Economic Growth, De-Population, and Macroeconomics with UPenn Econ Professor Jesus Fernández-Villaverde

>> Jesus Fernández-Villaverde: What we are trying to say is that the present of Japan is the future of the rest of the world. I have written in Britain a lot lately on demographic trends, and the biggest demographic trend is the way I always put it: winter. The demographic winter is coming.

And every country in the world, even poor and middle income economies, are going through a very, very fast fertility decline. Which means that there is going to be this big headwind of decreasing working age populations all across the globe. And that will force us to start rethinking about how we actually measure economic performance.

>> Jon Hartley: This is the Capitalism and Freedom and the 21st Century podcast, an official podcast of the Hoover Institution Economic Policy Working Group where we talk about economics, markets and public policy. I'm Jon Hartley, your host today. My guest is Jesus Fernández-Villaverde, professor of Economics at the University of Pennsylvania, a macroeconomist and frequent visitor to Hoover.

Welcome, Jesus.

>> Jesus Fernández-Villaverde: Thank you.

>> Jon Hartley: Jesus, you grew up in Madrid, Spain. How did you first get interested in economics and macroeconomics?

>> Jesus Fernández-Villaverde: Well, so I grew up in the 1980s and at that time the Spanish economy was not doing very well, we had high inflation, high unemployment, high government deficit.

The economy was not growing very fast. So I guess that for some kids who were more or less interested in how his country was going on, started thinking about economics and more in particular into macro was natural. So one day I decided I wanted to be an economist.

And here I am, like maybe 40 years later.

>> Jon Hartley: That's funny. I mean, you did your PhD in Minnesota and your advisor was actually Leo Haney, a senior fellow here at Hoover. Tell us about your path from growing up in Madrid to Minnesota and getting your PhD there.

>> Jesus Fernández-Villaverde: Well, so already when I was an undergraduate, I started trying to read things a little bit more advanced than perhaps the average undergraduate. And I bump into the very first textbook that Tom Sarrient brought on macroeconomics. It's a black book, I always joke that Tom has written three textbooks in macroeconomics.

And I really like it. I enjoy it a lot. It opened like a lot of new views for me. And he said, professor of economics at Minnesota, because at that time Tom was at Minnesota. So I thought, wow, I want to go to Minnesota. Then this was before the Internet and all these type of things.

So I wasn't quite aware that Tom had moved, I think at the time to Chicago, but nonetheless, I applied to Minnesota, they accepted me, and the rest is history.

>> Jon Hartley: That's amazing, I mean, what a fascinating place to study macroeconomics. It's produced so many famous macroeconomists, it's really the home or one of the homes of the rational expectations revolution.

We think Tom Sargent, Ed Prescott, many others who are part of that and many Nobel Prizes have come out of that, and a tremendous amount of influence in terms of how macroeconomic modeling is done. Find me a macroeconomic model that's published today that doesn't include some level of micro founded individual agents underline the model.

You do a lot of work on a number of things, growth, economic history, solving DSG models. In fact, I think you're the first to solve DSG models using quantum annealers.

>> Jon Hartley: You're also the director of the Penn Initiative for the Study of Markets, which you're also the founder of.

Tell us what that's all about.

>> Jesus Fernández-Villaverde: Okay, so a few years ago I started to grow a little bit unhappy with the state of undergraduate education in economics. I don't think we are doing a very good job at it. I think that we go to class and we tell students a lot about Lagrangians and first order conditions and how to solve optimization problems, but we don't really give them an economic understanding of what is going on.

And I'm not against math, I use a lot of math in my research, but I think that math must be built on the foundation of understanding the economic intuition. And I also was a little bit worried that the students were a little bit separated from things like the historical background of market economies, some of the philosophical foundations of market economies, and that there was some scope for a center at Penn that could provide some of those courses.

So I want to talk with my chair and then with the Dean. I was able to get a little bit of support. Not much. It has been a little bit of a struggle, to be honest. And we have been able to offer a lot of undergraduate courses. I think this year we are offering six.

Some of them I really think are quite cool, like economics and philosophy and history of financial markets. And we also have a little bit of visitors program. So I think it's very nice, I think it has made a big contribution to the undergraduate education at Penn and hopefully to a stream of graduate students and postdocs that help us over there.

>> Jon Hartley: Well, I'm sure many students go into the Penn Economics Department and Wharton as well. Appreciate that. I want to get a bit into your research and thinking around things starting with growth. So you have a recent paper titled the Wealth of Working Nations, and in it you're estimating, I think GDP per capita across countries.

But you're also taking into account the age of the labor force, which varies pretty significantly across countries. I think Japan, most of its population is much older. So that distorts perhaps the size of its working population. Or perhaps your GDP per capita figures don't really account for some of that, the size of its working population.

Can you tell us more about that and your other thoughts on demographic trends around aging populations, declining birth rates, and obviously also declining GDP per capita growth rates across the developed world?

>> Jesus Fernández-Villaverde: Of course. So, this research came from a very simple observation. So, you know, you stop the average person in the street and you ask them, you know, give me an example of a rich economy that has not been doing very well for the last 10, 20, or 25 years.

