Saturday, September 27, 2014

The Great Stagnation: the information transfer non-story

I think one of the issues I have with the limited interest in the information transfer model among professional economists is a language barrier. I'm not fully versed in the language of economics and most economists aren't versed in the language of physics. In the post below I make references to "degrees of freedom" and "strongly coupled" mostly out of habit where an economist would say "agents" and "not in partial equilibrium". I probably need to shift a bit more toward the economists -- especially since I'm having a go at reinventing their entire field. However, in the long run, if this information transfer model (ITM) is correct (a big if), economists will have to learn some statistical mechanics.

That's because there's another issue: the idea of a "story". I think this is intimately linked with the degrees of freedom in the theory being humans as opposed to particles. Scott Sumner didn't see the story [1] in my attempt to explain how a falling exchange rate isn't necessarily a sign of inflation. Paul Krugman didn't see the story in Stephen Williamson's deflationary monetary expansion. In statistical mechanics, I don't try to come up with a story for why a molecule in an ideal gas decides to occupy a given energy state -- it occupies a given energy state because that is the most likely thing for it to do given the infinite number of possible energy states that's consistent with the macroscopic information I know (like pressure and temperature). The main insight of the information transfer model is that it doesn't really matter what people think (see e.g. here or here) ... there is no story.

With that throat-clearing out of the way, let me set about writing the information transfer "non-story" of the Great Stagnation.

I wrote a comment on Scott Sumner's post on the mysteriously low long run interest rates in the US, Canada, the EU and Japan (and earlier on Nick Rowe's Canadian-centric post on the same subject). I made the claim that maybe markets were coming to grips with a world of chronically under-shooting of inflation targets (Canada isn't doing this yet, but should soon if the model is correct). The picture you should have in your mind is this one:


The upper left graph shows that as economies grow (under a given definition of money), inflation slows down. The bottom left shows the same for NGDP: stagnation. On the right side are simulations based on 100 markets with random growth rates. That is the source of the story. However, this is not a story of technological stagnation, per Nick's comment on Scott's post. It's (an absence of) a story about the most likely transaction being facilitated by given dollar becoming a low growth market.

Let's tally up a set of random markets by growth rate at one instant in time. Each box represents one market [2]:


High growth markets (industries) are on the right and low growth (or declining) markets are on the left. Now any given market might move from where it is in this distribution from year to year -- a typical story would be an industry starts up at a high growth state, moves to lower and lower growth and might eventually collapse. The distribution doesn't change, though. When that industry moves from the high side to the low side, it's position on the high side is replaced by some other industry. If it collapses completely, it falls off the diagram and is replaced by some new industry. In the picture above, when the growth in the market represented by the box with the "X" slows down, moves to some new location in the picture below:


The two pictures are drawn from the same distribution (a normal distribution with the same mean and variance) -- industry "X" just went from high to low growth and some other industry took its place (although you can see it doesn't have to in order to keep the distribution the same).

This is where the key insight of the information transfer model comes in: that replacement happens for some random reason -- invention of the computer, a war causes oil prices to go up and oil companies make big profits, everyone starts a yoga class, everyone buys an iPhone and stops buying Nokia phones. Some companies are mismanaged. Some are well-managed [3]. Borrowing a picture from David Glasner, some plans are thwarted, others work out better than expected [4]. There are thousands of such stories in an economy and they all tend to cancel out (we muddle through) most of the time leaving the distribution unchanged .

Well, almost unchanged. Sometimes the changes in the locations of the boxes become correlated and you get a recession (plans that depend on each other get thwarted [4]). Over time the economy grows and the distribution shifts. How does it shift during growth? Like this schematic:


The smaller economy is the blue curve and the larger one is the purple curve. A larger economy is more likely to have its low growth rate states filled simply because there are more ways that an economy can be organized where this is true (given the details of the macro state -- e.g. NGDP, monetary base, price level). This is analogous to the molecule in the ideal gas. It is unlikely to find all of the high growth states occupied just like how it is unlikely to find an ideal gas where all of the energy is in a few molecules [5]. It's also unlikely to find all of the markets in the average growth state -- just like an ideal gas doesn't allocate an equal amount of energy to each molecule. 

