Jesus Fernandez-Villaverde on European Economic History and Macroeconomic Modeling

Jesus Fernandez-Villaverde is a professor of economics and director of graduate studies of economics at the University of Pennsylvania. He joins the show to discuss both his extensive work in economic history as well as macroeconomic modeling. David and Jesus discuss the economic history of Germany in the 1920s and 1930s and the events that led to the rise of the Nazis as well as more recent events such as the struggles facing the Eurozone. They also discuss debates surrounding the usefulness of current-day macroeconomic models.

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Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Jesus, welcome to the show.

Jesus Fernandez-Villaverde: Thanks for inviting me. It's great to be here.

Beckworth: Oh, we are glad to have you on. Tell us how did you get into economics?

Fernandez-Villaverde: Okay. Well, so as I guess my name betrays I'm originally from Spain. When I was a kid in the mid 1980s, the Spanish economy was experiencing deep transformation. We had moved from a dictatorship to democracy. We were joining what was known at the time as the European Communities, which later became the European Union and we were recovering from a huge economic crisis. Just from watching the news, reading the newspapers, they cover economic policy all the time and I just got hooked on it. Maybe a little bit early when I was only 14 years old I decided I wanted to be an economist.

Beckworth: Nice.

Fernandez-Villaverde: A little bit earlier than other people. However, my goal at the time was not to be a professor. I wanted to be a top civil servant. I know that for many Americans, this may sound strange that when you're 15 you want to become a top civil servant in the Bank of Spain or the Ministry of Finance, but in many European countries, top civil service jobs are really regarded as highly prestigious occupations. They are very well paid and they are the door to other opportunities like becoming politicians, top managers in the business world, etc.

Fernandez-Villaverde: So I went to a university that had this joint degree in economics and law. It was a six year degree in opposition to our regular four year degree, but it was a perfect preparation for the civil service exam. Unfortunately, by the end of my second year, I realized I didn't want to be a top civil servant anymore. What I really wanted to be was a professor.

Beckworth: Okay.

Fernandez-Villaverde: I saw that the best economic research was winning the US, people like Bob Lucas, Tom ..., Neil Wallace, so I said that's what I want to do. So I started working pretty hard on trying to prepare myself to go to graduate school. I was lucky, I got accepted into Minnesota. I got there and it didn't go so badly after that. So that's a little bit the story.

Beckworth: Now, you are both strong in economic history and in macroeconomic modeling. So you do very technical DSGE type analysis, but you also do pretty extensive economic history. I mean, you have in fact, you have several books were working on, correct?

Fernandez-Villaverde: Yeah, exactly. Yes.

Beckworth: Tell us about tell us about these books you're working on. What do they cover?

Fernandez-Villaverde: Okay, so I'm working on three of them at the same time, which is probably a very bad idea. And I should work only on one of them unfinished, but anyway, let me tell you. So the first one is actually bureau macro. It's a textbook in dynamic macroeconomics, with my colleague, that ... Kruger who is also a professor at Penn. The idea was to write a book that was covering the gap between your average intermediate macro textbook think about that Olivia ... or ... you have any of the other standard in macro textbooks, and Ljungqvist, Sargent, recursive macroeconomic theory. The goal is to explain advanced macro, but without a lot of math. That makes it I think a very nice project, because you cannot really hide yourself behind a mask, you really need to explain the mechanism. We have been working on this for many, many years now. I will say we are around 75% done and we will really like to send it to the publisher by next summer. So that's kind of pure macro.

Fernandez-Villaverde: In economic history, which maybe people will find a little bit more attractive. And I have been teaching global economic history now I think for maybe eight or nine years. So I started writing up my notes, I was not very happy with any of the textbooks that existed on the topic. And most of the textbooks are very Western European oriented. Basically, they talk about the industrial revolution in England and coal and steel, and they only touch very lightly on maybe China or India or Africa. And also they have not incorporated a lot of what we have learned in economic history over the last 20 years, which is .... I said out. Well, I may have started right sup... on little by little I have been accumulating material. I have now perhaps around 500 pages. But there is still a lot to go because the project is very ambitious. So my objective at this moment is to accumulate enough sabbatical credits and take one year on leave and finish it maybe in one year of two. I have been circulating already a few of the chapters and they have been well received. People seem to like them, but I really need to work hard.

Fernandez-Villaverde: And finally the third project, which is a little bit, what I'm focusing on right now, in the very short run, is a joint project with Daniel Santos was a professor at Columbia University. And we are trying to think about the history of monetary unions and the political economy of those monetary units. This was motivated by my research on the Eurozone area and their political climate cycles on the euro area. And basically, we want to understand why countries enter into monetary unions, how the political economy of this country's evolve after they have entered into the monetary union, and how monetary unions eventually break down because so far, we have had a few cases of monetary unions that have survived, think about the US, but also many other cases of monetary unions that have broken down, the jury is still out. So we need to see what happens in a decade or so.

Fernandez-Villaverde: Right now, what we are doing is we are trying to outline the argument making it a little bit sharper. That is some of the papers we have written about it. And we are doing a lot of background reading. I have spent the last couple of weeks actually reading a lot about European Union law and the European Union process of integration, the banking union, etc.

Beckworth: Yes, in fact, we're going to talk about one of your papers here shortly as it regards the Eurozone. What's interesting, though, is that you're doing this quite in depth. So you mentioned you got 500 pages into your global economic history.

Fernandez-Villaverde: Yeah.