Chances are that this person reads the financial press at all, they will immediately say Japan. So, you know, out of curiosity, I started looking at Japan and I realized, look, there are much fewer Japanese of working age now than 25 years ago, just because Japan was the first rich economy that witnessed a very, very fast drop in fertility.

And yes, Japanese work a little bit longer on average than other people, maybe 68, 69 in comparison with 65, 64 in the U.S. but even when you control for that longer working age, there are much fewer Japanese in working age now than 20 years ago. So, what I did, and this is research work with Gustavo Ventura at Arizona State and Wenjao, one of my former students at Tsinghua University, was to say, let's look at the data.

And what happens if you somehow measure GDP in these units of working age population where you try to take account, as I was saying before, of this. And then turns out to be the case that Japan is doing pretty well. In fact, over the last 15 years is the country among all the G7 that has grown the fastest.

It's just that there are fewer Japanese and in comparison, other countries that sometimes are argue are doing very well. But once you take account that there are, for instance in the U.S, many more Americans now than 25 years ago, well, the performance of the United States is not that great.

Well, it's still good, but it's not as good as some people argue. And what we are trying to say is that the present of Japan is the future of the rest of the world. I have in Britain a lot lately on demographic trends, and the biggest demographic trend is the way I always put it, winter, the demographic winter is coming.

Every country in the world, even poor and middle income economies are going through a very, very fast fertility decline, which means that there is going to be this big headwind of decreasing working age populations all across the globe. And that will force us to start rethinking about how we actually measure economic performance.

>> Jon Hartley: That's fascinating. So I guess one question I have for you when you make this adjustment to GDP per capita and change it to GDP per worker, I'm curious you're saying that Japan has been growing faster by that measure even versus the US, i'm curious what about levels though?

If you were to look at GDP, I guess per worker for getting the growth rates, is GDP per worker still much higher for the us? Cuz when I think about these GDP per capita trends, at least the story that you get from looking at GDP per capita across countries today is that most countries in the developed world, so Europe, Canada, most of Western Europe, Canada and Japan basically haven't had any GDP per capita growth or much GDP per capita growth since the global financial crisis.

And in Japan's case, even prior to that. Whereas the US just keeps growing and it's very unique and arguably maybe it's because it has this tech sector that's very unique. These tech giants and culture of entrepreneurism really maybe only exists in the US, how does that all look when you look at these GDP per worker numbers?

In terms of levels.

>> Jesus Fernández-Villaverde: Yes, so in terms of levels, the US is still much richer. Since we basically argue that once you look at everything in working age terms or in worker terms, there is no big differences in economic growth. It basically means that Canada, Western Europe and Japan have not been able to close the gap with respect to the United States.

And that's what I will bring in all the arguments you make about entrepreneurship and tech and maybe a better business environment, because something that economists believe is some idea of technological diffusion that fine. You develop some new wonderful technology on Silicon valley, but that 10 years later, 15 years later, you should be able to implement that technology in Italy or in Spain or in Germany.

And the fact that Italy, Spain or Germany or Japan, since you asked about it, do not seem to be able to close the gap with the United States, only seem to be more or less keeping up at the same level, tells you that there is something deeply wrong with those economies.

But that's a slightly different story than the story of Japan being stagnated. It's just for whatever the reason, Japan cannot close the gap with the US. And the second thing that people should really understand is if the US is going to have in 20, 30 years the current demographics of Japan, then what we are thinking now as the very, very vital and dynamic US economy may not look so vital and so dynamic 20, 30 years down the road.

And we want to keep this in mind.

>> Jon Hartley: And I, I appreciate a lot your focus on growth. And you know, I think, you know, Robert Lucas, you know, famously said it best, you know, once you start thinking about growth, you can't start thinking about anything else. And it really is so important.

The difference in say GDP per capita between the US and say China is so stark. China's maybe 1/7th the GDP per capita of the U.S. or something to that degree. That's just a massive dispersion growth whereas, or in living standards, whereas a recession, something even a very bad recession like the Great Recession might be only say a 5% sort of divot in the GDP per capita growth rate.

I'm curious what your thoughts are on just this issue of. I don't think growth and business cycles are totally independent of each other. We think about there's these things, topics of hysteresis where countries essentially never recover from really bad troughs, and they're on new paths. But I guess if we're in a world where say GDP per capita is say flat, or isn't really growing very much, how do we think about, I guess, recessions in terms of defining them, how we should respond to them if the trend starts mattering a lot more for the cycle, if that makes sense.

There's been, I think, very famous papers Britain called the cycle is the trend or the trend is the cycle, and so forth. And it's very apparent I think outside the U.S. it's a big question outside the U.S. in part because the U.S. has this very unique ability to grow out of recessions very quickly in its post war time series.

But there's been a lot more hysteresis across I think.

>> Jesus Fernández-Villaverde: Yes.

>> Jon Hartley: World outside the US, I'm curious what you think about that.

>> Jesus Fernández-Villaverde: Yes, no, I always. So let me tell you an anecdote. When I was an undergraduate student. So this is my sophomore year in college and I'm taking intermediate macro and the professor walks in and we were using the textbook back then was Darwin's Fischer.

I don't know if you used that one, maybe some of the listeners use that one. I think like page four or page five of that edition had that graph where Dorvus and Fisher draw like a linear trend and then fluctuations around that trend. And the professor comes and says, well, that's false, because that's not how the world works.

