Monday, March 10, 2014

Macroeconomic Fables

I finished reading The Undercover Economist Strikes Back: How to Run -- or Ruin -- an Economy by Tim Harford. His first book in the series, The Undercover Economist, is amazing. If you read one pop econ book, that's the one to read. Let's just say that Strikes Back felt a little rushed and a little thin in comparison. The question and answer format did not sit well with me, either. However, there were a couple of great macroeconomic fables included.

The Island of Yap

If you think you know what money is ("whatever is used as a medium of exchange, unit of account, and store of value"), think again after reading about the "money" used on the Island of Yap (an actual island -- not the fake ones that economists usually make up).

Sadly, there is one description of how modern money and banking came to be that is still vastly under-appreciated and did not make the cut into Harford's book: Adam Smith's digression concerning banks of deposit, particularly concerning that of Amsterdam, The Wealth of Nations, Book IV, Chapter 3, Sections 12-29. The gist of that excerpt is this: Because people "clipped" metallic coins, merchants did not always know what the coins were actually worth. Banks backed by cities sprung up to vouch for the coin, storing it in a vault, issuing "bank money" guaranteeing it's worth, and charging depositors interest and a warehouse fee. Banks took away the uncertainty in the value of the payment and provided easier methods of payment (bank money is easier to transport than sacks of gold); that was the value they added to society. What's interesting about the bank of Amsterdam is that it did not lend out money; it kept 100% reserves. That's why depositors had to pay a fee. It's negative interest on those saving accounts! The upside? No bank runs.

It's just a small step from the process described by Smith to a central bank with an empty vault. As the Island of Yap and our modern economy based on fiat currency shows, it's not necessarily important for money to have "intrinsic" worth in order to be valued as a medium of exchange, unit of account, or store of value. Everyone just has to believe it.

The Phillips Curve and the Lucas Critique

Outside of economics, and unfortunately, sometimes inside economics, as well, it's under-appreciated how important it is to understand what is generating the data. You can't just look at correlations and draw broad policy conclusions because the actors that are part of the system (you and me) are making choices in response to policy and those choices often depend heavily upon beliefs. That's what makes economics (especially macro) hard.

The Phillips Curve and the Lucas critique is covered in this one hour talk on the book. If you want to skip the introductory material, the talk starts at minute 7:00. In the response to Harford's talk, Alex Tabarrok pushes Harford about exactly the right things.

Honestly, in this case, the "movie" is better than the book.

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