Arnold Kling  

Where are the Macro Theorists? Help Me Out

Too Clever... Mankiw, Rogoff, and Merton...

What macroeconomic theory says that we run the risk of a Depression if we don't have a bailout? Try to come up with an argument that is either already in a textbook or that you would put in a textbook. If macro is a genuine discipline, it has to consist of something more rigorous than "If Bernanke is worried, then so am I."

In layman's terms, we are trying to answer the question of how Wall Street relates to Main Street. How do you explain why we need to help Wall Street to help Main Street?

The IS curve, for example, represents a feedback mechanism from Wall Street to Main Street. When credit markets tighten, interest rates rise, and investment declines.

The LM curve represents feedback from Main Street to Wall Street. As the pace of economic activity picks up, people have to use more cash. They remove assets from Wall Street, and interest rates increase.

But what theory describes the motivation for the bailout?

The textbook analysis says that when interest rates rise, the Fed can supply more money to bring them back down. Why can't that work today? Any macro theorists want to answer? Bueller?

As far as I can tell, the theory that is implicitly being employed today is something like the following.

The Fed is constrained by a "bank capital trap." As in a liquidity trap, the Fed may be unable to end a recession by injecting reserves into the banking system.

In the liquidity trap, the problem is that borrowers already are paying minimal rates, but because of deflation the real interest rate is high. Clearly we're not in that situation. Borrowers' real interest rates are not high because of deflation. They are high because nominal rates are high, due to hefty risk premiums.

Insttead, we are in a capital trap, because the binding constraint at banks is capital requirements, not reserve requirements. Adding more reserves has no effect. If the Paulson plan is turned down, then this theory says that the binding capital constraint will lead to higher interest rates for borrowers, a slowdown in economic activity, more loan defaults, more erosion of bank capital, and a downward spiral.

I have not seen the "capital trap" theory in any macro textbook. How can we be undertaking one of the most extreme policy measures in economic history based on a theory that no one has ever studied?

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The author at PrestoPundit in a related article titled QUOTE OF THE DAY writes:
    What macroeconomic theory says that we run the risk of a Depression if we don't have a bailout? ..  If macro is a genuine discipline, it has to consist of something more rigorous than "If Bernanke is worried, then so... [Tracked on September 28, 2008 2:50 AM]
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Randy writes:

It seems to me that if we're actually on the edge of a depression, then $700 billion isn't going to stop it. And, if we're on the edge of a depression, then it needs to happen. Something is seriously out of whack and a serious correction is necessary - even if it brings about the downfall of the current political class - especially if it brings about the downfall of the current political class.

TC writes:

Thank you for posing the question in such a direct way.

What school of economic theory says that they way you avoid a recession is to have the Secretary of the Treasury start his own hedge fund?

Correct me if I'm wrong, but this idea has not only never been tried before, prior to a few weeks ago this idea had never been proposed before. But now we are told that this is only way to beat recession.

Let me ask you this..........

What would be the advantages and disadvantages of having the US Treasury purchase a large number of US Treasuries, increasing the money supply significantly and taking a big chunk of US Treasuries off of the market?

Let's just say for the sake of argument that the US Treasury decided to junk the Paulson plan and, instead of purchasing 700 billion dollars of Mortgage Backed Securities and other assets, decided to purchase an additional 700 billion dollars of US Treasuries beyond the amount of US Treasuries they had previously planned to purchase?

This would put more cash/liquidity into the market, although I suppose it wouldn't place as much in the market because US Treasuries are already considered reasonably liquid investments compared to Mortgage Backed Securities.

What would be the result? High inflation? A fall in the value of the dollar? A drop in foreign investment?

How would the various "players" be affected? How would this affect the ability and willingness of commercial banks to lend money, since this seems to be the mean motivation for those inclined to support the Paulson plan in the first place?

Jonathan Walz writes:

I don't know how any bailout can change the economic trajectory of a full economic depression. Recession, maybe, and then again, maybe not.

Very troubling, the sheer number of unanswered questions that sit atop this 700bln plan.

As for liquidity problems, I had the pleasure of listening to a friend who is an economist explain the "dire" conditions that exist at present and as she perceived the current situation (a variation on the domino effect).

If Enterprise A (shoe store) losses access to its full line of credit which it requires to meet payroll and purchasing for any given quarter, then Enterprise A will not be able to pay Enterprise B (shoe wholesaler), who also is suffering from the same credit dillema. Enterprise B is restricted in credit capitalization and hence cannot make payments to Ent.C and D and E etc,. The tight credit environment forces layoffs and cutbacks in spending and production. As this trend spreads, the result is economic contraction, collapse and long-term depression (from Wall Street to Main Street.)