The world basically you have expansions and then you have drops and then you very rarely recover further drops. You kind of lose that 2%, you lose forever. So he says I want you to tear out that page from the book. And we are kind of, everyone is saying, well, silly thing that the professor is saying.

So he actually goes to the first row and there is this girl and I still remember her name but I'm not going to say it here in public and picks the book from the girl and takes the page and in front of all the class actually turns out the page and says I want all of you to do the same.

And of course, you know, all of us very happily took out the book and turned the page apart. So yeah, he made his point, I'm still convinced. When you look at many countries really what is happening is that you lose 2, 3 points of GDP during a recession and you don't seem to ever recover them.

And even the US you can argue after the Great Depression, the big financial crisis of 2007, 2008 probably lost around 2, 3% of GDP and we have not been able to really recover them. I'm going back to the pre financial crisis trend and I think we have more and more evidence these days that the big difference.

Between at least rich countries is that relatively poorer countries have more of these drops and they just never recover from them. So in that sense, I think the US is very peculiar and is more the exception that the norm out there. So a lot of what I have done in my own research is trying to understand these links between the business cycle and economic growth in the long run.

>> Jon Hartley: Well, that's fascinating. And I guess one wonders too, I guess if we end up having declining population growth rates, whether or not that overpowers, I guess, the growth in productivity across countries. And if that's the case, maybe we would have negative GDP growth rates would become a common phenomenon, which seems almost crazy to think growing up in.

I guess if you grew up in the late 20th century, even though growth rates have slowly declined over time from what they were at in the middle of the 20th century, at the height of advanced economy productivity booms. And we've had productivity booms like in the 90s. Do you think that negative GDP growth rates could be the norm in the future?

>> Jesus Fernández-Villaverde: Yeah, definitely. So this is the way I put it, very simple for my undergrads. So I said, look, on average the US labor productivity has been growing a little bit less than 2% a year. Let's say 1.8, 1.7 and working age population grows around 1% in a year.

So pure accounting 1.8 labor productivity growth plus 0.1. Sorry, plus 1% growth of population, of the working age population, that gives you 2.8. So that means that on average you grow 2.8. When the economy is doing well for whatever the reason, maybe a fiscal expansion, you grow 3.8.

When the economy is not doing so well, maybe the Fed is cooling down the economy 1.8. So on average you are around there. Now let's think for a second that productivity still grows 1.8 and you will see how this is a heroic assumption. But now working age population is falling 1% like in Japan.

So again, just by pure accounting 1.8 minus 1%, it means that on average you are going to grow 0.8. So as soon as the economy enters into even the mildest recession or the Fed, the monetary authority even increases the interest rates just a little bit, you go into negative growth.

Now things are going to be probably worse because we know that a lot of technological innovation is done by young people. So an economy with a lot of older people keeping a productivity growth of 1.8 is going to be very unlikely. So let's suppose that we have productivity growth of only 1.2 and you still have a drop in working age population of 1%.

It means that your average growth is going to be 0.2, which means that in around 50% of the years you are going to have negative GDP growth. And it's a completely different world. You see why thinking about demographics completely changes your scenario of how the world economy or like any advanced economy is going to look like around the year 2050.

So we are really entering into a complete different environment. And it's quite striking to me how very, very few economies have interiorized that point. And the few that have thought about it use the words artificial intelligence, because apparently artificial intelligence now is the solution to everything. But even if you think about it carefully, you know, it's very difficult to see the largest economies in the world growing very, very fast in the year 2050, given the current demographic trends.

>> Jon Hartley: It's s amazing in terms of rewriting textbooks, you mentioned the textbook that was written by Sam Fisher and Rudi Dornbusch, two famous MIT economists. It's funny how a lot of textbooks may need to be rewritten in the future. Because I guess there's a couple of definitions of recessions, and I think one of the most famous ones is two consecutive negative quarters of GDP growth.

And if we're in this new period of negative GDP growth quarters happening all the time, I think we'll have to revisit what exactly it means to be in a recession.

>> Jesus Fernández-Villaverde: Exactly.

>> Jon Hartley: And I guess we'll still have the NBR recession dating committee that's been started and led by Bob Hall for quite some time, is now led by Valerie Ramey, and both Hoover senior fellows here.

But yeah, it's gonna be interesting. I think groups like that, along with the textbook writers, macroeconomists like ourselves, are gonna have to sort of rethink what recess mean in the context of being in some sort of permanent negative GDP growth periods. But perhaps we should be defining things on a GDP per capita basis or maybe GDP per worker basis and negative productivity growth rates in that sense.

I want to talk a little bit about models, just a bit because you spent a lot of time on models and coming up with new methods for solving them. And you've done a lot of really great work on that. And so on sort of this topic, topic of business cycles and DSGE models, VAR models, curious in your mind, for listeners that may not be familiar with DSG models versus VAR, dynamic stochastic general equilibrium models versus VARs or vector autoregression models.

How do you see the strengths and weaknesses of DSGE models vs VARs? On this podcast we spent a lot of time talking to former central bankers, other macroeconomists. And funny, one recurring theme on this podcast seems to be that central bankers don't really seem to find a whole ton of value in DSGEs.

