unfair. In fact, it is as easy a question as you could imagine. It’s basic S&D. It’s merely asking students what happens when the demand for movies shifts. I cannot imagine a less tricky question, or a more straightforward application of the laws of supply and demand. In the evening hours the demand for movies shifts right. Price rises. Quantity supplied responds. What’s so hard about that? And yet almost no student can get it right. Our students enter EC101 knowing one of the two things they need to know about S&D, and they leave knowing one of the two things they need to know about S&D. Maybe instead of having them memorize mind-numbing lists of “5 factors that shift supply,” and “5 factors that shift demand,” we should just tell them to read something that will explain what economics is all about, something that portrays economists as detectives trying to solve the identification problem, something like Freakonomics.

If there are any other economics instructors out there I’d like to know what you think. I really don’t think we need to teach students what happens when frost hits the Florida orange crop. Perhaps we should just put supply and demand into an appendix and tell them to study it if they need to. Instead devote 100% of chapter 4 to the identification problem. Leave all the technical stuff for students majoring in economics to take in their intermediate level courses. Or maybe the identification problem is too hard, and we should simply forget about teaching supply and demand. Devote the whole course to opportunity costs, incentives, marginal analysis, etc.”

Read the whole thing, then tell me supply and demand is not complex than what’s taught in college.

2. I don’t favor the IS-LM. It’s not because I don’t understand the technical mechanism of the IS-LM model. I will not argue that the IS-LM is “theoretically or technically” flawed. Instead, I don’t think that the reasoning economists have made from the IS-LM is correct. In other words, I think the IS-LM will cause economists to misinterpret certain situations. That’s why I almost always use AS-AD instead of the IS-LM(more precisely, I prefer using several models with a partial equilibrium perspective). First, I’ll start by saying that the IS-LM is a useful and well-working model for periods like the Great Moderation. But I believe this is due to a different reason than many people think(Taylor Rule).

I think the problem with IS-LM is that most people(even most economists) seem to think they can tell the stance of monetary policy and/or changes in monetary policy by looking at changes in short-term nominal interest rates. In contrast, short-term rates are only a variable that accompanies changes in the money supply relative to the demand for money. Therefore, changes in AD are driven by expectations for future changes in NGDP.

My problem with IS-LM is that while it may seem like a useful model for periods like the Great Moderation, it doesn’t work well during periods of high inflation, when inflation expectations change rapidly. Likewise, it does not seem to be a useful model in periods such as the Great Depression and the Great Recession, where expectations fall too fast. According to economists’ interpretations of the Great Depression using the IS-LM, monetary policy was supposed to be expansionary. Likewise, in 2008, many economists said that monetary policy was expansionary after looking at interest rates and the IS-LM. But it wasn’t. Hence the IS-LM can be useful when everything is stable, but otherwise it’s not a useful model. But why would we use IS-LM in our analysis if it is a model that is only useful in stable periods? I am not in favor of using a model that can mislead economists at critical times like 1929 and 2008.

One might argue that “the problem is not with IS-LM, but with economists misusing the model,” but I’m not making a technical objection to IS-LM anyway. Even if the IS-LM is technically a perfect model, it seems clear that economists were misinterpreting something in 2007. As I said above on supply and demand, low rates could result from a shift in the IS curve, but it’s clear that most economists didn’t think so in 2007 because they thought low rates implied expansionary monetary policy. That’s why I prefer a simple AS/AD model, where output can change depending on supply and demand shocks. And AD is equal to NGDP (determined by monetary policy), which is why I argued earlier that the concept should be called “nominal expenditure(s),” not AD. I think this model is more useful than the IS-LM model.

3. I don’t think corporate tax cuts benefit only the rich. On the contrary, it benefits everyone. Likewise, I think capital gains tax is meaningless. Wage taxes, in principle, tax current and future consumption at the same rate. On the other hand, a capital gains tax taxes future consumption at a higher rate than current consumption. What principle suggests that something like this would make sense? The new proposal will raise the rate above 50%. The highest rate in the world is 30% (Sweden), which is close to the current US top rate.

