Thefutureofmacroeconomics:whycentralbankmodelsfailedandhowtorepairthem

JohnMuellbauer,INET@Oxford.INETConference,October232017

Edinburgh

AttacksonNewKeynesianDSGE

• Buiter (2009)voxeu.org/article/macroeconomics-crisisirrelevance

• ”Researchtendedtobemotivatedbytheinternallogic,intellectualsunkcapitalandaestheticpuzzlesofestablishedresearchprogrammes ratherthanbyapowerfuldesiretounderstandhowtheeconomyworks- letalonehowtheeconomyworksduringtimesofstressandfinancialinstability. Sotheeconomicsprofessionwascaughtunpreparedwhenthecrisisstruck.”

• “BoththeNewClassicalandNewKeynesiancompletemarketsmacroeconomictheoriesnotonlydidnotallowquestionsaboutinsolvencyandilliquiditytobeanswered. Theydidnotallowsuchquestionstobeasked.”

• “Marketsareinherentlyandhopelesslyincomplete.Livewithitandstartfromthatfact.”

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Muellbauer(BIS,2010)

• “UnderlyingconceptualreasonsforthefailureofcentralbankmodelsoftheDSGEtypeincludetheirtypicalassumptionsaboutrepresentativeagents,perfectinformation,zerotransactionscosts,andofefficientmarkets.

• Formostofthesemodels….itisasiftheinformationeconomicsrevolution,forwhichGeorgeAkerlof,MichaelSpenceandJoeStiglitz sharedtheNobelPrizein2001,hadnotoccurred.

• Thecombinationofassumptions,whencoupledwiththetrivialisationofriskanduncertaintyinthesesupposedlystochasticmodels,andthelinearisation techniquesusedintheirsolution,rendermoney,creditandassetpriceslargelyirrelevant.

• Thecalibration/estimationmethodscurrentlyusedtoapplythesemodelstothedatatypicallyignoreinconvenienttruths.“

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• PaulRomer (2016)complainsthat`Formorethanthreedecades,macroeconomicshasgonebackwards’.Hefocusesoncalibration/identification.Butthreeseriousproblems,seehttp://voxeu.org/article/why-central-bank-models-failed-and-how-repair-them,werenot raisedbyhim:

• thechoiceofthewrongmicro-foundationsignoringtheasymmetricinformationrevolutionofthe1970sandDeaton-Carrollresearchonbuffer-stocksavingwhenhouseholdsfaceidiosyncraticuncertaintyandliquidityconstraints.

• theflawedbasisofinter-temporaloptimizationwhenstructuralbreaksandradicaluncertaintyareendemic,Hendry&Mizon,VOXEU2015;

• andthefailuretoallowforthemajorchangesinfinancialarchitectureandtolinkbalancesheetsandflowoffundstospending intherealeconomy.

• InthefashionableNewKeynesian‘scienceofmonetarypolicy’(Clarida,Gali andGertler,1999)creditsectors,moneyandassetpriceswerethoughtirrelevant.

Romer critiqueandbeyond

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Blanchard’smildercritique

• Blanchard(2016,2018)acknowledgesthatcurrentDSGEmodelsmake‘simplifyingassumptions,asanymodelmust,butassumptionsprofoundlyatoddswithwhatweknowaboutconsumersandfirms’.Healsoquestionscalibrationandestimationmethods,normativeimplicationsandtheireffectivenessascommunicationdevices.

• HefavoursmajorrepairsandalessimperialisticattitudesothatalternativeGEmodels,closertothedata,canflourish.

• Many(BOC,DNB,ECB,evenBOE)haverealisedtheneedfornon-DSGEmacromodels.

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Flowoffundsandbalancesheets

• Postcrisis,centralbankshavestudiedtheflowoffundsandfinancialbalancesheetsmuchmorecarefully.

• NewattentiontooldideasofTobin,resurrectedinstockflowconsistent (SCF)approachesofGodleyandLavoie(2012),Burgessetal(2016),BOE,StaffWorkingPaperNo.614.

