The swamps of DSGE despair

David Andolfatto (of the St. Louis Fed and the blog MacroMania) points me to this interesting recent working paper by Braun, Korber, and Waki. The paper bears the somewhat unwieldy title of "Some unpleasant properties of log-linearized solutions when the nominal rate is zero."

Basically, the authors of this paper take a New Keynesian model somewhat similar to the ones used by "Keynesian" macroeconomists - e.g. Paul Krugman - to help justify the use of fiscal stimulus in a depressed economy. They note that in most papers, the models actually used to measure the effect of government policy are "linearized" versions. 

For the uninitiated: A DSGE model starts with the assumption of optimization by various economic agents such as households and firms, which spits out a system of nonlinear equations representing people's optimal choices. These nonlinear equations are then "log-linearized" around a "steady state", and the linearized forms of the equations, which are very easy to work with mathematically and computationally, are used to compute the "impulse responses" that tell you what the model says the effect of government policy will be. The linearization is equivalent to the assumption that the economy undergoes only small disturbances. That might not be a good assumption when it comes to major events like the recent crisis/depression, but it does make the models a LOT easier to work with. It also generally makes the equilibria unique - in other words, if you use the full, nonlinear version of a DSGE model, you are likely to come up with a bunch of different possible paths for the economy, and which path the economy takes will be determined purely by quantitative factors (like, whether variable X is more or less than 2.076, or something like that) - not the kind of thing that DSGE models are good at getting right. Since "multiple equilibria" generally means "we really don't know what's going to happen," macroeconomists tend to stick to the linearized versions of models, so that they can say "we do know what's going to happen."

Anyway, Braun et al. decide to venture into no-man's-land, and work with a non-linearized version of a New Keynesian model with a Zero Lower Bound. They find that, unsurprisingly, there are multiple equilibria. In some of these equilibria, the kind of special ZLB effects found by Eggertsson and Krugman - for example, the "paradox of toil" - are present, but small in size. In other equilibria, the effects go away entirely. 

So can we conclude that the concerns of Keynesian economists about the ZLB are overblown, and that fiscal policy isn't the answer? Not so fast. Here is another working paper, by Fernandez-Villaverde, Gordon, Guerron-Quintana, and Rubio-Ramirez, which conducts a similar exercise with a slightly different model. Fernandez-Villaverde et al.'s model is extremely hard to solve and their results come from picking some interesting-sounding cases and then doing numerical experiments (simulations) to see what happens in those cases. In the main case they consider interesting, the ZLB ends up being pretty important, and the fiscal policy multiplier is around 1.5 or 2.

(Update: A commenter points me to this response by Christiano and Eichenbaum, two of the leading New Keynesian theorists. They show that most of the multiple equilibria found by Braun, et al. are not supported by a specific model of learning. Also, here is a multiple-equilibrium DSGE paper by Mertens and Ravn showing that in some equilibria, fiscal policy actually makes recessions worse. The Mertens and Ravn result also conflicts with the learning model of Christiano and Eichenbaum.)

So what do we learn from these sorts of exercises? In my opinion, we learn relatively little about the real economy, but that's OK, since we do learn some important things about DSGE models. Namely:

1. Almost every DSGE result you see is the result of linearization, If you drop linearization, very funky stuff happens. In particular, equilibria become non-unique, and DSGE models don't give you a good idea of what will happen to the economy, even in the fictional world where the DSGE model's assumptions are largely correct! As Braun et al. write:

There is no simple characterization of when the loglinearization works well. Breakdowns can occur in regions of the parameter space that are very close to ones where the loglinear solution works. In fact, it is hard to draw any conclusions about when one can safely rely on loglinearized solutions in this setting without also solving the nonlinear model.

So even putting aside the question of whether DSGE models accurately represent reality, we see that most of the DSGE models you see don't even accurately represent themselves.

