Tag: Economic Theory

Musings on the current episteme of the Federal Reserve

Posted on by Brad DeLong

Larry Summers attributes the Federal Reserve’s decision to tighten policy, in what appears to him and to me to be a weakly-growing and high-slack economy, to four mistakes, which are themselves driven by a fifth, overarching mistake. The four mistakes are:

  1. The Fed has much too much confidence in its models that tell it that the unemployment rate takes the temperature of the labor market and the Phillips Curve now still has the slope it had in the 1970s.
  2. The Fed operates as though FOMC members are tased whenever inflation rises above 2%/year, with no countervailing painful consequences of low inflation, low employment, or low output.
  3. The Fed believes–without empirical support anywhere that I can see–that quick sharp moves up or down in interest rates have larger effects in total than the same interest-rate change made gradually and over a longer term.
  4. The Fed thinks–without theoretical support that I can see–that zero interest rates are not a reflection of an economy in a pathological state, but rather a cause of economic pathology that is dangerous now that the economy is once again “normal”.

And Summers sees the fifth, overarching mistake the Fed is making right now as:

(5) The Fed is excessively committed to “existing models and modes of thought… in the thrall of orthodoxy”:

Larry Summers: My Views and the Fed’s Views on Secular Stagnation: “First, the Fed assigns a much greater chance that we will reach 2 percent core inflation…

…than is suggested by most available data…. Second, the Fed seems to mistakenly regard 2 percent inflation as a ceiling not a target…. Third, the Fed seems to be in the thrall of notions that… do not… have analytic support premised on the idea that the rate of change of interest rates, as distinct from their level, influences aggregate demand…. I know of no model in which demand will be stronger in say 2018 if rates rise and then fall than if they are kept constant at zero. Nor… do I know of a reason why recession is more likely if the changes are backloaded…. The argument… is in the category with the argument that I should starve myself in order to have the pleasure of relieving my hunger pangs. Fourth, the Fed is… overestimating the neutral rate…. The desire to raise rates reflects… a sense that zero rates are a sign of pathology and an economy creating 200,000 jobs a month is not diseased….

Why is the Fed making these mistakes if indeed they are mistakes? It is not because its leaders are not thoughtful or open minded or concerned with growth and employment.  Rather I suspect it is because of an excessive commitment to existing models and modes of thought…

I do think–confidently–that Summers is absolutely 100% correct in his identification of the four component intellectual errors that the Federal Reserve is currently making. And it is certainly true that these are the result of an excessive commitment to some current modes of thought–there are, after all, a lot of people who join the Fed in thinking that zero interest rates are a cause rather than the proper treatment of pathology right now, that the Fed needs to raise rates now to give it the space to lower them if need be later, that it is dangerous for inflation to rise above 2%/year ever, that the Phillips Curve somehow has a steeper slope than the recent evidence of the past generation can justify belief in, and that the unemployment rate rather than the detrended employment-to-population ratio gives the temperature of the labor market.

But do these beliefs on the part of the Fed really reflect an excessive commitment to existing models? There I have my doubts. Or, rather, it depends on what you think the proper function of economic modeling is. Are models properly idea-generating machines, in which you start from what you think is the case and use the model-building process to generate new insights? Or are models merely filing systems–ways of organizing your beliefs, and whenever you find that your model is leading you to a surprising conclusion that you find distasteful the proper response is to ignore the model, or to tweak it to make the distasteful conclusion go away?

Both can be effectively critiqued. Models-as-discovery-mechanisms suffer from the Polya-Robertson problem: It involves replacing what he calls “plausible reasoning”, where models are there to assist thinking, with what he calls “demonstrative reasoning”. in which the model itself becomes the object of analysis. The box that is the model is well described but, as Dennis Robertson warned,there is no reason to think that the box contains anything real. Models-as-filing-systems are often used like a drunk uses a lamp post: more for support than illumination.

In the real world, it is, of course, the case that models are both: both filing systems and discovery mechanisms. Coherent and productive thought is, as the late John Rawls used to say, always a process of reflective equilibrium–in which the trinity of assumptions, modes of reasoning, and conclusions are all three revised and adjusted under the requirement of coherence until a maximum level of comfort with all three is reached. The question is always one of balance.

