April 26, 2007

The U.S. worry:  investment spending not subprime mortgages.

I have been asked by a number of people about the potential macroeconomic impact of the subprime mortgage meltdown.  I would have to concur with Chairman Ben Bernanke’s take on it all;  people who borrowed money in these markets, and over extended themselves, will be hurt as the number of foreclosures increases.  And yes, many investors who saw the subprime market as a way to “get rich quick” are in for a very rude awakening.  Also some local real estate markets will be negatively impacted as a large number of foreclosures take place, and thus push down real estate prices in these markets.  Those speculators and households who bet on continuous increases in real estate prices in these markets will be hurt significantly.  Too bad for them.

But, the overall macroeconomic impact will, in all likelihood, be small.  Subprime lending makes up less than 10% of the mortgage market, the Fed reports, and a great deal of this default risk has been spread throughout the market thanks to the securitization of these mortgages.  So the total impact will be small.

This is not to say there are not things to be concerned about in the U.S. economy.  As the Fed reported in yesterday’s Beige Book, business investment spending over the past few months has been very weak.  Real outlays for new equipment and software weakened significantly over the past few months.  Part of this is due to a slowing in new home construction, but there is also decreased investment spending in the motor vehicle industry.  Certainly part of this is due to the general slowing down of the economy, but as Fed Governor Frederic Mishkin recently pointed out the “recent pullback (in business investment spending) seems to be greater than would be expected.”  What is puzzling about this is the weakening of business investment spending is happening at a time of strong corporate earnings, low interest rate spreads, and sufficient levels of liquidity in financial markets. 

So why the pessimism on the part of corporate managers?  Mishkin suggests it might be due to concerns about the prospects for long-term productivity growth and expected rate of return on capital expenditures.  He points to the Blue Chip Economic Indicators survey results as validation of his hunch.  On the other hand, Mishkin points out demand for high tech equipment, such as personal computers, main frames, etc. appears to have picked up recently.  But, keep in mind that the level of business confidence and how it impacts investment spending bears watching.

 

The French Presidential Election Next Month.

The French voters go to the polls next month to elect a new President.  In last week’s first round to the two top vote getters are Nicholas Sakozy of center-right UMP party and the Socialist Segolene Royal.  Watching their victory speeches one could see the significant differences between the two.  In his speech, broadcast in English on France 24 and aired on CSPAN, Sarkozy reached out to a wide range of voters while offering insurances that the French economy will be modernized and updated.  In her speech Royal kept to the same Socialist platform of the need to regulate “globalization.”  The wildcard in all of this is defeated centrist François Bayrou.  Whoever he throws his support to may turn out to be the winner.  The future of the French economy may lie in the balance.

 

What Next for the field of Macroeconomics?

First there was John Maynard Keynes with his ad hoc assumptions about consumption and investment spending.  Keynesian economics won the day as it helped to explain how to end the Great Depression.  Keynes and his policies guided us  in the West through World War II.  As the post war economy grew so did Keynes’ stature.  His mug appeared on the cover of Time magazine in 1965 even though he had been dead for nine years.

Of course Keynesian economics came under attack during the 1970’s and 1980’s as it failed to explain stagflation.  Robert Lucas and Thomas Sargent penned an article in 1978 aptly entitled “After Keynesian Economics.”  In doing so the fresh water schools (the economics departments at the University of Chicago and the University of Minnesota) took over macroeconomics from the salt water schools (Harvard, Oxford and Berkeley).  The freshwater schools pointed out that Keynesian economics violated most of what we know about microeconomics:  consumers spend based on maximizing utility, not current income.  Firms make spending decisions based on net present value, not current profits.  When these “microfoundations” were incorporated into macroeconomic models the outcome was very different from the Keynesian explanation.

But did the freshwater schools get it exactly correct?

In his Presidential Address to the American Economic Association in January, George Akerlof of Berkeley argued that while the freshwater school approach had the right idea, they got some things very wrong.  Akerlof’s speech has been reprinted in the March 2007 edition of the American Economic Review.

Akerlof argues that the utility function the freshwater schools use missed one key component:  norms.  Akerlof skillfully demonstrates that decision makers take into consideration how they should or should not behave in making decisions.  When this missing motivation is included results such as the Permanent Income Hypothesis, the Modigliani-Miller Theorem, the Natural Rate of Unemployment Theory, and Ricardian Equivalence all get thrown into question!

Akerlof points out that his approach isn’t really anything new.  Back in the 1920’s Vilfredo Pareto pointed out that utility functions should include aspects of motivation such as norms.  However Friedman’s 1953 essay on positive economics and his call parsimonious modeling resulted in well behaved and well defined utility functions.  Pareto’s norms would be left out of economic models.

While economists have ignored norms over the past five decades the sociologists have not.  Akerlof points to several examples from sociology as to why norms maybe important in explaining economic behavior.  Afkerlof suggests not only can economists learn from sociologists they can also learn a lot from natural scientists on how to conduct research.  He uses the example of Crick and Watson’s modeling of a single DNA molecule as an example of how economists should use intensive case studies to draw insight into macroeconomic behavior.  Crick and Watson’s DNA molecule model is the template that determines all of the cells of the organism.  That is the intense study of the small gives you great insight into the bigger picture.  Might the same hold true for economics?

Akerlof raises some very interesting questions.  His assertion that the inclusion of norms breathes new life into the Keynesian explanations of consumption and investment, to me, is a bit of a stretch.  But I think his larger points are important:  economists of today need to consider how “older” (and generally dead) economists explained behavior as they may have had more insight then we fully appreciate;  intensive case studies including laboratory experiments should play a larger role in our research;  historical case studies can add unique insight into our testing of models; and (most importantly) economists need to rethink parsimonious utility functions.  Things such as norms, group pressure, etc. may play a large role in explaining market outcomes.

Might these “new” and improved utility functions led to a 3^rd evolution in macroeconomics?  We shall see.

All the best,

M. Brandl