Beckworth: But if someone was to go look at your research, they'll also find some very sophisticated models. I mean, it's almost as if you're defying the law of comparative advantage. This isn't typical. So how were you able to get specialized in both areas so ably?

Fernandez-Villaverde: I don't know. I guess that the counter-factual will be if I would have specialized in only one of them, I could be doing a much better ...

Beckworth: All right, fair enough. So I'll mention to our listeners that Jesus has a new chapter out in their new hymn book of macroeconomics on DSGE modeling. So something to look forward to.

Beckworth: All right, let's move into European Economic History. And I want to kind of focus on monetary institutions, monetary history and kind of Germany in the focus, the focal point because of some interesting conversations we've had, you and I had offline. And to motivate this, let's go back to the early 1920s when Germany has just lost World War I, they're coming out of it, and they have their hyperinflation experience. Let's start there. Tell us what led to this hyperinflation and what was the resolution to it?

1920’s Germany Hyperinflation

Fernandez-Villaverde: Okay, so let me give you a little bit of background on how World War I ends in Germany. And basically what happens is by the summer of 1918, the British have put on the ground an extremely successful army. The British have been able to finally put together what is sometimes known as joint arms operation, they are the first to truly integrate modern artillery tanks, airplane support etc and especially with the help of the extra soldiers from the United States on all the economic and financial support of the United States, it is very clear that the allies are going to win the war. By September 1918, German elites decide it is better to surrender, to accept Wilson's proposal for a negotiated peace or what they believed was going to be a negotiated peace than to be defeated on the ground.

Fernandez-Villaverde: At the same moment, there is a lot of unhappiness and mutinies within the German Navy. And that precipitates the fall of the monarchy in Germany and a very quick fall to World War I. Why is this important? Because a lot of people in Germany finish the war without having interiorized they have lost the war. They thought they have reached some type of truce/peace agreement. Well, yes they were not doing so well, but they have not really been defeated. That's not true. They have really been defeated militarily, but a lot of the people in Germany have not understood this point. This means that when the Versailles Treaty is passed, it's a tremendous shock to a lot of Germans. They think the treaty is unfair. They thought they have arranged some type of negotiated peace and instead of a negotiated peace, what they are been offered is what historians call a diktat, a set of surrender terms.

Fernandez-Villaverde: And in particular, a lot of Germans do not want to cooperate with the clauses of the treaty. This leads after a number of conflicts to the French and Belgians occupying West Germany, the Ruhr area, and the German government responds by asking the citizens in that area not to work and they will pay their wages. So in that way, the French and the Belgians will not be able to get anything out of this area. And the German government will pay for the expenses of people living there. Of course, this leads to a hyperinflation because there is just not enough money. The hyperinflation completely wipes out the savings of a lot of the middle class and upper middle class in Germany, and that leaves a deep sense of resentment with the Weimar Republic. So think about, try to put yourself in the skin of an upper middle class German lawyer in 1923. You are very patriotic, you are very nationalistic because Germany was an extremely nationalistic country at the time. And basically what you see is this Weimar Republic, would you believe, has accepted a totally unfair peace treaty, and that has generated this hyperinflation that has made lost all your savings for the last three, four decades. You are bitter, you are unhappy, you are completely willing to listen to someone who will come from the outside and tell you that he has a different way to do things.

Fernandez-Villaverde: And this means that after 1923, there is going to be quite a lot of small parties on the rise gathering the boats of all these unhappy voters. Some of them are going to be more radical, some of them are going to be a little bit more moderate. The more radical ones one of them will be, of course, the National Socialist the Nazi Party, but there were many other that actually got relatively better electoral platforms at the Nazis for a while. There was a more mainstream party called the German National People's Party, the GNPP who was the party of the ..., the big land owners, the monarchies, the officers in the army, etc. and without being the type of ... like the Nazis that will go out on the street and beat up people. They were quite hyper nationalist and authoritarian.

Fernandez-Villaverde: The Weimar Republic surprisingly enough study license a little bit after 1924. There are few years of prosperity. There is a block constitute by the Catholic Party, by the liberals and by the Social Democrats who were more or less able to put together a stable coalition governments for a few years. But this is stability is completely a mirage. In 1929, the Great Depression comes and Germany enters into a very, very big economic crisis, and this will give enormous power to these parties on the right wing.

Beckworth: So let me go back and talk about the inflation, the hyperinflation. It was very severe. Today, if you read German commentary, it's often alluded to or referenced as a warning against any kind of profligacy at the Central Bank. It's in the German mindset, the German psyche. And it's hard not to see it. And so one of the interesting questions I've had and I've wrestled with, and this is what led us to our conversation is why do Germans tend to remember this hyperinflation more than they do the Great Depression and the deflation around that? Because part of the reason the motive in that question, this is where you can add some clarification is kind of a standard narrative has been told maybe incorrectly is that the reason the Nazis come to power is because of the Great Depression. Things get so horrible, so painful.

Beckworth: They look to a savior, the Nazis rise up, and there's some empirical evidence, but you told me that's a much more complicated story than that. So I guess two questions one, why did the Germans remember the hyperinflation more than they do the Great Depression? And two, what is the link between the Great Depression and the rise of the Nazis?

Fernandez-Villaverde: Okay, so with respect to the first question, my answer is going to be more tentative than the second one on the first one is going to be a little bit more of an hypothesis. The second one, I believe I have a tight answer. I think that the inflations affect everyone, everyone that has a little savings, lost everything they have and it's very clear that this is unfair, at least in the minds of people. The great recessions on the other hand, are very unequal on the way people are affected by them. If you keep your job in Germany in 1930 and 1931, and the key of course here is if you keep your job. I want to be very open about that. Life is not so bad. Maybe your wages have gone down 10%, 5%. But guess what? Prices are -20, -25%.