• Butbehaviourallinkswithspendingandhencetherealeconomyareasyetweak inallthesemodels,includingFRB/US.Somissbusinesscyclefeedbackloopsandunderstandingofriskstofinancialstability.

• FRB/USfailedacidtestincrisis:in2007JacksonHolesymposium,Mishkin reportedFRB/USsimulationsofa20%declineinrealhousepricesover2007-2008:GDPlowerthanbaselinebyatmostONLY0.25%inearly2009!

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NKDynamic,Stochastic,GE:thatwouldhavebeennice!

NewKeynesianDynamicStochasticGeneralEquilibriummodels• Notnew,basedonoutdatedideasmaderedundantbytheasymmetricinformation

revolutionofStiglitz,Akerlof,Spence.• NotKeynesian,ignoringco-ordinationfailures,especiallybetweenrealeconomyand

finance.• Notdynamicenough,misleadingonrealworldlagstructures.• Hardlystochastic(statisticaldistributions),missingbothradicaluncertainty(time

dimension)andheterogeneity(cross-sectiondimension)ofdistributions.• HardlyGE,missingmostofsystemfeedbacks.• Rationalexpectationsandinter-temporaloptimizationneedreformulationwhen

structuralbreaksandradicaluncertaintyareendemic,Hendry&Mizon,VOXEU2014;

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Outline

• Theendoftherepresentativeagentmodel• Asymmetricinformation,liquidityconstraints,incomeuncertainty.• Theimplicationsoftherevolutionincreditmarketarchitectureandwhydebt

matters.• Aconsumptionfunctionrelevantforunderstandingthefinancialaccelerator.• Modellingjointconsumptionandportfoliodecisions– towardsbettereconometric

macromodels.EvidencefromUK,FranceandGermany.• ThistalkdrawsonpaperwithDavidHendry,forthcomingOXREPspecialissueonthe

futureofmacroeconomicsincludingpapersbyBlanchardandStiglitzhttps://ideas.repec.org/p/oxf/wpaper/832.html

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1.Norepresentativeagent

• Unemploymentriskvariesgreatlybyoccupationandeducation,makingnonsenseofRBCrepresentativeagentmodelofunemployment.

• Creditconstraints,mortgagedefaults,negativeequityvaryhugelyacrosshouseholds:norepresentativeagent.

• Stochasticaggregation- workingwithmeansandotherdistributionalparameters- suggestswecanstillmakegreatprogresswithaggregatedata,includingunemploymentrate.

• Houthakker (1956)showedfixedcoefficienttechnology(nosubstitution)atthemicro-levelimpliedhighdegreeofcapital-laboursubstitutionformacro,givenParetocoefficientdistribution.

• Aron&Muellbauer(J.Urb.Econ.July2016)trackaggregateincidenceofUKnegativeequitygivenstabledistributionofmortgagedebt/equity.Driverofarrearsandrepossessions.

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2.Incomeuncertainty,liquidityconstraintsandbufferstocksaving

• OneareaofAngusDeaton’sworkhighlightedbyNobelcommittee:

• 1991Econometrica paper:

– laidthemicro-foundations,implyingbufferstocksavingandshortertimehorizons,i.e.muchhigherdiscountsonfutureincomethanincanonicalpermanentincome.

• 1992book,last10pages:

• summaryofthemassivemicro- &macro-dataevidenceagainstthesimplepermanentincometheory.

• ChrisCarroll(1992,2001,2014)hastakenthebufferstocktheorytonewlevels,evenwithoutcreditconstraints.

• Studyingstochasticincomeprocessesempirically,hecalibratesconsumptionresponsesunderplausiblepreferenceassumptions,atdifferentcash-on-hand/incomeratios.

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Illiquidassets

• Deaton(1992)saysthatsinceconsumers’balancesheetsincludeilliquidassetssuchaspensions,stocksandbonds,andhouses:

– “thepresenceoftheseilliquidandsometimeshigh-yieldingassetsneedstobeintegratedintothemodelofcredit-constrainedconsumers”.

