Monday, September 9, 2013

New Blog

I want to write about non-economic things and I've been itching for a rebrand so I've tenuously moved to Macrocracked at


Sunday, June 30, 2013

5 Pocket Models of the Macroeconomy

Economists, like all academics, spend most of their time becoming experts on very specific topics. One economist might specialize in the effects of micro-incentives in third-world countries, another might focus on the applications of game theory to the organ donor market, and a third may spend years pondering the causes of a particular historical economic event. When asked about their area of expertise, they give highly detailed, properly qualified, and usually accurate answers. However, when time is short and the question is novel, as when a policymakers need to respond to new and therefore unique macroeconomic event, economists tend to rely on a handful of basic models that most undergraduates learn in Econ 101.

The particular model varies by economist. For example, Paul Krugman proudly proclaims the IS-LM to be his favorite mistress.  In his book A Term at the Fed, economist Lawrence Meyer says that he relied on the concept of the NAIRU to guide his recommendations as a Federal Reserve Board governor from 1996 to 2002.  However, because his contemporaries on the FOMC, the committee that raises and lowers US interest rates, used different concepts and models to form their opinions, they often came to different conclusions. I suspect that an accurate map of economic ideology could be drawn simply by looking at which "pocket model" economists reference when answering questions on the fly.

As the "About" section of this blog proudly proclaims, I'm a quack without a flock, which means that I use a quirky pocket model of my own creation, although its basic principles aren't too far off of the mainstream macro track. I call it "The Spaghetti Model." They say that "it takes a theory to beat a theory" and I also often think that "it takes beating a theory to make a theory," so before making pasta, I'll explain why I don't like using the other common pocket models. I'll cover four:

  1. Classical Principles  
  2. Keynesian AS-AD (Aggregate Supply-Aggregate Demand) 
  3. Neoclassical AS-AD (Aggregate Supply-Aggregate Demand) 
  4. IS-LM (Investment-Savings-Liquidity-Money)
The DSGE is not on the list, primarily because the DSGE is not a pocket model, and secondarily because another post on this blog and also the theory tab tangle with it directly. In the interest of time I've also neglected Austrian and Post Keynesian models, which are respectively right and left of the mainstream and rarely used by policymakers in power. 

1) Classical Principles

Briefly, classical economics proclaims that markets are always efficient, money is always neutral, prices are always flexible, unemployment is always voluntary, supply always creates its own demand, and government intervention is almost always a bad idea. Classical principles are pretty easy to dismiss:

Despite its general lack of explanatory power, many economists still quote the tenants of classical economics like verses from the bible.  One must admit that classical ideas are appealing. Green pieces of paper aren’t valuable, so why should the quantity of money have any affect on the real economy? People can always offer to work for less money, so how can there be unemployment, except by choice?  Classical economics got a second kick in the 1970s and 80s, when real business cycle modeling seemed for a time to support old ideas.  Finally, economists who don’t like the AS-AD or IS-LM sometimes keep classical principles in their pockets simply for lack of a lesser evil.   Although today applied mainly out ignorance or out of spite, classical economics still influences policy and cannot be ignored. 

2) The Keynesian AS-AD Model

Supply and demand first entered mainstream economics with Alfred Marshall’s 1890 textbook, Principles of Economics, but originally the two iconic curves were used to describe equilibrium only in individual markets.  In 1937 in The General Theory of Interest, Employment and Money John Maynard Keynes put forward a theory of sticky wages and effective demand that allowed economists to draw the macroeconomy on axes of quantity and price. If aggregate demand increased (though mechanisms described by the IS-LM model, to be discussed), he argued, total real output, total employment and the price level would also increase.

In 1958 the unassuming New Zealand born economist William Phillips published a paper showing an empirical tradeoff between unemployment and inflation in historical UK data. His findings fit the Keynesian model well; greater employment came at the cost of inflation, and vice versa.  Governments could push the economy right or left along the “Phillipscurve” by manipulating aggregate demand through monetary and fiscal policy:

The IS-LM, the AS-AD, and Phillips curve formed the foundation for macroeconomic policy in the 50s, 60s and early 70s, until the Neoclassical AS-AD model replaced it as the pocket model of choice in the late 70s. Because of it’s similarity to basic supply and demand, the Keynesian AS-AD model is often used to introduce students to the study of aggregate relationships, but is generally snubbed by serious policymakers, because of what happened next.  

3) The Neoclassical AS-AD Model

In the late 1970s the economy started behaving in a way that defied the predictions of the Keynesian AS-AD; both unemployment AND inflation began to rise. In search of a better pocket model, Policymakers turned to Milton Friedman, who in 1967 had pointed out that the mainstream macroeconomic framework was missing one essential concept: inflationary expectations.

Friedman argued that if the government announced policy intended to increase employment, producers would expect inflation, and would therefore raise prices without increasing output or employment. Instead of pushing the economy right along the Phillips curve, the entire curve would shift out. With so-called “adaptive expectations,” Friedman continued, unemployment always tends toward a natural rate, determined roughly by the frictional unemployment necessary to match employers to employees and also possibly by the artificial minimum wage. In other words, government policy alone cannot produce real growth.

