Robustness

I am beginning a self-study of the textbook Robustness by Lars Peter Hansen and Thomas Sargent (2008). My macro professor from last semester, Demian Pouzo, briefly touched on the topic in a lecture devoted to relatively new extensions of the dynamic programming we learned during his course. At the time, what he told us about applying robust control techniques to macroeconomics sounded both fascinating and extremely useful--but I still had a long way to go in just grasping the basics of dynamic programming. The prospect of field exams motivated me in that, and now that exams are over, I feel reasonably literate enough to delve into Robustness.

Robust control theory extends rational expectations models to acknowledge fear of model misspecification. Here is a paragraph from the first chapter that convinces me just how fundamental this is for economists to address: 

Rational expectations models presume that decision makers know the correct model, a probability distribution over sequences of outcomes. One way to justify this assumption is to appeal to adaptive theories of learning that endow agents with very long histories of data and allow a Law of Large Numbers to do its work. But after observing a short time series, a statistical learning process will typically leave agents undecided among members of a set of models, perhaps indexed by parameters that the data have not yet pinned down well. This observation is the starting point for the way that we use detection error probabilities to discipline the amount of model uncertainty that a decision maker fears...(Hansen and Sargent Section 1.4.5).

Robust control theory began to be developed by control theorists and applied mathematicians in the late 1970s for application to a variety of engineering and physical problems. Model misspecification is probably a much greater problem in economics, where there is much less consensus about how the system works and what kinds of policies are effective. The engineering and physics applications don't include discounting, or at least not in the way that economists do. They also don't include multiple agents in a game theory context. Hansen and Sargent add both discounting and multiple agent settings to robust control theory in this text, greatly facilitating its application to economics.

As I start this study, there are a few things I am wondering:

• Positive or normative? Does robustness describe what policymakers do, or what they should do? In other words, by understanding robust control theory, will I be better able to understand why policymakers made the decisions they made, or what they should have done/should do differently?
• Can robust control theory incorporate policymakers' motives that may not be simply social welfare maximization? Reputation concerns, power struggles, etc. may lead to purposeful "misspecification."
•  Is there some concept like "retrospecification"? That's just a term I'm making up, but perhaps the policy justification comes after the policy in some cases?
• Does robust control theory apply to institutional design and regulatory design in a similar way as it applies to policymaking?
• Misspecification implies that there is a "true" model. Is there?

Please suggest other papers I should include in this study or other issues I should think about as I read the text!

American Exceptionalism: A Sequel

A few posts ago, I wrote about American Exceptionalism. For economic historians, this typically refers to the United States' industrialization and efficiency gains in the second half of the nineteenth. Economic historians refer to the first two thirds of the twentieth century  as the "American Century," due to the United States' considerable edge in productivity and wealth over the rest of the world. The American Century is thus the conceptual and chronological sequel to American Exceptionalism.

I previously explained how the concept of American Exceptionalism had become a rallying cry for Republican politicians. So too for the American Century. Here's Mitt Romney:

In 1941, Henry Luce called on his countrymen -just then realizing their strength - "to create the first great American century." And they succeeded: together with their allies, they won World War II, they rescued Europe, they defeated Communism, and America took its place as leader of the free world. Across the globe, they fought, they bled, they led. They showed the world the extraordinary courage of the American heart and the generosity of the American spirit...

Like a watchman in the night, we must remain at our post - and keep guard of the freedom that defines and ennobles us, and our friends. In an American Century, we have the strongest economy and the strongest military in the world. In an American Century, we secure peace through our strength. And if by absolute necessity we must employ it, we must wield our strength with resolve. In an American Century, we lead the free world and the free world leads the entire world.

Again, economic historians have to look for explanations other than the "extraordinary courage of the American heart and the generosity of the American spirit." Explanations of American Exceptionalism in the late nineteenth century largely focus on factors within the U.S.: factor endowments, technological development, railroadization, education, and so on. For the American Century--which included both world wars and the Great Depression-- international explanations are in order.

