## Thursday, December 5, 2013

### Message from Berkeley Chancellor

This came in a campus-wide email from Chancellor Nicholas Dirks:
Dear Campus Community:
Today, the UC Berkeley campus mourns the loss and celebrates the life of Nelson Mandela. We are all part of a global community united in grief and reverence for a man whose clarity of moral purpose and extraordinary perseverance brought freedom to the oppressed, hope to the hopeless and light to all the dark places where human dignity struggled to survive. We pause to not only mourn but also to reflect with gratitude on the good fortune we had to witness all that Nelson Mandela accomplished and exemplified.
At Berkeley we also remember the special ties that will forever bind our campus to this man and his movement. As we know, the Bay Area was the epicenter of the American anti-apartheid activity due, in no small measure, to the passionate engagement of Berkeley students. In 1990, on a worldwide tour after serving 27 years in prison, Mandela spoke to a crowd of 60,000 at the Oakland Coliseum. During that speech South Africa’s future president specifically cited our university’s “Campaign Against Apartheid” as having been particularly significant in hastening the end of white-minority rule in his country. That recognition highlights what is, in my opinion, one of Berkeley’s proudest moments.
Today, I am also thinking about something Nelson Mandela said that goes to the heart of who we are and what we stand for as a university: “Education is the most powerful weapon which you can use to change the world.” With that in mind, I have asked our academic leadership to begin working on a Spring event that will celebrate Nelson Mandela’s life and extend his legacy through an exploration of, and discussions about his historic accomplishments.
Words alone cannot pay adequate homage to an extraordinary life that so deeply altered the course of history. We can truly honor Nelson Mandela only through our ongoing individual and collective efforts to ensure that every man, woman and child reaches the final destination on humanity’s long walk to freedom.
Best,

Nicholas B. Dirks
Chancellor

## Wednesday, November 27, 2013

### The Economic Exhortation of Pope Francis

I'm glad to see Pope Francis' apostolic exhortation Evangelii Guardium featured so prominently in the media. With a 224-page document and a 2000 year Church history, however, media coverage is bound to include some oversimplifications. One is the title of Emma Green's piece in the Atlantic, "The Vatican's Journey From Anti-Communism to Anti-Capitalism." While the article includes a lot of good information, it does oversimplify historical Church teaching on the economy. Green writes:
Throughout 224 pages on the future of the Church, he condemns income inequality, “the culture of prosperity,” and “a financial system which rules rather than serves.”
Taken in the context of the last half-century of Roman Catholicism, this is a radical move. Fifty years ago, around the time of the Second Vatican Council, Church leaders quietly declared a very different economic enemy: communism. But Pope Francis’s communitarian, populist message shows just how far the Church has shifted in five decades—and how thoroughly capitalism has displaced communism as a monolithic political philosophy.
The Catechism of the Catholic Church, published in 1992, "presents Catholic doctrine within the context of the Church's history and tradition." According to the Catechism,
2425 The Church has rejected the totalitarian and atheistic ideologies associated in modem times with "communism" or "socialism." She has likewise refused to accept, in the practice of "capitalism," individualism and the absolute primacy of the law of the marketplace over human labor. Regulating the economy solely by centralized planning perverts the basis of social bonds; regulating it solely by the law of the marketplace fails social justice, for "there are many human needs which cannot be satisfied by the market. Reasonable regulation of the marketplace and economic initiatives, in keeping with a just hierarchy of values and a view to the common good, is to be commended.
The Church has a long history of rejecting both communism and capitalism in their pure forms. The Catechism elaborates on private property:
2403 The right to private property, acquired or received in a just way, does not do away with the original gift of the earth to the whole of mankind. The universal destination of goods remains primordial, even if the promotion of the common good requires respect for the right to private property and its exercise.
2404 "In his use of things man should regard the external goods he legitimately owns not merely as exclusive to himself but common to others also, in the sense that they can benefit others as well as himself." The ownership of any property makes its holder a steward of Providence, with the task of making it fruitful and communicating its benefits to others, first of all his family.
2405 Goods of production - material or immaterial - such as land, factories, practical or artistic skills, oblige their possessors to employ them in ways that will benefit the greatest number. Those who hold goods for use and consumption should use them with moderation, reserving the better part for guests, for the sick and the poor.
2406 Political authority has the right and duty to regulate the legitimate exercise of the right to ownership for the sake of the common good.
The following passages concerning economic activity and profit are also quite relevant:
2423 ...Any system in which social relationships are determined entirely by economic factors is contrary to the nature of the human person and his acts.
2424 A theory that makes profit the exclusive norm and ultimate end of economic activity is morally unacceptable. The disordered desire for money cannot but produce perverse effects. It is one of the causes of the many conflicts which disturb the social order.
2425 A system that "subordinates the basic rights of individuals and of groups to the collective organization of production" is contrary to human dignity. Every practice that reduces persons to nothing more than a means of profit enslaves man, leads to idolizing money, and contributes to the spread of atheism. "You cannot serve God and mammon."
These passages from the Catechism are based on a long history of Catholic teaching on economic justice, including Encyclicals from the Popes. Quadragesimo Anno, for example, written by Pope Pius XI in 1931, responded to economic conditions and inequality following the Great Depression. More recently, Pope Benedict in Caritas in Veritate stated that "Profit is useful if it serves as a means towards an end that provides a sense both of how to produce it and how to make good use of it. Once profit becomes the exclusive goal, if it is produced by improper means and without the common good as its ultimate end, it risks destroying wealth and creating poverty."

