Bonfire Of The Textbooks?

The Greeks had a word for it ‘:aporia‘. That state of ignorance and confusion you are condemned to pass through before you can entertain even the vaguest hope of achieving clarity and real knowledge. Well, taking a long hard look at what we know, what we think we know, and what we know we don’t understand for sure, I would say that this expression gives us a working definition of where economic science may be right now: in a state of ‘aporeia’.

Essentially we are in the frustrating condition of repeatedly finding that what is taught in the textbooks, and what we are encountering ‘out there in reality’, don’t make easy bedfellows. Above all it is China that has caused most of the head scratching. Morgan Stanley’s Andy Xie may have started it off by having the guts to come out and urge us to: “throw away the textbooks”, later an influential paper by Dooley Falkerts-Landau and Garber argued that conventional macro was all at sea when looking at goods and financial flows between China and the US. Today it is the turn of Robert Samuelson to say toss the textbook.

Andy Xie drew people’s attention to the fact that most macro textbooks start with the idea of a small open economy, and build out. Xie’s point was that in the globalised world we have today we may be methodologically better off treating the whole global economy as *one single developing economy* with imperfections which arise due to the existence of nation states.

Dooley et al make a slightly different point:

(The) growing chasm between what we know ought to be and what is can be bes summarized (by the relation between) 10-TIPS yields and the US current account balance. The long term real interest rate has been falling as the current account deficit has been growing into historically uncharted territory. Our standard theory of open economy macroeconomics been wildly wrong for five years. The data indicate that it is likely to be wrong for years more. Of course, some day the imbalances will be reduced, allowing us to resume teaching the standard stuff with some increase in confidence.”

In this uncharted water all of us have our own personal hitlists to bring forward. My own would be headed by the fact that most economics majors never do even a single course in demography, and by the fact that the relation between population and economic growth is normally only taught in the context of developing economies. Then again there is the notorious Harrod-Samuelson-Balassa effect. Even the ‘well known’ Feldstein-Horioka effect is normally justified from data which at its most recent comes from the late 90’s, with the possible implication that much of the data may now have been ‘superceded’ by a reality reeling under the impact of the rapid pace which globalisation has assumed in that handful of years which now constitute our ‘new’ century.

Samuelson’s own particular preoccupations? Well they’re mainly related to the current US connundrum, but the reach of their implications is much wider.

It’s not merely that we’re in the midst of changes (China and India’s entry into the global economy, the explosion of U.S. trade deficits) that are unfamiliar and, to some extent, unprecedented. What’s equally significant is that many assumptions that economists once casually accepted and taught are now suspect or discredited. Let m give you three examples.

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About Edward Hugh

Edward 'the bonobo is a Catalan economist of British extraction. After being born, brought-up and educated in the United Kingdom, Edward subsequently settled in Barcelona where he has now lived for over 15 years. As a consequence Edward considers himself to be "Catalan by adoption". He has also to some extent been "adopted by Catalonia", since throughout the current economic crisis he has been a constant voice on TV, radio and in the press arguing in favor of the need for some kind of internal devaluation if Spain wants to stay inside the Euro. By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".

12 thoughts on “Bonfire Of The Textbooks?

  1. A look at the history books instead might help as well. Isn’t the economic rise of China and India comparable to Germany in the late 19th century?

    Now take that idea and multiply it by a factor of at least 10, once for China (which goes rapid economic rationalization ) and once for India (which seems to have gone for slow but steady development).

    What would a late 19th century economist have thought?

  2. “comparable to Germany in the late 19th century?”

    Yep, Germany or the United States itself, you’re definitely in the right ballpark here.

  3. There is an enormous transfer of wealth going on between China and the U.S. Actually, this is also true for almost all exporting nations, ie. they are transferring wealth from the U.S. Edward suggests that demographics explains everything. He may be right, however; to me the end point is not clear. When does it stop? Will the end result be that there will be new consumers buying from the west? Other than real estate, what would they buy? This happened with Japan in the seventies and eighties. They bought a great deal of American real estate (including most of Hawaii). They later had a crash that was related to internal problems (banking) rather than being over extended. I don’t see that happening to China.

    I would appreciate an explanation from someone why all the rules no longer apply. I am referring to U.S. interest rates which are now less than 6% for thirty year mortgages, even though the prime rate has been increased seven times in the last few months.

    Where is this going?

  4. In dynamics, when you have two interrelated variables, one of which changes slowly and the other quickly, you are usually justified in pretending that the slow-moving variable is a constant, in order to simplify the analysis of the fast-moving variable. Since demographic change happens on the timescale of the human generation, say, 24 years, and many aspects of capital markets readjust themselves in more like 24 months, you need to find non-demographic explanations for the faster-changing aspects of markets.