Fernandez-Villaverde: So suddenly your real income is higher. So the people that kept their jobs do not necessarily remember very hard economic crisis in bad ways. I have experienced that myself. In the case of Spain, if you talk with some of my friends or my relatives that kept their jobs between 2009, 2013, they don't have particularly bad memories of those years. They will tell you things which sounds a little bit frivolous, but true nevertheless or they will say, "Oh, in 2012 it was so easy to go to a good restaurant and find a table. Now it's difficult again to find a table," Let me tell you just one anecdote. My parents, thankfully enough, we're not affected by the crisis. And you asked my mom about the crisis. And what she will tell you was, will be something like, "Oh, in 2012, I wanted to renovate the bathroom. So I called the contractor and the contractor say, I will be there in 15 minutes, and he was there in 15 minutes. 2005 you call a contractor and he will tell you, Well, I will show up in six months if you're lucky."

Fernandez-Villaverde: Hyperinflations tend to be much wider in their impact, and they tend to affect also the middle and upper middle classes. Then to create the narratives, what the French historians call the Lieux de Memoir, the places of memory that future generations remember. You are brighter and you are going to write about the hyperinflation. You are a historian you're going to write about the hyperinflation. You are a poor, unskilled worker, your plight during the Great Depression is very sad and very hard. But you are not going to, in that sense, affect the national memory in the same way.

Fernandez-Villaverde: And the second point I would like to add about that, is that I think many people in Germany See the link between the hyperinflation and the problems of 1929, 1933 as a continuum. They will tell you, "No, no, no. 1929 would have never happened without the hyperinflation of 1923." And they have a little bit of a point, maybe not the full truth, but a little bit of a point, they do have.

Beckworth: It's interesting. So your argument is that hyperinflation affects everyone. It doesn't discriminate. It takes away everyone's earnings, as well as upper income folks. And so they write the history. They are upset whereas the Great Depression, there's winners, there's losers. And that's a convincing story. What's interesting if you go to the US perspective, it seems like almost every macro economist in the US if you ask them, what's the defining moment? It's going to be the Great Depression. I guess I can't say whether it's as important in the average American's mind as maybe inflation is in the German's mind, but it seems at least macro economists here, there's a bias towards the foreign inflation where in Germany, the bias is towards the avoiding inflation. Maybe because we haven't had hyperinflation-

Fernandez-Villaverde: Yes. Yes. That was going to be my answer-

Beckworth: Okay.

Fernandez-Villaverde: ... In the sense that you remember the worst thing that happened to you. The worst thing that happened to you was the Great Depression. But the US in 1973 completely loses control of inflation, maybe we will be as obsessed with inflation as the Germans.

Beckworth: Right. And that's a fair point because I do think some of the concerns the Fed has had, they're fighting the last war, they are fighting against the 1970s repeat in some senses. There's older people, older generation who worried that we'd, so I think that there might be a fair point if it had been hyperinflations even more concerned about avoiding that catastrophe. So let's speak to now the contentious claim that the Great Depression led to the rise of the Nazis.

Did the Great Depression Empower the Nazi Party?

Fernandez-Villaverde: Okay. So I want to be very clear, I'm not going to deny that the Great Depression caused the Nazis coming to power. I just want to emphasize that the mechanism is a little bit subtler, is not, yeah all the great depression, people were unemployed, they were unhappy, they voted the Nazis, because I think that our reading of history teaches us the wrong lessons. So let me tell you, I need to give a little bit of background to people.

Fernandez-Villaverde: So, first of all who voted for the Nazis? Back then, we didn't have exit polls. So all the type of things we know about who voted from the Nazis is based on statistical methods. I'm not going to bore people with the details. But what we believe we know is that there were three types of voters in the Nazi constituency. First, it was Protestant farmers. Politics at the time in Germany wasn't very sectarian. The main determinant of whether you will vote one party or another was whether you were Catholic or Protestant. So Protestant farmers vote for the Nazis, protestants who were middle classes, especially artisans, small shopkeepers, lawyers, medical doctors, etc. They worked for the Nazis, and people who were living on a fixed income like retired workers and renters etc.

Fernandez-Villaverde: The Nazis made very, very little electoral progress among three other groups. First, Catholics, in particular Catholic farmers and workers. They voted in 1928 and in 1932, to Centrum, which was the main Catholic party and there was a small allied, Barbarian party with them. You actually look in the federal election of 1928, they got 15% of the vote. You look at them in 1932 they got 15% of the vote, so no electoral losses whatsoever.

Beckworth: Okay.

Fernandez-Villaverde: Then you have the skilled manufacturing workers, the guy who's working for the biggest steel company and has a skilled job. These people kept voting for the Social Democrats. The party is called the SPD. It is still around. The Social Democrats lost voters, but they lost voters because a lot of the people got unemployed, but conditional on being employed people still voted SPD. Where were all the unemployed people going? They were going to start voting Communist. The Communist Party in Germany goes from around 10% of the votes in 1928 to nearly 17% of the votes in November 1932. So if you put together the Catholics, the Social Democrats and the Communists together, they have nearly the same share of votes in 1928, which was around 55%, that in 1932, which was 52%.

Fernandez-Villaverde: This is very important to remember, even in 1932, Hitler is never even close to a majority. And 52% of Germans are still voting to parties who are deeply committed anti-Nazis.

