Uneasy Money

Commentary on rational expectations since the 2011 Nobel Prize in economics was awarded to Tom Sargent and Chris Sims continues to pour in.  Last week, in addition to a post of my own, John Kay posted a hostile assessment of rational expectations on his website, prompting a half-hearted defense of sorts from Matt Yglesias likening the rational expectations revolution to the Copernican Revolution, a comparison of which Noah Smith, launching a renewed attack on rational expectations and its claims to have transformed economics into a hard science, heartily disapproves.  In today’s Financial Times, John Kay returns to the attack with an ironic jab at the Nobel committee for avoiding any mention of rational expectations in its citation of Sargent and Sims, and some well-aimed barbs at the pretensions of rational expectations to a sort of infallible knowledge.

I agree with these criticisms of rational expectations, though as I suggested, the rational-expectations hypothesis can be, and often is, a useful one.  Rational expectations only becomes dangerous when transformed from an empirical hypothesis and a way of testing the coherence of a model into a methodological principle and an axiom purporting to embody a necessary attribute of the world, on the order of Newton’s laws of motion.  Thus, through a program of methodological imperialism, rational expectations has been imposed on much of mainstream economics as the only acceptable modeling strategy.

The spirit of this methodological imperialism is captured remarkably well by the abstract to the entry on “calibration” contributed by Edward Prescott and Graham Candler to the New Palgrave Dictionary of Economics, second edition.

The methodologies used in aerospace engineering and macroeconomics to make quantitative predictions are remarkably similar now that macroeconomics has developed into a hard science. Theory provides engineers with the equations, with many constants that are not well measured. Theory provides macroeconomists with the structure of preference and technology and many parameters that are not well measured. The procedures that are used to select the parameters of the agreed upon structures are what have come to be called ‘calibration’ in macroeconomics.

I would like to comment on another aspect of the methodological imperialism of rational expectations which is its reductionism.  (The reductionism of rational expectations has, to my knowledge, been noted only by Allesandro Vercelli in a paper “Keynes, Schumpeter and Beyond:  A Non Reductionist Perspective” in A Second Edition of the General Theory, edited by G. C. Harcourt.)  In philosophy, reductionism refers generally to the idea that all higher level (i.e., more particular theories) are (can be? will be?) ultimately derived from and translatable into (can be reduced to”) lower-level, deeper, theories.  Thus, the laws of chemistry, geology, astronomy, meteorology, biology (?) can ultimately be “reduced to” the laws of physics.

One field in particular in which the idea of reductionism is very much alive and discussed is in the nexus between brain science and the philosophy of mind — the old mind-body problem.  Many philosophers and brain scientists argue that all mental states are “reducible to” physical states.  The problem with reductionism in brain science and the philosophy of mind is that, unlike chemistry and physics, where the reduction is to some (unknown to me) extent already worked out, there is not even a glimmer of understanding of the physics that would allow one to derive mental states from physical states.  Thus, reductionism in brain science and the philosophy of mind is a purely metaphysical notion that has no basis in known science.  (Admittedly, I am speaking largely out of relative ignorance of the relevant philosophy and total ignorance of the relevant science, but my impression is that there are philosophers and scientists who would agree with my assertions about the current state of brain and physical science.)  Moreover, even if we had all the science worked out, it is still not clear that mental states would in fact be reducible to physical states because there is not necessarily any way of bridging the chasm between mental and physical.

Rational expectations as a methodological principle requires that agents in every model base their decisions on the expected values of the stochastic variables, ruling out divergent expectations among agents, thereby promoting the adoption of representative agent models.  Macroeconomic models not derived from explicit utility or wealth-maximizing assumptions and rational expectations are inadmissible.  This sharply limits the possibility for deriving anything like what Keynes referred to as involuntary unemployment.

Thus, involuntary unemployment is to rational expectations theorists what consciousness is to mental reductionists.  Even though we all have direct experience of consciousness, mental reductionists deny that there is any such thing as consciousness (which obviously is a far stronger claim than that consciousness is a figment of our imagination).  Similarly, rational expectationists deny that there is such a thing as involuntary unemployment even though we seem to have plausible evidence that there are people who would be willing to work at the prevailing wage but are unable to find work.  One can imagine that such evidence for involuntary unemployment might be discounted, but generally to do so, one would have to be able to provide a plausible reinterpretation of the evidence combined with compelling independent evidence that supported an alternative theoretical conclusion.  But where is the compelling alternative evidence of the rational expectationists?  And what is the plausible reinterpretation of the plausible evidence that there is involuntary unemployment?  Rather than confront these issues squarely, rational expectationists simply insist that they are following the dictates of rigorous science.  But their conception of rigorous science confuses an axiomatic method designed to deduce logical inferences from a set of assumptions and definitions with an attempt to compare the implications of alternative hypotheses with the evidence.  The latter it seems to me is closer to true science than the former, unless your conception of true science is very close to that of Ludwig von Mises.