I am very grateful for Pope Francis' exhortation. I do not think it represents a radical shift in Church teaching, but rather a renewed and louder cry for the teaching to be taken seriously. His cries that "The dignity of each human person and the pursuit of the common good are concerns which ought to shape all economic policies." I hope the world will listen.

## Friday, November 8, 2013

### Financial Networks and Contagion

"Financial Networks and Contagion," a recent paper by Matthew Elliott, Benjamin Golub, and Matthew Jackson, uses network theory to study how financial interdependencies among governments, central banks, investment banks, and other institutions can lead to cascading defaults and failures.

 Source: Elliott et al. 2013
While the model is quite technical, the main theoretical findings are fairly intuitive. They define two key concepts, integration and diversification. Integration refers to the level of exposure of institutions to each other through cross-holdings. Diversification refers to how spread-out the cross-holdings are; in other words, whether a typical organization is held by many others or just a few. The key finding is that at very low or very high levels of integration and diversification there is lower risk of far-reaching cascades of financial failures. The risk of a far-reaching cascade is highest at intermediate levels of integration and diversification. The authors explain:
"If there is no integration then clearly there cannot be any contagion. As integration increases, the exposure of organizations to each other increases and so contagions become possible. Thus, on a basic level increasing integration leads to increased exposure which tends to increase the probability and extent of contagions. The countervailing effect here is that an organization's dependence on its own primitive assets decreases as it becomes integrated. Thus, although integration can increase the likelihood of a cascade once an initial failure occurs, it can also decrease the likelihood of that first failure...
With low levels of diversification, organizations can be very sensitive to particular others, but the network of interdependencies is disconnected and overall cascades are limited in extent. As diversification increases, a "sweet spot" is hit where organizations have enough of their cross-holdings concentrated in particular other organizations so that a cascade can occur, and yet the network of cross-holdings is connected enough for the contagion to be far-reaching. Finally, as diversification is further increased, organizations' portfolios are sufficiently diversified so that they become insensitive to any particular organization's failure."
Near the end of the paper, they illustrate the model using cross-holdings of debt among six European countries. The figure above is their representation of financial interdependencies in Europe. They conduct something akin to stress tests, simulating cascades of failures under various scenarios that very roughly approximate conditions in 2008. The simulations find that, following a first failure in Greece, Portugal is fails from contagion. After Portugal fails, Spain fails due to its large exposure to Portugal. The high exposure of France and Germany to Spain causes them to fail next in most simulations. Italy is always last to fail due to its low exposure to others' debt. They emphasize that this is intended only as an illustrative exercise at this stage, but could eventually be refined and incorporated into analysis of failure and contagion risk.

*Edited to fix my mistake pointed out by Phil.

## Monday, November 4, 2013

### Argentine Inflation Saga Approaches Critical Moment

Argentina's time is up. In February, the IMF censured Argentina on account of its notoriously dubious inflation statistics. Under terms of the censure, Argentina was given until September 29, 2013, to improve the flawed data. The deadline has passed, and IMF Chief Christine Lagarde will report to the IMF Executive Board by November 13 on Argentina's progress (or, likely, lack thereof.)

