Thursday, January 29, 2009

Freshwater and Saltwater: macroeconomic theory and losing money

Background for the non economists. In 1976 Robert Hall christened the central schism in macroeconomic thought as being between the freshwater and saltwater schools. The division was picked by their location (on the Great Lakes and Rivers versus the coastal schools). The division exists today – and indeed is being played out in Krugman’s (saltwater) blog and by the Chicago economists who think he is a bozo idiot.

Having got through the background here is the post

Does everyone agree that Greenspan kept monetary policy too loose for too long?

I thought so!

When I did economics at University (admittedly at that Freshwater school on the Molongolo River called the Australian National University) that was meant to end in inflation – not deflation.

I like my theory to accord at least loosely with reality. Especially if I am going to bet real money on the outcome – rather than pontificate in papers from the ivory tower of academia.

More to the point – I thought (in true Freshwater style) that sustained low interest rates were a sign that monetary policy had been tight and that sustained high interest rates were a sign that monetary policy had been loose.

Given that basic understanding of macroeconomics I thought that regional banks that made more than half their profits out of carrying the yield curve would be carted out when loose monetary policy did eventually lead to higher long term interest rates. I was short a lot of banks – and whilst that was good – I spent a long time being short interest rate plays. I have detailed that mistake here. Bill Gross made a similar mistake declaring the 25 year bull market in long dated treasuries over – so despite Bill Gross’s saltwater location at Newport Beach I was in good company.

Now the subject of freshwater, salterwater and other macroeconomic elixirs is the thing in the subject de-jour amongst economic bloggers – but I have conducted the experiment – with real money – and I can confidently say (brutally backed by less-than-ideal-financial outcomes) that the saltwater guys were right.

John Hempton


Josh Kalish said...

It's not over yet. We may wind up with quite a bit of inflation. Also, remember the Minsky/Austrian interpretations that would imply a mal-investment recovery period.

Anonymous said...

Frome the debate link

As far as I can tell, fresh water economists have some respect for some thinkers other than fresh water economists. I think they have rather a favorable view of mathematicians and Physicists. I think it would be useful of mathematicians and physicists to look into fresh water macro and express an opinion.

This book has a very well thought out critique on "Freshwater" (or Chicago School") - More Heat than Light: Economics as Social Physics, Physics as Nature's Economics

To save you reading it - Freshwaters stole their ideas from 19th century physics in an attempt to replicate their success, not knowing or realising physics (via Quantum Mechanics) has rendered a lot of it obsolete anyway, moving on leaving the Chicago school wallowing in the 1800's

NB Disclosure: I went to a "brakish school" - home of evolutionary economics (think Schumpeter) and some neo-classicals

kmh said...

I recall an old philosophy professor who took great pleasure in pointing out that whenever you face two or more conflicting opinions the only thing that you can be fairly confident of is that at least one of them is wrong.

Smarmy old bastard...

RPB said...

Are you kidding? This debate is far from over. Brad DeLong's pompous posts about fiscal stimulus packages have been utter nonsense. He leaves unresolved issues such as: vendor nation finance decisions, stimulus in a service based/net import economy, investor future expectations, consumer future wealth/infation expectations, inventory management decisions, treasury financing issues and consumer debt problems. These are significant factors in examining the possible effect of any stimulus that he either downplays or ignores. The Salt Water School argument has been that us Chicago guys are making "freshman mistakes" (mistaking accounting identities and behavioral changes). He implies that the Chicago mistake is one of simple logic. He even makes references to text books that point out the Chicago mistake. . . in books Neo-Keynesians have written. Self supported logic is always sensical.

Three more points:

1. I do believe stimulus packages, in general, command poor outcomes for the long term, real economy. However, I am not 100% certain if this is preferable to strict free market deflation. I am yet to see analysis that examines this issue.

2. I KNOW this stimulus package will fail. Additionally, it is not a true stimulus as it is too rife with pork to possibly "stimulate." Based upon the highly politicized nature of government intervention into the economy, one could argue that a true stimulus package is impossible to create. Most importantly, with regards to the current stimulus package being debated, the bulk of the spending does not kick in until after several years. And even at that point most of the money is wasted on politically motivated, non-infrastructure projects. It is not a true litmus for stimulus.

3. It is not correct to lump an entire University's Economics Department with the ideology of its most vocal members. Many schools in either pact retain a diverse pool of talent.

Anonymous said...

i think you need to go back and "check assumptions." you start out saying that one would expect inflation if there were low rates; and that rates had been too low. your a-ha moment is that right now we are having deflation. sure, okay.

but rates had been low since 2001 (and i think one can argue before that, too). and we DID have inflation. check your indicators. sure, the one indicator in which the agency that publishes it has a conflict of interest (to keep it low), has been showing only run-o-the mill inflation (4-5% as of the peak). but $1000 gold, $145 crude oil, home prices at 7X+ household income and dollar that went to 1.6 usd/euro is good evidence of monetary deterioration. not complete debasement but certainly not sound money central banking.

so i think that your whole premise doesn't fly.

that said, i do enjoy your blog. i find many thought provoking posts. keep it up.

Anonymous said...

Fear the rip tide, listen to the life guard!

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