This simplistic explanation does not convince me of the wisdom of a 700bln bailout. I'm not entirely convinced that the above scenario is one to be taken seriously although it seems plausible given the reliance of large corporations on debt instruments (commercial paper) to fund business operations.

This is my understanding. I can only hope that someone will write a more cohesive narrative which answers Mr. Kling's question.

CB writes:

Isn't what's at stake the viability of the Federal Reserve Banking System model and foreign capital inflows? It seems to me that $700 billion plus the $300 billion to bail out the GSEs won't be sufficient to restore either.

De leveraging can be eased and confidence regained by restoring soundness (including limiting what we allow to be tacitly or otherwise associated with the treasury's full faith and credit), a relaxation of the mark to market rules in s/o and allowing the bargain hunters access through a capital gains rate cut or suspension.

Releasing the money to Paulson to buy back the $1.3 trillion in toxic waste held by China, Japan and a handful of European companies is like Paulson begging Pelosi on one knee to come back. She did, and it will get their attention, but why would they continue as they have, in the absence of confidence restoring structural changes?

shayne writes:

Every macro text/theory I've seen describes the various workable models for exercising control and constraints over INFLATION. But there is little, if any theory relating to DEFLATION. At best, macro theory instills a morbid fear of deflation in economists even to the point of recommending that the only remedy for deflation is to artificially induce inflation, so the inflation control theories can work.

That appears to be the remedy applied to the home/paper deflation phenomena in place now - borrow $700 Billion to re-induce inflation, then hope classical inflation control theories will control that problem.

But the classical inflation control mechanisms advocated by macro theory include shrinking money supply or increasing costs of money (interests rates), both of which are counter to the economic growth stipulated as reason for doing this in the first place.

It appears to me that the Fed, the Treasury and now the elected representatives are falling into the same 'time will solve this' sucker trap that the financial institutions applied. I see no indication that the sucker trap will be any more forgiving for the Fed than it was for the financials.

Indeed, any form of funded bailout at this point will induce inflation. But the 'toxic paper' in the markets is toxic precisely because it hopelessly under-priced the risks - an underestimated and hidden inflation, until recently. The risks are widely known now, so the now known built-in inflationary effects of the 'toxic paper', combined with the induced inflation contained in this bailout will be monstrous. And the Fed will have few tools available to combat it - and even the tools it has will be undesirable to use. The inevitable result is a severe devaluation of the currency that will be out of control.

An alternative ...
Let the existing legal/regulatory system work as designed. Consider outcomes of Lehman and Washington Mutual. Both cases illustrate ability of the existing systems - bankruptcy courts and FDIC takeover - to resolve this issue and separate the performing from toxic assets. In both cases, buyers immediately came forth to purchase the performing assets. Barkley's in the case of Lehman and J.P. Morgan in the case of WaMu. Creditors claims are at least partially satisfied and any remaining negative liability loss is limited by corporate law to the extent of the owner's (shareholders') investment in the prior corporation. Extent negative liability is killed, not spread across the taxpayer base.

The economy is going to take a hit on this, regardless of whether there is a bailout or not. But NOT having a bailout will at least leave our legal system and our currency intact. Any bailout, or even 'temporary' regulatory relaxation, is merely aiding and abetting evasion of the law (writ large) at best, and induce inflationary effects that will be out of anyone's control at worst.

Devin Finbarr writes:

The essential problem is that M0 - the money supply of green dollar bills - is around $800 billion. The broad money supply - M3 - is over $10 trillion. Unfortunately, M3 all consists of leveraged credit with explicit or implicit government backing. If the U.S. government announces it will perform no bailouts whatsoever, the money supply will collapse like a house of cards from M3 all the way back M0. That's a 90% money supply contraction. It would destroy all the price signals of the market, bankrupt every American with a loan, sink every bank, radically redistribute wealth, and force every contract to be rewritten. In other words, economic catastrophe. If the government announces it will only bailout FDIC protected accounts, the money supply would fall greatly, but I'm not exactly sure how much. That would be an interesting number to figure out. I'm guessing it would be enough to also collapse most banks and bankrupt everyone with loans.

I also can't understand your desire to lower capital requirements. Isn't that what got us into this mess? Wouldn't that just be delaying the crisis for a bigger one further down the road?