    Now, as for U.S. real estate, you have a situation where the median U.S. home price has increased more than 50% in the past five years. U.S. demographics haven’t changed nearly so profoundly in this time, so I imagine a number of people invested in the home market are asking how much of their newfound wealth has any basis in reality. Part of it probably does have some basis in reality: construction materials, especially lumber and steel, have shows sharp price increases, and the higher cost of new construction is providing a price umbrella under which the value of existing homes can rise. But on the other hand, you have Greenspan calling the real estate markets in a number of metropolitan areas “frothy”, so people do have cause to be nervous.

    A number of new U.S. homeowners have financed on terms that they can’t afford unless they can re-sell the home at a profit. If the market goes bust, the banks will have to take their loss and foreclose. Also, those who have bought second homes as investments may as well default if it comes to pass that they owe more on those homes than they are worth, and again the bank takes the hit. So, the finance industry has an interest in ensuring the real estate market does not go bust.

    If mortgage rates continue to be low, then there continues to be more potential home buyers, and there is a chance that the bubble, if it is a bubble, might have the air let out of it slowly rather than just popping. If the banks increase interest rates enough to scare off would-be home buyers, then they bring about the situation they wish to avoid.

  5. “Edward suggests that demographics explains everything”

    Not everything, Ray, just a lot more than people tend to imagine. Institutional frameworks (eg) are obviously important, cultural traditions are too.I think I am simply ‘bending the stick’.

    But take this from Business week:

    “But what if China downshifts? Most economists foresee mainland growth slowing to a more sustainable 8.5% or so in the next couple of years. At the start of 2004, China appeared to be in real danger of overheating and contracting severely, which would have been a disaster, since the country needs to grow at least 7% annually to create enough jobs for new workers.”

    The whole article is worth a read:

    Get that, China needs a minimum of 7% growth just for the internal migration and demographics. The US, according to Krugman, needs a 3% minimum for the same reason (as I write this I have just realised that Spain isn’t growing quickly enough at 2.7% when you consider the huge inward migration 1.5% of toatal population annually. This means that per capita incomes are rising as the % of people of working age is rising, but that *productivity* is falling, since the economy isn’t growing as quickly as the labour force, and this is what the OECD and IMF studies show. That’s an example of ‘demographics’ in action: quick, clean and efficient as a ‘rule of thumb’ analysis).

    “Other than real estate, what would they buy?”

    Well, intellectual property rights would be one thing. This is why it is important to get the institutional structures right. But remember this situation is only ‘lop sided’ because China is so poor. When China has nearer OECD average incomes it will be like trading with Germany. Meantime there are plenty of ‘higher value’ products and services to sell. This is why Blair is so right to insist on moving funding away from agriculture to R&D and education. Greenspan never tires of making the same point in the US.

    The difficult thing here isn’t the ‘end game’, it is the transition dynamics, especially in relation to the respective currencies. Part of the ‘equilibration’ will come from rising real wages in China, but the other part will come from a rising value of the yuan (and the rupee). The tricky point will be how to achieve this without destabilising everything. Remember this transition could last anywhere between 10 and 20 years, and we could have more than one ‘hiccup’ on the way.

    On the way we have to hope that China’s institutional and political system also matures.

  6. “you are usually justified in pretending that the slow-moving variable is a constant, in order to simplify the analysis of the fast-moving variable”.

    I like the way you put this Robert, this is a fair assesment of the bet most people are making. My feeling is that this is fine if ‘non-linearities’ are not significant. This I think is the basis of the Laplace approximation. My guess, and looking out there at what is happening is only making me more stubborn in holding to my *guess*, is that somewhere packed away in there ‘non-linearities’ are important. Crudely put, something, somewhere is extremely sensitive to rising median age across a key threshold. Take Japan, take Germany, take Italy, don’t miss Switzerland (interest rates virtually ZIRP). Counter example France: well known structural and labour market problems, not as efficient as Germany, but growth which is still relatively respectable. Demographics in France are not good, but they are much better than in any of the aforementioned countries. What I am arguing for is an element of empirical testability in how we apply ‘economic science’, it is easy to roll out ‘sexy theories’, but what is their predictive power when push comes to shove?

    I am *agnostic* on the US property market. There probably are local bubbles, but this is not the same thing as a nationwide bubble. Obviously not everything is clear. My feeling is that for US property to crash badly China would have to crash. I don’t see that as likely (crash, not slow down), so I think the US situation is more solid than many suspect. Of course Ray is asking the interesting question: where will that leave the US 10 or 15 years from now?