In yesterday’s post about the effects of QE2, I discussed the tendency of an increase in expected  inflation to cause the prices of real assets, including the prices of commodities, to increase.  That is, if we expect prices to rise in the future, we will choose to reallocate our asset holdings, exchanging cash for physical assets, driving up the prices of those assets in the process.  So the expectation of increased inflation occasioned last year by the announcement of QE2 undoubtedly was one factor in causing the subsequent run-up in commodity prices, expectations of accelerating economic growth and negative supply shocks being two others.

However, the rise in commodities prices triggered by an increase in expected inflation is not the same as an increase in inflation.  Rather it is a once-and-for all adjustment in the relative values of physical assets and money associated with the inflation-induced shift in desired asset holdings.  If inflation stabilizes at the newly expected rate, commodities prices will not continue to rise faster than the rate of inflation (for purposes of this exercise I am assuming that inflation is uniform across all good and services).  But this also means that measured inflation will tend to overshoot the new higher expected steady-state rate of inflation.  I note again that other factors probably contributed to the temporary spike in inflation, but increased inflation expectations, in and of themselves, tend to cause a transitional measured rate of inflation above the new expected rate.

The distinction between steady-state inflation on the one hand and a once-and-for-all increase in prices (apart from the expected increase in inflation) on the other may clarify one of the most puzzling (for me at any rate) passages in the General Theory (p. 142) in which Keynes criticizes Fisher’s distinction between the real and nominal rates of interest.  After observing that an expected reduction (increase) in the value of money would tend to raise (depress) the marginal efficiency of capital curve, Keynes goes on to make the following comment on Fisher:

This is the truth which lies behind Professor Irving Fisher’s theory of what he originally called “Appreciation and Interest” – the distinction between the money rate of interest and the real rate of interest where the latter is equal to the former after correction for changes in the value of money.  It is difficult to make sense of this theory as stated, because it is not clear whether the change in the value of money is or is not assumed to be foreseen.  [The latter comment is itself a curious statement by Keynes inasmuch as Fisher was totally explicit in basing the distinction on foreseen changes in the value of money.]  There is no escape from the dilemma that, if it is not foreseen, there will be no effect on current affairs; whilst if it is foreseen, the prices of existing goods will be forthwith so adjusted that the advantages of holding money and of holding goods are again equalised, and it will be too late for holders of money to gain or to suffer a change in the rate of interest which will offset the prospective change during the period of the loan in the value of the money lent. 

Keynes, referring to changes in the value of money, seems to have had in mind a once-and-for-all change in the price level rather than a change in the rate of change in the price level (i.e. a change in the rate of inflation).  Fisher, however, when discussing the distinction between the real and the nominal rates of interest, was clearly analyzing changes in the rate of inflation .  There is a lot more to be said about Keynes’s views on the effect of inflation (or changes in the price level) on the rate of interest and other macroeconomic variables, but this simple point may help to achieve some sort of reconciliation between Fisher’s and Keynes’s views on the rate of interest.  Allyn Cottrell wrote a very interesting paper on the subject many years ago.  A couple of years ago this subject came up on Scott Sumner’s blog, and Kevin Donoghue was helpful to me in understanding what Keynes was saying.  By the way I seem to recall that in the Treatise on Money, Keynes accepted Fisher’s distinction without quibble.  If Kevin is out there and would care to weigh in on the subject, I would be glad to hear from him.

In Thursday’s (October 13, 2011) Financial Times, Tim Bond, investment strategist at Odey Asset Management, wrote a column welcoming “a world without QE.”  Acknowledging that equity markets around the world were disappointed by the failure of the Fed to restore a program of monetary easing, some form of QE3, Mr. Bond contends that the reaction was “myopic and mistaken,” calling QE2 “a mistake with problematic unintended consequences.”  He explains:

The underlying defect in QE is that it stirred investors’ fears of monetary inflation, whilst stimulating the wrong sort of inflation in the wrong places. The early positive economic effects were subsequently overwhelmed by a negative inflationary blowback that played a key role in disrupting the recovery.

This is a rather different take from mine, which is that investors don’t fear inflation, they yearn for it, as evidenced by the strikingly positive correlation, since spring 2008, shortly after the downturn starting the previous December, between changes in the TIPS breakeven spread and changes in the S&P 500 .  (I have presented  evidence for this correlation, based on data through the end of 2010, in my paper “The Fisher Effect Under Deflationary Expectations” available here, and I explained why the stock market loves inflation in this posting.)