In physics, we'd say a bigger economy has higher entropy: there are more possible states for each of the constituent markets to be in consistent with the macro information we know (like NGDP). We are missing more information about the exact microstate given the macrostate when the economy is larger (another way of saying it has higher entropy).

There isn't a reason or a story behind this. By random chance you are more likely to find an economy with markets occupying a distribution of growth states with an average that gets smaller as the economy gets larger. If you follow a dollar in the economy, as the economy grows larger, you are more and more likely to find that dollar being used in a low growth industry.

Maybe a better way to put it is this: because there isn't a reason for the markets in an economy to be in any particular growth state (no one is coordinating a market economy), you treat all possible states are equally likely and the result is a distribution where the average growth rate decreases with the size of the economy. 

This is the "Great Stagnation" (the supply-side version) or "secular stagnation" (the demand-side version). Supply and demand are strongly coupled in the ITM (i.e. not in partial equilibrium) so reduced demand growth is reduced supply growth and vice versa. It's not because all the easy things have been invented or the easy gains from the inventions that happened during WWII have been realized. It's not slowing growth of the working age population. It is quite literally a combinatorial problem with Dollars (or Euros or Yen, etc) and units of NGDP. And it happens because there is no story. It happens because the economy isn't being coordinated by anyone -- we just find it in its most likely state. That most likely state is one that grows more slowly as the economy expands.

How do we solve this problem? One way is to coordinate the economy, like in WWII (or communist economies) -- but the coordination problem is hard to solve [6] and the economy would probably collapse eventually. Another way is to change the combinatorial problem by redefining money through monetary regime change or hyperinflation. A third way is to leave it alone and provide better welfare programs to handle economic shocks [7]. Secular stagnation essentially renders the central bank impotent to help against the shocks. This third option seems preferable to me: it reduces the influence of an un-elected group on the economy (e.g. the ECB or FRB). The lack of inflation will be harder on people who borrow money, but hey, interest rates fall!

Footnotes:

[1] In the original comment, Sumner was saying that he didn't see the story where inflation doesn't lead to currency depreciation. However, in that case, the story is a traditional economics story -- in exchange rates, ceteris doesn't seem to be paribus (supply and demand shifts are strongly coupled) and an expansion of the currency supply is always accompanied by an increase in demand to grab it (at least empirically).

It's actually a similar story to "loose" money leading to high interest rates -- there is a short run drop due to the liquidity effect, but inflation and income effects cause rates to rise in the longer run. In fact, it is governed by the same equation (except that in the case of interest rates the information transfer index varies causing the relationship to change slowly over time).

[2] I'm assuming all the markets are the same size right now, but that is not a big deal. Fast growing markets will get big with slow growing (or shrinking) markets getting smaller relative to the other markets. As these markets move around the distribution, their average growth rate will be the average of the distribution.

[3] Note that there is little evidence that a CEO has a significant effect on the company's stock price which tends to follow the industry average (or the SP500).


[4] I borrowed this picture from David Glasner who describes an economy in terms of the coordination of plans:
The Stockholm method seems to me exactly the right way to explain business-cycle downturns. In normal times, there is a rough – certainly not perfect, but good enough — correspondence of expectations among agents. That correspondence of expectations implies that the individual plans contingent on those expectations will be more or less compatible with one another. Surprises happen; here and there people are disappointed and regret past decisions, but, on the whole, they are able to adjust as needed to muddle through. There is usually enough flexibility in a system to allow most people to adjust their plans in response to unforeseen circumstances, so that the disappointment of some expectations doesn't become contagious, causing a systemic crisis. 
But when there is some sort of major shock – and it can only be a shock if it is unforeseen – the system may not be able to adjust. Instead, the disappointment of expectations becomes contagious. If my customers aren't able to sell their products, I may not be able to sell mine. Expectations are like networks. If there is a breakdown at some point in the network, the whole network may collapse or malfunction. Because expectations and plans fit together in interlocking networks, it is possible that even a disturbance at one point in the network can cascade over an increasingly wide group of agents, leading to something like a system-wide breakdown, a financial crisis or a depression.
[5] This isn't always true -- a laser works by creating a population inversion where the high energy states are occupied. 

[6] I'm so glad I get a chance to link to what I consider to be the greatest blog post of all time anywhere.

[7] Shocks -- unmitigated by monetary policy -- are the major drawback of secular stagnation.