Further, Friedman and his supporters argued that the only thing that could increase output in the long term was an exogenous shock to productivity. This neoclassical spin on the AS-AD allowed that because of price stickiness, unemployment could in the short term rise above or below this rate, but such imbalances would always eventually be corrected by changes in the price level. Only the natural rate of unemployment tied to the natural rate of output produced price stability, a quantity he dubbed the Non-Accelerating Inflation Rateof Unemployment, or NAIRU.

This probably violates Mankiew's copyright, but you can see his explanation on slides 14-34 of this powerpoint. 
Today the Neoclassical AS-AD, with the IS-LM, is one of the primary macroeconomic models taught to students, and probably the most generally accepted on this list. While I think that Milton’s incorporation of expectations was appropriate, in my eyes the Neoclassical AS-AD is still far from the perfect pocket model. Three reasons:
  1. It offers no explanation for aggregate demand, an omission that becomes acceptable if the model is taken in conjunction with the IS-LM, but the integration isn’t clean and I’d also rather have one working pocket model than two half-functional ones.
  2. It completely divorces technological progress from demand, which given a second’s thought is obviously incorrect. The Internet wasn’t handed down to us by benevolent exogenous gods, it was developed and funded by those who anticipated that consumer demand would produce massive profits. Ideally we should be able to model the interaction between business cycles and long-term growth in the same model.
  3. On a related point, the NAIRU is hard to accept, both morally and empirically. If the goal is to conquer unemployment, assuming a natural rate admits defeat before the battle. More importantly, a natural rate isn’t “naturally” discernable from the data. 

4) The IS-LM model

The IS-LM model was first formalized in 1937 by John Hicks in his paper "Mr. Keynes and the Classics: A Suggested Interpretation," and was again was based on ideas sketched during by John Maynard Keynes in the The General Theory of Interest, Employment and Money. With the Keynesian AS-AD and the Phillips curve, IS-LM was hot in the 40s, 50s, and 60s.  Today the IS-LM is taught to undergraduates but almost never applied in formal academic papers.

The IS-LM plots two curves on axes of output and interest rate.   The IS curve is downward sloping because when the interest rate is high, people tend to save more and spend and borrow less, and when the interest rate is low, people tend to borrow and spend more and save less. The LM curve is upward sloping because the demand for money, or liquidity preference, is positively correlated with output and negatively correlated with the interest rate.

The IS curve can be represented by this equation:

And the LM curve by this equation:

The IS-LM curve isn’t particularly easy to understand, and many explanations exist; Hicks starts from another place entirely, Krugman takes a useful angle here. In his standard economics textbook, Greg Mankiew the two curves from two other graphs, the Keynesian Cross and the Money Market:

Again violating Mankiew's copyright, check out slides 35-69.

The IS-LM is quite handy because it allows one to easily model the effect of fiscal policy and monetary policy. Taken in conjunction with the Keynesian AS-AD, it was thought to model long-term effects on output, but after adaptive expectations came into favor economists began to think of the IS-LM as only as a short-term model. (Although what “short-term” means is still up for debate).  Today, Paul Krugman models liquidity traps with the IS-LM; when equilibrium dips below the “zero lower bound” the economy is stuck at low output, and won’t get out until we can manage to move the IS curve out.

Krugs creative manipulation is actually pretty useful, although still weird 

Partially because it’s so oddly constructed, many people strongly dislike the IS-LM. Of the four models listed so far, the IS-LM is by far my favorite, but still, three problems:  
  1. It cannot model the effects of changes in productivity on output or aggregate demand and also has nothing to say about the price level. These omissions become acceptable if the model is taken in conjunction with the AS-AD, but again, I’d rather have one model. 
  2. It draws a bright line between illiquid interest-bearing assets and liquid non-interest bearing money, which may have been a legitimate assumption in Keynes’ day when financial markets were less developed; but in today's world, when consumers can cash in securities in five minutes with a smartphone app, does a  general theory of liquidity preference still make sense? It might; I'm not sure. (For the more wonkish reader: I'm cool with the precautionary motive, but not with the transactions motive, and I'm iffy about the causal power of the speculative motive). 
  3. In general it places too much importance mechanical relationships, and not enough on subtler shifts in expectations. You can correct for this by observing that changes in expectations shift the constant variables, but then again if you’re determined you can hack almost any model to show what you want. Take Krugman’s zero lower bound application. If the only way to illustrate current events with the IS-LM is by adding a quadrant that was never intended to be part of the model in the first place, maybe we can do better?

Another commonly cited problem with the IS-LM is that it implies that the central bank targets the money supply, not the interest rate directly, as most central banks have been doing for decades. David Romer of the University of Berkeley proposed an adjustment, which he labeled the IS-MP (Investment-Savings-Monetary Policy) model to better reflect this reality, which essentially replaces money market with a horizontal line determined by the central bank. I don’t think that this adjustment cuts at the heart of my problems with the IS-LM, and I also don't like how it pretends that the central bank can play god. (Because let's face it, sometimes Bernanke is just pushing on a string). 

5) The Spaghetti Model

To define The Spaghetti Model, I’ll start from two problems all of the models above share.