Intimating that the rise in commodity prices prompted by the QE2-induced expectation of rising inflation took everyone, especially policy makers, by surprise, Mr. Bond observes that “fears (my italics) of monetary inflation prompted a widespread portfolio reallocation into commodities.”  However, a portfolio reallocation from holding cash to holding physical capital is a key element of a recovery from a sharp downturn such as we experienced in 2008, expectations of increasing returns from holding capital assets relative to returns from holding cash spurring investments in working capital (i.e., inventories, including raw materials, intermediate goods, and final goods) and in fixed capital (machines and structures).  Why this salutary reallocation constitutes “negative blowback” is not explained, Mr. Bond apparently considering the adverse nature of any increase in commodity prices too obvious to require any elucidation on his part.

But  the “more important flaw in QE,” according to Mr. Bond,was that it “stimulated large financial flows into China and other emerging market (EM) economies, as investors sought a higher-yielding, hard currency alternative to the dollar.”  These hot money flows fueled an unwanted credit expansion in China, triggering a sharp rise in inflation and a real-estate bubble.  Rising inflation in China added to the pressure on commodity prices, boosting global inflation.  The increase in global inflation, in Bond’s view, is responsible “for the sharp slowdown in global growth since the start of the year,” presumably because “higher inflation eroded household incomes and demand at a time of very slow nominal income growth.”  The credit bubble forced the Chinese authorities to tighten policy, producing a slowdown in Chinese economic growth.

Mr. Bond attributes large recent money flows into China to a desire to avoid a depreciating US dollar.  That is a superficial view.  Large quantities of dollars have been flowing into China for over a decade, especially from about 2002 to 2007.  The primary cause of those dollar flows was a desire by China to accumulate foreign exchange and to promote Chinese exports (the two are closely related and it is not clear which desire is the more fundamental) by limiting the increase in Chinese consumption.  Criticism of China’s exchange-rate policy of pegging the yuan exchange rate against the dollar mistakenly focuses on the fixed nominal exchange rate between the yuan and the dollar.  That focus is misguided.  A fixed nominal exchange rate did not force China to limit the growth of Chinese consumer demand and to accumulate huge hoards of foreign exchange.  A more balanced Chinese monetary policy than that which has been followed (though the policy seems to have been moderated in the last couple of years) would, even with a fixed yuan-dollar exchange rate, have allowed Chinese wages to rise more rapidly than they did, fostering rapid growth in the non-tradable-goods sector in China rather than forcing all the growth into the tradable-goods sector.  The rapid increase in Chinese property values, mistakenly called a bubble by Mr. Bond, reflects the underinvestment by the Chinese in their domestic housing stock, not an inflationary real-estate boom, and certainly not a boom fueled by the modest QE2 program pursued by the Fed for only about 8 months.  To attribute recent hot money flows from the US to China to an increase in expected US inflation ignores the simple fact that if economic growth and, hence, real interest rates in China are much higher than in the US, cash will be drawn, one way or another, from the US to China pretty much irrespective of what the US rate of inflation is.  Even if some of the dollar flow to China is driven by speculation on an appreciation of the yuan, it is hardly clear how much of a role QE2, or QE3 if it were to happen,would play in the decision to raise the value of the yuan.

Mr. Bond confidently posits an almost immediate connection between increased inflation and reduced growth since the start of 2011, but the closest he comes to providing an explanation for this connection, lacking any basis in economic theory detectable by me, is that “higher inflation eroded household incomes and demand at a time of very slow economic growth.”  Obviously begging the question of how nominal income is determined, Mr. Bond evidently is suggesting that nominal income is determined by factors independent of monetary policy.  But if monetary has no effect on nominal income, the question then presents itself :  how is it that QE2 could have caused commodity prices to rise in the first place?

If Mr. Bond is prepared to assert both that QE2 raised commodity prices and that QE2 did not raise nominal income, he is a brave soul indeed.  Bravery is undoubtedly a virtue, and compensates for many shortcomings. Defective logic, however, is not one of them.  The audacity of confusion has its limits.

Though the Nobel Committee has yet again inexcusably overlooked the matchless contributions to economics of Armen Alchian, its selection of Thomas Sargent and Christopher Sims to receive this year’s Nobel Prize in economics was, by any objective standard, an outstanding choice.  No one can dispute that Sargent and Sims are truly deserving of the honor bestowed on them.