Beckworth: Okay.

Fernandez-Villaverde: So how can it be that Hitler gets to power? Well, he basically does two things. The first one is, remember I was telling you there were all these small anti system parties, they were called Volkish parties for people. Well, the Nazis are the most dynamic of them. And he basically concentrates the votes that have been in the past divided among all these parties. And I particularly believe that this will have happened no matter what, even without the Great Depression, just because Hitler and the other leadership within the National Socialist Party was much more dynamic and much better prepared for modern electoral politics.

Fernandez-Villaverde: The second group that they gather is traditional conservative voters, people that had voted in the past for, remember I mentioned, the German National People's Party, the National Conservatives and a more mainstream, Moderate Conservative Party called the German People's Party, and Hitler gets around between 60 to 90% of this middle class traditional conservative Protestant voters. And yes, some of these voters are not doing great during the Great Depression. But the average person in this block is not unemployed, the average person is not in the street searching for a place to live. What these people are really afraid is of the very fast growth of the Communist Party. They are really afraid the communists are going to come, they are going to take power and there is going to be a communist revolution. And what Hitler is promising them is, "I'm going to be tougher, and I'm going to be more assertive against the communist and I'm going to defend the foreign interests of Germany better that all these traditional conservative guys that at the end of the day couldn't deliver."

Fernandez-Villaverde: Let me say it in terms of economics, is not a partial equilibrium effect of, "Oh, I'm unemployed, I vote Nazi," it's a general equilibrium effect. There are more unemployed people that are voting communist, I'm a middle class guy who's really very afraid of the Communist, so I vote Hitler to be sure that the Nazi votes will come and will beat up the communists very hard. And that's what I think sometimes people miss that-

Beckworth: Interesting.

Fernandez-Villaverde: ... say that this is exactly, how the particular details of how Hitler comes to power in January 30th, 1933. Actually, what some few people remember is that the Nazis by the end of 1932 are losing votes. The economy's doing a little bit better. People is feeling a little bit more optimistic about the future. There is a second federal election in November 1932. And the Nazis are losing a lot of votes. And then there are several regional elections where they are voting, they are losing even more votes.

Fernandez-Villaverde: So in the New Year editorial of first, the main newspaper in Frankfurt, it's still the main newspapers in Germany, they are actually very optimistic about the new year. They say, "The Nazi danger is gone. Democracy has survived." And what really happens is because the traditional conservative elites believe that Hitler now is much weaker, they can bring him into government precisely because he's weaker, use his soldiers and his supporters to destroy the power of the communists and the social democrats and then get rid of Hitler. Of course, what they cannot count on is that Hitler is going to outmaneuver them, because when you make a pact with the devil, you end up losing.

Beckworth: Very interesting. So maybe a more accurate short story and I probably won't get this correctly all together, but would be that the Nazis come to power both because of Great Depression issues, but also because of fears of communism?

Fernandez-Villaverde: Yes, yes.

Beckworth: Okay. All right. Well, let's let's move forward. Because these stories are interesting. Let's move forward more recently to Germany and Europe, and the Exchange Rate Mechanism that occurred in the early 90s. Let's go to that period where the German currency, the Deutsche Mark is the anchor currency for the countries that were part of this Exchange Rate Mechanism, the ERM, and tell us what happens then. Germany is again at the center of a monetary controversy here, what's going on now?

1990s Deutsche Mark and the Exchange Rate Mechanism

Fernandez-Villaverde: Well, during the 1980s, a lot of European countries, particularly France, and to a little bit less degree, Spain and Italy start a policy that was called a competitive devaluation or sometimes it's called the policy of the strong Franc. And the idea was if we tie ourselves to the German Mark, this will control inflation at home. It will force trade unions on the big industry to accept wage moderation and price moderation. And that will help us to break the traditional spiral of high inflation, devaluation, high inflation devaluation that many of these countries had gone for decades.

Fernandez-Villaverde: I will say that between 1985 to around 1991 that this works pretty well. But then you get into the recession of 1992, and there is a lot of speculative attacks and there was a very large literal dawn in these speculative attacks. Paul Krugman was one of the main guys in that field that suggested that the crime of trying to keep a peg is that you're subject to this type of multiplicity of equilibrium, which basically means if everyone believes that you are going to keep the peg, you actually don't need a lot of resources reserves to keep the peg, but if everyone is afraid that the peg is going to be attacked, no matter how many resources you have at the end of the day, it turns out to be impossible.

Fernandez-Villaverde: So you get to this very terrible end 1992, 1993 and the sterling pound leaves the mechanism, the British had only reluctantly got into it. So they were always never fully committed to it. But Spain is forced to reevaluate several times and I remember I was at college at the time, it was a national drama that we could not keep the value of the peseta. And everyone talk about this as nearly as sad as of national team losing a soccer game. There was the consensus then after this big monetary storm, that the only way forward was going to the next step, creating a euro, creating a unified currency. And that without a unified currency, the promise of a common market of, by the time the people still started to use the expression the single market was going to be impossible.

Fernandez-Villaverde: And the French in particular thought, "Look at the end of the day, one way or another, we need to have a common monetary policy with the Germans. If the Bundesbank does it in his own, we cannot really do anything, but to follow them. If we create a European Central Bank, at least we will have something to say in it. So let's do it." The Germans were not thoroughly convinced by it because they liked the Bundesbank so much. But at the end of the day, the commitment to European integration, which is the basic fundamental cornerstone of German politics in 1945, really pushed them to accept it. So a little bit as a consequence of all these problems and the instability that the Exchange Rate Mechanism had in the early 1990s, we ended up having the Euro.