Lagarde's impending report follows a long and nearly unbelievable saga (see timeline at the end of this post.) The gist of the matter is that officially-reported inflation has been in the vicinity of 10% for the past few years, while a variety of private estimates place the true value at 25% or higher. Oh, and the independent economists who publish these private estimates are threatened with criminal prosecution. This September, economist Orlando Ferreres published his estimate that June monthly inflation was 1.9%, compared to the official estimate of 0.8% (with compounding, that's a big difference) and could face a two-year prison sentence. I searched for Ferreres' website on November 3, and it appears to have been hacked (see image below.) I could not find Ferreres' independent inflation estimates on his site; only official estimates appear.

Red flags were raised in earnest in 2007, when then-President Néstor Kirchner dismissed several staff statisticians at INDEC, the statistics institute that publishes the official consumer-price index (CPI) for Argentina. The government takeover of INDEC included the demotion of Graciela Bevacqua, director of the inflation index, who had prepared the inflation data for six years. In 2005, Bevacqua estimated that inflation was over 12% and rising. Bevacqua says that Interior Commerce Secretary Guillermo Moreno began pressuring her to underreport inflation data in May 2006. From then until her demotion, Moreno harassed her unrelentlessly, challenging her data and methodology and demanding more "favorable" estimates. Bevacqua refused to comply, resulting in her demotion and eventual resignation from government.

The 2007 Presidential elections certainly contributed to the pressure for more "favorable" inflation data. With Kirchner's appointees in place at INDEC, end-of-year inflation "fell" from 12.3% in 2005 to 9.8% in 2006 to 8.5% in 2007. Christina Fernandez de Kirchner, wife of Néstor Kirchner, was elected President. After the elections, the data manipulation had to continue, to cover the previous manipulation.

In Argentina, inflation statistics have political significance that extends even deeper than their economic significance, as is common in countries with a history of hyperinflation. In the 1970s, like several other Latin American countries, Argentina borrowed heavily to fund its industrialization efforts. A variety of factors combined to exacerbate a debt crisis in the 1980s, which was accompanied by high inflation in Argentina and neighboring countries. Argentina faced quadruple-digit inflation in 1989 and 1990, with a hyperinflationary peak in March 1990. The disastrous consequences of hyperinflation, including stagnation of growth and capital flight, prompted structural reforms in the 1990s, under direction of the IMF, which restored inflation to low levels. For a time, Argentina was viewed as a model of success.

The situation in Argentina took a turn for the worse around the time of the Brazilian devaluation in 1999. A protracted recession erased most of the decade's gains in poverty reduction. As the federal government deficit widened to 2.5% of GDP in 1999, the IMF advised the De la Rúa administration to implement austerity measures. Distress escalated to full-scale crisis, climaxing with the largest debt default in history in December 2001. Following the default, Argentina faced exclusion from international capital markets and 41% inflation in 2002. Legal battles with a subset of the bondholders continue to this day.

With this history, it is not surprising that both inflation and IMF relations are sensitive issues for Argentina. Bevacqua says that Secretary Moreno "said that if we didn’t aim for zero inflation, we were unpatriotic.” The  irony is that the deceptive data, intended to improve appearances, fooled no one, and made the country look worse rather than better. Consumers in Argentina are well aware that inflation is several times the official rate. A consumer survey run by Torcuato di Tella University has measured inflation expectations near 30% for several years.

 Source: Torcuato di Tella University. Yellow bars indicate median expectation and gray line indicates mean expectation.
MIT economist Alberto Cavallo published an investigation into Argentina's official price index in the widely-read Journal of Monetary Economics in 2012. Here is the abstract:
Prices collected from online retailers can be used to construct daily price indexes that complement ofﬁcial statistics. This paper studies their ability to match ofﬁcial inﬂation estimates in ﬁve Latin American countries, with a focus on Argentina, where ofﬁcial statistics have been heavily criticized in recent years. The data were collected between October 2007 and March 2011 from the largest supermarket in each country. In Brazil, Chile, Colombia, and Venezuela, online price indexes approximate both the level and main dynamics of ofﬁcial inﬂation. By contrast, Argentina’s online inﬂation rate is nearly three times higher than the ofﬁcial estimate.
Cavallo suggests that "the way the data is being altered is far simpler than commonly assumed. INDEC is a large organization, with many employees involved with the data collection and construction of the price indexes. Instead of changing the prices at the item level, it is probably easier for the government to change the aggregate numbers, which are seen by just a handful of people at the end of the CPI calculation process."