To be honest, I’d prefer to repeal income tax for both individuals and corporations(and inheritance tax) and replace it with a consumption tax. Then a VAT where the poor pay 0% would be ideal. Likewise, I’d prefer a progressive payroll tax. And a progressive property tax. And, of course, the carbon tax.

This tax system would be more efficient without requiring the high rates we have now. Perhaps one could argue that the consumption tax will be regressive, but that’s not true:

Consumption tax is almost all about being consistent over time. We can have a tax system that is more progressive but simple, useful, and efficient.

4. One of the reasons I prefer the term “nominal expenditure(s)” is because it refers to a specific amount. That’s why I think AD is actually something different from “demand.” For the same reason, I think using different models for business cycles will give more precise results. I prefer to use one model for nominal shocks and a separate model for everything else (real shocks). The second includes the natural rate of unemployment, technology shocks, taxes, etc. It will help to explain the changing factors. These are especially important when prices are flexible.

But the sticky wages/prices problem makes it impossible to explain business cycles by using only real shocks. Indeed this problem is very different from the rest of economics(which is why I think DSGE models are unreliable). The model I would prefer to use for nominal shocks would focus on explaining changes in nominal aggregates. That’s a model that focuses on employment fluctuations attributed to price and wage stickiness. The “optimal level” will vary depending on the type of wage stickiness, requiring us to define nominal shocks in terms of wage stickiness. This is why nominal expenditures are more useful than “AD”: when we talk about nominal shocks, we will ultimately focus on wage stickiness. Instead, many macro models focus on variables that do not affect the nominal optimal level.

Sticky prices, nominal shocks, and the optimal level are key variables in explaining business cycles. So when I saw Sumner’s model for a few days ago, I thought it was pretty close to the model I’ve been considering for a few years. It’s not exactly the same, but it almost is:

 When I used to teach macro, students had all kinds of trouble understanding AS/AD, partly because they assumed it was basically a supply and demand model.  Thus if I asked them to show the effect of population growth, they might shift the AD curve to the right.  In fact, population growth shifts the AS curve to the right, causing deflation (as we saw during 1870-95).

Why were students confused?  Probably because in microeconomics an increase in population really does shift demand to the right.  More consumers out shopping, etc., etc.  But aggregate demand isn’t really about demand at all; it’s about money.  More specifically, it’s about the medium of account.  In the late 1800s, gold was the medium of account, the thing in terms of which prices were measured.  Population growth didn’t cause more gold to circulate.

By removing the terms ‘demand’ and ‘supply’ from the AS/AD model, I hope to shake students out of their complacency, to show them how truly strange this model actually is.  It’s not a supply and demand model at all; it’s a model of how nominal shocks interact with sticky wages and prices to produce short run (but not long run) effects on real output.

P.S: Bill Wirtz has a new piece on global minimum corporate tax:

The conversation about global tax rules is tiresome because they deal in the age-old erroneous belief that companies actually pay taxes. Again, only three actors in a company can pay taxes: shareholders through reduced dividends, workers through receiving lower salaries, or consumers through paying higher prices. Nobody else can pay the tax; the building cannot, the carpets cannot. The fallacy of the corporate tax is, in its fundamental essence, not just that the negotiations between countries lead nowhere, but that the tax in itself is just another tax on consumers.

There is no reason to worry – yet

The Fed announced the CPI for May:

0.6% is still at a fast pace. But I don’t think we should worry. The rates announced so far match Claudia Sahm’s predictions:

If we look at the PCE index, inflation has started to made-up its dip in 2020, but this does not necessarily imply that tightening is needed(say within 1-2 months). By the end of this year, inflation may fall as base effects, and supply bottlenecks may work in reverse. In this case, tightening will cause inflation to fall below the average. For example:

What I understand from the Fed’s statements is that they do not only want to hit 2% inflation on average, but that they want a sustainable average of 2% inflation. For this reason, even if inflation reaches an average of 2% in (say)June, monetary policy does not need to be tightened for the rest of the year. Base effects and supply bottlenecks will eventually reduce inflation towards the end of the year, which will be consistent with the 2% inflation target for 2020-2021.