2. In order to be usable, DSGE models have to have a LOT of simplification. These nonlinear New Keynesian models go so haywire that they often have to be simulated instead of solved. Furthermore, neither of these models has capital or investment. Since investment is the component of GDP that swings most in recessions, you'd think this would be an important omission. But putting in capital would make these already mostly intractable models into utterly hopelessly intractable models (And if you don't believe me, ask Miles Kimball, who has spent considerable time and effort working on the problem of putting capital into New Keynesian models). Never mind putting in other realistic stuff like agent heterogeneity!

Basically, every time you model a phenomenon, you face a tradeoff between realism and tractability - the more realistic stuff you include, the harder it is to actually use your model. But DSGE models face an extremely unfavorable realism/tractability tradeoff. Adding even a dash of simple realistic stuff makes them get very clunky very fast.

3. DSGE models are highly sensitive to their assumptions. Look at the difference in the results between the Braun et al. paper and the Fernandez-Villaverde et al. paper. Those are pretty similar models! And yet the small differences generate vastly different conclusions about the usefulness of fiscal policy. Now realize that every year, macroeconomists produce a vast number of different DSGE models. Which of this vast array are we to use? How are we to choose from the near-infinite menu of very similar models, when small changes in the (obviously unrealistic) assumptions of the models will probably lead to vastly different conclusions? Not to mention the fact that an honest use of the full nonlinear versions of these models (which seems only appropriate in a major economic upheaval) wouldn't even give you definite conclusions, but instead would present you with a menu of multiple possible equilibria?

Imagine a huge supermarket isle a kilometer long, packed with a million different kinds of peanut butter. And imagine that all the peanut butter brands look very similar, with the differences relegated to the ingredients lists on the back, which are all things like "potassium benzoate". Now imagine that 85% of the peanut butter brands are actually poisonous, and that only a sophisticated understanding of the chemistry of things like potassium benzoate will allow you to tell which are good and which are poisonous. 

This scenario, I think, gives a good general description of the problem facing any policymaker who wants to take DSGE models at face value and use them to inform government policy.

So what's my suggestion? First I'd suggest detailed studies of consumer behavior, detailed studies of firm behavior, lab experiments, etc. - basically, huge amounts of serious careful empirical work - to find out which set of microfoundations are approximately true, so that we can focus only on a very narrow class of models, instead of just building dozens and dozens of highly different DSGE models and saying "Well, maybe things work this way!" Second, I'd suggest incorporating these reliable microeconomic insights into large-scale simulations (like the ones meteorolgists use to forecast the weather); in fact, any DSGE model that incorporates all of the actual frictions we find is likely to be so complicated, and so full of multiple equilibria in the full nonlinear case, that it demands this kind of approach. Third, and in parallel to the weather-forecasting effort, I'd echo Bob Solow's call to use simple models when trying to explain ideas to other economists and to the public (explanation of ideas being what DSGE models are mainly used for, given their abysmal performance at actually predicting anything about the economy). Note that I don't have a ton of confidence in these alternatives; after all, it's a lot easier to find flaws in the dominant paradigm than it is to come up with a new paradigm.

But in any case, few people in the macroeconomics field seem to be particularly interested in that sort of alternative approach, or any other. And the scientific culture of macroeconomics doesn't seem to demand that we find an alternative; in fact, in the macro profession, you pretty much have to back up any empirical result or simple model with a fully specified mainstream-ish DSGE model in order to be taken seriously.

So instead of trying to find which set of models really works, everyone just makes more models and more models and more models and more models...

(Note: If you know basic math and want to learn what DSGE models are all about, start with this chapter from David Romer's Advanced Macroeconomics.)

Update: Stephen Gordon agrees, and adds his own misgivings about DSGE.