I mean, there's a bit of economic intuition that they have, but it turns out that VARs generally produced much better forecasts. But a lot of economists, central banks, are still producing these DSGE type models. I mean, what is the best case in your mind for the DSGE models?

I guess from both an economic theory standpoint and from just sort of, I guess, a practical standpoint of say, a policymaker.

>> Jesus Fernández-Villaverde: Okay, so first of all, I have written many papers on DSGE models and many papers on VARs. And as you say, I think they have advantages and disadvantages.

To me, the main advantage of a DSGE model is that it really ties down or discourse or narrative. And what I mean by that, I have also been a little bit involved in economic policy. I have seen many, many times, and I'm not going to name any concrete person, someone coming and saying, X should happen.

And let me tell you a simple regression or simple VR that tells you that X will happen if Y occurs first. And then two years later they come and they say, no, no, Z will happen if A happens. And you say, look, Z if A happens and Y if X happens.

They are incompatible, they are logically inconsistent. How do you fit this square, how do you square this circle? And I think that the DSGE models, and it's just not the DSGE models, I mean, in general equilibrium models, they really tie down your hands and they force you to think through the whole logic of the system.

Now, having said that, what people forget is that the reduced form of a DSGE model, at least when you linearize it is just a vector autoregression. It's just a vector autoregression that has a lot of restrictions imposed by theory. So if you go to the data and you estimate an unrestricted VR, of course, you are going to do a little bit better than when you estimate the restricted VR from the DSE model.

So what do you gain? You gain extra flexibility from the VR, you lose some economic interpretability, and especially you lose the ability to run a lot of counterfactuals. So if I were a central banker, what I would like to have is a battery of models that will help me to think about all these situations.

And in a metaphor that I use all the time, this is like saying, what is better, red wine or white wine? No, that's silly, okay? Sometimes you have a nice steak and you want red wine, and sometimes you're having a nice fish and you want a light white wine.

And I think that central bankers and in general policymakers should understand that economics offers a wide many of choices, and that really the ability of a great policymaker is to select the right wine pairing for the night, and that's what leads to success.

>> Jon Hartley: I might be of the view that red wine strictly dominates white wine.

>> Jesus Fernández-Villaverde: You are not European, Jon, so I need to forgive your lack of civilization.

>> Jon Hartley: It's too funny. Yeah, I mean, it's interesting, and I think it's interesting to think about the DSG literature and how much of it is really moved to central banks and finance departments away from macro departments.

I mean, do you have any general thoughts on just sort of macro as a field? I feel like there's a lot of folks from certainly the applied micro world who kind of say, well, macro models are kind of the science fiction, this work of science fiction. And a lot of them lack identification and, say, natural experiments or examples of exogenous shocks.

And of course, you can sort of take parameters, estimates from those sorts of studies and plug them into macro models. But there's a lot of assumptions even in doing that, whether it's external validity and combining all these, putting all these parameters to one model. I'm just curious, what are your thoughts on sort of the state of macro in general, and where do you think it could do better?

Are you a believer that empirical macro with better identification is kind of one future path to sort of bring more credibility revolution, maybe, to macro? Many out there, say, Jon Steinsson and Emi Nakamura and their students and many others are sort of entering. I myself am sort of one of these people as well.

But I'm curious if you have a sort of take on sort of the future of macro.

>> Jesus Fernández-Villaverde: Yeah, so a couple of thoughts over there. The first is I think that in macro, we have not been forceful enough over the last ten years to explain why we also have identification.

I think that some of the people in the applied micro, they have argued, you don't have identification in that sense, and I think that those arguments are weak. And they are weak because they are thinking about identification in a very particular context. Those type of identification arguments, I don't think they make terribly sense when you're thinking about the aggregate.

It's inherently very different to think about what is the consequence of, let's say, reducing a class size in a high school, that thinking about what are the effects of reducing the class sizes in all high schools of the United States? And I think that macro models and macro econometric tools were designed to answer the later where they are interested in the former.

And in the same way that they say, well, maybe we don't believe many of your results, my counterargument is, well, guess what, I don't truly believe a lot of your results either.

>> Jesus Fernández-Villaverde: And I think that a considerable amount of what is done in applied economics these days, I don't find it terribly useful.

Now, having said that, there is a second thought, which is I think that at this moment in macro, we are still digesting the revolution of heterogeneous agents. And we are trying to really understand where you want to apply heterogeneous agents and where you want to apply the enormous amount of micro data that we have been accumulating lately.

Myself, I have been working a lot on that over the last 10, 15 years and it's still not very clear where we want to be in the balance between a lot of detail and incorporating a lot of important margins of adjustment versus having more stylized models that are a little bit easier to understand.

So along that dimension, I think the field is still evolving and I myself don't have a 100% clear answer of where really the line between parsimony and detail should fall in the long run. What I know for sure is that we have so much new data and we have, in addition to it, so many good solution methods that this is going to transform the profession over the next ten years.

And where we will end, well, who knows? But that's why it's fun to do research, cuz we don't quite know what we are doing.

>> Jon Hartley: I feel like, you know, a lot of macro, certainly, you pointed out heterogeneous agents is one big trend in modeling recently. I think another recent trend has been trying to, I guess, maybe relax some of the assumptions around full information, rational expectations.