I think Sahm’s projection better describes the Fed’s framework. However, it should be said that the Fed should be more clear in defining AIT. Many people understood AIT not as a sustainable average inflation target of 2%, but as hitting 2% on average. There is no reason to worry, many businesses are still recovering – we are not yet at the level to make up. But we’re getting closer.

We should always be cautious about inflation, but we should also look at other variables. What I see is that the average %2 inflation will be achieved at the end of the year. If we tighten it now, it will mean slower growth and more unemployment. Not yet.

P.S: NGDP data suggests we still have to go. NGDPLT would be a more efficient and understandable framework than AIT.

P.P.S: Employment data released last week:

Tyler Cowen quoted Betsey Stevenson last week:

The problem is that old jobs are long gone for the vast majority of those who remain unemployed.

I think this may be true. Workers were suddenly leaving their jobs at record rates:

Scott Sumner looks at employment rates by age groups here, and it’s pretty interesting. Read the whole thing.

Maybe the old jobs are really gone. In the last two years, especially the shopping sector has undergone many changes, we will see if this will change in the post-covid period. But a significant part of the old work does not seem to be coming back.

P.P.P.S: Tom Spencer has a Substack post on inflation alerts in the UK. Similar to the US, there is no reason to worry:

As we exit lockdown and reopen the economy we must not make the same mistake. The Bank of England should and does expect a slightly higher rate of inflation during our recovery. Stable forecasted inflation tells us that individuals and businesses alike have confidence in the economy and they’re willing to spend. This is something we should embrace and celebrate – it shows that people have faith in Britain. Those economists fearing a return to 1970s style stagflation must not be allowed to stop this recovery from happening and must embrace a slightly higher rate of inflation in the short run.

Economics failing us. What about the EconTwitter?

There has been a buzz on EconTwitter and academia lately. I think the first thing I saw on this was Tyler Cowen’s post, where he compared blogs and Twitter. Although I preferred to use Twitter until last year, then I opened this blog for my own reasons. Even though it is a topic that I want to talk about, I postponed publishing this post for a while, but the discussion has been heated in the last few days, and I felt the need to write something.

Let’s start with Tyler’s last post at Bloomberg:

On Twitter (and, earlier, blogs), barriers to entry are very low and a Ph.D. is not required. That can be a good thing, but quality checks are extremely weak.
Here’s the dirty little secret that few of my fellow economics professors will admit: As those “perfect” research papers have grown longer, they have also become less relevant. Fewer people — including academics — read them carefully or are influenced by them when it comes to policy.

I agree with Tyler about the entry barriers, but I don’t think that’s the only reason. I do not think that the current entry barriers in the academy cause us to reach more reliable results. True, we have a high standard today, especially in technical terms, but we cannot deny that many journals fail in terms of quality control. Methods such as appendices, robustness checks, co-authors, etc., may technically give us better quality products. Still, we should not assume that we are reading works free from academic bias or ideological concerns. When I look at today’s journal world, I see inflation of ivory towers. In a world where echo chambers and intellectual bubbles expand so much, I don’t know if there is anything important that high technical barriers bring us in practice.

But it’s not just academia suffers from that; the low barriers on Twitter allow anyone to say “you don’t know anything” on a highly technical issue. In blogs, we place more emphasis on cross-checks, if not as much as in academia; but it’s hard to focus on this aspect of economics on Twitter. Nobody reads floods of 50 tweets like nobody reads journals. So you have to write in simple words, saying very little, and it is pretty difficult to do so.

One solution for this is to set up Substack. Then, you can write longer posts and share your post with a summary. That would be getting around the negative side of Twitter. However, I still can’t understand the difference between Substack and the blogosphere. I do this on this blog (except for features like subscribing, of course). While the blogosphere feels old-fashioned, Substack seems like a more modern and new alternative, but I’m not sure if there is a fundamental difference (feel free to comment if you think there is).

Here’s more:

Actual views on politics are more influenced by debates on social media, especially on such hot topics such as the minimum wage or monetary and fiscal policy. The growing role of Twitter doesn’t have to be a bad thing. Social media is egalitarian, spurs spirited debate and enables research cooperation across great distances.