I suggest you go read Mencius Moldbug's latest post, he's making the most sense of anyone.

GMartinez writes:

Dear Arnold,

I've been explaining the crisis to my class as a drastic increase in Money Demand - in demand for extremely liquid assets and a rejection of bonds. Flight to quality, rise in spreads, etc.

Could the Fed have dealt with the crisis via monetary injection? No, for the reasons that you mention ("a capital trap"),

...but also because a) they were too close to a zero nominal interest rate for comfort and b) they were aware of the fact that monetary policy is too broad an instrument (may generate inflation) even if it had been effective.

Finally, as you well know, the fact that it isn't in undergraduate textbooks doesn't mean that Bernanke's (1983) analysis of the non-monetary factors in the Great Depression is a "theory no one has ever studied."

Today's US crisis, I am sorry to say, is a sad repetition of every post-financial de-regulation crisis that scourged the emerging markets in the last 15 or so years. It's amazing to see what we haven't learned.

... and yet, we have. The people at the Treasury and the Fed (and in Cambridge, MA) dealt with this kind of problem, made mistakes, and are applying quite a few of the lessons.

I hope that another lesson we don't forget is that which the work of Tornell and Westermann (2008) has demostrated: financial liberalization is more risky - no doubt about it - but also the path to greater growth.

As Greg Mankiw points out, there are some who would have us forget.

OneEyedMan writes:

Macro economists don't use IS/LM curves much any more. A couple of years ago my introduction to graduate macro economics professor explained briefly what it was and then hurriedly erased it from the board before any of her macro colleagues saw it and thought she was advocating it.

Milky Way writes:

My respect for you and Alex Tabarok has grown very quickly recently. And my respect for Greg Mankiw has sunk like a stone.

These few days revealed a lot about many macroeconomists (and, in another arena, self-described conservatives).

Dave Tufte writes:

Macroeconomists don't have as much to say about this crisis as we ought to because we have spent generations pushing towards models that combine representative agents with Walrasian equilibrium.

I like both of those directions, and am proud of the strides that macroeconomics has made over the last 40 years.

But ... we gave up something to go in this direction, and there are a great many macroeconomists who aren't even aware that they are missing something.

What we gave up is an awareness that encompasses the possibility that some motivations and consequences in macroeconomics are distributional.

This is not a call for (silly) heterodox approaches, or a return to the legitimately discredited Keynesian approach.

But, none of us should fail to recognize that a representative agent simply can't get into a situation like this where there has been a mismatch between buyers and sellers. An agent in an OLG model might, but then we run into the problem that both types of models are Walrasian - which has many good features - but suffers from the problem that all anyone ever analyzes are interior solutions. For my part, this sure likes like a corner solution, or even better - a catastrophe (in the dynamic modeling sense).

What we're left with is: 1) models where the economy basically is the financial sector, then this is horrible and we need a bailout, or 2) the economy is so much more than the financial sector that we can assume the latter away, and then we don't need a bailout. No one has a model of an economy with two highly interdependent sectors in which the incentives in one sector are so seriously skewed that prices can become undefined within the model.

Paul Prentice writes:

"Where are all the Macro Theorists", you ask?

As F.A. Hayek demonstrated, there is no such thing as macroeconomics. It is the smoke and mirrors of the Wizard of Oz: Pay no attention to the man behind the curtain.

If you want to understand what is happening, your only hope is to abandon the Keynesian and Chicago schools of economic thought and investigate the Austrian school, best found at and at These are the only professional economics websites that are actually talking about the causes of the problem, rather than just talking about the symptoms.

How many times have you read that the problem is the decline of housing prices? Or, the problem is the bad mortgages? Or, the problem is greed, or lack of regulatory oversight, or ...?

Nonsense. The root problem is the deadly combination of:

1) A fiat currency system.
2) A fractional-reserve banking system.
3) A federal government that has broken free of its constitutional constraints -- which, upon further thought, is itself just a symptom of (1) and (2).

Part of the comment posted by Devin Finbarr is spot-on, regarding the $800 billion in monetary base supporting $10 trillion in M3. "Money" has been inflated and turned into "credit". Nothing can stop the de-leveraging that, in my opinion, must occur.

crazy writes:

Excellent points all, but aren't we really stuck in a "crap trap?" IOW, the system is essentially frozen until somebody takes the crap out. Unless Treasury plans to trash the crap after buying it, it's hard to see how this will do anything but keep the crap in the system all because of political fear.

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