Beckworth: There's an interesting kind of story that starts after World War II continues up to the present, and this episode in the middle as you said, kind of catalyzes the push towards a common market, a common currency. And what was fascinating to me though is you see the legacy of that early 1920s hyperinflation experience because the Bundesbank and the early 1990s what's going on as you mentioned is the unification between East and Western Germany, Germany is concerned about inflation from Eastern Germany, so they start to raise interest rates and any country that pegs is going to have to follow that increase, that tightening if they wanted to maintain the peg and unfortunately for the UK was already having weak economic growth. Was it already going into a recession when it had to raise interest rates at that time?

Fernandez-Villaverde: I think so.

Beckworth: Yeah, that's my recollection. It was already weak. And it's fascinating story with George Soros comes into the picture. He bets against the UK because there's no way, the government of the United Kingdom will cause people to suffer so intensely just to maintain this link to the Germans. And again, I mean, all this goes back to the Germans and their big aversion to any with inflation. They couldn't tolerate anything happening. So it's neat to see these lengths and to understand that you have to go back in history and understand monetary history.

Fernandez-Villaverde: Yeah, let me put it also in this way. So imagine that you're a German voter. I think that people who are critical with the Germans never really tried to do the, I will say exercise of putting themselves in the skin of a German voter. You're in 1992. What have you seen? You have seen that between 1914 to 1945, there were 30 years of ... in your country. Everything went wrong. You went from being the most powerful and richest nation in Europe to being destroyed, occupied, a barrier among international nations. After 1945, you say no, no, no, no. Starting now, I'm going to stabilize inflation. I'm going to finance the budget, I'm going to follow the rule of law, I'm going to be very serious with policy rules. By 1992, you are again, the richest country in Europe. So how in the world are you going to explain to this voter that a little bit of inflation can be a good idea?

Beckworth: You're right, right.

Fernandez-Villaverde: It's just impossible. It goes against everything he has seen, even if you and me may agree that doing a little bit of deficit and fiscal stabilization and monetary stabilization may work, what this your man is going to tell you is, look, I was an alcoholic. And because of alcoholism, I nearly died. I put my life together. And now I'm again rich and prosperous. And you're coming to tell me that there is some empirical evidence that drinking a little bit of red wine at dinner may increase my heart health? No way. What?

Beckworth: Great analogy. Great analogy.

Fernandez-Villaverde: Yeah, it's basically what we are telling them.

Beckworth: This is again, it's fascinating because there's this common thread going through there, this alcoholic story is and I think it's also part of the story with what's happened in Europe, the Eurozone crisis. Briefly, I'll just mention also the Bretton ...Woods and Bretton Woods, every currency in the West is tied to the dollar. Yes, the US kind of cheats, it's over expansionary. But Germany is one of these countries that really complains about it, because Germany is having to sterilize, all these dollars are flowing in and it's going to cost them either fiscally or higher inflation and they don't want that inflation because of this alcoholic analogy, a story you give.

Beckworth: Well, let's move forward then into the more present, the Eurozone. So you have a great paper in the Journal of Economic Perspectives that looks at the Eurozone from an, it's kind of an interesting angle I hadn't considered and that is the motivation for the Eurozone is that it would lead to structural reforms, these uncompetitive countries in the periphery would get more efficient. But instead it had the opposite effect. Tell us about that.

Efficacy of the Eurozone

Fernandez-Villaverde: Yeah. So you went absolutely right. That was the way that Euro was solved in Italy or Spain or Portugal. You need to get your act together because now you will not be able to use the exchange rate anymore to recover from bad economic times. What no one foreso, and this is both among European and among American economists, was that entering into the Euro will create, will induce a dramatic fall on the real interest rates that Southern European countries had to pay for their debt. Which meant well, I need to pay now only half of the interest rate that I pay before I can have twice as much debt. And that's exactly what or how people reacted.

Fernandez-Villaverde: In the case of Portugal and Greece, it was mainly public debt. In the case of Ireland, which I guess in this case is considered our honorary southerner. And Spain, it was a private debt. So we engaged, for instance, in the case of a Spain on an Ireland, into huge a construction booms. Because suddenly you could get mortgages at 3%, 4% when just a few years before the only mortgages you could get were at 12%. And this generated a number of very bad political economic dynamics. One of them, for instance, was that politicians could engage in a lot of wasteful spending without serious consequences in the short run. If you talk with people like Paul Krugman, they will tell you "Oh, look, a Spain had a small government surplus in 2007. So how are you saying that these guys were not fiscally serious," and he's getting it completely wrong.

Fernandez-Villaverde: What is happening is the economy is going through this real estate boom, we have this fiscal system that is very, very sensitive to real estate activity in the ways it's designed. So Spain was raising a lot of revenue that was not sustainable in the middle run. And at the same time, we would engage in a lot of public expenditure programs that were not sustainable either in the long run. So let me give you an example. Imagine that you decide to open a new public university in a small town because you want to be sure you get that member of parliament. That people will vote for your party. So you go to that a small town and you say, "Well, I will open a new university for you." And the first year of the university, what is the cost of the university? Next to nothing, because you just have a founding president and maybe a secretary. The second year, you have a founding president, a secretary and maybe you hire two or three professors. It's only 10 years later that this is a very expensive public policy program.

