Beyond models

Simon Wren-Lewis asks heterodox economists a question: how do you answer the question "what do consumers do if they are told that taxes are rising temporarily?" without some appeal to representative agents?

My answer is: I would start from a representative agent model (which predicts consumption smoothing) but I wouldn't stop there. On this issue, as on most other macro ones, I'd ask two further questions.

One is: do we have any reason to suspect that the representative agent perspective might be wrong? For example, some households might not have savings to run down in response to a tax rise, and might be unable to borrow; this is true for a minority (pdf).These people might be forced to cut spending.In this sense, heterogeneity matters, because models in which everyone is credit-constrained or nobody is are both wrong.

Heterogeneity also matters for firms. Geroski and Gregg's study of the 1990s recession found that most of the fall in output and employment was concentrated in a minority of firms, and Xavier Gabaix has shown how a few large firms can generate productivity fluctuations.Real business cycle theorists should make more of this.

The second question is: are there any cognitive biases which bear upon this issue?

For example, if consumption is determined by habits then agents' desire to smooth spending might (or not!) be even stronger than the conventional representative agent model predicts. But if agents have limited attention and so don't listen to the message that the tax rise is temporary (or don't believe it), then spending might fall by more.

Of course, models with both heterogenous agents and cognitive biases very quickly become fiendishly complex*. But then the economy is complex and as Wittgenstein said, a clear picture of a fuzzy thing is itself fuzzy. 

But in the realm of policy advice, do we need to build such models? Isn't it better to be roughly right than precisely and elegantly wrong? As Stephane has complained, perhaps there's a cost to formal modelling - it can distract us from other ways of thinking about the economy.Worse still, in the wrong hands (which are not Simon's), it can distract us from the facts.

* I suspect one way forward is the use of agent-based computational models; this sort of thing might be the future of economics.

Comments

[Luis Enrique]

well if you have a model-free way of being roughly right and your models are precisely wrong, then ditch models. But models might be roughly right too, and a good model might be better than the alternatives.

In this instance, it might be relatively simple to introduce some heterogeneity, assume some proportion of households are credit constrained or lack savings, and some proportion of households are myopic, or habit formers, and do your best to calibrate these proportions. I think I've seen text book models like that.

[Ralph Musgrave]

I find Wren-Lewis’s questions bizarre. Obviously it makes sense to refer to representative agents in answering his question. Who said otherwise?

Another of his questions (to which the answer seems to me to be obvious) was “what do consumers do if they are told that taxes are rising temporarily?” My answer: they do more consumption smoothing than if they think the tax increase is PERMANENT.

Another of his questions: “what’s the impact of a temporary increase in government spending, financed by taxes, would do to output in an open economy.” My answer: if stimulus is the objective (which presumably it is), what on earth is the point of the taxation? Tax has a DEFLATIONARY effect (the opposite of the desired effect). You might as well chuck dirt all over your car before washing it.

In other words I agree with a German economist, Claude Hillinger, who said, “An aspect of the crisis discussions that has irritated me the most is the implicit, or explicit claim that there is no alternative to governmental borrowing to finance the deficits incurred for stabilization purposes. It baffles me how such nonsense can be so universally accepted. Of course, there is a much better alternative: to finance the deficits with fresh money.”

Readers acquainted with Modern Monetary Theory and Positive Money will recognise that Hillinger’s thoughts are similar those of MMT and PM.

[Bill le Breton]

Ralph, you report that Hillinger says, 'Of course, there is a much better alternative: to finance the deficits with fresh money.'

And I so agree, but I am told that the Maastricht Treaty 'outlawed' this for all EU members (and not just Eurozone members).

Is this the case?

[Ralph Musgrave]

Bill, I think your “outlaw” point is correct in that for example the UK cannot simply print or create new money and spend it. But borrowing and spending £X and then immediately doing QE to the tune of £X comes to the same thing and printing and spending £X.

[Sam]

"what do consumers do if they are told that taxes are rising temporarily?"

I suspect that the answer is in fact "know that the politicians are lying to them, and plan for a permanent tax increase". In the UK, the income tax was a temporary measure to fund the Napoleonic war, came back again 40 ears later as another "temporary" measure, and has been reinstated every year since. The income tax in the US was first introduced as a temporary measure to pay for the civil war, but soon returned as a permanent tax.

The state of Illinois currently has "temporarily" increased income tax rates, but the problems with the state budget are not temporary, but are long-term and structural, so it's unlikely that those "temporary" increases will go away. There are plenty of similar examples.

Or perhaps one should consider the scheduled expiration of the "Bush tax cuts". When introduced, these tax cuts were explicitly time-limited (because of somewhat arcane Senate voting rules), but the natural expiration of these temporary cuts is viewed by almost everyone as a tax increase.

[Keith]

I don't think Chris should participate in Internet point scoring as it would devalue the utility of this site for the public interested in economic ideas.

Leaving aside the MMT debate I see no reason why a democratic Government should not cut taxes or raise spending for macro economic reasons if it wants to try it out as a policy. And just borrow if it wants to and there are people who will lend. The idea of treaties limiting any governments fiscal discretion is absurd. If the policy fails the remedy lies at the voting booth.

Criticism of Government borrowing ignores the role of debt instruments as collateral in financial markets. If more government debt increases financial intermediation and thus borrowing by the private sector why would it be a bad policy for the economy? Recoveries from recession always involve a period of higher government borrowing; and that debt forming part of the wealth of the private sector increases demand and thus brings the recession to an end. Why has it become fashionable to ignore the mechanism by which recessions actually end? That is a more relevant question for Chris to answer.

[Woj (@BubblesandBusts)]

The first question regarding households is a critical point missed by the mainstream. Households (private sector) may be unable or unwilling to borrow regardless of low interest rates or bank liquidity. Monetary policy has struggled for this reason. Demand for loans remains especially weak in Europe (http://bit.ly/MJrpmb) and continues to be a primary deflationary drag on economic growth.

[Neilwilson]

"And just borrow if it wants to and there are people who will lend."

There will always be people to 'lend', since it is those savers that are causing the problem in the first place.

At that point the only choice for the entity left with the spare central bank liabilities is to leave it on deposit with the central bank or buy government securities. They ain't going to spend it as the decision to save has already been made.

Which leads to the obvious solution. The Treasury should *always* borrow from the central bank. The central bank is as capable as any entity in setting an appropriate interest rate and amount of loan facility for the Treasury.

Then private sector entities are left with the interest rate offered by the central bank on deposits or reserve accounts.

That makes central bank the conduit by which injections happen, and gives it another 'QE' route - it can just increase the size of the loan facility made available to Treasury.

[Luis Enrique]

"The first question regarding households is a critical point missed by the mainstream"

no, I think you mean the first question regarding households is an obvious one discussed in undergraduate macro classes with plenty of mainstream references.

[Homodox]

Luis is quite right. This is exactly the liquidity trap / "pushing on a string" problem of lack of demand for credit that we all learned about in undergraduate macro.

Why are the self-styled heterodox set so unaware about what the mainstream actually knows?

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