He adds, in conclusion, that "There is no obvious reason for why the government continues to manipulate the ofﬁcial price indexes. Some economists point to lower interest payments for inﬂation-linked bonds, while others highlight the fact that, by using artiﬁcially low inﬂation estimates in the budget, the government can avoid distributing any excess tax income to the provinces. However, these short-term resources are negligible next to the negative effects and uncertainty the manipulation has introduced in the economy."

Regarding Argentina's inflation-linked bonds, doubts about data accuracy began to wipe away their market in 2007. Argentina originally issued inflation-linked bonds in 1973, and the "linkers" came to play a large role in public debt management. Even as late as 2009, a third of Argentine debt was linked to inflation. But in September 2009, Argentina launched a new bond, the Bonar 2015, as part of a debt swap that replaced much of the inflation-indexed paper.

The collapse of Argentina's inflation-indexed bond market, though destructive, pales in comparison to the harms that have been inflicted on workers and consumers. A government-imposed price freeze implemented in February, and another in June, appear unsurprisingly ineffective. The mismatch between official data and generally perceived cost-of-living increases makes satisfactory wage negotiations between trade unions and the Ministry of Labor impossible. Erosion of purchasing power is likely much worse in the informal sector, which accounts for an estimated 40% of Argentine workers. In addition, strict capital controls fuel a large currency black market.

Lagarde describes the IMF censure of Argentina as a "yellow card." When Lagarde makes her report to the IMF Executive Committee later this month, if the data is not suitable, she will give a "red card." It is not clear how harmful any potential IMF sanctions could be. Argentina is already the only Group of 20 country that refuses to allow the IMF to conduct an annual review of the economy known as the Article IV consultation, and may not be overly concerned with further deterioration of relations with the IMF. A likely, if unsatisfactory, outcome is some knuckle-rapping and maintenance of the status quo for all practical purposes. The IMF could suspend Argentina's voting and related rights and begin the process of compulsory withdrawal from the fund. A top international priority should be the minimization of contagion to other emerging markets-- which should be possible, since the situation is sufficiently Argentina-specific. The way out of the mess in Argentina is difficult to foresee. The way into the mess is outlined in the timeline below.

### Timeline

1970s: Argentina borrows heavily to fund industrialization efforts.

1973: Argentina issues inflation-indexed bonds.

1980s: Argentine inflation heats up in the midst of Latin American debt crisis.

March 1990: Argentina's hyperinflation reaches peak.

1990s: Argentina implements IMF-directed structural reforms.

1998-2002: Argentina suffers severe recession.

June 31, 2001: Argentina swaps $29.5 billion of debt and defers$7.8 billion in interest payments.

December 5, 2001: IMF announces it will not release $1.3 billion in aid to Argentina because austerity measures are insufficient. December 23, 2001: Argentina defaults on$100 billion in debt.

May 25, 2003: Néstor Kirchner becomes President, succeeding Carlos Menem.

2007: Kirchner replaces several statisticians at INDEC with political appointees.

December 10, 2007: Christina Fernandez de Kirchner becomes President.

## Wednesday, August 21, 2013

### Diversity in Economics

Bank of England Governor Mark Carney, in an interview earlier this month, pointed out that there are no women on the Monetary Policy Committee (MPC). There also happen to be no female ministers in the Treasury. Carney suggested,
“What we have to do at the Bank of England is grow top female economists all the way through the ranks. That adds to the diversity in macroeconomic thinking, it adds to qualified candidates for the MPC including qualified candidates to be a future governor.”
This seems like a reasonable message, but Philip Booth at the Institute of Economic Affairs wonders "why Osborne and Cameron are not hauling Carney in for a dressing down." He makes a deeply confusing comparison between Carney and Larry Summers, and then adds:
"It is worth noting that I am quite comfortable with the idea that the sexes are complementary and that, in any business, social or family situation, they may (on average) bring different characteristics to the table. However, if Carney holds this position, there are some interesting conclusions because, if it is accepted that women (on average) might exhibit certain skills in greater preponderance than men, then the opposite may have to be accepted too. But, let’s move on…"
Before moving on, though, what are these "interesting" conclusions? If men do exhibit certain skills (like passive-aggressive ellipses usage) in greater preponderance than women, do we really know that each of these man-skills are beneficial for monetary policymaking?