Although I do not think that this is inherently bad, I believe that such an approach on Twitter can cause problems. We need to discuss whether social media is egalitarian(I don’t think it is). If we mean that anyone can write what they want or be popular with enough engagement, yes, it is. But we have a good reason not to think that this is totally fine.

Consider the barriers and expenses required to release an album in the ’90s. Nowadays, you can release any song/album you want on Spotify, Youtube, or similar platforms with a very low barrier and little expense. This isn’t necessarily a bad thing, but it does lead to band/song inflation. The effort you need to spend to discover a high-quality band is increasing day by day. Although Spotify has specific solutions for this, it is not enough, and there is no such solution for EconTwitter. I wonder how many tweets are posted on EconTwitter in just one day and how much effort it takes to read just the good ones. If you’re a multidisciplinary person, let’s say political science, you have to spend an incredible amount of time. I don’t think this is a sustainable thing. One could say the same about journals. Today there are hundreds of thousands of journals, and thousands of papers are published in all of them. We cannot read them all. But I’d already argued that it’s not just Twitter’s problem; I think we have serious academic publication inflation, and obviously, high technical barriers aren’t the solution.

In his Substack post, Joshua Miller argued that “Economics Twitter involves more steelmanning of arguments than twitter.” I partially disagree with this. Of course, Twitter is slightly more personal, but I believe this can push it into more toxicity than more steelmanning arguments. This may not have happened yet, but there is always a possibility. More importantly, it is important to remember that such personalization can further separate echo chambers or bubbles from one another. You could say that blogs make echo chambers worse, but I can’t think of an argument that Twitter is better. Over time, the people you interact with become more like the content you choose to see, and the Twitter algorithm does this on purpose because it naturally wants you to interact with people who are similar to you. Without this mechanism, Twitter wouldn’t make any sense. You may be trapped inside a tiny bubble without realizing it.

Joshua later writes that “Economics Twitter is arguably more plugged in to actually academic discourse than blogs are.” It is true that most of the most successful economists of our time do not have blogs or that top papers are being talked about more on Twitter. Still, I don’t think that necessarily leads to the conclusion that EconTwitter is preferable to blogs. It could be a simple matter of preference, or it could result from any Twitter user sharing something about every part of their life. Most bloggers also have Twitter – they don’t contradict each other. Lastly, I totally agree that Twitter is more fun than blogs; memes are not something we often see in the blogosphere.

Tyler then talks about the ideologization of the economics profession:

As economics has become more ideological, it has also become less forthcoming about its ideologies. And that has led to less intellectual diversity and fewer radical new ideas. That, in a nutshell, is the main problem with the economics profession.

I agree, but economics has never been a profession without ideologies. I don’t think we can think of Hayek, Friedman, or Keynes without an ideological perspective. Likewise, the fact that market monetarists have more libertarian leanings cannot be explained without ideological interpretation. The problem may be more ideologicalization (as Tyler argues), but I don’t think the problem is just about that. Matthew Yglesias talks about this in his latest Substack post:

But in economics, which I do know well, I think it’s a big issue. If someone tweets something you agree with, it is easy to bless it with an RT or a little heart. To take issue with it is to start a fight. And conversely, it’s much more pleasant to do a tweet that is greeted with lots of RTs and little hearts rather than one that starts fights. So I know from talking to econ PhD-havers that almost everyone is disproportionately avoiding statements they believe to be locally unpopular in their community. There is just more disagreement and dissension than you would know unless you took the time to reach out to people and speak to them in a more relaxed way.
My strong suspicion is that this is true across domains of expertise, and is creating a lot of bubbles of fake consensus that can become very misleading. And I don’t have a solution.

I think that’s exactly the problem. The real world is more complex and controversial than the world of academia or Twitter. On an issue where there is no consensus even in the academic world, you might think that there is consensus during your time on Twitter, and this can lead you to wrong conclusions as Twitter is clearly a more left-leaning platform. Likewise, what you repeat in your echo chambers in the world of journals can lead to misinterpretation of the world and a kind of intellectual laziness. I suspect this problem has caused a sort of recession -not only in economics but in the social sciences or academia in general. The post-truth period has an impact on the social sciences becoming this way; this is an undeniable fact. On the other hand, we should not forget the social scientist’s arrogance of being the only person who knows the truth and his/her delusion that he/she has no ideology. That’s why I think the analysis of “ideologization” misses something. The academia’s recession stems from arrogance, non-ideologization, and separation of echo chambers rather than ideologicalization.