Fernandez-Villaverde: So that's what the Spanish politicians do between 2004, more or less in 2008. They promised a huge expansion of public expenditure, but that public expenditure will not take off in another five, six years, just because of the momentum that you need on this type of things. And at the same time, you are getting all this extra tax revenue because of the bubble. So if you go in 2006, and you tell the voters, "Hey, guys, we are doing something here very, very wrong. We are committing ourselves to a lot of expenses we cannot finance in the long run." The answer that you will get, and I know because I tried to make that argument in 2006 was, "But if we have a surplus of 1%, what are you talking about?"

Beckworth: Yeah.

Fernandez-Villaverde: ... And we call this a signal destruction problem, which means that voters tend to focus very often on headline numbers, and not on a structural cyclically adjusted decisions. And in 2006, 2007, thanks to the bubble created by the Euro, a lot of the headline numbers of the Spanish or the Irish economy were very, very good. And there was no incentive for voters too worried about the future because of this signal destruction problem. And that's the story we are trying to tell.

Beckworth: Yeah, I think it's a very convincing one. What you say in the article that the Euro loosens the budget constraints and many of these countries and put off the inevitable day of reckoning or put off the immediate structural reforms that would have avoided the day of reckoning. I've written a paper on this myself, and I thought more about after reading yours. I mean, I think one of the reasons for this is now that you've joined the Eurozone, implicitly your backstop by all the other countries, your backstop by the EU and that's why Greece is long term yield on bonds could fall so far. I mean, there's this implicit backing, which in some sense has been fulfilled over the past few years.

Beckworth: There's another angle, though I think that's an important part of the story. But you mentioned the bubble, the Euro created the bubble. And for me, I'm a monetary policy guy. I look at the ECB is playing a role in that in the following ways. And again, ultimately, the ECB is the result of the euro. So you can tie it all back to the euro. But the ECB, when it came into being, Germany was very sluggish, slow growth. You had Ireland, rapid growth, all these countries on the periphery had really faster growth. Germany had slower growth. You're the ECB, what do you do?

Fernandez-Villaverde: Exactly.

Beckworth: And so if you go for the average, it's going to be inappropriate for anyone. But Germany makes up a bigger part of the Eurozone. So I've seen some work on some tailor rules, and it looks like the ECB did monetary policy that was more consistent with those core countries like Germany so that monetary policy was too easy for the periphery during the boom years, but during the bust years, more recently, ECB policy has been more appropriate for Germany and too tight for the periphery. So I guess my question is, do you see this one-size-fits-all monetary policy from the ECB being a part of the boom bust cycle there?

ECB’s Culpability in the Boom-Bust Cycle

Fernandez-Villaverde: Yes. And I think so. Let's think about in terms of the traditional optimal currency area approach?

Beckworth: Yeah.

Fernandez-Villaverde: I don't think the European Union was by any stretch of the imagination and optimal currency area in 1997. And I don't think it's an optimal currency area today. And the goal in 1997 was, well, maybe we are not an optimal currency area today, but once we bind ourselves into these Eurozone, we will eventually become one. It hasn't happened and it hasn't happened because at the end of the day, you have the language barrier in the US. If you are from Massachusetts, you can pick up the car and drive to Texas and they roughly speak the same language. If you are from the southern of Spain, you pick up your car you drive to north of Germany and he speaks something totally different. And it's not only the language, it's the culture, the food, the arts, the TV. And that's never no matter how much you try to fix that does not going to disappear for many generations.

Fernandez-Villaverde: Second factor is we don't have a federal budget of any meaningful sense. The European Union budget is only around 1% of the European area of the Eurozone GDP. So you cannot do any type of meaningful fiscal transfers. And that's a problem. Basically says that the Eurozone has a fundamental design flow. Now, the question then is what do we do about it? And here is where my position has always been a little bit nuance. So I was against the creation of the Euro. I think I was one of the very, very few Spanish economists who thought the Euro was a bad idea, and believe me when I was saying those things in the late 1990s, people thought I was a lunatic, but fine.

Beckworth: It's true. Most American economists were warning most European economies before it. So you're right.

Fernandez-Villaverde: Yeah, exactly. And I think that most European economies were just too much in love with the idea of the European unification to put it ahead of their economic sense. I think that if you have taken that very same European economies and tell them that Brazil and Argentina, were going to get into a monetary union, they would have said, "No way. This will never work."

Beckworth: Yep.

Fernandez-Villaverde: Fine. But now that we are into the Euro, I'm not sure we need to break it up. This is a little bit the same. That getting married is a very different decision than getting a divorce.

Beckworth: Hmm, interesting.

Fernandez-Villaverde: You may be reluctant to get married, but once you have a wife and three kids and a mortgage, divorce can be really costly. And that's my view right now about the Euro, that breaking it up will be so costly, and more than be so costly, it opens so many unknowns that I don't think we should do that. So the relevant question in my opinion is, which is the set of reforms we need to introduce to be sure that this Euro area works and this very fundamental symmetry between what is good for Germany and what is good for Portugal can be somehow fixed?

Beckworth: That sounds like a tall order. It's very difficult to do. You mentioned the optimal currency area, I thought that I was reading your paper and really what these folks were arguing was for an endogenous optimal currency area. The idea in the literature that, "Look we're not an optimal currency area now, but just wait and see. Once we got those open borders, there will be more competition, less exchange rate uncertainty and you will see firms across the EU converge, " and it never happened. And so you have this massive misalignments of real exchange rates. And so it's interesting to see I got to throw an idea out there by and see what you think. So some observers have suggested that we keep the EU, but we actually form a second currency. So maybe the Euro stays put with some of the countries in the periphery, maybe even France, but Germany and maybe a few other austere countries leave and form kind of a more hard currency. Is that, one, possible and two, a good idea?