14 comments:

  1. Really nice post! todo: your footnotes... I took a glance at the Crooked Timber one.

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  2. I liked your comment about physics vs economics language. There are certainly differences between disciplines (engineers use exp(j*theta) and everyone else uses exp(i*theta), for example), but when I saw economists using lower case Greek letter pi for something other than the ratio of circumference to diameter of a circle... I did a double take! Talk about thumbing your nose at the rest of the world! :D

    I'm trying to imagine the thought process there: "Hmmm, I need a symbol... perhaps a Greek letter! Here's one that not used for anything important... perfect!"

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    1. Ha! Yeah, I had the same response to the use of pi ... it is one of the more easily accessible Greek letters on early computer systems so maybe that is the reason. It's weird that it stands for inflation. I guess they wanted to avoid the letter i for the same reason engineers do -- it's frequently an index. There is one other standard use of pi in mathematics:

      http://en.wikipedia.org/wiki/Prime-counting_function

      I laugh at the use of the "Greek letter" "vega" in finance:

      http://en.wikipedia.org/wiki/Greeks_(finance)#Vega

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    2. Vega: I'd never heard that one before... but it is funny! Pig Greek? It opens the door to other possibilities: Womega? Qiota? Calpha? Jamda?

      Somehow I knew you'd come up with another example of pi being used in a non-standard way. :D

      Also, the story I heard about why engineers use "j" instead of "i" was that "i" is current. Of course I heard that from an electrical engineer.

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    3. I soooooo want to do a presentation using all the "Pig Greek" letters now... just carry on as if it's the most natural thing in the world, trying very hard not to crack a smile.

      "Greek letter Jambda here representing the transfer function between blah and blah"... that would be *hilarious*... watching everyone squirm a little. It only works if you're the most senior person there... you want your audience to feel uncomfortable challenging you on it... ... I so hope Einstein or Feynman pulled that prank once!

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    4. Ha! Jamda is awesome. I think I want to come up with a good use of that here, denoted with a j.

      That's probably a better answer on the imaginary unit -- I think it's Python that uses j for the indexing reason. Although sometimes the reasons for things aren't exactly what you'd think and there are post hoc rationalizations ... one of my favorites is this one about zero indexing arrays:

      http://exple.tive.org/blarg/2013/10/22/citation-needed/

      Another nonstandard usage in particle physics is as a pion field, though there it usually carries and index or has a vector symbol, which helps distinguish the usages:

      http://arxiv.org/abs/hep-ph/9911472

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    5. I have a friend that is a journalist that wanted to write her story on Ethiopia but refer to it as "Etheropia" every time and see if anyone noticed.

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    6. Also regarding your prank, it made me think of the origin of penguin diagrams:

      http://en.wikipedia.org/wiki/Penguin_diagram

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    7. Ha, I love that story about the penguin diagrams. Thanks!

      Etheropia: reminds me of "Elbonia" in Dilbert cartoons. It's too bad no journalists have asked any politicians about Elbonia... oh, man, that would be so worth getting banned-for-life from the capital hill/white house press corps for... I can think of a few I'd want to quiz about their views on Elbonia (or Etheropia) right now.

      Also I just re-comfirmed the i=current story from one of the old-timers here, who happens to be in this weekend too. :D

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  3. I think this is a contender for top 5 post. Succinctly summarizes the philosophy of what you're trying to do and why it naturally ties into / falls out of the ITM/ITE framework. But good luck convincing people on throwing out "stories" of why things happen :) For that, as I think I may have mentioned earlier, you need to restart economics 200 years ago and move it away from it's moral philosophy roots...

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    1. Thanks Karthik. I agree that macroeconomics remains too tied up with morality -- and that may be the hardest slog.

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  4. I agree that this is definitely one of your best posts. Also, it may be reaching a bit, but given economist's fondness for evolutionary explanations, you might want to consider the relationship between your "non-story" and the explanations of adaptive radiation into unpopulated environments in biology (maybe niche theory in general). Anyway, it seems to me that your explanation has a similar flavor.

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    1. Thanks Robert. I don't know much about models of adaptive radiation, but I did some quick searches and found some pretty neat stuff ... I will have to read a bit more to see if I can formulate some analogies -- thanks for the tip.

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