The Iraq War: a cost-benefit analysis

Mark Steyn strikes me as the kind of guy who would trick his buddy into picking a fight, then laugh as his buddy got punched in the groin. In fact, that's pretty much typical of the people whom we have come to call "neocons" - bombastically blathering about empire and glory and destiny and national will from the safety of their manicured subdivisions while someone else's kid watches his intestines fall out of his abdominal cavity in some God-forsaken hellhole halfway around the globe. These are the sort of grinning fascists in whose minds democracy equals national weakness, and hence is a great thing to foist on our enemies while quietly suppressing at home.

OK, but that said, let's be economists about this. Let's do as Steyn purports (and in my opinion utterly fails) to do, and do a cold, calculating, rational cost-benefit analysis of the Iraq War.

This is very difficult to do, for two reasons. First, a counterfactual history is nearly impossible to construct; who knows how many of the things that have happened in connection with the Iraq War would have happened anyway, and who knows what other things would have happened? Second, the long-term effects of the war are not known; as with the French Revolution, it's "too early to tell" and always will be. But in these cases, you work with what you've got. So...

Costs of the Iraq War

* 150,000 - 200,000 Iraqis killed. This is a low estimate, but like many historians I tend to believe low estimates when it comes to war casualties, since there are a lot of refugees in wars, since government systems for counting people break down, and since a lot of people would have died anyway, especially given the crushing sanctions regime in place before the war. So let's make it 150-200k with an asterisk; it might have been three times that. (What's a factor of three between friends?)

* 4,400 Americans killed. Why list Americans separately from Iraqis (aren't they all humans)? Answer: Because many people care about this difference.

* 32,000 Americans wounded.  This could range from a cut on the arm to four lost limbs. Due to improved battlefield medicine, there are more of the very severe "four lost limb" type injuries now than in past wars.

* Hundreds of thousands of Iraqis wounded. Probably. I'm not sure anyone has been able to count this.

* About 6 trillion dollars of U.S. money spent (about 40% of one year of U.S. GDP)

* A moderate, permanent loss of American prestige in Europe (possibly inevitable due to the end of the Cold War).

* A large temporary loss of American prestige in Europe, reversed when the Obama administration came into power.

* A moderate, permanent loss of American prestige in the Islamic world, from an already low level.

* A solidifying of the Russia-China alliance, which looks very capable of containing American power globally. 

* A temporary distraction from the hunt for al Qaeda, reversed when Obama came into power and successfully killed al Qaeda's leadership.

* A long-lasting degradation of the quality of U.S. public discourse and the quality of U.S. politics. This item bears some explanation. In order to sell the war to the American people, large amounts of lying and distortion were necessary. Because of the stickiness of partisan opinions and worldviews (no one ever wants to admit their side was wrong), this meant that Republicans and conservatives had to retain that Bush-distorted worldview long after the war. That might be the reason why Tea Party types are up in arms about Benghazi, while the rest of America doesn't even know what Benghazi is. 

* An increase in geopolitical strength for Iran, commonly believed to be a strategic enemy of the U.S.

* An acceleration of Iran's nuclear program, seen by Iran as the only deterrent that can prevent a U.S. invasion.

* A high continuing rate of violence in Iraq.

Benefits of the Iraq War

* The removal of the Hussein family from power in Iraq, and their replacement with marginally less effective, malign, and insane dictators.

* The elimination of the tiny, tiny risk that Saddam would one day develop WMDs.

* An improved Iraqi economy. Iraq's GDP, which had been crushed by sanctions, after the war recovered strongly, growing robustly in every year since 2006. Part of this, of course, is a windfall due to high oil prices; but if the Iraq War hadn't happened, sanctions might have prevented Iraq from selling a lot of its oil.

* An Iraq that is slightly more free than under Saddam. Iraq is still rated "Not Free" by Freedom House, though its ratings have improved ever so slightly since the war. Freedom House is a U.S. government-sponsored NGO, so it's not a good idea to trust their data implicitly, but this seems to agree with many other reports. 