• Recentliteratureonheterogeneousagentmodelsisdoingthis:KaplanandViolante(Econometrica 2014)andKaplan,Moll&Violante HANKwp 2016,forthcomingAER);Hedlund,Karahan,Mitman &Ozcan,2017withbettertreatmentofhousingandliquidity.

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3.UKcreditmarketarchitecture

• UKabandonedexchangecontrolsin1979;eliminated‘corset’onbanklending;

• Banksinvadedmortgagemarket;

• Buildingsocietiesresponded,newlibertiesin1986BSAct.

• Centralisedmortgagelendersinvadedin1986-1990.

• Mortgagecrisisledtocreditcrunch.

• After1996,creditliberalisationforbuy-to-letmarket;increasedsecuritisation;newbreedofcentralisedlenders.

• Fernandez-Corugedo andMuellbauer(BOEWP2006)trackmortgagecreditconditionsindexconsistentwithabove.

• From2008,creditcrunchandre-regulation,partialrelaxed.

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4.Whydebtmatters

• IrvingFisher’s1933debt-deflationtheoryofgreatdepressionsandbookonBoomsandDepressions:– creditavailabilityexpands,pushesupspending,debtandassetprices,

irrationalexuberanceraisespricestovulnerablelevels,negativeshockscanthencausefallsinassetprices,baddebt,creditcrunch,riseinunemployment,deflation.

• ExplainingthecollapseinUKpersonalsaving(MuellbauerandMurphy,1990):– (unsustainable)credit-liberalisation-drivenhousepriceboom:evidencethat

debthadfarmorenegativeeffectonspendingthanpreviouslythought

– Hencecrucialtocontrolfortheshiftincreditconditions!• AdairTurner(2015) BetweenDebtandtheDevil:Money,Creditand

FixingGlobalFinance• Mian andSufi(2014)HouseofDebt.• Jorda,Schularick andTaylorEconomicPolicyJan2016onroleofreal

estatecollateral.

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Modellingthehouseholdfinancialaccelerator(Ducagraphic)

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LowerDemandforHousing

SlowerGDPGrowth

? HomePrices&Wealth,SlowerConsumption

MortgageandHousingCrisis

LessHomeConstruction

LowerCapitalofFinancialFirms

? Counter-PartyRisk,Money&BondMktsHit

CreditStandardsTightenedonAllLoans

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5.Amoregeneralconsumptionmodel

• Weneedamoregeneralconsumptionfunction&incomeforecastingmodeltocapturetheconsumptionchannelinthefinancialaccelerator.

• UnlikeEulerequation,thebasisofNK-DSGE,donotthrowawaylong-runinformation onincomeandassets.

• Networth=liquidassets– debt(mortgageandother)+illiquidfinancialassets(pensions+stockmarket)+housingwealth.

• Absurdtoassumeeffectonaggregatespendingisthesameforeachelementandtoassumenoshiftsincreditaccessalsoinnon-DSGEpolicymodels,e.g.FRB/US,newECB-MC,oldMTMM&OBR.

• Consumptionfunctionisconditionalonendofpreviousperiodportfolios,onassetpricesandonaccesstocredit,soneedtoexplaintheseinafullmacromodel.

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Institutionsmattergreatly

• Restrictive(conservative)creditmarketssuggestaggregateconsumptionfallswhenhousepricesrise:- (e.g.GermanyorJapan)

- futurefirsttimebuyers(andrenters)savemoreforadeposit(orhigherfuturerents),thoughaggregatenegativeeffectshouldbelowerwhereproportionofowner-occupiersishigh(Italy).

- home-ownershavelimitedaccesstohomeequityloans.

• Liberalmortgagemarketsimplytheopposite:- alowerratioofdown-paymentstovalueapplies,sofuturefirsttimebuyers willsave

littleandnotrespondmuchtohigherhouseprices;

- Greateraccesstohomeequityloansraisesresponseofspendingtohousingcollateral.