A few other grad students and I currently have a book club on Barry Eichengreen's "Golden Fetters." We read and discuss a chapter per week, and are on chapter 9 now. It has me convinced that the international monetary system, and especially the gold standard, is a key thread to understanding those remarkable decades. The pre-WWI gold standard worked well because of credibility and international cooperation. Eichengreen's intuition for political economy is strong, and he carefully traces why credibility and cooperation were sustainable before WWI but not in the interwar period.

The war greatly strengthened the U.S. balance of payments. Germany paid reparations to the Allies, who in turn repaid war debts to the U.S. American lending to Central Europe and Latin America rounded the circle of capital flows. But the balance of the whole system hinged on the U.S. keeping domestic interest rates low to encourage American gold to flow abroad. And for awhile, this worked just fine. The U.S. was more than happy to maintain low interest rates when it was also convenient for their domestic goals. However, starting in 1928, around the time of the Wall Street boom, Federal Reserve officials decided to tighten monetary policy, which curtailed foreign lending. To stay on the gold standard, other countries had to respond drastically, causing the U.S. downturn to both spread and deepen. The "golden fetters" also prevented policymakers from injecting liquidity into the banking system to contain bank runs. I strongly recommend reading at least the first chapter of Golden Fetters for more. The book is filled with examples of cooperation and coordination failures in the interwar period.

Anyhow, by the mid 1930s most countries dropped off of the gold standard and finally began to recover. The U.S. economy grew rapidly, save for a downturn in 1937-38. After that, monetary expansion in the form of huge gold inflows stimulated the economy. The gold inflows were at least in part due to fears of another war on European soil, causing capital flight from Europe. After WWII, the dollar was the dominant currency for international transactions and reserves. The Bretton Woods agreement of 1944 established a system of fixed exchange rates based on gold valued at $35 per ounce. Both world wars, then, were inadvertently beneficial to the United States relative to other countries. And our Great Depression was detrimental to the rest of the world. So it is hardly surprising that the United States' relative productivity and wealth grew in this era. Or that by the mid 1960s, Japan and Europe began to narrow the gap, and that Bretton Woods collapsed by 1971.

I will try to add more in future posts about what was going on in the American Century. So far it is not apparent that we want to repeat it. But maybe there are some features of the American Century worth striving for. For now I need to get back to studying for my economic history field exam on Wednesday. Today was macro-- quite difficult, a heavier than expected emphasis on stochastic dynamic programming.

An Oversight in Krugman's End This Depression Now

I started reading Paul Krugman's new book, End This Depression Now!, and felt compelled to point out one problematic remark from the first chapter. In chapter 1 he writes, 

"Clearly what we're interested in is involuntary unemployment. People who aren't working because they have chosen not to work, or at least not to work in the market economy- retirees who are glad to be retired, those who have decided to be full-time housewives or househusbands- don't count. Neither do the disabled, whose inability to work is unfortunate, but not driven by economic issues."

The problem is the last sentence. In fact, for people with disabilities, unemployment may be even more sensitive to economic issues than for others. People with disabilities may be the first to be fired when the economy makes a turn for the worse and the last to be hired when things begin to improve. The employment gap between men and women with and without work- related disabilities has increased over the past 20 years, reaching its largest ever recorded in 2009. Many people with disabilities are willing and able to work with sufficient accommodation. Often a small and relatively inexpensive change is all it takes. Since Krugman supports government spending and investment projects to End This Depression, why not target some of it towards workplace inclusion? Entrepreneurship and virtual or otherwise nontraditional work situations may also be viable--and productive-- options. These issues are all topics of a report of the National Council on Disability called "The Power of Digital Inclusion: Technology's Impact on Employment and Opportunities for People with Disabilities." I worked on the report while at the Center for Advanced Communication Policy at Georgia Tech.

Long-term unemployment, Krugman writes, is "deeply demoralizing for workers," and "the blow to dignity and self-respect can be devastating." Krugman's book is poignantly dedicated "to the unemployed, who deserve better." What an unfortunate carelessness to exclude the disabled even in the first few pages! 