Fernandez-Villaverde: Okay, so let me put it in this way. I'm a little bit conservative with lowercase c in the following sense, I really think that as economist we suffered from the pretense of knowledge, as ... will say and very suspicion of anyone tried to say, "Oh, I work out through this institution in the blackboard of my office and I got all the incentive constraints right. This is going to work right." So my instant reaction about any reform in monetary terms has to be always I don't know, I'm really worried about it.

Fernandez-Villaverde: But that's a little bit my personal bias. I just wanted to point that out. I think on my personal view, is that having those type of currencies will take away from southern Europe the very last amount of discipline and commitment that has been left after the crisis. And it will do it in a moment where right now, we know the Euro is not such a bad idea. And if you look at the real exchange rate of Spain, Portugal or Greece, it is probably where it should be.

Beckworth: Okay.

Fernandez-Villaverde: When you look at fundamentals and I know I do econometrics so I know this is hard, but if you look at where the real way Spain should be given a level of productivity, they are more or less where they should be. If you look at the real estate prices, I will say that in fact, most real estate in Spain now is under value. So, in some sense leaving now, the Euro is not really going to help as much. It may be the case that in 10 years when the real exchange rate is again misaligned, it will be useful. But thus, creating two currencies may have make sense in 2010, it doesn't make sense now, where we have already paid adjustment cost.

Beckworth: All right so, one of the issues is, if you can adjust your exchange rate then you have to adjust domestic prices to stay competitive. And so, what you're saying is, that has already happened, the deflation these countries have experienced has put their a real exchange rates more in line with the need to be.

Beckworth: All right, very interesting. Let's move on the time we have left to your other areas of expertise and that is macroeconomic modeling. There's a lot of issues, a lot of heat being thrown around these days about DSGEs, and for our listeners, in case you don't know this, Dynamic Stochastic General Equilibrium models, which is kind of the workhorse of modern macro economics, if you get a PhD, you have to learn these models and they're being used in literature, even published research, they're important to know. So, where does the kind of state of the art now stand with DSGEs and what do we make of these critiques? Paul Romer recently lobed a few grenades at the DSGEs, and I guess my question is, are they useful, are they practical? We use them as academics, but where does it stand?

DSGE Models in Macroeconomics

Fernandez-Villaverde: Okay. Well, these are huge questions for me.

Beckworth: Sure, sure.

Fernandez-Villaverde: Let me pick up the highest ... utility parts of the answer.

Beckworth: Okay.

Fernandez-Villaverde: Well, I think that when people say DSGE models is one of the situations where different people mean different things. Because, first, the name, dynamic. Well, of course, we want models that are dynamic. I mean, who wants a model that is a static? Stochastic; stochastic here means that there are shocks. Of course, we want models that are have shocks, and general equilibrium. Well, of course, we want models in general equilibrium, we want to see how the economy interacts. So at a very abstract level, who can be against a model that has these properties?

Fernandez-Villaverde: So in that sense, you can think about the DSGE models as they're saying, well, less derive models of the aggregate economy that are dynamic and that have probabilistic structures and that have a general equilibrium component. And what I think many of the critics complain about are about some of the very concrete modeling choices that these models have. And different people pick different parts that they don't like. And it's a little bit hard to go over all the criticisms because some of them are well-informed, and some of them are and I'm sorry if I sound a little bit harsh, not that well-informed. So for instance, things that I agree with the critics, general equilibrium models or DSGE models could do much better pricing. In the way prices are set up in our models, especially of the New Keynesian fashion, is a little bit silly. There is like some ... process that lets firms change prices or not, or maybe they need to pay so many prices, so many costs to change their prices. But we haven't really made a lot of progress in truly understanding how prices are set up.

Beckworth: Is this the Calvo Fere you're talking about?

Fernandez-Villaverde: Yeah, exactly. So the Calvo Fere for the listeners who don't know, it is this very silly abstraction where you flip a coin and if it is heads, I can change my price and if it's tails, I cannot. And it kind of works, it's an approximation to a better problem. But like all approximations, there are some cases where it makes sense, and there are so many other cases when it doesn't. And the problem with only ... and macro is not different is you have 10 people doing good work, but you have another 10 people whom do not fully get it. Maybe they were they apply the paper doesn't make a lot of sense.

Fernandez-Villaverde: And other aspect of their model of the standard DSGE models, where I am very critical of is what Tom ... calls the communism of expectations. And what he means by that is that everyone in the model has the same expectations and the same set of beliefs. And we know that's not true. We know that you go in 2012, you put together, not even 10 economies, but 10 participants in the bond market, or 10 people who were major hedge fund investors and you ask them why do you think it's going to happen with the dollar over the next year? What do you think is going to happen with interest rate? They're going to tell you very different stories. So we really need to face models where people have different beliefs about the world, different sets of information, etc. and making progress along those dimensions is hard.

Fernandez-Villaverde: Some of the other criticisms, I think are less well-founded. So for instance, Paul Romer makes a big fuss about identification problems. Identification in a very quick way is whether or not there is enough information in the data to tell models apart, learn about parameters of the model. And I found that criticism very puzzling, because I go to the econometrics seminar regularly. I sit there, I write papers in econometrics, and half of the papers are about identification. You can complain we have not made a lot of progress that maybe affect the decision, but complaining that we forgot about it seems completely wrongheaded.