There's a lot of folks that work on so-called behavioral macroeconomics. And so there's a few trends there. And then even going back farther than earlier than that, I think there's for many years, and to some degree that still goes on, these massive, massive battles between sort of the various different schools of thought.

And many of these sort of crept their way into these policy discussions in public. And you sort of had very famously for a long time the sort of so-called Keynesian schools of, or maybe old Keynesian schools of Harvard and MIT, I think Paul Samuelson and many others. Versus Milton Friedman and sort of the neoclassical Chicago school, later the so-called new classical folks in Chicago and Minnesota, where you spent some time and did your PhD.

I feel like those battles loomed so large for a long time, and maybe just at the same time that applied micro folks started to gain a lot of credibility in terms of the much smaller questions that they started answering. But I'm curious, where do you think those old debates lie now?

Given that I feel like a lot of the giants of those schools have recently passed, what are we sort of left with? I've seen some papers now that try and make empirical cases that sticky wages and sticky prices are kind of the fundamental cause of recessions. But I think even some of that evidence is maybe not perfect or somewhat scant.

Obviously, the end of Minnesota sort of approach, or at least one part of it, argues that productivity shortfalls are the causes of recessions. And I think if you look at certain banking crises and tech crises, maybe that wasn't the case there. But I'm curious, what is your take on sort of schools of thought?

Do they still matter now in those battles? Do they matter less? And how do they influence your own modeling?

>> Jesus Fernández-Villaverde: Okay, so first of all, I was always a little bit unhappy about this idea of presenting macro as the struggle between two schools. Three schools or I think when I was an undergrad I even read this book about the seven schools of macro because it really gives undergraduates the impression that this is like picking your soccer team, that you are either Real Madrid fan or Bayern Munich fan.

And in fact most people try to look at the data, try to look at the theory and try to make a consistent answer. My own reading of the situation was that kind of the Minnesota, Chicago, Rochester won in terms of methodology. They insisted that you wanted to be very explicit about the micro foundations, about how people made decisions about information flows, about being sure that general equilibrium restrictions hold, while perhaps more of the MIT harbor side warned in terms of substance, of saying, look, financial frictions matter, nominal rigidities probably matter a lot, markets quite often do not clear or output is demand determined.

And I think that by the early 2000s, especially as you were saying, some of the older generation start passing away or maybe not yet passing away, but at least been a little bit older and retiring from active research. The next generation was a little bit less personally invested in some of the, you know, more sticky discussions and much more open to think about in constructive cumulative terms.

This is still the case today that when you go to the market and you read your market papers, it's easy to tell if this is a macro person from MIT or a macro person from Chicago, but the difference is probably smallest that it has ever been. And I think that what we are trying to figure it out is okay, fine, people don't.

You were mentioning before behavioral, and I fully agree with the idea that people don't have full information. You asked me today, for instance, what is the exchange rate between the US and the Euro? I'm going to get it probably perhaps within 5%. And look, I'm an economist from Spain living in the US.

So if there was someone who should know the exchange rate between the Euro and the US dollar, it should be me. And yet I only have a fussy idea about it. On the other hand, we want to think a little bit carefully about how people, if people are building their beliefs and people are coming up with rules of thumb, we want to be a little bit more constructive that just say no, people is silly and make systematic mistakes.

My impression was always that a lot of behavioral macro was a little bit like that. Or let me assume that people make this mistake or have this bias and let's look at the consequences. I think that much more productive, and that's something I have been working on lately, is thinking about, well, let's Imagine that people have very simple learning systems and are using deep neural networks and say, well humans actually our brains are just deep neural networks how we learn about that.

Can we come up with simple rules of thumb given the observations? And that gives us a constructive way to work out through these things. So in that sense, you know, I think that we are making progress and we are certainly moving forward and I think we are going to see very good work on this area over the next ten years or so.

>> Jon Hartley: It's interesting cuz I guess behavioral macro is all about how, I think a lot of behavioral economics for a long time was just sort of making this point that well, people actually don't maybe follow full information rational expectations correctly. Which is hard to kind of argue in the sense that you sort of have to argue that one that there isn't some sort of a systematic model out there.

But if, I guess the sort of new holy grail of I feel like of sort of behavioral economics or behavioral macro as well is how do people systematically make mistakes and what biases or how are people actually thinking I guess in terms of complex systems or you're talking about neural nets but it hasn't been quite enough to just I guess say on the part of Thaler and others will look this is a violation of these past assumptions.

Well, maybe we just had the utility functions wrong. What are the correct or what are the better utility functions? And how do you square a lot of micro evidence with our models? And I feel like that's still very much an ongoing debate. On the schools side of things, it's amazing in all our ECON 101 textbooks one of the first things we're taught in macro is that there are these different schools of thought.

And I do wonder how the textbooks will be written in the future given that maybe they matter a bit less. But I do think there's some very real world implications of some of these shifts in terms of. I think you're right in saying that MIT and Harvard is one the substance of things.

But I think because of that we only in models tend to care about interest rates or tend to include interest rates. So things like monetary aggregates or money are completely withdrawn or non-existent. Whereas a lot of people on Wall street for example would like to point out that look at M2Is was rising a lot when we saw inflation in the early 2000 and twenties.