  1. First, none deal well with time. Even the Neoclassical AS-AD, which incorporates curves for both short term and long term supply, is at any one point only a snapshot of a single period.
  2. Second, it’s not always easy to translate the models into empirical data. Wouldn’t it be nice to build a model from what we have? The five most important economic aggregates we track today are probably:
    • Nominal GDP
    • Inflation
    • Unemployment
    • Monetary aggregates
    • Interest rates
Given these two considerations, let’s start by graphing Nominal GDP over time:  
Units of Account is more accurate and more internationally inclusive than dollars. 
 Next, let’s add in inflation. We could just graph inflation on the same chart, as is often done, but instead let’s use inflation to calculate Real GDP. Plotting Real GDP on the same axes as Nominal GDP requires us to pick some point in time where Nominal GDP = Real GDP, but because we’re concerned about relationships, this point is arbitrary. A positive rate of inflation increases the gap between the two curves, and deflation decreases it.
Next, unemployment. Macroeconomists often speak of a hypothetical quantity called “Potential GDP,” the output the economy could produce if it was at full employment. Potential Real GDP is usually thought to be determined by the level of technology and the capital stock, and is difficult, if not impossible, to measure. So let’s use the unemployment rate to define Potential GDP relative to real GDP:

Now we have three curves, but still really haven’t said anything about money. Here comes the twist. If we can plot a curve representing Potential Real GDP, why can’t we plot a curve representing Potential Nominal GDP, the maximum amount of money you could possibly spend in a period? Potential Nominal GDP clearly should have some relation to monetary aggregates, but it’s equally clearly a separate variable, since nearly all of the monetary aggregates we track are lower than Nominal GDP. Potential Nominal GDP in a period should be the money times the potential velocity of money. As we assume that the level of technology and existing capital stock determine Potential Real GDP, we can assume that technology and capital determine potential velocity, the speed at which economic value can be exchanged. If technology improves or the money supply increases, Potential Nominal GDP will also increase.

Unfortunately, because it’s a composite variable we can’t chart Potential Nominal GDP directly off of measures of monetary aggregates. Enter the interest rate. We can think of the interest rate, like the unemployment rate, as a pressure gauge; as demand drives Nominal GDP toward Potential Nominal GDP, the pressure increases and the interest rate goes up, and vice versa. Defining Potential Nominal GDP in this way also conveniently allows us to sidestep defining it directly, like using unemployment to define Potential Real GDP deflects ugly questions about the nature of “value.”

Now we have a full model approximated with four of the five variables above, Nominal GDP, inflation, unemployment and the interest rate:

Simple. Straight. Uncooked Spaghetti. 
Expectations and government policy move curves, and the other curves react through push and pull.

  • If a positive state of expectation, or a bull market, pulls up Nominal GDP, the increase in spending will in turn pull on Real GDP and Potential Real GDP.  
  • Because production responds slower to changes in expectation than spending, Real GDP usually increases less than Nominal GDP in a bull market, leading to a rise in the price level as well as a rise in output, like in the Keynesian AS-AD model.   
  • Potential Real GDP responds even slower to changes in expectation, and often productivity gains don’t arrive until after the bull market is over. 
  • Because Potential Nominal GDP is partially defined by technology and the capital stock, productivity gains cause both curves to increase in tandem. 
  • The two "Potentials" or “Capacities” roughly chart long term trends, where the other two curves chart business cycles. 
  • If expansionary monetary policy increases Potential Nominal GDP, that will pull on spending, but if that monetary expansion is accompanied by an increase in inflationary expectations, it will not pull on Real GDP or Potential Real GDP. 
With the Spaghetti model, we can model a number of common macroeconomic phenomena quite easily:
Why spaghetti? Well, if you actually graphed these four curves with historical data, it would probably look a lot like spaghetti:

 3 More things about I like about The Spaghetti Model:

  1. It has NGDP at its heart and so fits with a currently popular and I think useful macro fad.
  2. The Federal Reserve seeks to influence unemployment and inflation via the interest rate, and the model conveniently relies on all three.
  3. Little about the model is mechanical, there are no all-important but unintuitive constants like the Marginal Propensity to Consume or the NAIRU to define. Some might complain that The Spaghetti Model leaves too much to discretion, and they would be justified; you can plausibly argue for almost any degree of push and pull. But then again you can do the same with IS and LM, AS and AD shifts. You can also pull out the push-pull and actual-potential relationships into charts that resemble the IS-LM and AS-AD; I'm too lazy to do that here, and this post is already enormous, but you can check out the last section of the theory tab for some of that. 
Most of all, I like this model because I find it to be most useful; that’s why I keep it in my pocket.

I stole this image from a momblogger

Sunday, June 9, 2013

Hayek, Polyani, and Why Nations Fail

Once upon a time I finished the books I started, but like most students, I was poisoned in college by impossible quantities of "required" reading.  I learned freshman year that it was better to skim a bit of Foucault, read an essay of Hume's, and a digest a passage or two of Aristotle's than to read one, or to read all and sacrifice my social life.   By now my personal pile of partially digested books would surely reach my third-floor window, if properly stacked. 