But it is clear to me that if you give even minor weight to the first–see well-founded models as a way of generating new insights rather than just organizing old beliefs–that the line of work into the economics of the liquidity trap that I see as well-represented by Krugman’s (1999) “Thinking About the Liquidity Trap” tells us, very strongly, that the Federal Reserve is on the wrong track intellectually right now. It tells us that what is out of whack has not been and is not the real money stock, but is instead the expected inflation rate. Or, rather, that because the expected inflation rate is too low, there is no value of the real money stock consistent with full employment equilibrium. If expected inflation were higher, the existing money stock would be ample, or even require shrinking.

This is the conclusion of Krugman (1999): that the economy needs higher expected and actual inflation, and that the free-market economy with full price flexibility would deliver that inflation. But the Fed does not appear to acknowledge either that the economy needs higher inflation, that the flexible-price benchmark would deliver this inflation, or that the job of the Fed is to mimic that full employment-generating price structure as closely as possible.

Moreover, the Fed does not engage in reflective equilibrium. It rejects the conclusions of what I regard as the standard Patinkin-style existing model of Krugman (1999). But it does not propose an alternative model. There seems to me to be no theoretical ground, no model even considered as a filing system, underpinning the “orthodox” modes of thought that the Fed believes. And it does not seem to feel this absence aaa a problem. I find that somewhat disturbing.

Must-Read: David Leonhardt: ‘Chicagonomics’ and ‘Economics Rules’

Posted on by Brad DeLong

Must-Read: David Leonhardt: ‘Chicagonomics’ and ‘Economics Rules’: “Adam Smith’s modern reputation is a caricature…

…He was a giant of the Enlightenment in large part because he was a careful and nuanced thinker. He certainly believed that a market economy was a powerful force for good…. Yet he did not have a religious faith in the market…. Lanny Ebenstein’s mission, in ‘Chicagonomics,’ is to rescue not only Smith from his caricature but also some of Smith’s modern-day acolytes: the economists who built the so-called Chicago school of economics…. Ebenstein argues that the message of the Chicago school has nonetheless been perverted in recent years. Many members of the Chicago school subscribed to ‘classical liberalism,’ in Ebenstein’s preferred term, rather than ‘contemporary libertarianism.’…

Dani Rodrik… has written a much less political book than Ebenstein has, titled ‘Economics Rules,’ in which he sets out to explain the discipline to outsiders (and does a nice job)…. Rodrik has diagnosed the central mistake… [of] contemporary libertarians have made… conflat[ing] ideas that often make sense with those that always make sense. Some of this confusion is deliberate… act[ing] as a kind of lobbyist working on behalf of the affluent…

What is the free-market solution to a liquidity trap? Higher inflation!

Posted on by Brad DeLong

Three seventeen-year old quotes from Paul Krugman (Paul R. Krugman (1998): It’s Baaack: Japan’s Slump and the Return of the Liquidity Trap, Brookings Papers on Economic Activity 1998:2 (Fall), pp. 137-205):

Suppose that the required real rate of interest is negative; then the economy ‘needs’ inflation, and an attempt by the central bank to achieve price stability will lead to a zero nominal interest rate and excess cash holdings…

And:

In a flexible-price economy, the necessity of a negative real interest rate [for equilibrium] does not cause unemployment…. The economy deflates now in order to provide inflation later…. This fall in the price level occurs regardless of the current money supply, because any excess money will simply be hoarded, rather than added to spending…. The central bank- which finds itself presiding over inflation no matter what it does, [but] this [flexible-price version of the liquidity] trap has no adverse real consequences…

And:

A liquidity trap economy is “naturally” an economy with inflation; if prices were completely flexible, it would get that inflation regardless of monetary policy, so a deliberately inflationary policy is remedying a distortion rather than creating one…

Thinking about these three quotes has led me to change my rules for reading Paul Krugman.

My rules were, as you remember:

  1. Paul Krugman is right.
  2. If you think Paul Krugman is wrong, refer to (1).

They are now:

  1. Paul Krugman is right.
  2. If you think Paul Krugman is wrong, refer to (1).
  3. And even if you thought Paul Krugman was right already, go reread and study him more diligently–for he is right at a deeper and subtler level than you would think possible.

Let us imagine a fully-flexible distortion-free free-market economy–the utopia of the Randites. Let us consider how it would respond should people suddenly become more pessimistic about the future.

