Is the IS-LM Model Outdated?

As an undergraduate student, I used to disdain the IS-LM model as an obsolete tool of macro policy analysis. In time I have come to the conclusion that there is not a sounder model out there. Despite its limitations -such as its static set up, ad-hoc nature and lack of microfundations- the IS-LM model provides accurate information on the behavior of some variables after a public policy decision.

The lack of microfoundations is important in second order. Lets not forget that it is, at the end, a general equilibrium model. Moreover, the IS-LM model is a synthesis of the goodnes of general equilibrium economics and comparative advantages of Keynesian economics.

Although Paul Krugman is lately a maverick economist, opposing to every other collegue, it is worth taking a look at Krugman's thoughts of the IS-LM model. Personally, I have more respect now for the model. Not because its limitations are minor, but because its usefulness has been proved over years of economic policy.

The fact that international agencies such as the IMF or central banks use the model -along with some dynamic stochastic general equilibrium- shows its value for the profession. I find it hard to believe that after tons of macro papers written out there, only a small proportion has proven useful for macro policy.

Two facts have changed my view of the model: First, I prefer to be an "engineer macroeconomist" in Mankiw's definition. Second, when learning advanced models of economic growth and policy, the IS-LM provides the right intuition. So it makes it easier to understand the important results.

Hopefully the current economic crisis will trigger interest in making economic modelling closer to reality. It is true, economic science evolves slower than it looks. Maybe modern macro models are over a path in o a new and more useful model than the IS-LM. In the mean time, it is not a waste of time to learn it well if you like macro.

The Economist on Mexico's last Election

It is fairly straight to conclude that the following three years -before elections for President- will be the hardest of the Calderon administration. The Economist sum-up a clear picture of it.

The liberal magazine also displays the only way out of the "political gridlock", stating that co-governance with the PRI party is a necessary condition, with the implicit hope that the PRI will allow for critical reforms and thus would receive a country in expansion. If you are interested in estimated numbers of the low chamber composition, Eduardo's Blog provide some from the media.

The Economist's view of Mexico it's almost fully accurate, it only fails to mention the low proportion of total votes with respect to registered citizens, and all nule votes.

With the Congress majority leaned to the PRI party, much of economist's creativity should be invested in the next fiscal reform. VAT in food and medicines will not be an option.

IMF Issues Debt!

The IMF will issue debt soon according to the FT. The latter rises some interesting questions. How will IMF's debt affect economic variables? Will prices in countries be distorted? If so, in which countries lenders or borrowers? To what terms would be issued? John Cochrane explains how can long term debt be useful for a government trying to exchange present for future inflation. Will effects like this lack of importance?

It sounds like some details should be discussed, one thing for sure is that the US will stop receiving savings from surplus countries, if the dollar depreciates, trade deficit in the western hemisphere will fall, still, trade surplus in Asia will not necessarily fall.

Another interesting feature is that if the IMF's absorbs saving excess, the consumption and investment components of aggregate demand in rich countries will suffer. There are a few untied ends of the proposal, but it is probably in the right direction. A popular direction at present.

The Political Economy of the Next Fiscal Reform -After the election-

Results of the election show that the Revolutionary Party (PRI) will be the first minority in Mexican lower chamber with more than 210 seats. A strong position with respect to its present 106 seats. The official National Action Party (PAN), will have 133 seats a big lost from the former 206. In the last three years, history has recorded that whenever the PAN wanted to go ahead with any major reform, it had to agree with the PRI first.

Now all negotiations will be harder for the official party. Taken PRI's ambitions to return ruling Mexico in 2012 as given, a fiscal reform that raise the tax base or the marginal tax rate of existing tributes looks ever more difficult.

Taking a glimpse in to the future, and assuming the PRI is willing to raise tax revenue, the optimal strategy for the Democratic Revolution Party (PRD) will be -with emphasis- to condemn those taxes and then trying to re-gain the second place in voters' preferences. The PRD did very bad too in the recent election, it will have only 67 seats nearly half of its current number 126.

All the latter would leave the PAN in a historical weak position and as an all time looser. The PAN would present to the 2012 elections as a party with the poorest performance in both economic and public safety terms. Taken the last election as an advanced indicator of the 2012's, the PAN should focus in not loosing its place as the second major party.