For most books, just a taste is enough.   But other books, once tasted, linger in your stomach and demand full treatment.  Unfortunately these books also usually take the longest to read. I can read a bad book in a few hours. A good book will take me a week. A great book can take me a year. 

In the past couple weeks, I finally managed to finish a couple great books and one good book. I read Frederich Hayek's The Road to Serfdom for the first time from start to finish, having only skimmed when I was required to read it for class; then I killed off the last few chapter's of Karl Poyani's The Great Transformation, a book that defies scanning and demands completion; finally, inspired by my success, I polished off the remaining 2/3 of Daren Acemoglu & James Robinson's Why Nations Fail.

The three books have many differences: Hayek, Acemoglu and Robinson wrote to convey a few key points to a broad audience, and their books are eloquent but plainly written. Polyani wrote for scholars, and, expecting more from his reader, his work contains contains more references and covers more ground.  Acemoglu and Robinson wrote from firmly within the mainstream, Hayek from just outside it, and Poylani from the minority. Polyani, Acemoglu and Robinson ground their arguments in the grand scheme of history, and Hayek relies primarily on logic and a few (important) examples.  Hayek and Polyani wrote during World War II, and both imbued their books with the gravity and consequence of the time. Robinson and Acemoglu published their book only last year, and while they obviously care about their conclusions, they did not write with the urgency of Hayek or Poylani who saw words as the only weapon they had to fight for the world crumbling around them.  Hayek's and Polyani's  books are universally recognized as great. Acemoglu's and Robinson's book may become great (although statistically, the chances are pretty slim). 

All three books however, strike at the heart of political economy. Polyani, Acemoglu and Robison's subtitles probably encapsulate the topic best: The Political and Economic Origins of Our Time, and The Origins of Power, Prosperity and Poverty, respectively (Hayek didn't have a subtitle, and in truth his scope was somewhat narrower). All authors make sweeping arguments on a scale rare for experts.  I'll try to summarize them as best I can, in order of publication: 
  • Hayek argues that economic planning, or "collectivism" is essentially incompatible with progress, because it is economically less efficient than market organization and also because it inevitably leads to the growth of arbitrary power, and encroachment on individual political rights. Hayek argues for "individualism," a return to more or less classic liberalism with a small state that encourages only institutions that support competition.  
Hayek says no 
  • Poyani argues that at the root of the the great conflicts of the first half of the 20th century lies a double movement between the expansion of the market economy, including the unnatural commoditization of land, labor, and money, and the interests who seek to defend traditional "habitation." Displacement and inequality caused by the market economy is often unbearable, but incomplete attempts to correct and protect can be even worse. 
  • The great and endless battle
  • Acemoglu and Robinson argue that the wealth and poverty of nations is primarily determined by political institutions. Political and economic centralization is a first step, and from centralization growth proceeds either slowly under "extractive institutions," or quickly under "inclusive institutions." History is not determinate, but highly contingent on key "critical junctures." 
Just add Magna Carta 
While the four authors each approach the essential problem of political economy from a different angle, use different language to describe the same phenomenon, and do not directly address each other's ideas, they are comparable. You can see the similarities in this table (click to enlarge): 

Especially alike are Hayek, Acemoglu and Robinson's conception of Rule of Law, although Acemoglu and Robinson may have been inspired largely by Hayek, and Polyani, Hayek, Acemoglu and Robinson's conception of the main problem with markets, although the Polyani and the others disagree on the magnitude of the problem. Little things also overlap; for example, Acemoglu and Robinson give many examples of Kings and Queens actively preventing technological advance for fear of creative destruction, and Polyani also notes that the monarchy often aligns with habitation in the double movement. It seems to me that all four authors are talking about two great essential ills: 
  • Uncertainty: If people don't believe that they will be able to keep the fruits of their labors, either because of an appropriative state or because of general lawlessness, they won't invest or produce and the economy will stagnate
  • Disruption: Progress and innovation in an unregulated market will inevitably and unfairly destroy some people's livelihoods and or change the balance of power

Although the three books have many similarities, they each also treat on a slightly different aspect of political economy. Acemoglu and Robinson trace the evolution of institutions and economies over time, and attempt to describe a general pattern of progression. Polyani focuses on the reasons why that progression is contested, and does not always happen. Hayek focuses on just the tail end of Acemoglu and Robinson's grand scheme, arguing that attempts to progress forward through planning can only lead to disaster. 

As usual, I tried to put what I had learned into a picture. It's certainly a bit wacky, and I don't really expect it to make sense to anyone else (like most of my pictures), but for me it's a helpful mash up of the four author's thoughts.  The arrow on the left swings from individualism back to decentralization because Hayek argued that if you can't create pro-competitive institutions that deal with the problem of disruption, it's usually best to leave it be (lassiez-faire, although he rarely says it). I see laissez-faire essentially as decentralization, and indeed, Hayek is often categorized as a libertarian by modern commentators. Thus either extreme of the spectrum between individualism and collectivism will lead backward, and societies can only stay at high growth inclusive institutions by carefully walking the line. 