Booth writes, "Surely, there can only be two reasons [for Carney's remarks] – that Carney believes that there are intrinsic differences between the ways in which men and women reason and assess evidence or that their social experiences are different from those of men who have similar career patterns."

Really, can these be the only two reasons? Isn't it also plausible that Carney thinks the lack of women on the MPC is a sign that some qualified candidates are, for various and perhaps subtle reasons, not making it into or up the ranks, and that excluding part of a talent pool is a generally bad idea? It is not just that the social experiences are different for men and women who have similar career patterns-- different social experiences also lead men and women to having different career patterns. Does Booth himself think that it is just a big coincidence that there are zero women out of nine on the committee? Surely his manly math skills are good enough that he doesn't chalk that up to random chance. So even though Booth is chiding Carney for implying that men and women are intrinsically different, he seems to be working off of some "interesting" assumptions himself.

Next, Booth manages to list eight female economists, but doesn't personally think that any of them would add diversity to the MPC. He thinks Gillian Tett might add diversity to the group, "but it is the fact that she is an anthropologist that ensures that her views add diversity, not the fact that she is a woman." (In fact, a survey of 400 economists documents notable differences of opinion between the genders.) Then he gets to the most telling paragraph:
"It does not follow that adding those women who choose to become economists to a group of male economists adds to the diversity of thinking of the group of economists. It may be the case...that those women who ‘add diversity’ in intellectual life do not choose to become economists. This would mean that women contribute to diversity in society but not necessarily to diversity amongst economists."
He is inadvertently proving Carney's point, just as he is trying to tear it down. If he thinks that intellectually diverse women do not choose to become economists, he needs to ask himself why that is. It might help to read Neil Irwin's article about what happens when a certain female economist does "contribute to diversity":
Yellen has a perfectly solid relationship with Bernanke, as best as I can tell, but she’s more of her own thinker within the institution. She has spent her time as vice chairwoman urging Bernanke and her other fellow policymakers to shift policy to try to do more to combat unemployment, and thinking through ways to do just that...And people dealing with her within the Fed have viewed her not so much as Bernanke’s emissary but as her own intellectual force within the organization.
Felix Salmon summarizes Irwin's reasons why the White House is uneasy about Yellen:
"The first is the 'team player' attack: Yellen is an independent thinker more than she is a loyal deputy to Bernanke... She never became part of the boys’ club which was making enormous decisions on a daily basis in the fall of 2008... The 'team player' argument, then, is basically the 'one of us' argument, thinly disguised. Which is the first place that the sexism comes in...
This second reason essentially takes the 'team player' argument past its breaking point, to the point at which the Obama team is basically saying 'Yellen needs to share our biggest weaknesses.'"
I hope this post was not too much of a rant. I just wanted to make the point that Governor Carney's remarks are perfectly acceptable and in fact welcome.

## Monday, August 19, 2013

### What Does Abenomics Feel Like?

Depending on whom you ask and when, Abenomics is or is not working, and Japan is or is not entering a recovery. What if you ask the people of Japan?

The closest thing to asking them is looking at the Bank of Japan's Opinion Survey on the General Public's Views and Behavior, a quarterly survey with a nationwide sample of 4,000 individuals who are at least 20 years old. The results from the June 2013 survey were recently released, giving us a glimpse of how the general public of Japan is experiencing economic life under Abe.

When asked, in the abstract, about the "growth potential" of the Japanese economy, responses are less pessimistic than in previous quarters.  But when asked about their own household's experience, the situation still looks pretty bleak. In one question, respondents are asked, "What do you think of your household circumstances compared with one year ago?" Only 4.9% say they are better off, while 39.2% say they are worse off, and the rest say it is difficult to tell. While not great, these numbers are a minor improvement over a year prior, when only 3.6% said they were better off and 47% said they were worse off. Of the households who reported worse circumstances, 73% said a reason was that their income decreased and 42% said a reason was that their income was not likely to increase in the future (they could choose multiple options).