People feel poorer. Feeling poorer, people want to spend less now. However, today’s productive capacity has not fallen. Thus the market economy, in order to incentivize people to keep spending now at a rate high enough to maintain full employment, drops the real interest rate. It thus makes the future more expensive relative to the present, and makes it sufficiently more expensive to incentivize keeping real spending now high enough to maintain full employment.

The real interest rate has two parts. It is equal to:

  1. the nominal interest rate,
  2. minus the inflation rate.

If money demand in the economy is interest elastic, the fall in the real interest rate will take the form of adjustments in both pieces. First, the free-market flexible-price distortion-free economy’s equilibrium will shift to drop the nominal interest rate. Second, the equilibrium will also shift to drop price level will drop immediately and instantaneously. Then the subsequent rebound of the price level back to normal produces the inflation that is the other part of The adjustment of the real interest rate.

If money demand takes the peculiar form of a cash-in-advance constraint, then:

  1. the interest elasticity of money demand is zero as long as the interest-rate is positive, and then
  2. the interest elasticity of money demand is infinite when the interest-rate hits zero.

In this case, the process of adjustment of the real interest rate in response to bad news about the future has two stages. In the first stage, 100% of the fall in the real interest rate is carried by a fall in the nominal interest rate, as the price level stays put because the velocity of money remains constant at the maximum technologically-determined rate allowed by the cash-in-advance constraint. In the second stage, once the nominal interest rate hits zero, and there is no longer any market incentive to spend cash keeping velocity up, 100% of the remaining burden of adjustment rests on the expected rebound inflation produced by an immediate and instantaneous fall in the price level. These two stages together carry the real interest rate down to where it needs to be, in order to incentivize the right amount of spending to preserve full employment.

The free-market solution to the problem created by an outbreak of pessimism about the future is thus to drop the nominal interest rate and then, if that does not solve the problem, to generate enough inflation in order to solve the problem.

Now we do not have the free-market distortion-free flexible-price economy that is the utopia of the Randites. We have an economy with frictions and distortions, in which the job of the central bank is to get price signals governing behavior to values as close as possible to those that the free-market distortion-free flexible-price economy that is the utopia of the Randites would produce.

In particular, our economy has sticky prices in the short run. There can be no instantaneous drop in the price level to generate expectations of an actual rebound inflation. If the central bank confines its policies to simply reducing the nominal interest rate while attempting to hold its inflation target constant, it may fail to maintain full employment. Even with the nominal interest rate at zero, the fact that the price level is sticky in the short-run may mean that the real interest rate is still too high: there may still be insufficient incentive to get spending to the level needed to preserve full employment.

A confident central bank, however, would understand that its task is to compensate for the macroeconomic distortions and mimic the free-market flexible-price full-employment equilibrium outcome. It would understand that proper policy is to set out a path for the money stock and for the future price level that produces the decline in the real interest rates that the flexible-price market economy would have generated automatically.

Thus a confident central bank would view generating higher inflation in a liquidity trap not as imposing an extra distortion on the economy, but repairing one. The free-market flexible-price distortion-free economy of Randite utopia would generate inflation in a liquidity trap in order to maintain full employment–via this instantaneous and immediate initial drop in the price level. A central bank in a sticky price economy cannot generate this initial price-level drop. But it can do second-best by generating the inflation.

All of my points above are implicit–well, actually, more than implicit: they are explicit, albeit compressed–in Paul Krugman’s original 1998 liquidity trap paper.

And yet I did not come to full consciousness that they were explicit until I had, somewhat painfully, rethought them myself, and then picked up on them when I reread Krugman (1998).

On the one hand, I should not feel too bad: very few other economists have realized these points.

On the other hand, I should feel even worse: as best as I can determine, no North Atlantic central bankers have recognized these points laid out in Paul Krugman’s original 1998 liquidity trap paper.

Central bankers, instead, have regarded and do regard exceeding the previously-expected level of inflation as a policy defeat. No central bankers recognize it as a key piece of mimicking the free-market full-employment equilibrium response to a liquidity trap. None see it as an essential part of their performing the adjustment of intertemporal prices to equilibrium values that their flexible-price benchmark economy would automatically perform, and that they are supposed to undertake in making Say’s Law true in practice.

But why has this lesson not been absorbed by policymakers? It’s not as though Krugman (1998) is unknown, or rarely read, is it?

It amazes me how much of today’s macroeconomic debate is laid out explicitly–in compressed form, but explicitly–in Krugman’s (1998) paper and in the comments by Dominguez and Rogoff, especially Rogoff…