Of course, always a spectre is haunting political economy- the spectre of Marx.  (Disclaimer, I haven't read Marx front to back yet; if a great book takes me a year, Das Kapital will probably take me a decade...) To me, Acemoglu & Robinson's stage-based description of the evolution of institutions smacks of historical materialism; decentralization is akin to primitive communism, extractive institutions parallel the Slave Society and Feudalism stages, and inclusive institutions parallels capitalism. Of course, Marx predicted that the next stage after capitalism would be socialism, and in the image above it certainly would be natural to add a fourth arrow.  However Hayek's argument makes clear that societies cannot push through to socialism through brute force, because the planning required inevitably sends society back to extraction. Nor, according to my Hayek add-on, can paradise be achieved through perfect individualism, because that sends society only further backward. 

So how can society move forward? 

It was perhaps a little unfair of me to categorize inclusive institutions as "preventing uncertainty" and extractive institutions as "preventing disruption" above. I essentially agree with Acemoglu & Robinson that inclusive institutions are superior to extractive institutions in basically every way, including preventing disruption; theoretically with inclusive institutions all citizens should be able to appeal for a better life, shaping the rules until the rules suit everyone.  Drawing from Polyani, one can imagine inclusive institutions as the trucemaker in the battle between habitation and improvement. True, Kings may have defended traditional livelihoods from Capitalists from a time, but truly inclusive institutions cannot be captured for the benefit of certain interests at the cost of others.  I optimistically believe that there is a set of institutions both prevents uncertainty and prevents disruption. Hayek's arguments make it clear that this set of institutions cannot be developed quickly without falling too far toward either collectivism or individualism. So for me progress becomes a slow push toward ever more perfect institutions. And if you compare today with 1950 years ago, you can clearly see that slowly but surely most developed states have been pushing towards socialism.  

Come to think of it, that's more or less what I believed before I read these books, so perhaps I'm just being stubborn. One thing's for sure; when Danerys wins back the 7 kingdoms she should definitely sign the Magna Carta.

Wednesday, May 8, 2013

A Payments Tree Grows in Providence

So yesterday I decided to hunker down and really try to understand the payments industry. It's a landscape I often dance around but rarely deal with directly at work, and I figured that it was about time I got my digital wallets straight.  Here is an incomplete list of topics that I consider to be "payments." If you know what more than 3 of these things are you're probably ahead of most people:
  1. eCommerce and shopping carts
  2. Point of Sale (POS) systems 
  3. Payment processing, payment gateways, and card networks 
  4. Near Field Contactless (NFC) mobile payments 
  5. Contactless card payments (EMV)
  6. Digital Wallets
  7. Peer-to-peer payments 
  8. Bitcoins and cryptocurrency 
  9. ACH & NACHA  
  10. Electronic Funds Transfer & Instant Funds Transfer 
  11. M-Pesa and mobile balances 
  12. Whatever Paypal is up to these days
  13. Remote deposit capture and checks 
  14. Biometric payments 
  15. QR Code Payments 
  16. Prepaid Cards 

Anyone involved knows that the payments industry isn't exactly easy to understand.  More precisely, in the words of my roommate who works for a payments startup, "It's fucking endless."  When I'm confused about something, I usually try to google a diagram that lays out the topic succinctly in two-space. If you are a newcomer to payments, this tactic is pretty much useless, because while infographics about the industry abound, I don't think anyone has managed to accurately and concisely map it out at a level of abstraction that's meaningful. The best graphic out there probably looks something like this:

There are a couple good explanations of how online and offline payments work, most notably this animated series of graphics from and this graphic from Dwolla:

Better, but still feeling a little woozy 

This graphic shows how money is transfered when you swipe your credit or debit card. There are at least 5 different organizations in between you and the merchant you are purchasing from; the card reader or Point of Sale (POS) system, the payment processor, the payment gateway, the card network (Visa, Mastercard, Amex or Discover), and the bank.  All of these organizations take a cut of the interchange, a 2-5% cut of your purchase paid by the merchant. The poor merchant also has to set this whole headache up.  No wonder the little guys don't accept cards.

Companies like Square and the the startup my roommate works for, Swipely, are working to make this process easier and cheaper for merchants, but they're leaving the general architecture essentially the same. Regardless, Dwolla and's wonderfully informative graphics only explain a fraction of the space.

So anyway, I decided to make my own graphic. I only spent like 2 hours on it, so overall it's a rather poor contribution, but I'll post it anyway. If this makes no sense to you, then congratulations, you are not insane. 

Yup this graphic was still made in powerpoint.Also the base is a little wonky because I was originally thinking its roots were in like 1600
Basically, I brainstormed every different type of payment I could think of today, and then sorted them into categories.  The outline below is actually a little more complete than the infographic because I wrote it after I made it:

  • Currency Based Payments 
    • Commodity Money Payment 
      • Gold, Cigarettes, etc 
    • Cryptocurrency Payment
      • Bitcoins, etc 
    • Cash Payment 
      • Dollars, Euros, Rupees, etc 
  • Account Based Payments 
    • Nonbank-Based (Non-bank institution maintains account, although unused funds may be swept into a bank account by the maintaining institution, as with Paypal) 
      • Closed-Loop Prepaid Card Payment
        • Gift Cards 
      • Open-Loop Prepaid Card Payment
        • Bluebird, Green Dot, Plastyc 
      • Preloaded Digital Account Payment
        • Paypal, M-Pesa 
    • Bank-Based (Direct bank to bank transfer) 
      • Check Payment  
        • Paper checks 
      • Electronic Funds Transfer
        • Direct Deposit, Wire Transfer, Western Union etc. 
      • ACH Transfer
        • Account to account via NACHA 
      • Dwolla Payment  
        • Dwolla gets it's own category 
    • Card Network Based (Visa, Mastercard, Amex, Discover) 
      • Card 
        • Credit Card Payment
        • Debit Card Payment
        • Contactless Card Payment
          • EMV (Eurocard, Mastercard, Visa) NFC enabled cards, etc
      • Digital 
        • Card-Linked Digital Payment, Online or Mobile 
          • Venmo, Paypal, Dwolla
        • Card -Linked Contactless Digital Payment, Mobile
          •  Google Wallet, Square Wallet, LevelUp, BumpPay, etc 
        • Card-Linked Biometric Payment 
          • Paytango 
I wanted to show how the types of possible payments have changed over time, and also how the different types of payments are related to each other. A tree seemed like a natural metaphor. The need for leaves to eventually taper off into points also gave me a natural way to insert my judgement about what payment types are on the rise (increasing as a percentage of total payments) and what types of payments are diminishing. For example, I checks are clearly on their way out, but I think Dwolla is gonna kick it. 

It's highly imperfect, but there you have it. 

Tuesday, April 23, 2013

The Sorry Demonization of the Confidence Fairy

Why I Believe in the Confidence Fairy 

I developed my economics worldview in relative isolation, because, like most of my peers, I didn't really keep up with current events in college.  In retrospect, that situation was at once dangerous and necessary; ignoring the world is generally not a best practice when forming opinions of the world, but there are so many economics theories, thoughts, and ideas floating about on the internet that even trying to keep afloat requires all of one's mental energy.

Painting by Roy Litchtenstein. #GCB 

Since graduation I have followed a plunge and retreat pattern; every once in a while I binge on the blogosphere, reading, commenting, criticizing, scowling, nodding, noting and expanding, and then I cut myself off and let my natural hatred of twitter, short form argument, and human interaction control my instincts. When I go out into the world, I try to be a sponge and soak up as much as possible, and when I come home I hide in the library and wring myself out, and try to use what I've absorbed to build a boat that can support me next time I go sailing. (The true test of vessel is always whether it can weather the water).

Before the first plunge, I had already decided that the world largely depended on the state of expectation, also known as trust, also known as confidence, also known as the opposite of uncertainty, fear, and pessimism.  In other words, I believe that life is one big self-fulfilling prophecy.  If you believe that your paycheck will come at the end of the month, you'll splurge $15 on the old fashioned at the cocktail bar. If you believe that you'll easily be able to make $100k a year as an orthosurgeon, you'll put yourself $200k in debt to pay for medical school. If you believe that Joe Shmoe can make and sell widgets like nobody's business  then you'll lend him money to hire some people and make widgets. If you believe that none of these things will happen, then there will be no widgets, no doctors, no delicious whisky drinks, and you can sit alone in your room and cry.

Wouldn't you prefer to have a drink? Credits: Paul Kernfeld, Adrian Pio, Max Monn
The problem is that expectations don't always come true. I believe that economic actors make decisions under bounded rationality; they do try to optimize their own happiness, but the information, time, and brainpower they have to make decisions are limited and sometimes they are wrong. Because of unmet expectations, workers sometimes find themselves hard up against their budget constraint at the end of the month, students sometimes find that when they graduate the market is already glutted, and sometimes investors realize too late that nobody gives a damn about widgets.  In addition, factors not traditionally considered economic, like social relations, shame, honor, etc, play large roles in preferences, and what may seem like a mistake in estimation may actually be a perfectly rational, optimizing decision, as when the choice to become a doctor is motivated more by a mother's wish than by economic practicality.

Phew, beliefs stated.

Disillusionment, Confusion, and Presidents with Wings 

During one of the plunges last year I encountered an interesting phrase: "confidence fairy." Now mind you, I devoured more than my fair share of preteen fantasy lit in that awkward period after picture books and before Charles Dickens, and I fondly remember the fair folk as pseudo-elemental, pseudo-spiritual, and very serious creatures  Therefore at first I saw no inconsistency between my belief in the all-importance of expectations and its personification as mythical but symbolically important being:

Wise, isn't she? 

I also generally consider myself to be quite progressive monetarily, fiscally, and socially, (although I'd rather avoid direct regulation where possible,) and would rather pile taxes and QE to the moon than see a 5% rise an unemployment.  Thus you can imagine my horror when I realized that "fairy" meant "ridiculous," and that it was originally invented by Paul Krugman to lampoon arguments for austerity.

