Economic Modeling in the Post Great Recession Era

Incomplete Data, Imperfect Markets

John E. Silvia, Azhar Iqbal, Sarah Watt House

• Publisher: Wiley
• Year: 2016
• Print ISBN: 9781119349839
• eBook ISBN: 9781119350828
• Edition: 1
• Topic: Economics
• Subtopic: Economic Theory
• Index: Economics

Reality-based modeling for today's unique economic recovery

Economic Modeling in the Post Great Recession Era presents a more realistic approach to modeling, using direct statistical applications to address the characteristics and trends central to current market behaviors. This book's unique focus on the reality of today's markets makes it an invaluable resource for students and practitioners seeking a comprehensive guide to more accurate forecasting. While most books treat the economy as if it were in a vacuum, building models around idealized or perception-biased behaviors, this book deals with the economy as it currently stands—in a state of recovery, limited by financial constraints, imperfect information, and lags and disparities in price movements. The authors identify how these characteristics impact various markets' behaviors, and quantify those behaviors using SAS as the primary statistical tool.

Today's economy bears a number of unique attributes that usual modeling methods fail to consider. This book describes how to approach modeling based on real-world, observable data in order to make better-informed decisions in today's markets.

• Discover the three economic characteristics with the greatest impact on various markets
• Create economic models that mirror the current post-recession reality
• Adopt statistical methods that identify and adapt to structural breaks and lags
• Factor real-world imperfections into modeling for more accurate forecasting

The past few years have shown a clear demarcation between policymakers' forecasts and actual outcomes. As the dust settles on the Great Recession, after-effects linger—and impact our current recovery in ways that diverge from past experience and theoretical expectations. Economic Modeling in the Post Great Recession Era provides comprehensive guidance grounded in reality for today's economic decision-makers.

CHAPTER 1
Setting the Context

Returning from holiday on September 3, 1928, Alexander Fleming began to sort through petri dishes containing colonies of Staphylococcus, a bacterium that causes boils and sore throats.

Fleming noticed something unusual, imperfect, on one dish. The dish was dotted with colonies of bacteria, save for one area where a blob of mold was growing. The zone immediately around the mold—later identified as a rare strain of penicillin—was clear, as if the mold had secreted something that inhibited bacterial growth.

Fleming found that his “mold juice” was capable of killing a wide range of harmful bacteria. Such was the beginning of penicillin and a better life for all of us here.

In economics, it is the unusual, the imperfect, that provides the clues about the way forward—stagnation in the 1970s, tax policy and deregulation in the 1980s, and the financial crisis and subsequent reforms over the past 10 years.

THE PROBLEM WITH UNCRITICAL ASSUMPTIONS IN A LESS-THAN-PERFECT ECONOMY¹

Yet in empirical work, economists are too frequently guided by a number of uncritical assumptions on how the world works. First, as economists, we must recognize and discourage straw man arguments that improperly identify the false choices in economic decisions or portray the outcomes of such decisions only in the context of an idealized economic model.

Second, we must be more critical of arguments that fail to recognize the assumption—or violation—of ceteris paribus when the outcomes of economic decisions are quite different when those ceteris paribus assumptions do not apply.

Third, we must be more critical of the simplistic view of the efficient market hypothesis—both information and foresight are not perfect.

Fourth, we must be more critical of the argument that economic markets discount all available current information, but fail to distinguish that markets are not clairvoyant for all future information.

Fifth, we must be more critical to distinguish that private market failures do not automatically imply that government can do better or do something at all.²

Finally, following the line of reasoning of Captain Barbossa, economic rules are more like guidelines rather than rules.³

THE PROBLEM WITH MODELS IN AN IMPERFECT ECONOMY

Economic outcomes rarely come about as seamlessly as predicted by theories and models. As economists, we should be more critical on overly simplistic models that assume away the complexities of the modern economy.

As economists, we should be more critical of irrelevant models that solve problems that no one is seeking to address.

As economists, we should be more critical of models that assume away the essential problem to achieve precise mathematical results in an imprecise world.

As economists, we should be more critical of essays that claim—with surprise—that no one before has looked at this problem.

As economists, we should be more critical about models that assume supply and demand balance out rapidly and unfailingly and that perfect competition reigns in markets.

As economists, we should be more critical of models that cannot assign a probability to a critical event and then rule out that critical event when that event is crucial to a fair assessment of risks. Low-probability events, with high costs, are still very expensive.

As economists, we should be more critical about models that exclude almost all consequential diversity and uncertainty of households and firms—characteristics that in many ways are fundamental to the outcomes of the actual economy. This also includes the failure to include an extensive financial sector in many models.

As economists, we should be more critical of models that are useful only in a trend economy where they are estimated—when recessions, financial instability, and periods of the unusual are the real challenge to examine.

FOUR CHARACTERISTICS OF A LESS-THAN-PERFECT ECONOMY

Dynamic Adjustments—Things Take Time

First, we are familiar with the proposition that monetary policy acts with lags, often long and variable. In theory, we have also begun to appreciate that the efficiency of countercyclical fiscal policy has been diminished by the significant recognition of policy implementation lags since the 1960s. Unfortunately, however, the distinction between temporary and permanent policy changes has been continuously lost in policy making in recent years. Milton Friedman won his Nobel Prize for the permanent income hypothesis, but the failure of the 1968 tax surcharge appears to have been forgotten by today’s policy makers. Temporary, lump-sum tax rebates are simply timing changes—not permanent action—and do not jump-start the economy. Cash for clunkers is a classic recent example. As a result, countercyclical fiscal policy has fallen by the wayside and now the focus of fiscal policy is more on long-run growth—incentives and disincentives for labor, capital, technology, and innovation.

Identifying permanent or temporary changes in economic policy has been made particularly difficult by the significant political election turnovers during the past 20 years. This has led to inconsistent economic policy and a significant shortening of time horizons for decision makers—especially for long-lived investment. In contrast to the Eisenhower vision on infrastructure—the interstate highway system—the focus today is on isolated, one-off, pork barrel projects to jump-start the economy; consider, then, the experience of Japan.

Moreover, one...

Table of contents

• Cover
• Series
• Title page
• Copyright
• Dedication
• Preface/Justification
• Acknowledgments
• CHAPTER 1 Setting the Context
• CHAPTER 2 Dynamic Adjustment in an Economy: Frictions Matter
• CHAPTER 3 Information: Past Imperfect, Present Incomplete, Future Uncertain
• CHAPTER 4 Price Adjustment and Search for Equilibrium
• CHAPTER 5 Business Investment: This Time is Different
• CHAPTER 6 Corporate Profits: Reward, Incentive, and That Standard of Living
• CHAPTER 7 Labor Market Evolution: Implications for Private-Sector and Public-Policy Decision Makers
• CHAPTER 8 Inflation: When What You Get Isn’t What You Expect
• CHAPTER 9 Interest Rates and Credit: Capital Markets in the Post–Great Recession World
• CHAPTER 10 Three-Dimensional Checkers: Open Economy, Capital Flows, and Exchange Rates
• CHAPTER 11 Assessing Economic Policy in an Imperfect Economy
• About the Authors
• Index
• EULA