* A revitalized American liberal movement. The blogosphere as we know it really took off in response to the Iraq War, becoming the liberal answer to conservative talk radio. Truly liberal media outlets like MSNBC also emerged as answers to Fox News. And the general galvanization of America's dormant left might have enabled the election of Obama and sped the conservative retreat that we now see happening.

* The breaking of 9/11 fever. This is also hard to pin down, and may not even be real, but after 9/11 I felt a real sort of general madness in America. Terrorists could hit us any time, anywhere. The government was eliminating civil liberties right and left and people seemed to be fine with that. America seemed headed for a dark period of fear-based fascism, or Islamophobic ethnic conflict, or...well, something. Then the Iraq War came and brought more than half of America back to its senses. We remembered that the biggest threat to us is our own stupidity. We realized that the panic over a global jihadist wave was 99.9% paranoia. While the Republicans stayed nuts, the Democrats came back to the reality-based community.

Of course, these last two are a little silly to include as "benefits" of the war, since they weren't intended by the war's promoters (though neither were most of the costs). It's a bit like saying that the creation of the UN and the democratization of Europe were positive effects of Hitler's invasions, or that the worldwide condemnation of genocide was a positive result of the Holocaust. You should never start a war in the hope that you'll be defeated and that your defeat will invigorate the forces of good.

Anyway, so what do we conclude from this cost-benefit analysis? It's very hard to put dollar figures on these things, but I didn't try, because what this exercise should clearly demonstrate is that very, very little apparent benefit resulted from the decision to invade Iraq, while there were a whole lot of very apparent costs. This fact should dominate all discussions of the war. Who cares if we "won"? Who cares if the Surge (i.e. paying Sunni militias to stop bombing us, while pretending to make a show of force) worked? Who cares if Saddam was a brutal, awful guy? 

What should matter is that we paid a lot, and we got not much. There are a lot of two-bit dictatorships we could randomly invade and depose in bloody wars. There would be benefits to getting rid of Kim Jong-Un, or Robert Mugabe, or the mullahs of Iran. They just wouldn't be worth the price tag.

Markets in almost nothing

...Nothing important to human beings in rich countries, that is.

One of the first things I noticed when I started studying economics was that goods that can't be bought and sold are basically ignored. That might be fine for determining prices of stuff (especially if people have quasilinear utility), but when you have massively incomplete markets, the basic big results of first-year microeconomics - the welfare theorems - go totally out the window. In addition, to get comprehensible results for the prices and quantities of exchange-able goods, you need to make a lot of heroic assumptions about the non-exchange-able goods - in other words, when people spend most of their time working for things that money can't buy, their behavior toward the things that money can buy gets a lot more complicated.

And when I think about it, I realize that people do spend much of their time working for things that they can't possibly buy. Here are some examples of things that can't be purchased in any market, even with one hundred billion dollars or a million tons of gold:

* Love

* The respect of your peers

* A feeling of career "success"

* The ability to fit in with other human beings

* Close friends

* Your family being proud of how your life turned out

* The feeling of being good at what you do

* Dignity

There are many more examples. It's not a question of whether these things should or shouldn't be traded in markets. It's simply that they cannot be.

Now, of course you can purchase things that help you get the items listed above. You can buy a cell phone that will help you hang out with your friends or meet your lover for a date. You can buy a car that takes you to where your friends are, or where your job is. Etc. But markets won't get you all the way there. If you want a hamburger, in contrast, markets will get you all the way there - just slap down the cash and the burger is yours.

Also, some of you may be thinking "But, people who make more money get more respect and are seen as more successful!" And this is (often) true. But that's not the same thing as exchanging money for respect. Exchange is voluntary - I give you some good (or some financial asset, e.g. money, that represents claims to goods), and you give me some other good. But when you get respect for being rich, you are not giving up your money in order to get more respect. (Sometimes you can engage in conspicuous consumption, but that's a bit different.) So "money leads to respect" does not mean that there is a market for respect.