The 4.9% of households who thought their circumstances improved were also asked why. About 22% responded that their interest income and dividend payments increased and 26% said it was because the value of their assets increased. Insofar as Abenomics has led to a rising Nikkei, this has only been enough to lead about one or two percent of households to notice improvements in their circumstances. (More households might have benefited from the rise, but not enough to offset other challenges.) The stock market rise greatly increased the net profits of regional banks, but the benefits don't seem to have been widely spread.

Positive inflation and higher inflation expectations are cornerstone goals of Abenomics. Deflation has plagued the Japanese economy since the latter half of the 1990s. Japan's CPI less food and energy rose 0.2% from a year earlier in June, the largest rise since 2008. At Bloomberg, Toru Fujioka and Andy Sharp report that "the world’s third-biggest economy may be starting to shake off 15 years of deflation." Fujioka and Sharp declare this a "Boost for Abe," and write that "the increase in consumer prices could stoke inflation expectations and encourage companies and consumers to spend more, bolstering the economic recovery."

The June 2013 survey shows that consumers are noticing rising prices and expect prices to continue to rise. In particular, 50.5% of survey respondents felt that prices had gone up in the previous year, and over 80% expect prices to go up over the next year. However, of the respondents who noticed rising prices, 81.6% described the price rise as "rather unfavorable." This makes it seem unlikely that stoked inflation expectations will encourage consumers to spend more. In fact, 44.8% of respondents plan to decrease their spending over the next year, and only 6.1% plan to increase spending.

I previously wrote a post about how Europeans really dislike inflation, even when it is low, but I think the reason Japanese consumers dread rising prices is different. If price inflation is not accompanied by wage inflation--and is not expected to be-- then the pass-through from inflation expectations to consumer spending is broken. Fujioka and Sharp quote Akiyoshi Takumori, chief economist at Sumitomo Mitsui Asset Management, saying “business executives must have forgotten how to increase pay after decades of deflation." Japanese companies are reluctant to raise base pay. In June, while average total monthly cash earnings, including overtime and bonuses, rose 0.1%, regular pay fell 0.2%. The rise in total earnings was attributable to higher summer bonuses. Over 80% of survey respondents are slightly or quite worried about working conditions such as pay, job position, and benefits.

## Monday, August 12, 2013

### Heisenberg's Uncertainty Index

The title of Matt O'Brien's recent post--"Uncertainty Isn't Killing the Recovery"-- summarizes a slurry of recent articles. O'Brien writes, "as Jim Tankersley of the Washington Post points out, uncertainty has actually fallen a lot the past few months, but hiring hasn't picked up." Tankersley's title proclaims a similar message: "'Uncertainty' Isn't a Problem Anymore."

The boldest title of all (no surprise) comes from Paul Krugman: "Another Bad Story Bites The Dust."

I thought about following the Very Descriptive Titles trend and calling my post "Whoa, Whoa, Wait a Minute Guys," or "Let's Not Throw Out the Baby with the Bathwater Just Yet" or "Uncertainty Might Matter So Maybe We Should Let Smart People Keep Studying It If They Want." (But I was too much of a nerd to resist the title I actually chose, which I will eventually explain.) Legitimate criticism of political discourse is one thing. But we shouldn't, in the meanwhile, dismiss a large, promising, and growing area of research.

The recent articles find fault with the Economic Policy Uncertainty index of Scott Baker and Nick Bloom of Stanford and Stephen Davis of the University of Chicago. The index is based in part on how often major newspapers talk about phrases related to economic policy uncertainty. The basic idea of the criticism has to do with uncertainty a la Heisenberg. The non-technical version of the Heisenberg Uncertainty Principle is that, in observing something, we change it. The usual context is quantum mechanics, but it applies in other contexts too. In this context, the idea is that once the Economic Policy Uncertainty index was publicized, conservative politicians and pundits found it a useful talking point, and by talking and writing about it so much, they actually drove the index higher. So what the economists were observing--the frequency of mentions of uncertainty-related phrases-- was actually altered by the attempt to observe it.