And even some Minnesota type economists who I know some new classical economists who I know who are still around, some younger, some older still sort of bemoan that shift in the sense that sure, maybe monetary aggregates can't be used as a tool because my demand isn't really predictable, but at some level it still explains inflation.

Well, when you see big jumps in M2 various monetary aggregates, I'm curious if.

>> Jesus Fernández-Villaverde: Yeah.

>> Jon Hartley: You have thoughts on that as a minister.

>> Jesus Fernández-Villaverde: Yeah, actually, this is interesting that you bring this up because around 2010, 2011 there, maybe even a little bit earlier 2009, there was all this discussion in particular from people in financial markets about how the big monetary expansion at the Fed at the time quantitative easing was to create a lot of inflation, maybe even hyperinflation.

And I remember I had an MBS student shouting in my class at Wharton that we were going to have hyperinflation. And my thinking at the moment was the very basic fiscal theory of the price level that basically states that you want to think about really the interaction between the fiscal side and the monetary side of policy and that if the fundamental deficits of the future, parts of deficits have not changed, issuing more money, the only thing you are doing is you are switching one type of debt of the public government, which is long term debt, for another type of debt, which is the short term debt that we call money.

And that was not going to have much an effect. In fact there is a very famous paper by Neil Wallace in American economic review, either 1981 or 1982 that basically shows an irrelevance theory. Anyway, I made that argument and I remember. So I basically said, look, there is not going to be inflation, don't worry, there will be no inflation over the next 10 years.

And I think that was a big victory for economic theory and it was a big victory for macroeconomics and anyone who had studied macroeconomics seriously at the time. And I remember because I had a few friends in the financial markets and man did I get hate emails like you don't know anything.

You are typical ex head at the university that don't understand anything whatsoever. I'm moving all my investment into inflation protected asset classes. And I was telling them there is not going to be any inflation, don't worry about it. And, I guess that even by 2019 when we were talking about this 2020, they were still saying okay.

Inflation didn't happen, but we are not quite sure why we are unwilling to believe the fiscal theory of the price level. And I guess on the other hand, in 2021, I was among the ones who argue, again, think through the logic of the fiscal theory, the price level.

Now, we are going to have inflation. And again, now I guess that there were people who kind of overlearned the lesson. You know that old joke that we always generals always fight the last war. And people were saying, there was no inflation in 2010. There is not going to be inflation either now.

And I was saying, no, no, no, no, no, because the argument is completely the opposite. The argument is now we are changing structurally the fiscal situation of governments with everything we did around Covid, and we are also changing the supply curve of the economy. And that's very different from what happened in 2010.

Now, we are going to have inflation. And again, my, the same friends from the financial markets were telling me, no, no, no, no, no, this is not going to happen. And guess what? We had inflation. So in that sense, even if this is not something that macroeconomists are really bragging about, I will say that macroeconomics were successful.

Okay, let me be very careful. The macroeconomics that you will learn in the standard first year graduate school textbooks was very successful at predicting both the lack of inflation in the early 2010s and inflation in the early 2020s. A very different thing is that the type of people that write for the New York Times or the type of people who write for the Wall Street Journal are a very particular subset of the profession.

And some of them, I have strong reasons to believe, are not really up to date on the best economic theories. And they say silly things because they are playing a different game. They are playing the rhetorical game. They are not playing the game of trying to understand the world.

>> Jon Hartley: Well, I guess like one response that I may have in I partially one of the things I say is fiscal theory. One of the things I think I just find a little challenging with fiscal theory is measuring expectations about future deficits, right? And you can do certain things.

You can look at centuries of data and maybe assume that people have unbiased expectations. I's a huge assumption, and try and test the theory that way. But at some level, it's hard to know, and you can't really follow CBO forecasts just because of their current policy and current law and so forth and don't really reflect what fiscal expectations are.

And the story that perhaps John Cochrane or Eric Leeper would tell is that one in 2008 and 2009, when there was a big fiscal spending, there was a promise to pay it back. Whereas in this case, with the early 2000s fiscal stimulus, there weren't any promises to pay it back.

And I think that it's certainly, I think, a somewhat compelling story. But how you actually measure that, as someone who's just an empirical macro person, I feel like it's a bit of a difficult to measure thing. Whereas you look at something like M2, for example, in the 2010s QE, M2 didn't really go up a whole lot, and why?

Because when all the central bank was doing was buying up treasuries and swapping them with reserves. Whereas what I think was fundamentally different. And you also had a stimulus that was very focused on government spending with the ARRA or American Recovery Reinvestment Act. Whereas the early 2000s fiscal stimulus was really all about transfers, whether it was stimulus payments, unemployment insurance, PPP and so forth.

And so in that case, you had this massive uptick in monetary aggregate measures like M2, and why? Because the amount that was going, all this fiscal stimulus was in part going into people's demand deposits, which are measured in M2. So you had a massive jump this time, something that you didn't have last time.

So the character of fiscal policy was very, very different in the early 2020s versus 2008, 2009, and I feel like that matters. I'm curious if you have any thoughts on that, even though essentially very similar QE was embarked upon.

>> Jesus Fernández-Villaverde: Okay, so first of all, for those listeners who know more about this fiscal theory of the price level, I have joke on a few conferences and interviews that I'm a moderate fiscal theory of the price level person in comparison with both Eric and John.