Others of you may be thinking "OK, well, some people are born with these non-exchange-able things. Those lucky people have higher baseline utility, but I don't see how this changes how markets work." Ah, but here's a key point: Many of these non-exchange-able goods can be produced. Good relationships, for example, are not something you are born with - they take time and effort to build. Similarly, the respect that comes with a successful career requires that you put a lot of work into the career.

So, basically, markets provide only a limited slice of the things that humans want. In fact, I'd argue that in rich countries in which food and security are not a problem for the majority of people, the vast bulk of our effort is spent producing non-exchange-able goods like "success", "respect", "love", and "relationships".

We live in a world of Massively Incomplete Markets.

What does this mean for economics? First of all, it may help explain a lot of the phenomena we see in markets. For example, a lot of people's "leisure" time is spent working at the production of (non-exchangeable) love and relationships; this could be the source of "consumption-leisure complementarites" and other phenomena that describe people's behavior toward work and leisure.

A second example: Though people in rich countries work a bit less than people in poor countries, the super-rich often work very hard (at least, the ones I know do). This is a puzzle for the type of simple utility functions used to explain labor-leisure choice in macroeconomic models. Why do the super-rich work? It could be because working itself provides them with utility, or it could be because working enables them to produce the feelings of self-worth and capability that their huge bank accounts can't possibly buy in any market.

A third example: People may choose to be unemployed for a very long time if the new jobs on offer represent a loss of "dignity" (due to, for example, their family or spouse seeing the new job as a "step down" in their career). This could lead to search frictions that might explain a lot of long-term unemployment. Dignity concerns also probably affect wage demands, which could lead to sticky real wages in addition to the more commonly used sticky nominal wages.

A fourth example: People notoriously like minimum wages better than government handouts like the EITC, even though most economists agree that the EITC is a lot more efficient. Why? Probably because "earned" income gives people a feeling of dignity, while "handouts" reduce dignity. The former can only produced through work, not bought in a market.

So I think that non-exchange-able, but producible, goods might have an absolutely enormous impact on economic behavior of all kinds. What gets exchanged in markets is heavily dependent on what must be produced outside of markets.

Also, I think that non-exchangeable producible goods should have an impact on our analysis of human welfare and government policy. Assuming that all consumption can be bought with money leads one to support policies like the EITC, but these policies may be extremely sub-optimal when goods like dignity are brought into the equation. Additionally, government should think about how its policies discourage the formation of human relationships - for example, by subsidizing low-density suburban sprawl that makes it hard to meet people.

Now, of course, in the most general sense, incomplete markets are a technological problem. After all, when the Beatles sang "Money can't buy me love," money couldn't even buy you hair. Someday we may get the ability to buy our emotions and desires from vendors. That will be a very weird day! But for now, Massively Incomplete Markets define our world.

(Note: I'm sure people have thought very long and hard about this already, but I don't know the literature, so feel free to recommend papers in the comments or on Twitter!)

John Taylor's austerity model

John Taylor, possibly more than any other economist who writes in the press, likes to simplify things for public consumption. Personally I think this is kind of a shame, since A) any WSJ reader who understands economic models will not understand what Taylor is talking about until they actually go read his research, and B) any WSJ reader who doesn't understand economic models probably already believes that "austerity = good", and doesn't really care if there's a DSGE model backing up the assertion.

Fortunately, your friendly neighborhood Noah is here to read and explain where Taylor is getting his arguments.

In today's column on austerity, Taylor writes:

This week the House of Representatives will vote on its Budget Committee plan, which would bring federal finances into balance by 2023. The plan would do so by gradually slowing the growth in federal spending without raising taxes. 

Still, the plan has been denounced by naysayers who assert that it would harm the economic recovery and that, at the least, any spending reductions should be put off until later. This thinking is just as wrong now as it was in the 1970s... 