This is a valid, but not devastating point. First, we don't know how large this "Heisenberg effect" is. Conservative punditry could have had only a small effect on the index. Second, it is not that hard to think of ways to improve the index to minimize this problem. Simplest idea: exclude articles that include the exact phrase "economic policy uncertainty index" or the words Baker, Bloom, Davis, Stanford, or Chicago. Slightly less simple idea: Aren't there really sophisticated quantitative text analysis tools available these days that could measure the amount of uncertainty in the tone of economics/business articles? Third, and most important, is that there is much more to Baker, Bloom, and Davis' research than the index itself. Bloom's 2007 paper, "The Impact of Uncertainty Shocks"--written before the construction of the index-- helped kick off a surge of macroeconomic uncertainty research. Many of Baker, Bloom, and Davis' contributions, and those of authors they have motivated, have been theoretical. A slightly flawed measure beats no measure at all if it encourages researchers to pay attention to an important subject. And I would venture to guess that the vast majority of these researchers are not motivated by a political agenda. They are motivated by the desire to understand something they think might really matter.

For what it's worth, I think the Economic Policy Uncertainty index does have decent construct validity. The creators of the index make an analogous index for Europe. In an unpublished working paper, I make a totally different uncertainty index for Europe, based on the how uncertain professional forecasters are in their probabilistic forecasts for GDP growth 2-years ahead. (I chose Europe instead of the US because of data availability.) My uncertainty measure is plotted along with the Economic Policy Uncertainty index below; the correlation coefficient is 0.8. The fact that they are created by totally different methodologies, from totally different data sources, and yet are this highly correlated, makes me think that there is at least some measurement validity.

I appreciate John Aziz's more moderately-titled post, "On Policy Uncertainty," in which he writes:
Krugman is right to... trash those who view the sluggishness of the recovery as solely Obama’s fault. But he’s wrong, I think, to throw policy uncertainty out of the window entirely as a proximate cause of some of the problem’s we’re now facing.

## Wednesday, August 7, 2013

### Raghuram Rajan is Not Paul Volcker

Raghuram Rajan will take over leadership of the Reserve Bank of India (RBI) on September 4. The BBC lists some of the challenges facing the Indian economy, including a large current account deficit, weak rupee, the slowest growth in a decade (around 5%), and inequality, adding, "Many believe that the single biggest failure of the government's economic policies in recent years has been the inability to control inflation in general and food prices in particular."

It's clear that Rajan will have his work cut out for him, but what kind of work will that be?

"The monetary situation is such that he may be forced to act as India’s Paul Volcker, hiking up rates and perhaps even orchestrating a recession to get the currency and inflation under control," writes Dylan Matthews. Matthews notes that "By law, India’s central bank doesn’t have much political independence, as Rajan serves at the pleasure of the government and can be sacked at any time. That could deter him from making tough moves against inflation that could have unpopular implications for growth. But Subramanian thinks he’ll have a great deal of flexibility in practice, even if the opposition Bharatiya Janata Party comes to power again."

There is a tendency to want to frame the challenges of the Indian economy in terms of a power struggle between monetary and fiscal authorities-- an "unseemly battle of wits over interest rates," according to Rajrishi Singhal at Bloomberg.  Singhal describes how the Finance Ministry has piled pressure on Rajan's predecessor, RBI Governor Duvvuri Subbarao, to keep rates low. The idea is that, if only the new Governor can stand up to "bullying" and raise rates, then inflation and the rupee can be stabilized. But India in 2013 is not the U.S. in 1979, and Raghuram Rajan need not imitate Paul Volcker.

A central banker's role in India is much different than a central banker's role in the United States or Europe. Monetary policy, remember, is ultimately based on frictions. Prices and inflation are nominal variables. In a frictionless economy, there is no role for monetary policy. It is because of certain frictions that monetary policy can have short-run effects, and these frictions provide the justification for using monetary policy to stabilize economic fluctuations over the business cycle. The optimal monetary policy depends on the nature and magnitude of these frictions. Sticky prices and sticky information are the two categories of frictions most used in the analysis of monetary policy. Both have similar implications for how monetary policy should generally work.

The theory behind the Taylor rule is based on the sticky price friction. The rule recommends a relatively high interest rate or “tight” policy when inflation or employment is relatively high, and a relatively low interest rate in the opposite scenario. According to the Taylor rule, India's policy rates are currently too low. As Ashok Rao writes (in a very excellent post), "A healthy Taylor rule requires an accurate estimate of the output gap which is founded on long-run trend growth. “Trend” growth is a useless concept in countries like India and China, whose growth rates have both a high mean and variance."

But there may be a more fundamental reason why the Taylor rule is not suitable for India. The Taylor rule is based on the sticky price friction, which may not be the dominant friction. Amartya Lahiri suggests that the dominant friction is asset market segmentation (emphasis added).