Eric Leeper and John Cochrane, who I will say they are like the purest, the pure orthodox fiscal theory of the price level. I'm more of a moderate that puts a little bit of fiscal of the fiscal theory of the price level with a little bit of NEO models.

So in that sense, I'm perhaps closer to Chris Sims. So in that sense, I also think that issues related with supply and with prices stickiness matter. But I think that the explanation you just gave me, I will argue, is a fiscal explanation. And that really the only difference between what I tried to say before and the way you put it is more on the emphasis or in the pure rhetorical aspect of, in the sense of discourse of how you structure the argument that in the substance.

And basically in 2000, okay, let me put it in the following way. In 2010, people were not going to the restaurant because they didn't want to go to the restaurant. They were worried, they wanted to save. And what the Fed is doing is saying well I'm going to take your 30 years bonds, and I'm going to give you cash instead.

And people are saying okay, how is this changing my situation? How is this changing the issue that I'm worried about the future and that I don't want to save a lot. While exactly as you say in 2021 people are not going to the restaurant because they are afraid of COVID, so we send them $500, and we tell them, go and ask on DoorDash.

And then, yes, people went and start ordering a lot of takeout at DoorDash. So I think we were basically saying the same. But the point I was trying to say is that if you pick, I would say the top 10 macroeconomists in academia in 2010 and in 2020, 21, they probably did a much better job in forecasting inflation not in like the next month.

But like in the big picture of what was going to happen using a standard tools of economic theory that what the savvy people from the financial markets did. And I think we should be proud of it and be, brag about it because people are not really getting this point.

>> Jon Hartley: Yeah, I guess like it's. So I think there's still a difference to be made though with I guess like both sort of monetarist and even your sort of old Keynesian Islam like reasoning which is more, more static. And where saying that look there were all these transfers today and that's what was causing inflation.

And now, I mean there were lots of people saying it was all about supply chains and so forth, and it can be both too, right? Like a supply curve shifting leftward and a demand or an aggregate demand curve shifting, shifting right can produce inflationary conditions together. But I think, there is still a big difference in terms of just the mechanisms.

Whereas the IS-LM and Montrose models are very sort of static models.

>> Jesus Fernández-Villaverde: Yes.

>> Jon Hartley: Fiscal theory at the price level is really all about expectations. And I still think there's a big difference there.

>> Jesus Fernández-Villaverde: Okay, that's fair enough. But I think that what the fiscal theory of the price level, even if you just go back to the very old school of Wallace and Sargent and Wallace and unpleasant monetaristic.

Arithmetic says, I think, that both the old Keynesian story and the monetary story miss a fundamental linchpin, which is the connection between fiscal and monetary theory, sorry, policies, and that if you think about just one of them in isolation from the other, chances are that you are going to make systematic mistakes in how you think about the world.

And what the fiscal theory of the price level, with all its limitations is telling you really try to think about these two things together and to me, that's a big advice.

>> Jon Hartley: Yeah, I think that's right. And I think, at some level, a lot of these models are somewhat observationally equivalent.

So it is really difficult to really distinguish, say, between them. There's something to be said, I think too, about what central banks have actually been doing too, which is these massive QE largely announcements or central bank swap line announcements that seem to have this ability to quell financial panic and provide liquidity to the financial system in moments of panic.

Which is a bit of a different thing than say, the fiscal policy, fiscal transfers, say, causing inflation through these different mechanisms and all that's something that's due in terms of how central banking is done. I want to just pivot a little bit to economic history. You're working on an economic history book.

Tell us a little bit more about that. You've done a lot of really great work on things like Fractured Land Hypothesis, many other great works of economic history. I'm curious. Tell us more about your economic history interest in your forthcoming book.

>> Jesus Fernández-Villaverde: Okay, so first of all, I guess I was always a little bit more interested in economic history than macro when I went to college.

Economic history when I went to college was a little bit boring. It was about textiles in Yorkshire. So we basically, spent one semester in my freshman year in college learning about the spinning Jenny and the mule and I'm probably getting all these things wrong, but about textiles in Yorkshire during the late 18th century.

And that to me was so boring. So I kind of lost interest in economic history at the time. At the same time, I was always very concerned about, let me call the big, big picture questions. In one particular case for me, since I'm from Spain, is why did Spain miss the train of industrialization in the 19th century?

Why then did Spain industrialize in the second half of the 20th century? And as we were saying before, why Spain? Convergence to the level of the US stagnated by the late 1980s. So I was always very concerned about these issues. And most of the answers that people were given were loose, they were kind of big ideas, but not really trying to sit down and thinking about them.

And in the late 1990s, early 2000s, we started having a new generation of economic history and of course this year the Nobel Prize went to Daron Acemoglu, Simon Johnson and Jim Robinson, which I'm very happy about precisely because they brought in those big questions back into the center of economics.

And we can fight a little bit at the margin whether or not the instrument that they use is the right instrument or not, but to me, those discussions miss the big point. And the big point was to say, look, the really big issue is why did Japan industrialize and China did not?

Let's try to work through this and let's try to use the modern tools of economics to work about it. So I thought, Gee, this is in some sense what I wanted to do from the beginning. So I went and asked to be allowed to teach a class on economic history.