According to our research, the spending restraint and balanced-budget parts of the House Budget Committee plan would boost the economy immediately. With the Budget Committee's proposed tax reform included, the immediate impact would be even larger... 

Our assessment is based on a modern macroeconomic model (developed with Volker Wieland of the University of Frankfurt and Maik Wolters of the University of Kiel)[.]

A modern macroeconomic model! Watch out, kid, you could put someone's eye out with that!

(Random note before we get started: The "1970s" reference is pure conservative herp-derpery. People weren't trying to fight stagflation with fiscal policy in the 70s; deficits were quite low. "The 70s" is just a word that conservative writers throw into their pieces so that conservative old men who read the article will nod their snowy heads in sage agreement and mumble "Yes, the 70s. Carter. Stagflation. Mmm-hmm!")

OK, but I digress. Why does Taylor think austerity will produce growth? The article doesn't tell us a lot about the aforementioned "modern macroeconomic model," so let's go to the source. Here it is. 

Taylor's paper basically uses a Smets-Wouters type DSGE model, i.e. the most popular and successful DSGE model in existence at the moment. It's a New Keynesian model, which means that demand shocks exist and have an effect, through sticky prices, and hence monetary policy matters. So it's not a "freshwater" or RBC-type model (though Taylor et al. do also show that their results hold with an RBC model, somewhat unsurprisingly). 

In other words, Taylor's model is not the type of model that many (including myself) have criticized for being too easily biased toward conservative policy conclusions. Instead, it is a very mainstream type of model, of the kind usually used to justify the Fed's role in managing aggregate demand. Of course, Taylor uses it for something quite different.

So anyway, I'm not going to copy the equations from the paper, because that would just bore you, and you can just read it yourself. However, I'll try to summarize. The upshot of the paper, as Taylor said in his WSJ piece, is that a certain kind of austerity plan would be good for the economy in both the long-run and the short-run.

Here are the basic things you should know about where Taylor gets his results:

1. This is NOT the "Treasury View." 

The "Treasury View" is the simplistic and wrong idea that any dollar spent on "stimulus" has to be one dollar not spent by the private sector, and hence government spending is incapable of raising output. Taylor is not espousing this view. In fact, as we'll see, in Taylor's model changes in government spending most definitely can affect output.

2. This is NOT the "Confidence Fairy."

The "Confidence Fairy" is the idea that uncertainty over future government policy restrains investment, and usually involves the notion that austerity decreases policy uncertainty. However, Taylor's model doesn't have policy uncertainty in it.

 3. The economic boost of austerity comes entirely from tax cuts.

Taylor's model has distortionary taxation in it, and the distortions are large. Hence, spending cuts mean lower taxes and hence less distortion, both now and in the future. In other words, the GDP boost in Taylor's model doesn't come from reducing the deficit, it comes from cutting taxes. The government's long-run budget constraint, along with forward-looking expectations (the same force that powers "Ricardian Equivalence" in other models), means that spending today --> taxes tomorrow --> distortions tomorrow --> distortions today because of forward-looking expectations.

4. The "Sumner Critique" is in this model. 

Normally, New Keynesian models of this type focus on finding the optimal monetary policy. But since Taylor is looking at fiscal policy, he assumes that monetary policy is set according to an unchanging rule.  OK, I'll put in ONE equation. Here's the rule:

This is a backward-looking Taylor rule with interest rate smoothing. Unfortunately, in this working paper I can't find what values Taylor uses for the coefficients on output and inflation. But he does put in some coefficients, that's for sure.

Remember, this is a New Keynesian model with sticky prices, so aggregate demand does matter. But Taylor assumes that the Fed is already doing pretty much everything a New Keynesian would have the Fed do.  So in Taylor's model, the Fed cancels out most aggregate demand shocks, including positive demand shocks from stimulus. So it's hardly surprising that Taylor is not going to see government spending doing much good for the economy; he's assumed that 1) the Fed is perfectly capable of managing aggregate demand, and 2) the Fed will tighten to partially counteract stimulus. This is just a softer version of the common "Sumner Critique" of fiscal policy, though of course Taylor probably didn't get it from Sumner.