One translation of an often cited Bible verse is "He who does not work, shall not eat" (II Thessalonians 3:10). Another translation of what Paul wrote to the early Christians is "He who is not willing to work, should not eat." Nowadays there is a distinction, but back then the translations would be equivalent. Involuntary unemployment was not a common part of the human experience. In pre-industrial society, farmers farmed and fishermen fished and servants served. But it was not the case that the "labor market" "failed to clear," leaving people involuntarily unemployed.

In fact, the rare biblical cases of involuntary unemployment mostly involve people with disabilities-- blind, deaf, lame, or lepers. They do not work, but Paul and the apostles do not argue that they shouldn't eat. Rather they spread Jesus' message of charity and compassion. This is the Christian attitude toward involuntary unemployment, not an attitude of "let them starve." Jesus' interactions with the lepers teach that they have human dignity, in an era when it was widely believed that disability was a punishment for sin.

When medicine, technology, and social understanding evolved enough to make it possible for people with disabilities to work, Christian teaching promoted this. Krugman cites Ben Bernanke and some happiness studies as his source that work lends dignity to human life, but this message was spelled out emphatically in 1981 in Pope John Paul II's "Laborem Exercens" ("On Human Work"). Laborem Exercens includes a section on disability.

Recently, national communities and international organizations have turned their attention to another question connected with work, one full of implications: the question of disabled people. They too are fully human subjects with corresponding innate, sacred and inviolable rights, and, in spite of the limitations and sufferings affecting their bodies and faculties, they point up more clearly the dignity and greatness of man. Since disabled people are subjects with all their rights, they should be helped to participate in the life of society in all its aspects and at all the levels accessible to their capacities. The disabled person is one of us and participates fully in the same humanity that we possess. It would be radically unworthy of man, and a denial of our common humanity, to admit to the life of the community, and thus admit to work, only those who are fully functional. To do so would be to practise a serious form of discrimination, that of the strong and healthy against the weak and sick...  The various bodies involved in the world of labour, both the direct and the indirect employer, should therefore by means of effective and appropriate measures foster the right of disabled people to professional training and work, so that they can be given a productive activity suited to them. Many practical problems arise at this point, as well as legal and economic ones; but the community, that is to say, the public authorities, associations and intermediate groups, business enterprises and the disabled themselves should pool their ideas and resources so as to attain this goal that must not be shirked: that disabled people may be offered work according to their capabilities, for this is demanded by their dignity as persons and as subjects of work. Each community will be able to set up suitable structures for finding or creating jobs for such people both in the usual public or private enterprises, by offering them ordinary or suitably adapted jobs... Careful attention must be devoted to the physical and psychological working conditions of disabled people-as for all workers-to their just remuneration, to the possibility of their promotion, and to the elimination of various obstacles...

This was in 1981! (And the rest of the document is equally far ahead of its time). Over 20 years ago, the Church proclaimed that unemployment of the disabled is involuntary unemployment and contrary to human dignity. Now Paul Krugman, who may or may not have a larger readership than the Pope, is finally proclaiming that involuntary unemployment is contrary to human dignity, but has to add the unfortunate aside: the disabled don't count.

Unsecured Consumer Credit with Risk of Default

Here are my slides for a presentation I'm giving tomorrow on a paper by Chatterjee, Corbae, Nakajima, and Rios-Rull called "A Quantitative Theory of Unsecured Consumer Credit with Risk of Default" (Econometrica, November 2007). It is a very technical paper that incorporates the main characteristics of U.S. consumer bankruptcy law into a general equilibrium model.

The paper represents a relatively recent trend of taking household balance sheets seriously in macroeconomics. Macro models commonly abstract away from household debt, assumed that since one person's assets are another person's liabilities, in the aggregate it washes out. But as Chatterjee et al.'s paper and others by Mian and Eggertsson and Krugman show, the distribution of household debt matters a lot, especially when thinking about the effectiveness (or lack thereof) of various types of fiscal, monetary, and other policies in a recession.

