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Thursday, November 28, 2013

Simon Wren-Lewis on the Representative Agent in Action

     He claims that heterodox econ can't constructively engage with the mainstream and as an example asks how you can answer the question of what effect a short term increase in government spending will have on the behavior of individuals without the representative agent. He argues that the RA and EMH do have some uses but are not so good for other uses. 

       "My question was what the impact of a temporary increase in government spending, financed by taxes, would do to output in an open economy. It was not a trick question – I just happened to be thinking about a presentation on exactly this issue to policymakers, so it was on my mind. Now policymakers, in response to such a question, do not want long lectures on the sins of representative agents, rational expectations or whatever, and they certainly do not want to be told it is a bad question. They want some simple macro analysis."
               
      "So, what do consumers do if they are told that taxes are rising temporarily? First, do they take any notice of what they are told, or do they assume the tax increase is permanent? It really matters which. If the former, do they smooth the impact on consumption, as the representative agent intertemporal model (and other earlier models) suggests, which by the way means that the consumer sector goes into deficit."
                
      "If they do, output will tend to rise. How do traders in the FOREX market react? Do they try and work out if interest rates will rise, and if they do what are the results of this calculation? Do they say that in the past when output has increased the central bank has raised interest rates, or do they recognise that (as I assumed) we are at the zero lower bound and so no interest rate increase was likely?"
                
     "There are no obviously right answers to these questions, but I’m genuinely curious about how you would answer them without some appeal to representative agents. You could avoid rational expectations by assuming something simple like static expectations, but that would imply for consumers (after the initial surprise at taxes rising) the same thing as taxes rising permanently – until they were surprised by taxes falling again. And is the idea of consumption smoothing misguided, or just the idea that it results from optimisation?"


    I get it that policymakers don't want to be told it's a stupid question. Still my first response would be: why do we want it to be financed by taxes? In such an economy we'd be better off with a deficit financed spending increase. I don't know that I need any model to say this. One commentator took up WL's challenge. His style was as I agree is too common of heterodox guys a little overly polemical perhaps but I think he makes a good point. I'm not using his name as I have a hard time reading it I don't know what language he used for his name-Latin?

     "Your problem has relevance only for the world of representative agents."

      "It has no real solution because it is not defined properly even in the mainstream logic. Consumers and everybody else approach taxes as tax *rates* and not as amounts. Apart from ex post / ex ante problem of budget spending and taxing you can not claim that an increase of government spending has to be accompanied by an increase in tax *rates* to balance the budget. Your problem is over-assumed, it is missing critical information and therefore has no relevance for economic analysis in this world."

     "The only possible application of your representative agent problem and balanced increase of spending to the real world is if you increase government spending and then immediately tax the whole amount of it from the recipient. I just wonder why you spend your time and everybody else on such nonsensical "problems" ...

     WL retored:

     "A government can increase spending, and finance it by - say - not uprating tax allowances. No tax rate need change. Of course it will not get exact balance ex post, but that is not important. As the government says that it would like to increase demand without increasing debt, and this policy does just that, I think it deserves a little more respect than you give it."
:
     He responds

     "I give it full respect. But if people react to tax *rates* and there are no tax *rate* changes required to balance the budget, what is your argument then? Noone thinks of taxes in terms of volumes because taxes are predominantly relative. And budget result bounces up and down all the time and without any discretionary decisions on behalf of the government."

    "I also say that an assumption of balanced spending increase is without any basis in the real world. It does not happen and if it happens then it will be a pure luck/coincidence. It is impossible to balance the budget ex ante regardless of all political/economic desires. What does your question really want to ask? Why should anybody even bother with answer?"

    "Additionally, what does it mean to "increase taxes"? In this world tax codes are probably even thicker than legal codes. There is no such thing as "increase taxes". There are zillions of them with all loopholes and attached conditions. So which taxes will increase? And here it becomes a political/institutional issue and not an economic one. You can not assume such problems away. However if you approach them properly then you can not assume a representative agent. There are all types of non-linear re-distributional effects going on that any representative agent smell test fails in the first phase. You can surely increase granularity but every such gradual increase destroys your argument of representative agent. In the end you will have to admit that you simply have to rely on averaging certain cohorts due to information/computation limitations. However averaging and representative agent approaches are not even closely the same thing."

     "Again, his style is maybe a little overly combative-which NCers always use as an excuse not to respond to the arguments, it seems to me that he's on the right track. To put it more simply, even if you want to 'pay for it'-again, if I were advising anyone I'd discourage that-it may well not require tax rates to go up. It could just be 'paid for' by the stimulus leading to higher growth which increases revenues without having to raise taxes-this is what happened to huge WWII government military spending."

    P.S. As I can spell the commentator's name-as it seems he wrote in Sanskrit or something, here is a link to him. 


     

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