5. There is no Zero Lower Bound.

Note that in the monetary policy rule written above, there is nothing that says that interest rates can't go negative. In other words, Taylor assumes what most New Keynesian models assume, which is that there is no Zero Lower Bound (or that we're always far from it). Any of you who are familiar with the New Keynesian DSGE literature will recognize that Taylor's result is a very common result in this literature: Away from the ZLB, fiscal policy is not very effective. The "New Old Keynesians" such as Paul Krugman and Gauti Eggertsson, who advocate fiscal stimulus, explicitly make reference to the ZLB as the reason stimulus works. Taylor just ignores that idea in this paper.

6. In Taylor's model, if you cut government purchases, it throws the economy into a recession.

Taylor's suggested austerity plan makes big spending cuts, but the cuts are almost entirely cuts in transfers (like entitlement payments or welfare) rather than in government purchases (like infrastructure spending). Here's a picture of Taylor's austerity plan:

Now as you should remember from Econ 102, government purchases make much more effective stimulus than transfers, because government doesn't buy the same things that people would buy if you just mailed them checks (but people still receive the checks). So any Keynesian would expect cuts in transfers to be much more benign than cuts in government purchases. In fact, the difference between purchases and transfers is a consistent theme in Taylor's work, which makes me think he's more Keynesian than he makes himself out to be. But anyway, let's take a look at what Taylor's model says would happen if we implemented austerity through reductions in government purchases instead of cuts in transfers:

Wow! In Taylor's model, implementing austerity by cutting government purchases would throw the economy into a deep recession. The reason he gets short-run benefits from spending cuts has everything to do with the fact that it's almost all transfers being cut.

6. In sum, Taylor's result is a standard New Keynesian result.

Upshot: If you have no Zero Lower Bound, and if the Fed partially counteracts the demand-side effects of fiscal policy, and if people have forward-looking expectations, and if you don't cut government purchases much, and if taxes are very distortionary, then austerity works. This is not really a new result, but it rarely gets shown so explicitly, so it's good that John Taylor and his co-authors went ahead and did it.

That said, the result basically ignores the real Keynesian critique that has emerged since 2008, which is that the Zero Lower Bound matters a lot. It also probably assumes that taxes are a bit more distortionary than they really are. And it also probably overestimates the Republicans' real willingness to cut transfers (entitlements are the "third rail", after all), and underestimates their willingness to cut government purchases. In real life, spending cuts usually fall on the things that are politically most easy to cut, but are economically most valuable in both the short and long runs - infrastructure and research. Finally, Taylor's plan ignores distributional concerns, but that's pretty much par for the course.

(Oh, also, neither Taylor's model nor the RBC or Keynesian alternatives includes nonrival government capital (public goods). But that's not the point I'm trying to make here. Oh, and also, modern macroeconomic models - and any other macroeconomic models currently in existence - don't actually come close to describing reality. But that's also not the point I'm trying to make here.)

So John Taylor is not committing some major fallacy. He's just using a standard mainstream New Keynesian DSGE model to stump for the Republicans.


Update: Miles Kimball says that Taylor's result is basically all about the monetary policy reaction function (i.e. the equation I posted above). Furthermore, Kimball notes that Taylor has supported a tighter monetary policy, in direct opposition to the kind of Fed reaction function he assumes in the paper. In other words, if Taylor got the monetary policy he wants, then his own DSGE model would go *poof* and suddenly austerity of the transfer-cutting type would become much more harmful.

Update 2: A commenter points out that in Taylor's simulations, real interest rates never fall below zero. That means there's something odd about the parametrization, since real short rates are negative right now. But I don't know where the oddness comes from.