After the Crisis

An interesting reading to kick off the semester warns of "the dangers of presuming a precision and degree of knowledge we do not have." The article, by Ricardo Caballero, is called "Macroeconomics after the Crisis: Time to Deal with the Pretense-of-Knowledge Syndrome," and appeared in the Fall 2010 Journal of Economic Perspectives.

Caballero, who is an MIT professor, writes that "On the methodological front, macroeconomic research has been in 'fine-tuning' mode within the local-maximum of the dynamic stochastic general equilibrium world, when we should be in 'broad-exploration' mode."

Basically, the general approach to macroeconomics these days is to begin with a stochastic neoclassical growth model-- a basic model of households and firms that everyone learns at the beginning of grad school-- and tack on some special effects, like money, monopolistic competition, or nominal rigidities. The problem is that "by some strange herding process the core of macroeconomics seems to transform things that may have been useful modeling short-cuts into a part of a new and artificial 'reality,' and now suddenly everyone uses the same language, which in the next iteration gets confused with, and eventually replaces, reality.
Along the way, this process of make-believe substitution raises our presumption of
knowledge about the workings of a complex economy."

We try to make incremental improvements to the model, adding a parameter here and there, but actually bring it further and further from reality by compounding absurd assumptions. "In realistic, real-time settings, both economic agents and researchers have a very limited understanding of the mechanisms at work. This is an order-of-magnitude less knowledge than our core macroeconomic models currently assume, and hence it is highly likely that the optimal approximation paradigm is quite different from current workhorses, both for academic and policy work. In trying to add a degree of complexity to the current core models, by
bringing in aspects of the periphery, we are simultaneously making the rationality
assumptions behind that core approach less plausible."

Caballero makes a distinction between uncertainty and Knightian uncertainty. The latter involves risk that cannot be measured and hence cannot be hedged--things you'd never think of thinking of. This is the kind of uncertainty that is involved in most crises and panics. In one sense, it is very discouraging that novelty and surprise is such a big part of financial crises, for then, how can we ever hope to model or understand them? On the other hand, there are nevertheless some insights: widespread confusion triggers panics which trigger demand for broad insurance (and a role for government). Macroeconomists need to embrace complexity and recognize that human reaction to the truly unknown is fundamentally different
from reaction to the risks associated with a known situation and environment.

Last semester, I took a course in Psychology and Economics with Matthew Rabin. The types of models we studied there captured things like belief-based or reference-dependent preferences, ego utility, social preferences, and framing and bracketing effects. All of these tweaks to the standard models are made for the sake of increased realism, but still, they are just tweaks. Usually they involve adding a nice Greek letter to the model. The standard model is a special case for which the Greek parameter is 0 or 1. Agents are allowed to have particular types of risk preferences, but the risks can always be measured, and in fact the models almost always impose rational expectations. Rational inattention is allowed, but Knightian uncertainty is not; agents are perfect Bayesian updaters with well-defined Bayesian priors. In this sense, as Professor Rabin describes in the syllabus, the course is "purposely, pointedly, persistently, proudly and ponderously mainstream."

Caballero says we need to go further from the mainstream and into areas like complex-systems theory and robust-control theory. In doing so we may need to "relax the artificial micro-foundation constraints imposed just for the sake of being able to generate 'structural' general equilibrium simulations."

This semester, I have one course that teaches precisely the methodology that Caballero so harshly criticizes. It's a theory-intensive course in macroeconomics, and the main textbook is Recursive Methods in Economic Dynamics by Stokey and Lucas. I'm excited to balance this course with a new course called Empirical Methods in Macroeconomics and Finance taught by Professor Atif Mian. This course will focus on new ways to integrate finance and macro. We will also get to learn about some new data sets and work at developing research ideas. Yet another complementary course will be Professor Barry Eichengreen's European Economic History course. Theory, empirics, and history sounds like a balanced mental diet for this semester.