Fernandez-Villaverde: And so I think that for the time being DSGE, models are still going to be the workhorse probably, and we are going to derive better and better models. And in particular, what I think we are very close to is a big revolution in having a heterogeneous agents. So let me explain this for people who may be a little bit less familiar. So in the standard macro model we have what we call a representative agent, a household that stands for all the households in the economy. And for some problems, that's not about approximation. But if you want to talk about inequality, if you want to talk about life cycle issues, if you want to talk about tax policy, these type of models do not make a lot of sense.

Fernandez-Villaverde: And we really wanted to derive models with heterogeneous agents, but it was always very hard and very difficult. And over the last five, four years, there has been a lot of advances, both in terms of methods and in terms of computation. And that's what I have done a lot of my day to day researches precisely there that are really opening the door to what I think would be a new generation of models with individual heterogeneity, which will probably teach us a lot of very interesting things about the economy.

Beckworth: Now going down that path of heterogeneous agents, I mean, you're addressing this concern you have about the communism of expectations that if you have these different agents, you have different expectations. If you take that to the loan, I guess another interesting question is, does this lead us down the path of agent based modeling or is this different?

Fernandez-Villaverde: This is different in the sense that you are really trying to be much closer to traditional economics. You are only introducing for instance different set of beliefs about some stochastic processes, etc. while agent based modeling was more about let's have models where you have these very simple automata that follow a very reduced set of instructions, and let's see what happens. And in the same way, that you could argue that the rational expectation representative agent model is an agent that is way too sophisticated, my view always has been that these very simple automata are, on the other hand, a little bit too simple.

Beckworth: ... simple. Okay.

Fernandez-Villaverde: That people sit down and actually think about it. Let me put it in this way. When I bought my house, my wife and I were deciding how much we wanted to pay as down payment, how much to borrow, how much to keep in the stock market, we did our numbers. We may have been wrong, I may have had the wrong expectations about what the market was going to be in the next year. But it's not that we just randomly follow some rule of thumb. And something that is important to remember, is a lot of the prices and allocation in the economy are not democratically weighted by the number of people, but they are wealth weighted. It is way more important for an economy that Bill Gates gets his investment right than 1 million people that have $20 in their savings account, get their investment right. And my suspicion is that Bill Gates have a lot of very smart people doing their investment decisions for him.

Beckworth: Interesting. We have a few minutes left, I want to go down one less avenue in this discussion on modeling, because near and dear to my heart as a money guy, and that is how we deal with money and these models. So traditionally, if you wanted to look at money and a DSGE model, you'd put it in the money in the utility function or you'd use the cash in advance constraint. And that was the way you did money in the models but those were always kind of questionable or particularly the cash in advance constraint that always bothers me because money enters in as a friction. Money is a friction, but it reality, money emerges as a way to reduce search costs, transaction costs.

Beckworth: And so it always kind of bothered me, but now we have these new models, which you can a lot of work on. I've tinkered with co-authors, but you've done a lot of work with the Legos right models of monetary search. And my question to you is, do you see it getting more and more acceptance? Because frankly, we've submitted some articles, gotten pushback, "Oh, we don't like these type of models." I mean, what is your sense of the field? Is the field heading more towards these monetary search model angles?

Fernandez-Villaverde: Okay, so I have a little bit of eclectic beyond that. My perspective is that there's some questions for which having money in the utility function is okay. So probably we are going to think about the normal business cycle and you want to think about the effects of productivity shocks or the effect of an oil shock. Such frictions are not going to be of the essence. So, you may as well write a model with money in the utility function. We have many simplifications in the model. So that is just another one. And there are other questions for which modeling money explicitly is fundamental. And those questions involve issues like what I have been working recently, cryptocurrency, and Bitcoin. Several of my students are currently thinking about models of the financial sector, models for instance they are brokers and dealers and there is ripple and you need to find someone who wants to take the other side of a contract and another set is really of the essence.

Fernandez-Villaverde: So, I will say it depends a little bit on what you want to use this models for. If I can be a little bit critical with the essential models of money with Legos right tradition and I do this with with deep admiration for Randy Bryce who was my colleague for many, many years and for Neil Wallace and Nobu Kiyotaki who have always been very nice and very kind to me. And that literature suffered a few times from a little bit too much worried about proving a theorem, and a little bit little concern from having to say something interesting about current problems.

Beckworth: Yeah.

Fernandez-Villaverde: So it's not that I'm against proving theorems, I have proven a few in my life and are perfectly fine. But especially not the kind of the core members of the group, but kind of maybe in the fringe, kind of the second level. A lot of times many of the papers were literature-driven, in the sense that people will prove "Oh, I have this new model. And I have this model with a random sets," and then they will come and say, "Oh, but now I'm going to do the model, but with a slightly different version, and a slightly different thing." And then they will work for like 10 years on that. And that meant that many macro-economists thought that some of these essential models of money were a little bit kind of a subgroup that will talk with each other. But I really believe that these models are very important. And I really believe that more and more we are going to see people using these type of models to talk about a lot of interesting things.

Fernandez-Villaverde: And if you go to Randy Bryce web page at Wisconsin, and you look at about some of the stuff he's doing these days, about assets and financial markets, and the effects of money ... all these types of things, I think are really truly a lot quite exceptionally good papers and deep papers.

Beckworth: Very interesting. On that note we have to end. We are out of time. Our guest today has been Jesus Fernandez Villaverde. Jesus thank you so much for being on the show.

Fernandez-Villaverde: Okay, thanks. For me here has been a lot of fun.

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.