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CCIincludingpost2001dummies

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DecomposeUKlong-runsoln (a)

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DecomposeUKlong-runsoln (b)

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InsightsfromUS&UKconsumptionfn

• Onhowconsumption/incomebehavedoverthelong-run,inthebuild-uptothefinancialcrisisandduringthecrisis.

• Notebuildupofdebtobligationduringlongperiodofcreditliberalisationandrisesinassetprices.

• Insightsintoroleofdebtandshiftingcorrelationswitheconomicgrowth:negativeroleforlevelofdebt,positiveforgrowthofdebt noticedbymanyobservers.

• Reconciledbyshiftsincreditsupplyandcontinuousnegativeimplicationsoflevelofdebtforconsumption.i.e.omittedcreditsupplyexplainsshiftingbivariatecorrelationsofdebtwithgrowth.

• Short-runroleforchangeintheunemploymentrate- proxyforincomeinsecurity,andinUK,cash-floweffectsofchangesinnominalinterestrates.

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Householdsystemneeded

Needconsumption-portfolio-assetpricesystem.• Toplugconsumptionfunctionwithdisaggregationofwealth

intoamacromodel,weneedequationsforassetsanddebt.

• Extractcreditconditionsaslatentvariablesfromsamesystem(LatentInteractiveVariableEquationSystem).

• ECBw.paper1904onGermanywithFelixGeigerandManuelRupprecht ofBuBa;draftpaperwithValerieChauvin,BdeFrance

– estimate6-equationsub-systemforconsumption,unsecureddebt,mortgagedebt,liquidassets,housepricesand‘permanentincome’.

• EstimatedunsecuredandmortgageCCIsimplysmalleffectsonGermanconsumptioncomparedtoUKorFrance.

• Solvespuzzleofdivergentrealhousepricesandhh savingrates.

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Neweconomicstories

• MonetarytransmissioninGermanyisverydifferentfromtheUSandUK,andsomewhatdifferentfromFrance.

• Changingdemographyismuchmoreimportantforchangingcompositionforaggregatehh portfoliosthanforconsumption,conditionalonthoseportfolios.

• Willslowlyfeedthrough,viaportfolios,toconsumption–relevantforsecularstagnationhypothesis.

• Empiricalevidenceonnegativespendingimplicationsofhouseholddebtcastsdoubtonpost-crisismonetarypolicy.

• Micro-evidenceISimportant:testbehaviourhypotheses,helpcalibrateeffectsofdemographyanddistributionalchanges.

• Macro-shiftsincreditconditionsandassetpriceshavemacroeffectsthatshouldnotbeignored.

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Otherinsights

• Someremarkableempiricalinsightsnotavailablefrommicro-cross-sectionsorshortpanels:

• Contrarytotext-bookview,majorroleforNOMINALinterestrateindrivinghouseprices(andmortgagestock);roleofusercostincreaseswhereleverageishigher(highLTV).

• Increasedaccesstounsecuredcreditreducesdemandforliquidassets– ignoredbypreviousresearchonhh demandformoney.

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DefendersofNK-DSGEclaim…

• thatmodelisflexible• needmodeltotell‘economicstories’builtonmicro-

foundationsandtoincorporateexpectations.Aucontraire:• Eulerequationisstraitjacketstronglyrejectedbythedata.• Theclaimedmicro-foundationsaresand:thereisno

representativeagent;information-economicsrevolutionimpliesheterogeneityand,onaverage,shorthorizonsinthefaceofliquidityconstraintsandincomeuncertainty.

• KeyeconomicstoriescannotbetoldinNK-DSGEbutcan betoldwithnewformulationofhouseholdbehaviour.

• NK-DSGEisnotstochasticenough,notdynamicenoughandnotgeneralequilibriumenough:failstocapturesystemfeed-backs.Moreover,notnewandnotKeynesian.

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