Throwing In The Towel On A 4% Fed Funds Rate

Since I do not do market forecasting, my comments on the actual state of bond markets have been sporadic. I just want to refresh my views, particularly since I have had a recent increase in readership. Although writing a book on recessions obviously skews my thinking, my argument is straightforward: the U.S. Treasury curve is priced so that the next big move is down, and the likely trigger for cuts would be a recession. That recession need not be imminent; if we look at the 10-year (as above), it just has to hit in the next 9 years or so.

Inherent Limitations Of Linear Economic Models

Linear models used to be a popular methodology in economics, such as the log-linearisations of dynamic stochastic general equilibrium (DSGE) models. Rather than look at particular models, it is simpler to examine the properties of linear models themselves to see why they are inherently unable to capture key features of recessions, or rely on “unforecastable shocks” that represent an absence of theory about recessions. Since the author is unaware of anyone putting forth linear models as being useful in this context, this discussion is kept brief, and is perhaps only of historical interest. For example, if one wants to examine why the Financial Crisis acted as a theoretical shock, we need to understand how it conflicted with the popular linear models of the time.

Understanding DSGE Macro Models

Dynamic Stochastic General Equilibrium (DSGE) articles have attracted a great deal of attention in economic squabbling. In my view, the existing discussions of DSGE models -- mine included -- have been confusing and/or misleading. Properly understood, DSGE macro models are an attempt by neoclassical economists to weld together two standard optimisation problems, but with the defect that the neoclassicals lacked the notation to state the resulting problem clearly. This lack of clarity has made the debates about them unintelligible. Once we clean up notation, these models have a variety of obvious limitations, and it is unclear whether they have any advantages over stock-flow consistent models.

Update 2017-03-18 I finally tracked down an article that is useful for my purposes (one day after publishing this, of course). This working paper from Bank of England researchers acts an exception to some of my comments on the state of the literature. At present, I do not think I need to retract many comments (although a speculative one was heavily qualified), as I noted multiple times that I was basing my comments on the literature I examined. That said, the article conforms to my description of the "reaction function interpretation" (explained within the text). There is a technical update added below with further details.

What Did We Learn From The MMT Maelstrom?

My guess is that every prominent economist that wants to mouth off about Modern Monetary Theory (MMT) has already said their piece, and the arguments that swamped my Twitter feed may finally go back to their earlier levels. It is abundantly clear that the prominent New Keynesians who attacked MMT want it to disappear, but that seems unlikely (although I am obviously biased in that assessment). From the perspective of the history of economic theory, the neoclassical reaction was following past form, and we can expect the same patterns in the future.

Big MMT Textbook Incoming

The text Macroeconomics by William Mitchell, L. Randall Wray, and Martin Watts is now available as a pre-order for the paperback edition (the ebook edition may already be available; I have not had time to validate). As anyone who has been paying any attention for the past few weeks, Modern Monetary Theory (MMT) has been the subject of controversy. Although I am certainly biased, roughly 99% of the recent high profile attacks are just attacking straw men; one needs to actually read some of the actual theory to critique it. Although there are tons of free primers and so forth on the internet, for many people, their time is worth more than the cost of the textbook. It is my understanding that this textbook will be advanced enough to cover the topics that are beyond the internet primers, and it will provide references to the literature if one wants to purse the primary literature.

The Awkward Question Of Time In Neoclassical Models

The use of dynamic stochastic general equilibrium (DSGE) models to discuss recessions runs into an extremely curious generic drawback: what does the time axis in the model refer to? From the perspective of fixed income practitioners, the time axis has a simple interpretation: it is a forward pricing curve. However, as fixed income practitioners are also very well aware, there is a time axis in the real world -- calendar time. We cannot mix up those two time axes, and if we are doing empirical work (and not arbitrage pricing), we are almost entirely concerned with the behaviour of the curve on the calendar time axis. The author cannot claim to be an expert on the subject of DSGE macro, but even a cursory examination of the literature shows that modelling work is almost entirely focused on the forward pricing curve, and not how to relate this to the passage of calendar time.

DSGE Macro "Proves" There Are No Financial Constraints On Government

In this article, I run through the mathematical logic of standard ("workhorse") dynamic stochastic general equilibrium (DSGE) models, and show how they imply that there is no financial constraint on government in a practical sense. (There is a disclaimer; one can imagine a default constraint, but that is a quite separate issue, as I briefly discuss.) This verbal description aligns with the verbal description of Modern Monetary Theory (MMT) given by Modern Monetary Theorists (MMTists)*. The Fiscal Theory of the Price Level (FTPL) makes an appearance, but as I argue, it is really the Fiscal Assumption of the Price Level.