    The difficulty is to look at the US economy and to screen out whether you like or dislike George Bush. Methodologically this is essential, and this will hold true whatever the ‘new’ textbooks may or may not say.

    “If mortgage rates continue to be low,”

    My feeling is that, in the current global climate, this is more or less guaranteed. Just ask yourself what will happen to the dollar if Greenspan keeps raising interest rates, and what would this do to the CA deficit and the internal price level in the US?

  7. Mr Xie also has some interesting views on the oil price and Chinese development: he argues a lot of the current buyers are speculators who bought-in to the “Chinese demand” story, but that this story is played out. Apparently Chinese oil demand in the first quarter fell year-on-year although industrial production was up 16.3%. This isn’t perhaps as counterintuitive as it looks (although that’s the definition of counterintuitive): economic development goes through phases of more or less energy-intensive growth, and China’s demand for oil grew at something like 7 per cent annually through the 90s and slightly more since then (compared to just over 1% elsewhere).

    If they are transitioning from extensive to intensive growth, a process one would think was slow but might happen quickly in the context of Chinese development, he might be right.

    Wasn’t somebody trying to find out what the huge “others” line item in Russia’s foreign reserves was?

  8. “Mr Xie also has some interesting views on the oil price and Chinese development:”

    Yes, I was reading his recent piece on that topic. It is interesting, even if he may or may not be right.

    One of the reasons the demand for oil is dropping is that they are using a lot more coal. This raises the interesting point about China not really being a market economy. Ironically this may be one of the reasons behind its dramatic success.

    China has opened, but China has not ‘deregulated’. This may be a pretty pragmatic way of achieveing development, and then gradually de-regulating.

    Most of the OECD economys got to be OECD economies this way, the other path, the ‘full market treatment’ from day one is simply a hypothesis waiting to be confirmed.

    Full ‘deregulation’ may actually be more appropriate for already developed economies, in a similar way that ‘full democracy’ may need more economic and social development than Iraq has at this stage.

    Back to oil, since China is not a market economy, it can take strategic energy decisions, like substituting coal for oil. In the internal Chinese pricing system this may not be too big a problem (although they do seem to have a high number of major industrial accidents) but the externalities for the global climate of all this coal may be important. Come to think of it, I would far rather they were discussing this than discussing textiles with China.

    Anyway, Xie is almost certainly right that if the Shanghai property market takes a knock, oil futures will too. There is something strange about this current spike, with global growth slowing and everything. Interesting.

    One of Xie’s most interesting articles is this one:

    Productivity, inflation and exchange rates:

  9. Edward, have you played around with GDP growth figures adjusted for various demographic indices? If so, what are the results?
    I haven’t even been able to find GDP growth rates with population growth factored out. Do you know where such figures can be found? Cheers.
    (Btw non-linearities are not necessarily prohibitive for coarse-graining. I am still a fan of the phase transition metaphor myself…).

  10. “I haven’t even been able to find GDP growth rates with population growth factored out. Do you know where such figures can be found?”

    Hi there Daniel.

    Well normally you can find numbers which strip out changes in population and capital formation in the growth accounting material. This is what leaves the famous ‘residual’ (called TFP, or MFP) that no-one really knows how to interpret. (Essentially most arguments from this point in apply some form of circular reasoning).

    I have a lot of this stuff, but I’ll have to dig it out and mail you.

    I have been re-doing my demography page

    and what you will find links to there are papers which look at the impact of population on GDP, balance of payments, growth (the Swedish school), studies of the role of savings and population structure in the rise of the Asian Tigers (Deaton, Williamson), David Bloom’s work generally.

    The important point to bear in mind is that it is not population change per-se that is important, but changes in the age structure. Bloom has run numbers on this, and Malmberg and Lindh, amongst a growing band of people now interested in looking at the problem from this angle.

    Hope you find some of this useful.

  11. Hi Edward!

    Thanks for the plentiful references, I will follow them up as soon as I get the chance. I do like your redesigned site! (though the font is tiny)

    A naive question: Wasn’t there a relative lack of younger people in the age structure of some European countries after WW2? Was this demographic effect entirely masked by the demand surge of reconstruction after the war?

    PS I was glad to discover you were blogging again after the strange demise of Bonoboland!

  12. “Wasn’t there a relative lack of younger people in the age structure of some European countries after WW2?”

    What I would say Daniel is that I don’t really know. I think what we need to do first is refine the argument a bit, so we know what it is exactly we are looking for, then there will be plenty of material to run numbers on, just like the case you mention.

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