The Capital Note

What Are Economists Good For?

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Welcome to the Capital Note, a newsletter about business, finance, and economics. On the menu today: a defense of macroeconomics, inflation expectations rising, tech-stock tumbling, and a look at Paul Romer’s 1990 paper on technological progress. To sign up for the Capital Note, follow this link.

In Defense of Macroeconomics
The field of macroeconomics has come under heat recently thanks to what some see as a disconnect between macro models and reality. Accommodative monetary policy, for instance, tends to be associated with increased inflation, but inflation has run persistently below the Fed’s 2 percent target despite near-zero interest rates and large-scale asset purchases.

Economist Tyler Cowen used his Sunday Bloomberg column to push back on critics of his field. He argues that the core tenets of macro remain sound and useful for policy-makers.

Recent inflation shortfalls, for instance, are largely in keeping with the conventional inflation model, called the “quantity theory of money.” Cowen explains:

If central banks go crazy increasing the money supply, the result will be high price inflation. There is one exception to this, which was evident in 2008 and 2009, when the Fed paid interest on bank reserves: If central banks simultaneously act to decrease the velocity of money — that is, if they take measures to reduce borrowing and lending — then price inflation will be limited accordingly.

Originally proposed by Copernicus (who studied economics in his free time), the quantity theory states that, holding output constant, prices are determined by two factors: the money supply and the “velocity” of money, or the rate at which currency circulates through the economy. An increased money supply raises prices because there is more to spend on a fixed amount of goods and services. But the impact of changes in the money supply depends on the rate at which businesses and households transact. Taken together, the two variables distinguish between purely monetary inflation and “organic” inflation driven by increased demand.

Models such as the quantity theory are most useful when data defy our expectations, because a disconnect between the model and reality means one of two things: (1) We are not imputing variables correctly into the model (as when commentators fail to account for velocity), or (2) there is a residual effect that our model is missing. That is why even faulty or incomplete models are better than no models at all, and why theoretical macro remains a worthy pursuit.

Consider the work of Paul Romer, who won the 2018 Nobel prize for his 1990 paper formalizing the effect of technological change on GDP growth. Romer, and Robert Solow before him, saw that models of economic growth that did not account for knowledge gains were incomplete. Over time, growth in GDP per capita depends on productivity growth, which is driven by innovation.

Solow added the “knowledge” factor to traditional growth models, which took labor and capital as the only two inputs to GDP. Romer built upon Solow’s work by formalizing the ways in which economies allocate labor and capital to research. He concluded that governments should incentivize human-capital formation by granting patents and subsidizing research.

A lot of hot air is blown forecasting the trajectory of economic indicators. Underneath it all, the fundamentals of macro remain sound and useful.

Around the Web
Bond traders expecting a rate hike sooner than the Fed has indicated

Interest-rate swap markets are pricing the first 25 basis point of Fed hikes around mid-2023, versus the early-2024 timeframe priced in at the beginning of this month. The shift has coincided with improved prospects for U.S. stimulus spending as well as vaccine roll-outs, leading to enthusiasm about the global economy’s prospects. Market-based measures of inflation have jumped, reflecting those rosier feelings, and bonds have sold off around the world.

And that’s hurting tech stocks

The Nasdaq Composite fell sharply on Monday, as rising bond yields and investors’ bets on an economic rebound weighed on the shares of technology giants such as Apple and Microsoft…. The tech-heavy Nasdaq lost 341.41 points, or 2.5%, to close at 13533.05. The broad-based S&P 500 fell 30.21, or 0.8%, to 3876.50, in its fifth consecutive losing session.

Random Walk
For today’s Random Walk, an excerpt from Romer’s 1990 paper:

Growth in this model is driven by technological change that arises from intentional investment decisions made by profit-maximizing agents. The distinguishing feature of the technology as an input is that it is neither a conventional good nor a public good; it is a non-rival, partially excludable good. Because of the nonconvexity introduced by a nonrival good, price-taking competition cannot be supported. Instead, the equilibrium is one with monopolistic competition. The main conclusions are that the stock of human capital determines the rate of growth, that too little human capital is de- voted to research in equilibrium, that integration into world markets will increase growth rates, and that having a large population is not sufficient to generate growth . . .

The most robust welfare conclusion from the model is that because research projects exchange current costs for a stream of benefits in the future, the rate of technological change is sensitive to the rate of interest. Although all the research is embodied in capital goods, a subsidy to physical capital accumulation may be a very poor substitute for direct subsidies that increase the incentive to undertake research. In the absence of feasible policies that can remove the divergence between the social and private returns to research, a second-best policy would be to subsidize the accumulation of total human capital.

The most interesting positive implication of the model is that an economy with a larger total stock of human capital will experience faster growth. This finding suggests that free international trade can act to speed up growth. It also suggests a way to understand what it is about developed economies in the twentieth century that permitted rates of growth of income per capita that are unprecedented in hu- man history. The model also suggests that low levels of human capital may help explain why growth is not observed in underdeveloped economies that are closed and why a less developed economy with a very large population can still benefit from economic integration with the rest of the world.

— D.T.

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