Finally, the self-censorship of intellectuals is also a major problem. Whether you interpret this through the woke/cancel culture or something else, it hinders productivity and progress. At this point I must say that I am an exception, albeit partially. I don’t mind taking unpopular stands on economic/political issues on my blog, but I feel compelled to be more careful on Twitter(at least in English).

Like Yglesias, I don’t have a comprehensive solution to this. However, in academia, I recommend quality barriers rather than technical barriers. It is also important to focus on reliable institutes and research centers where top-tier economists work together(Mercatus does this). In this way, we can get a little further away from publication inflation. And so we can compensate for the negative aspects of Twitter. I think academia, Twitter, and blogs can work together; we don’t have to choose one over the other(Substack showed us this). So the “Why not both” approach might be better. For myself, I’ll probably still give more weight to blogs, but EconTwitter looks promising – once we get out of the academic recession.

No one has described the problem with Twitter better than the official Twitter account:

P.S: It is also possible to see the academia as a pyramid scheme in a sense. I remember a story a friend told me. Someone who studied Egyptology had to get a MA/phD after graduation because there was no job in the field, and now he is teaching students at the university a profession that they can’t do any job outside of academia.

Can overshooting also cause recession?

In recent years, the Fed predicted inflation would be below the target. For a while, inflation remained below 2%. It has risen above 2% this year, and it looks like it will stay around for a while. Actually, this situation itself is not a problem. Last summer, the Fed switched to “average inflation targeting,” which includes offsetting periods below 2% with periods above 2%(and vice versa).

As I wrote earlier, I am not worried about inflation staying in this situation for the time being. However, I believe there is another reason for us to worry. The danger is that the Fed is unwilling and conservative to adjust its policy instruments according to changing economic conditions.

One might say, “The Fed will be fine.” Don’t mistake; I think Powell did and does a pretty good job. Nevertheless, what we have witnessed before shows reason to worry. George Selgin here argues that the increase in interest rates in 2015 was not related to the target, but because very low interest rates were not desired for “uncertain and difficult to describe” reasons. If you start to think that the policy tools are the policy goal itself, then you will go astray.

Today we may be experiencing an opposite scenario. While it may be too early to say something, the Fed may be treating low rates as the goal itself, not as a means to reach the inflation target. So I believe there is a possibility that the Fed may hesitate to raise interest rates, even if economic conditions call for it.

When the ECB was established, it adopted inflation targeting to control(and reducing) inflation. However, the process resulted in the ECB trying to increase inflation due to the problems created by inflation targeting. Likewise, AIT may result in the Fed trying to reduce inflation at the end of the process(say to zero bound).

5-year TIPS spreads increased to 2.6-7%. This means PCE inflation of about 2.3-4% in 5 years, and that’s enough to offset:

Many people know and understand that tight monetary policies can create business cycles, but much less know and understand that expansionary monetary policies are equally likely to create business cycles(Austrians like Hayek got it). The optimal rate is roughly 4% growth of NGDP each year. No more, no less.

Right now, I’m not worried about the overheating of the economy, but certainly not because I don’t think it’s bad. The overheating of the economy is the footsteps of a major crash and will likely create a recession soon after. So don’t listen to people who were already discredited in 1968, that is, claiming that overheating would not be so bad as it would help workers find jobs. The real risk of an overly expansionary monetary policy is that it will later cause a recession.

If the TIPS spread reaches 3%, it will be an obvious sign that the Fed is falling behind the curve and will likely overheat. Another sign could be a sharp increase in long-term T-bond yields. Fortunately, we are not at this point now. The bond yields are pretty low, so we don’t have to worry for now.

The Fed should repeat its 2% AIT commitment regardless of whether this commitment is easier or tighter money. Moreover, they should say that your interest rate target will depend on the data, and if necessary, they can make significant changes in the fund target to keep the average inflation at 2%. And they must strive to internalize this perception. Because as long as people do not internalize this perception, it can cause bigger problems: