Friday, 25 April 2014

Simon Wren-Lewis Defends the Status Quo



The report from the Manchester Post-Crash Economics Society has renewed discussion about the teaching of economics and prompted a few responses.  Simon Wren-Lewis agrees that "[s]tudents should certainly be shown something of heterodox (non-mainstream) thought", but disagrees strongly with the idea that the "current dominance of mainstream economics should be reversed, and that we should go back to ‘schools of thought’ economics."

He gives three reasons for this, all of which deserve some comment.

1. "..because [mainstream economics] has proved far more useful than all of its heterodox alternatives put together."

I'm not going to attempt to address the question of which is more useful - mainstream or heterodox - partly because I think it's hard to specify the question precisely, but mainly because I think it's the wrong question.

Instead, what I think we should be asking is whether the ability to apply different approaches is more useful than only being able to apply one.  And in particular, whether heterodox approaches give us a valuable additional perspective on economic issues.

Amongst the strands of heterodox economics, I mainly look to the post-Keynesian stock-flow consistent modelling approach, most comprehensively set out in the works of Godley and Lavoie.  Whilst there are elements of their work that I would certainly question, I find the balance sheet and flow of funds methodology one of the most useful frameworks for understanding and addressing many questions of monetary economics.

This is especially true in understanding the interactions of financial balances and the dynamics of debt.  I know a number of recent graduates in economics that have subsequently discovered the work of Godley and Lavoie and have seen it as a revelation - a way to finally see how various things fit together.   

But again, the point is not whether one approach is better than the other.  It is whether looking at the issue from different angles is more enlightening than sticking to one. 

2. "...because mainstream economics can be remarkably flexible."

It may well be the case that it mainstream economics has managed to say something useful about a wide range of issues.  However, to me it is the very inflexibility of the mainstream approach that makes the best case for the use of alternative tools.  I think this is particularly the case when it comes to the insistence on microfoundations.

I think it is an excellent principle that what we assume about aggregate behaviour should be grounded in what we think about how people actually behave.  However, the requirement to model from one to the other is sometimes too onerous.  It may be possible in principle to formalise the underlying behaviour for many of the things we want to look at, but it may then be impractical to extrapolate from that.  Reference agents, smooth time horizons and well behaved utility functions are all chosen for tractability.  Sometimes that's fine, but in many cases it forces us into too narrow a perspective on some of the most interesting things that are going on.  It's just too restrictive.  We don't need to throw it out - we just need to be able to be able to look beyond it.

3.  His last reason is simply that he has found" ...at least as much intolerance on the other side. Some heterodox economists appear to reject almost everything that is mainstream, which is frankly just silly."

Now, I have some sympathy with this.  I think there are many heterodox economists who think mainstream economics can tell us nothing.  I think this is unfortunate and I think they are wrong.  But, in any event, what certain advocates of a particular school of thought happen to believe is not a basis for judging the merits of that school of thought.

So, I don't find any of these three reasons very convincing.  I think a more "schools of thought" approach is exactly what is needed in economics education.

49 comments:

  1. Has anyone made a coherent criticism of the Godley and Lavoire book? If not, I find it hard to understand why it isn't the standard economics text book.

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    1. Not that i know of. The reason it isn't used though is just the mainstream dominance.

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    2. Good post.

      Krugman wrote an article about Wynne Godley and he dismissed "hydraulic economics" (you could probably search for that phrase). As is not too surprising, Krugman was taken to task for not understanding Godley.

      But I think the mainstream argument would focus on "microfoundations" - the importance of model-consistent expectations.

      An additional advantage of the mainstream methodology is that it puts central banks at the center of policy. This is not true of G&L, in their work fiscal policy works. Most macro research is driven by central banks, and so the preference is the monetary policy centric mainstream methodology.


      I am not a fan of mainstream macro because I think the models are mis-specified. If they want to pretend that they are "mathematically sophisticated", they need to do the math correctly.

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    3. Yes, I think the mainstream critique would probably be: a) the behaviour functions are not microfounded; and b) the expectations are not model consistent.

      And my view on that is:

      a) sometimes we have to make a choice between what we can microfound and what we believe is a useful description of what we think people actually do. If we can do both, great Otherwise we have to compromise. If we choose the latter, we should still think carefully about whether our assumption is consistent with behaviour at a micro level. But that doesn't mean that microfounded stuff is automatically fine. Many of the assumptions made in the interest of constructing tractable microfoundations strike me as extremely ad hoc.

      b) I have no problem with models based on non-model consistent expectations, but I think it is important to understand what the consequences are. Are any of the results wholly dependent on systematic errors. That doesn't invalidate them - we just need to know.

      Also agree on the different fiscal / monetary perspective. Actually, this is one reason why I think looking at different schools of thought is particularly useful.

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    4. Nick, is it possible for you to give some examples of microfoundations you consider useful for writing out behavior functions in SFC models?

      Anton

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    5. I'm not suggesting that SFC functions should be microfounded, just that we should think about what the underlying behaviour is at the micro level. However, overlapping generational behaviour does tend to lead to the same sort of results as typical stock-flow functions. I think it can be a useful exercise to look at, or even model, what might be going on at the micro level and see what it looks like in aggregate. This then brings in issues like ownership of housing and borrowing levels. Unfortunately, trying to work with realistic fully micro-founded functions is quite complex and the risk is that you are then forced to leave out stuff which really needs to be in there. I think they have to be separate: 1) look at what the aggregate result might look like for certain assumptions about the micro behaviour; and 2) use aggregate functions which are broadly consistent with (1).

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  2. I have to disagree with the last point because I have found most answers I look for in heterodox texts. Now someone may say that the things I am looking for is limited but I haven't found anything good really except maybe some insightful analysis by Ronald McKinnon.

    I have tried to keep an open mind but can't find anything in standard texts and those all look like the Holy Bible to me. To some extent, it is not true - people like Stiglitz and Dani Rodrik sound nice but they are essentially dissenting but yet on the side of mainstream. And then they end up making the same Monetarist errors.

    Some don't count James Tobin as heterodox but he was heavily dissenting against economists most of the time.

    I remember a quote by Wynne Godley in which he says he tried to scan through neoclassical textbooks and try to learn the diagrams but didn't help.

    In my schooling days, the transition from Class X to XI has a big jump and even the most brilliant struggle at basic things, even though looking back it all is so simple. Economics is like that. Economists simply struggle at basic things.

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    1. Well, I think it's very important to view the different approaches, not as being either the right or the wrong answer, but as simply being more or less useful ways of gaining some insight into how a very complex system works.

      I know there are some mainstream economists who do not see it like that, or at least don't come across that way. They seem to talk about their models as if they were the truth. But we shouldn't be put off by that. The important question is whether mainstream approaches can help us understand some of the things that are going on. Personally, I find they help me. But that doesn't mean I look at a piece of mainstream analysis and come away thinking this is how it must be. It's more that I find it useful to think more deeply about a problem.

      Part of the problem here is that there seems to be an idea that mainstream means rejecting everything heterodox or that heterodox means rejecting everything mainstream. Simon Wren-Lewis maybe makes this assumption about what heterodox means. But if indeed that is what they mean then I reject both.

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    2. Yeah agree with you in some sense.

      Sometimes being wrong is not the end of it because it reminds us of how one can go wrong.

      Sometimes some people do see that there is an important problem/question even if they mess up the solution.

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    3. I think that's right. I see it a bit like this.

      Take a useful macroeconomic question, like for example: "would imposing tougher loan to value constraint on bank lending reduce the extent of business cycles?"

      To the extent there is in fact a "true" correct answer to that question, it is not practical for us to know it. We cannot conclusively demonstrate it either way. The system is too complex and involves too many unknowns. We are limited to making an informed judgement.

      Mainstream and heterodox approaches to the question will tend to differ. Mainstreamers will construct models built up from rational optimisers. Heterodox economists might take a variety of approaches, including maybe some type of SFC models. Neither approach is right in the sense of being conclusive proof of the answer because, as I say, that's just not possible.

      So the actual conclusions that come out of those models is much less important than the issues that they throw up. And different approaches throw up different issues. Necessarily, because in order to address the problem requires massive simplification and simplification requires abstracting away various complications and the different schools choose to abstract away different things. So really, it doesn't matter whether the model suggests a yes or no answer to our loan to value question; it's much more about adding to the picture of what factors might be involved.

      And the more sense we have of the different factors involved, the better placed we are to address the question. And of course none of this means that you can't view one approach as being better and more useful than another.

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    4. There are a lot of different countries in the world and a lot of different economic policies get tried out. Is there not a lot of scope for putting forecasts to the test? Just as weather forecasting has improved by being put to the test all the time and modified accordingly, couldn't the same be done for our understanding of economics? Some people did say that QE would cause inflation and some said it wouldn't. Isn't that a bit like a failed weather forecast -it shows how things should move on?

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    5. You can certainly do tests, but there are so many complicating factors, it's difficult to draw any conclusions (although that doesn't stop people trying - usually selectively to support their preferred explanation).

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    6. Nick, Simon Wren Lewis's next post was also about what is and isn't the right way to do macroeconomics. I'd mulled over the point about doing tests and the comparison to weather forecasting. Weather forecasters are really rigorous and comprehensive in assessing their predictive capabilities in a way that macroeconomists seem to shirk. The comment I put on there was

      "With say weather forecasting, any forecasting model is constantly being scrutinized. Likewise I don't see why any economics program hoping for respectability shouldn't need to provide an ongoing continuous forecast for numerous different countries around the World. Let's say provide one month, six month, five year and ten year forecasts for USA, Japan, China, UK, France, Germany, Brazil, India, Indonesia, Nigeria, Russia or whatever giving child mortality rate, median wage, unemployment rate, GDP, inflation, government debt, current account deficit etc. It would need to be a formal commitment to keep up the comprehensive forecasts for the wide slew of countries otherwise it would be no true test, just an anecdotal, inconclusive mess such as we currently suffer from.
      Economics is, I guess, really a form of engineering -it is understanding how certain policy frameworks translate into what happens in the economy. Hopefully that understanding can inform policy makers to make better decisions. But if we don't know what will have what effect, we can't move on.
      In principle weather forecasters could make "elegant" mathematical models with ill foundered simplifying assumptions and claim that those models gave them insight even though they didn't predict the weather. We would nevertheless still want proper weather forecasts."

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    7. I don't really know anything about weather forecasting. I can't imagine it's easy, but I feel that macroeconomic forecasting must be several times harder. In fact, I might go so far as to say it's probably impossible. All we can hope to do is to be able to say that Action X should make Outcome Y more or less likely.

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    8. But, for instance some economists did make assertions that the fiscal regime in Latvia would lead to a prolonged depression whilst other economists said that it would cause economic revitalization. I'm just meaning how to sort out who is able to get the direction right more of the time. If it were all utterly hopeless then economics would be utterly hopeless. But clearly some economic policies have had near miraculous results (eg post WWII German reconstruction or post independence Singapore) whilst others have been calamitous (eg Haiti ever since independence or perhaps less dramatically Argentina for the past 100 years). If macroeconomics has any point at all isn't it to determine what causes such transformations?

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    9. Well yes that is the point of it but the fact that, for all the time spent on it, economists can still have very different opinions, should demonstrate that how difficult it is to determine the true answers. And, to be honest, if you were to conclude as a result that economics is utterly hopeless, you would probably not alone. There are some mainstream economists who think that heterodox economics is utterly hopeless and some heterodox economists who think that mainstream economics is utterly hopeless. Maybe they're both right.

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    10. I don't think that opposing opinions in themselves indicate that the question is indeterminate. There are different schools of medicine such as homeopathy and such like. They are only shown to be bogus by clinical trials. Astronomers make predictions but can not do experiments as such. They have to rely on observing natural experiments. Isn't macroeconomics just like astronomy in that sense? BUT macroeconomics lets the myriad of natural experiments entirely go to waste because there is no rigorous program of everyone having to pin themselves down and make formal transparent predictions that can be tested as time passes.
      The controversies in macroeconomics seem astoundingly basic. They are really at the root of the subject. They are not so much like the details of weather forecasting -more at the level of how gross geography influences climate, whether higher altitude makes things colder or whether being an island gives a more temperate climate than being far from the sea.

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    11. Even clinical trials don't produce that much certainty - they can't tell you whether it will work with a particular person or whether that person will get side effects - they just tell you a percentage, which even then often has a significant margin of error. But if economics could even do that it would be great. But you can't do anything like a clinical trial. For a start, expectations play a huge role in economic outcomes. How could you do a blind macroeconomics trial? And what useful thing would it tell you anyway?

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    12. I agree that in macroeconomic (as in astronomy or geology) you can't do experiments and can only observe "natural experiments". What I'm saying is that whenever some event or policy change takes place the macroeconomists could adjust their constant ongoing forecasts (sixth month, one year, five year, ten year and twenty year forecasts say) in the direction that they predict it will change things. I find it hard to believe that that couldn't go a long way towards sorting out the wheat from the chaff. There have been many dramatic "natural experiments" over the last few decades whilst macroeconomics has been rehashing the same old controversies. Predicting what would come of Thatcher's changes, or of the Euro, or of Latin America governments borrowing in USD in the 1980s and 1990s, or of Reaganomics, or QE, or Iceland's dramatic financialization -all of those were perfect natural experiments that any astronomer or geologist would salivate at but there was no rigorous comprehensive program by which macroeconomists proved themselves at being able to judge what consequence was going to come from them.

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    13. Epidemiology is perhaps even more like macroeconomics in that the advice that epidemiologists give directs how events unfold. Think of the foot and mouth crisis or of cholera in 1800s London.

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  3. I am not sure that the quest for "microfoundations" is an excellent idea. So, physicists and engineers would have discarded all of thermodynamics until it was reconciled with micro behavior by Boltzman? BTW, physicists have yet to come up with grand unification--so we stop building bridges and space shuttles?

    I might even be more sympathetic if micro behavior analysis was well settled. Alas, that is not true--there are simply too many anomalies of expected utility theory.

    You are trying to engage with the mainstream and it is commendable--but I think many in mainstream are simply disingenuous when they debate with heterodox. In my view, the real problem with heterodox economics today is too many of them are anti-capitalism. There is no Keynes.

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    1. I certainly wouldn't say that the microfoundations project is excellent and I like your point about building bridges and space shuttles. This is exactly in line with what I'm trying to say. All I was saying was excellent was the principle that we should use assumptions about aggregate behaviour that makes sense in terms of how we think people actually behave. In fact, I think a lot of mainstream microfoundations fail on this.

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  4. When JKH wrote "The neo-classical concepts of exogenous money and the money multiplier and loanable funds and ISLM and supply/demand equilibrium are part of the fog within which mainstream has constructed some economic imagery that is in fundamental conflict with the facts of accounting logic and real world financial measurement. This is all documented pretty cogently in ‘Monetary Economics’."
    -It seems to me that those concepts either have to be right or wrong. It is just like homeopathy either is baseless nonsense or is correct. If mainstream economics has errors, then they need to be declared as such and likewise with heterodox economics. I do think it is important to be friendly and good natured but also to be straight about when something is wrong and to clearly explain how and why.

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    1. I think that any model that is fundamentally inconsistent from an accounting perspective is likely to be very unhelpful. On the whole, though, I don't think that many neo-classical models do fail on this (although I believe that sometimes finding a solution involves shortcuts which might, but I'm not convinced how fatal that is). Exogenous money, money multiplier and loanable funds are not in conflict with accounting logic, so they're not right or wrong in that sense. It's just a question of whether they are useful ways of looking at things.

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    2. Nick, this link claims that the loanable funds theory is in conflict with accounting logic:
      http://www.boeckler.de/pdf/p_imk_wp_100_2012.pdf

      Is that wrong? To me this isn't something we can afford to tiptoe around. One way or another someone is badly badly wrong. It is like having the entire NHS budget being spent on homeopathy -the question is simply what is the economics version of homeopathy -is it or isn't it mainstream economics?

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    3. I haven't read that paper, but looked at this one recently by the same author.
      http://werdiscussion.worldeconomicsassociation.org/?post=does-saving-increase-the-supply-of-credit-a-critique-of-loanable-funds-theory

      I don't think he is saying that loanable funds theory is inconsistent with correct accounting; I think he is saying that proper consideration of the accounting helps show why it is not correct. I think the question of loanable funds theory is a question of cause and effect, i.e. what causes saving to equal investment? Cause and effect is not an accounting matter.

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    4. Quoting from that link,

      "However, quite in contrast to the real world, loanable funds theory claims that more financing
      would be available if households (or any other economic agent or group) were to save more
      financially: According to Mankiw, saving leads to “flows [of loanable funds] into the financial
      markets”. Thus lower expenses by households, governments or foreigners would increase the
      availability of finance for domestic firms."

      To me it seems so hard to understand how that can neither be said to be right or wrong. To me this critique of loanable funds theory seems correct and so it is a travesty that it is "heterdox", but I want to understand why it shouldn't be viewed as clear cut. Is it really OK to not factor in credit expansion or to conflate unsold inventory that perishes with investment in machines or such like?

      I come from a biology background where everything seems so simple, either right or wrong.

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    5. Don't forget that in order for that financing to come about, somebody must save more (as an accounting matter). So it's just picking out the cause and effect. It actually comes down to saying is the amount of saving driven by the amount people want to save or the amount of financing that takes place. If it were simply an issue of pointing to accounting identities, this wouldn't be an issue at all.

      But don't get me wrong on where I stand on this. I'm not trying to promote loanable funds theories here.

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  5. Nick, what are your thoughts on the power of expectations? There's a battle or sorts brewing amongst the main mainstream regarding what Noah Smith calls the real mainstream and the Neo-Fisherite rebels (the latter of which he's declared himself to be a tentative member of).

    http://noahpinionblog.blogspot.com/2014/04/the-neo-fisherite-rebellion.html

    Rowe jumps in the comments with a defense of the main mainstream, as JKH points out, sounding bizarrely like a Neo-Wicksellian.

    I wondered out loud there (underneath Rowe's comment) if we had a nation of hypothetical devout Neo-Fisherites, might their economy respond to an increase in interest rates with *higher* (not lower) inflation based purely on the power of their expectations?

    I'm curious how someone like yourself might answer that coming from a position external to that particular battle. BTW, Rowe had an interesting response when I brought up expectations regarding his post about commercial banks being able to create an excess supply of money. Also, I plug your blog over at pragcap.

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    1. Rowe has sometimes used the analogy of trying to direct an inverted broom balanced in the middle of your hand: in that you may need to move your hand the opposite direction initially from the direction you ultimately want the broom to go. I think his analogy was regarding CB actions at the ZLB, but in my hypothetical world of Neo-Fisherites that might be standard operating procedure when not at the ZLB (if you are examining the monetary base: i.e. first shrink it to raise the interest rate, then expand it to accommodate the resulting growing inflation).

      Also Rowe resumes his normal tone when he says how stupid it is for the CB to signal with rates, thus he's not being inconsistent.

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    2. Mainstream economists , particularly monetarists , are smart. They always have a few ironclad copouts they can rely on which critics can't even begin to unravel or disprove. "Expectations" is probably their favorite. When the economy goes belly-up under their direction , they can blame " unpredictable , ultimately unknowable " expectations , leaving their theories and models intact.

      The inverted broom story brings to mind a technique they use to project the superiority of their thought process - simply make all of your theories sound "counter-intuitive ". Morons of the world will be eating out of your hand , amazed at your ability to make 2+2 somehow equal 5.

      Marko

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    3. I had read the Noah Smith post. I think the idea is nuts, but maybe I'm missing something.

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    4. Marko

      "simply make all of your theories sound "counter-intuitive."

      Maybe that's the reason... but then again a lot of useful theories are counter-intuitive. It turns out that lightening and thunder aren't actually angry gods (although I'm sure it seemed to make sense that they were at first).

      MM sympathizer David Glasner takes on "common sense" on the WSJ editorial page here, and I think pretty well:

      http://uneasymoney.com/2011/08/18/why-the-wall-street-journal-editorial-page-is-a-disgrace/

      He takes on Thomas Sargent's "common sense" ideas here:

      http://uneasymoney.com/2014/04/25/memo-to-tom-sargent-economics-is-more-than-just-common-sense/#comment-98542

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    5. Marko, you may like this:
      http://thefaintofheart.wordpress.com/2014/04/26/how-to-make-a-great-stagnation-come-true/#comment-13798

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    6. I don't deny that some of the events and processes that happen - in economics , and in life - would have been considered counterintuitive in advance. I just think it's insane to assume that a counterintuitive bias would be the most successful default position. We evolved having a strong sense of intuition , presumably because it perpetuates survival of the species - it succeeds as a survival mechanism more often than it fails. " Common sense" - which may combine intuition with more conscious analytical processes - would seem to me something we should adopt as a default strategy , as well.

      Now , you may say : " Well , of course. Who would just abandon their intuition and common sense , especially regarding economics , which has the potential to effect the well-being of the entire society ? "

      Um , .....

      "I'm a right wing liberal because I have a counterintuitive view of the world"

      http://econlog.econlib.org/archives/2014/04/larry_summers_s.html

      In the same piece , he laments :

      "It really is a miracle that Milton Friedman was so persuasive. I don't know how he did it."

      Friedman was a master propagandist. Thankfully , the MMs are not , at least not yet.

      Marko

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    7. Marko, in fairness though the "move the hand one way to get the broom to go the other way" idea is not something Rowe brings up all the time. His argument on Noah's blog about the BoC raising rates to move inflation lower and lowering rates to move them up is pretty standard "common sense" type reasoning, don't you agree? Oh shoot, I suppose I should try to bring up one of Rowe's broom quotes so we can be precise about it... ... I think it was on Williamson's blog (who, by the way, gets catches a lot of flak today here and here and here).

      OK, here's the balancing the broom quote:

      http://newmonetarism.blogspot.com/2013/12/volcker-and-bernanke.html

      Williamson gives him a good tongue lashing there too... "You are a fully grown (tenured) professor, so act like one!!" ... (paraphrasing).

      The weird thing is, reading it now, that Rowe's broom analogy makes sense to me. Does that mean it's too late for me? Too steeped in Monetarist thought? :D

      Also commentator "Dave" brings up a broom analogy in 2010 to Williamson and Williamson remarks: "What is it with broom handles and such? Nick Rowe has a story like this too." ... so it's obviously not the first time.

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    8. Marko, there's a bit more in that post on broomsticks:
      http://newmonetarism.blogspot.com/2013/12/volcker-and-bernanke.html?showComment=1386558383664#c2515015154139924669

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  6. There is also a post on this at
    http://longandvariable.wordpress.com/2014/04/23/if-i-was-devising-a-panics-and-bubbles-course/comment-page-1/#comment-799
    For me, the comment on there by Sakir Devrim Yilmaz in the comment section was really useful with lots of links.

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  7. Nick, you state about G&L "Whilst there are elements of their work that I would certainly question". Which elements are this?

    Anton

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    1. The behavioural functions of banks, for example, and the demand for credit. More fundamentally perhaps, I'm much less sure than I used to be about the idea of a steady state stock flow ratio for household wealth (although I know I often use models which assume it).

      But none of these things detract from the usefulness of their modelling framework. I see I as a template, where I can modify the assumptions as I see fit.

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  8. OK, do you mean things like:
    - banks are more willing to supply loans if rL-rM is increasing;
    - households are more willing to take loans rL - rr is decreasing;
    - firms are more willing to take loans if their profit margin is increasing;
    - consumption of households out of wealth is not simply equal to a certain fraction of this wealth (a2 * V-1) but also dependent on things like consumer sentiment, real interest rates and actual capital gains.

    Anton

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    1. On loans, I think banks try to lend out as much as they can based on their capital, and then see what rate they can get, rather than supplying loans on demand. I also think credit considerations play more dynamic role - if banks can't hit target returns, they often relax credit limits in response.

      On consumption, I think that some wealth may not figure in spending at all, but it depends on distribution.

      But these are quite detailed topics, which maybe I'll look at it in some later posts.

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  9. Sorry, I don't mean rL -rr is decreasing, but rrL is decreasing

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  10. Nick, O/T: any thoughts on Svensson's non-Taylor rule here? (at the top):
    http://www.econjobrumors.com/topic/deflation-in-sweden-svenssons-advice-is-the-problem-williamson

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    1. Really, just what I said to you before, that I don't consider the interest rate on its own to be a very effective means of managing aggregate demand.

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    2. Thanks. But do you think managing AD is an appropriate goal (for the CB say)?

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    3. Managing demand is tied up with controlling inflation and yes I do see that as being part of the central bank's role.

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  11. Nick,

    I gave one of the heads of the student movement your email address. They are having a big conference this summer and I thought that it might be good to have someone making the case for SFC models on a panel with a DSGE representative. Hopefully they'll contact you soon. Just a heads up.

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