One of the few ways a fiscal reform would take place, must involve the PRI's akcnowledgement of the fact that without enough revenues, Congress alocates fewer resources. At the same time, the fiscal reform should include all parties, so that none of them could make campaign against it.

Sadly, evidence of reforms including all parties in the current period shows that they have turned out to be weak when compared with its motivations. The latter is the case of the last fiscal, energy and voting system reforms.

Only reforms agreed by a small number of parties are near to satisfy the needs reality demands, such as the pension reform of the State workers of 2007.

Mexico's President will face tougher obstacles now, with its safety policy struggling to convince Mexicans it is the right way, an economý faltering and expected to grow slowly, added to low expected public revenues, the PAN has to take serious action and deal with the PRI, otherwise, the country of 2012 will be ever more distant from that promissed in 2006. Voters acknowledge that.

Animal Spirits -A First Glance-

Berkeley economics' professor George A. Akerlof and Yale's Robert J. Shiller recently published a book that awake interesting feedback so far. The title reads "Animal Spirits" invoking a popular phrase of J. M. Keynes regarding the underlying factors that come to play when it comes to investment decisions.

This already shows some biased in the convictions of the authors, which can be summed up in the following: governments should play a more active role in the economy than free-market advocates claim.

I have not read the book yet -I will soon- however, I have a clearer picture of its contains. Shiller visited recently the LSE and gave a lecture on it. One of the central points made was that, unlike we economist assume, individuals make decisions based in shakier, less technical premises. One in particular caught my attention. Akerlof and Shiller state that individuals base their decisions in "stories". This is, in someone else's experiences. Frankly, this falls in place if we look to how investment decisions are made in cities like Guadalajara, in Mexico.

It is fairly common to hear that someone decided to get in the carwash bussines because he heard how well someone else was doing. It is easy to replicate the latter in mobile phone stores, haircutt shops, caffe internet, real state buying, and so on. There are no feasibility studies behind, just stories from acquaintances.

Of course, it is true that not only Guadalajara corroborates Akerlof and Shiller's hypothesis, just as is true that there are hundreds of counter examples. Nevertheless, the "stories" story seems a lot like the forgotten adaptative expectations. So, in a way, the authors suggest that models -such as the modern macro models- should be re-assessed to include the latter and delete the "rational" approach.

This is my hope at least, otherwise it would be hard to model those indivuduals' "animal spirits". Still, there is some reading to do.

Alternative Approaches to solve Global Imbalances

The World Bank has proposed a provocative way to get the world out of recession: Expand developing countries aggregate demand. This really makes sense. Remember that current imbalances show that rich economies save too little, and emerging ones save too much.

Despite differences among emerging economies, one truth abides: imbalances must be corrected. There are three straightforward ways: either China, India, Brazil and alike consume more; the U.S. the U.K. Spain and alike save more; or both.

Some aspects of political economy in the second and third alternatives are important; they automatically imply that rich countries must renounce to some extent to its quality of life. Saving more resources imply consuming less, or as the basic economics lessons say: exchange more current consumption to get more future consumption.

The latter idea respects the same spirit as the World Bank's. According to this approach economic policy pulling aggregate demand should be seen, far more among developing countries than in rich countries. One setback of the World Bank's approach relies in the principal-agent issue. If rich countries are not credit worthy, then how a developing country can fulfill the lower-risk demand of financial markets?

The idea from the World Bank is clear, capital flows into emerging economies are just a quarter of what they just to be a year ago. Rich countries' currencies are appreciating, then higher risk aversion is a binding constraint in capital markets.

So there are at least two major obstacles to shift the power of aggregate demand from rich to emerging economies. However difficult, this would correct global imbalances, would also strengthen infrastructure in rich economies and would create jobs in developing ones. It will probably lower wages in the former and increase them in the latter. Sounds like a nice solution, if the loss of quality of life was not true. Unfortunately this sounds like a dead-end: there is not enough wealth for all countries in the world.

Neo-Classical theory states that further investment should be done in order to create wealth, this sounds like a feasible way out of the dead-end. The latter needs capital flows restored from rich to emerging economies, maybe this is a necessary endeavor the World Bank and the International Monetary Found will have to undertake.

Global Imbalances from the IMF

Olivier Blanchard wrote this piece in Financial Times. Consensus is growing stronger. China should consume more, US should consume less. As simple as that.