For example, in the 2012 election cycle Mitt Romney, who campaigned on promises of drastic spending cuts, tried to claim that his election would foster confidence and thus growth, saying,
"If it looks like I’m going to win, the markets will be happy. If it looks like the president’s going to win, the markets should not be terribly happy. It depends of course which markets you’re talking about, which types of commodities and so forth, but my own view is that if we win on November 6th, there will be a great deal of optimism about the future of this country. We’ll see capital come back and we’ll see —without actually doing anything — we’ll actually get a boost in the economy."  
Krugman seized the opportunity to call him the confidence fairy, and thus simultaneously aligned my darling sprite with the side of evil, and denied her status as a real player in economic growth. My heart sank.

I was doubly confused because, having read a few of Krugman's academic papers before extensively reading his blog, I knew that he puts as much weight or possibly even more on "confidence" than I do.  More specifically, expectations about future prices are the engine of economic growth in several of his papers, as they are in all New Keynesian models. If expectations are optimistic, the economy grows; if expectations are less optimistic, it doesn't. Sounds an awful lot like confidence, right?

I had also seen Gauti Eggeretsson, Krugman's primary coauthor for the last few years, stand up and deliver a presentation where he claimed that FDRs announcements about changes in monetary policy, not his actual implementation of policy, but his announcements, could explain huge volatility in stock markets and price levels.  Perhaps they just disagree, but coauthors don't tend to go on coauthoring when they differ on something so fundamental. 

This is a real life Gauti Eggertsson slide I found after about two seconds on the google image search, I believe from a presentation about his 2008 paper, Great Expectations and the End of the Depression.

So....FDR is the confidence fairy? 

What's going on here? 

How the Confidence Fairy Was Kidnapped by the Right

To understand how the confidence fairy came to be cast as a counterproductive sidekick to Mitt Romney, we have to go back in time. We could trace the history of confidence in political economy as far back as ancient Greece, but in the interest of brevity I'll start just 100 years ago, at the dawn of World War I. 

In the 19th century governments spending was small and inflation kept in check by the global supply of gold. It was the Gilded Age of liberalism, when commerce moved briskly and the world looked infinite and rosy--to those on top. But the illustrious peaks rose over deep and jagged gorges; if you fell, no safety net would catch you. World War I changed this by placing unprecedented demands on government budgets. To beat the Germans the Brits had to resort to extraordinary measures; they excised special taxes on the British public, they took ruinous loans from the Americans, and suspended convertibility to gold, code, in 1914, for printing money. 

After the war most politicians wanted to return to small government and the gold standard, and used austerity to appreciate the currency and cut away at spending and debt.  However, the relative success of the extraordinary measures taken during the war and the pain of austerity encouraged opposition to the main line.  This new school of thought believed that government spending and inflation could be used as a tool to foster economic growth.  The most vocal and adamant member of this new school was John Maynard Keynes, who argued against return to the gold standard in a series of articles in the 1920s. 

Keynes won many to his cause, but still "Sound money" became the rallying cry for the British, French, and American citizens who wished to see the international monetary system return to what it was. If businessmen were to invest, if banks were to lend, and if capital was to flow across boarders as it had before, there had to be confidence that the currency and the exchange rate would not rapidly depreciate.  

In the late 1920s and the late 1930s the sound money view was buttressed by the Treasury View, the &quote wikipedia belief that "Any increase in government spending necessarily crowds out an equal amount of private spending or investment, and thus has no net impact on economic activity." According to the Treasury View, not only did uncontrolled spending increase the risk of hyperinflation, it was also contributed nothing to economic growth. 

A Cartoon criticizing government spending, Chicago Tribune, 1934
Thus, but the time Keynes published his magum opus, The General Theory of Interest, Employment and Money, in 1936, the conservatives had already claimed confidence for austerity.  Keynes, however introduced a new type of confidence, something he called "the marginal propensity to consume." The propensity to consume is the percentage of each additional dollar of income spent; when the average propensity to consume is high, Keynes argued, the economy grows quickly, and when low, it slumps.  Today, most people know the average propensity to consume by a simpler name: consumer confidence. 

Further, Keynes argued that by redistributing money to those with the greatest marginal propensity to consume, ie, the poor, fiscal policy might actually be able to increase the total marginal consumption, and that even if it can't, fiscal policy is still a band-aid necessary to keep up effective demand when the propensity to consume is low.  Inflation, Keynes argued, is  not a cure-all but also not a problem, because a constantly eroding currency encourages current spending, ie, raises the propensity to consume.  

And so by the start of WWII the confidence fairy was caught in a tug of war between two sides; the right, who claimed her influence on investment, and the left, who claimed her influence on consumption.  Most of the time, neither side called her directly by her true name, preferring to fight with epithets such as "fiscal prudence" and "inflation-employment tradeoff."  Pixies are notoriously elusive.  

All custom images in this post were created in powerpoint. I have neither the patience nor the budget for photoshop.
The Keynsians were winning the tug of war for quite sometime, until a new set of heavyweights began to pull for their right. Their names were Milton, Muth, Barro, Sargent and Lucas, and they had had very particular ideas about expectations. At a 1968 American Economic Association dinner, Milton proposed something called "adaptive" expectations, arguing that after a while consumers adjust to the money supply and that inflation can have no long run effect on employment. In 1979, Barro wrote a paper noted that, if consumers were perfectly rational, they should realize that government spending today means taxes tomorrow, and adjust their spending accordingly. This "Ricardian Equivalence," essentially an update of the Treasury View, denied the ability of government spending to increase or even compensate for a low propensity to consume.  Adaptive expectations and Ricardian equivalence flipped consumer confidence from an argument for spending to an argument for austerity, and trapped the confidence fairy in a blood red box.