And I was lucky enough that my dean accepted that proposal and I have been working since then on a book. So now last week I was actually at Northwestern and I bumped into Joel Mokir. Joel Mokir, the book is under contract with him for Princeton University Press and he gave me what I think you guys call a dress down.

He basically told me what is happening with the book. So the book is suffering from two problems. The first one is I think I've been a little bit over ambitious by now. I think I have like 800 pages and that's probably too many and I'm still not even like one-third down.

The second one is I really, really need to find, let's say six, nine months in a desert island at the top of a mountain, in a monastery away. Just yesterday I woke up in the morning and I said, today is Thursday. I'm going to work on the book for the whole day, impossible.

I got like 200 emails and just handling emails, answering students, working with co-authors. So I really need. So my main goal now in life, if anyone knows about that monastery, please let me know. Find a place where I can go hide for nine months and finish the book.

So I will say the book.

>> Jon Hartley: There's a place in California called Hoover.

>> Jesus Fernández-Villaverde: Yeah, I keep telling them that. They don't seem to get the hint. But really go in a place, hide for nine months, disconnect myself from the Internet. Internet, send my wife to a wonderful, touristic trip around the world and finish the book.

And I really like the drafts that I have, I have shown it to some people, and the drafts of the chapters I have, I think it's a very creative and innovative book. I'm really bringing, like, everything we have learned about economic history over the last 20 years. It's just that it's a global economic history textbook, it's a lot of effort and you really need to spend a lot of time learning stuff.

So, for instance, last year I wanted to write about Latin America, like the chapters thinking about why Latin America fail. So I basically had to learn a lot about Latin America economic history, I didn't know that much myself. And that was fun and I spent like maybe nine months.

So now I'm your person, I'm the guy. If you want to ask questions about Argentinian economic history in the 19th century, I know how to answer them. But

>> Jon Hartley: Would you describe yourself as economic institutions? Like, is what your sort of fundamental cause?

>> Jesus Fernández-Villaverde: Yes. So my punchline yes is institutions.

I think some countries, for whatever the reason, can get the institutions right, and some countries don't. So let me give you an example of my favorite question, I asked this question in nearly, I would say 50% of my midterms. And I don't ask that question more often because otherwise, the students will be able to forecast it perfectly.

Why did the oil industry first appear in the United States? The United States doesn't really have a lot of oil in comparison with other countries. And yet the United States is even today the largest oil producer in the world. Well, because there is a fundamental difference between the US and nearly every other country in the planet.

If I go back to my backyard, I'm looking at my backyard now through the window, and I dig and I find something, it's mine. If I go to the backyard of my dad in Spain and I dig and I find something, is the government's, okay? Is what, for instance, in the British common law system was, in the English common law system is called crown's property.

So if in a country where I dig. And that belongs to the government. You are not going to have a lot of digging in a country where you dig and that's yours, you are going to have a lot of digging. So the US develop a very vibrant. The first oil industry in the world and even to today is the main technological leader in oil industry is precisely what we have, why?

Because the US has better institutions. It's not that the US institutions are perfect, the area is better. Now, what I think I differ perhaps not, but perhaps a little bit from some of the other institutional guys is that I like to link this a lot with a rich historical narrative, trying to understand these institutions.

Yes, they appear, but they appear because of the confluence of a lot of different reasons. It's kind of hard to have a one-size-fits-all. The US is in the way the US because of a lot of events, and a lot of them were random and a lot of them were more structural.

And what I'm trying to tell is a history that highlights institutions. On the other hand, I also trying to be very balanced. And in the book I try to also give some, I will say reasonable amount of space to alternative theories and say, look, maybe there is some other type of officials that may be important.

>> Jon Hartley: Like culture, geography.

>> Jesus Fernández-Villaverde: Yeah, exactly. So geography, I give a lot of space. And the reason for that is because I actually don't think that geography per se matters that much. But for instance, you mentioned my work before on the fractured land. Geography is key on determine the type of institutions that you have.

And these things matter in a lot of subtle ways. And I don't think that economies and economic histories experience have really work out all those subtleties and all those nuances.

>> Jon Hartley: Yeah, and I agree, I think there's a lot of these nuances to work through. With institutions as well, Acemoglu, Robinson and Johnson just won the Nobel.

I think institutions matter a lot for growth, but which institutions and why? It's a huge question. And I think even their taxonomy of inclusive versus extractive institutions isn't perfect, I think. And I asked Daron Acemoglu, and this when he came on the podcast, which is I think, at some level how do you explain the success of what I would call liberal economic institutions or massive market reforms?

If you look at India in the early 90s or Chile in the late 20th century, or you look at Eastern Europe after the fall of the USSR and a lot of these sort of stories about inclusive versus extractive institutions? I don't think it fully answer that. But it's been a real honor to have you on and hear about your career and ideas.

You're also a prolific Op-ed writer in Spain as well in your home country. And I highly recommend that our listeners check out both all your academic writings as well as your popular writings as well. Thank you so much for joining us.

>> Jesus Fernández-Villaverde: Thank you. Thank you for having me.

>> Jon Hartley: This is the Capitalism and Freedom in the 21st Century podcast, an official podcast with the Hoover Economic Policy Working Group, where we talk about economics, markets, and public policy. I'm Jon Hartley, your host. Thanks so much for joining us.