Why the Left Let Them Have Her

The coup of rational/adaptive expectations was a great blow to liberals everywhere, and, combined with an uncomfortably severe period of inflation, it essentially sent Keynsianism to the grave. The Keynsian economists put their tails between their legs and hid behind increasingly robust econometrics in the hallowed halls of Academia. They reconsidered, compromised, and regrouped, and reached deep back into the General Theory to rebuild their models on sticky prices, another of Maynard's insights. They came back toward the end of the 20th century with an awkward, watered-down model of underconsumption: the Dynamic Stochastic General Equilibrium.

The liberal who has tried hardest to use DSGE modeling to defend spending and inflation is of course, Paul Krugman. He studied Japan's "lost decade" and found that when interest rates are near zero, the only thing that matters is expected nominal future income. In other words, when the economy is depressed, deficit spending and inflation are fine, because both increase expected income.  The terms of his paper on the subject, including "interest rate zero bound" and "liquidity trap" pepper his NYT posts.

These charts clearly show how the economy behaves in a liquidity trap. Yeah, they're pretty painful. 

Essentially, Krugman argues that sometimes, especially after financial crises, low expectations of future income present the greatest obstacle to recovery. Consumers expect to earn LESS in the future than they do today, and therefore prefer to sit on their money than go spend it.   Why make widgets if you believe they'll stay on the shelves?  Why go to med school if you think you'll make diddly squat? Why buy cocktails if you're afraid you'll lose your job? (Vodka from a plastic bottle is much cheaper). Only a heady dose of inflation or government spending can shock consumers out of their pessimism, increase expectations, and return spending. This is what FDR did in the 1930s, and why Gauti Eggertson (metaphorically) gave him wings.

He's talking about confidence, and he knows it. From a September 23rd 2012 post:
Some readers have asked whether there isn’t an inconsistency between my view that the Fed can promote economic recovery by changing expectations about future policy, and my ridicule of austerity proponents who invoke “confidence” as a reason to believe that austerity will actually be expansionary. But there isn’t really any inconsistency; it’s an orders of magnitude thing.  What the expansionary austerity types are claiming is that the indirect effect of austerity on confidence will outweigh the large direct depressing effect of cutting government spending now. 
He goes on to explain why, right now, the positive effects of government spending and inflation on expectations/confidence outweigh the negative effects of government spending and inflation. I won't go into that now. Suffice to say that the current economic debate is not about the importance of confidence, it's about the effect of policy on confidence. 

Here's one way to look at it: there are two confidences, the "up and the air" confidence, influenced by discount rates, policy shocks, state solvency, etc, and the "obvious" confidence, determined by the size of the paycheck you expect to get next week.  The two confidences don't always push in the same direction.  For example, both my parents work for the federal government.  Right now they have very little "up in the air" confidence, and keep sending me invitations to "fix the debt" initiatives that, in the name of greater long term welfare, aim to introduce austerity measures (facepalm).  However, because their paychecks are not directly affected by the sequester, their "obvious" confidence is strong and they haven't reduced their spending, despite the anti-debt rhetoric.  Ironically, if fix the debt measures succeeded to the degree my parents would like, they are more likely to suffer a pay cut and decrease spending to compensate.

Sometimes you miss what's right under your nose. 
The "obvious" confidence is in almost every case more important, but it's not usually called by the name  "confidence." Krugman has found it easier to keep using "confidence fairy" to criticize austerity advocates who place too much weight on "up in the air" confidence and his wonkish vocabulary to defend "obvious" confidence then to try to create new connotations.  I sympathize. A good phrase can be powerful, and even if "confidence fairy" is misleading, it may convince people that austerity is a bad idea. "Invisible hand" has certainly done a lot of damage.

However, I do regret the confusion it causes. For the non-academic reader, the demonization of the confidence fairy is a step backward, not a step forward, towards understanding how the economy really works. What's more, for some readers it may actually be counterproductive. It's easy to read one of Krugman's anti-confidence fairy posts and decide that he is deliberately ignoring something important. He's not, and a deeper look makes that clear, but to understand why you have to jump over a whole lot of wonk.

Arguments built on shaky foundations are always eventually be torn down, even if they're the right arguments. Luckily right now popular favor seems to be turning against austerity, but if today's rhetoric doesn't improve,  I'm quite sure austerity will be back. Besides, I like fairies, and I'd rather treat them with respect.

This doesn't really apply to this post but it's always good to throw in some wisdom from wise fairies:

If we shadows have offended,
Think but this, and all is mended,
That you have but slumber'd here
While these visions did appear.
And this weak and idle theme,
No more yielding but a dream,
Gentles, do not reprehend:
if you pardon, we will mend:
And, as I am an honest Puck,
If we have unearned luck
Now to 'scape the serpent's tongue,
We will make amends ere long;
Else the Puck a liar call;
So, good night unto you all.
Give me your hands, if we be friends,
And Robin shall restore amends.