In explaining the selection, the Nobel Committee focused on the contributions of Sargent and Sims in developing  new econometric techniques by which to analyze macroeconomic time series data, techniques now essential to empirical macroeconomics.  The motivation for developing these techniques in Sargent’s case was to test empirically assumptions about expectation formation.  Using these techniques, Sargent was able to provide empirical support for a vertical long-run Phillips curve, a key implication of the rational expectations hypothesis, perhaps the most important empirical result in macroeconomics of the last several decades.  The Nobel Committee cited Sargent for his contributions to the empirical testing of rational expectations rather than for the development of the rational expectations hypothesis itself, presumably because Robert Lucas had already received the Nobel Prize for developing the rational expectations hypothesis.  But Sargent could easily (and justly) have been chosen to receive the prize in 1995 along with Lucas.  It gets complicated.

At any rate, because Sargent is a key figure in the development of rational expectations, his selection as winner of the Nobel Prize provides an occasion for some reflections on rational expectations and the place of rational expectations in economic theory.

Rational expectations emerged as an empirical hypothesis in the course of the debates in the 1960s about the Phillips Curve and whether a stable trade-off exists between inflation and unemployment that, as Samuelson and Solow suggested in a famous paper, could be viewed as a menu by policy makers.  Friedman and Phelps independently refuted that interpretation of Phillips’s empirical result, a less original refutation, by the way, than is generally supposed, Mises, Hayek, Haberler, Alchian and Kessel, Irving Fisher and David Hume, among others, having already long since showed that inflation would have no stimulative effect on output and employment once it became expected.  The original step taken by Lucas, building on John Muth’s seminal paper formalizing the concept of rational expectations, was to argue that even a policy of accelerating inflation designed to stay a step ahead of the public’s expectations of inflation could not work, because the public would catch on to the implicit policy rule, thereby frustrating its implementation.

This was an important advance both at the conceptual and practical levels because it helped clarify how to think about the role of expectations in economic models and because it exposed clearly constraints on economic policy-making not previously recognized (though as mentioned above many economists had for a long time been generally aware of the issue and had argued that policy makers had to take it into account).  But from an empirical (i.e., testable) hypothesis about expectations formation, rational expectations (along with its cousin the efficient markets hypothesis) fairly quickly evolved into an axiomatic (and hence irrefutable) principle, more or less on the same level in economic theory as the rationality (wealth- and utility-maximization)  postulate.  As a result, the substantive (i.e. empirical) content of macroeconomic theories was increasingly dictated by the adoption of a methodological principle, having only limited and ambiguous empirical support.

New Keynesian theorists have tried to strike a balance between the Lucasian rational expectations paradigm and a desire to rationalize a role for counter-cyclical stabilization policy by adopting the dynamic stochastic general equilibrium (DSGE) paradigm while positing a variety of informational imperfections causing departures from the optimality results associated with DSGE models combined with rational expectations.  This was in fact the basis of Lucas’s own early approach positing the inability of agents to distinguish between relative and absolute price changes.  All in all, I don’t think that this has been a good bargain for the New Keynesians or for the profession at large.

The problem, it seems to me, is that elevating rational expectations into a methodological principle converts a property that one would expect to obtain only in a full general equilibrium into a necessary property of any acceptable economic model.  It is legitimate to test the coherence of a model by asking whether the model’s results are consistent with the assumption of rational expectations.  We want models that have that fixed point property.  But that is not the same as saying that every model of the real world must exhibit rational expectations under all circumstances.  To some extent, Sargent’s own work, and that of his students, on learning is a recognition that it does not make sense to impose rational expectations as a universal property of economic modeling.

I am pressed for time and there is much more to be said on the subject.  Perhaps I will have a further post on the subject next week or the week after.  This will be my last post for the week, and I will not be replying to comments either, so don’t be alarmed or upset at my silence for the next several days.  I hope to return to the blogosphere on Sunday.

In a comment  earlier today to this post, David Pearson shocked me by quoting the following passage from the Financial Services Regulatory Relief Act of 2006:

Balances maintained at a Federal Reserve bank by or on behalf of a depository institution may receive earnings to be paid by the Federal Reserve bank at least once each calendar quarter, at a rate or rates not to exceed the general level of short-term interest rates.

As I said to David Pearson in my reply to his comment, I am flabbergasted by this.  The Fed is now paying 0.25% interest on reserve balances while and the interest rate on 3-month T-bills is now 0.01%.  Yet the statute states in black letters that the rate that the Fed may pay on reserves is “not to exceed the general level of short-term interest rates.”  In fact, as can be easily seen on the Treasury’s Daily Yield Curve webpage,  only on rare occasions was the 3-month T-bill rate as high as 0.25% in 2009 and it has been consistently less than 0.20% for most of 2009 and all of 2010 and 2011.  Perhaps the definition of short-term interest rates is more than 3-months, but the yield even on a one-year Treasury has been in the neighborhood of 0.1% for months and has been below 0.25% since April.  So can anyone explain to me by what authority the Federal Reserve System continues to pay banks 0.25% interest on their reserve balances held at the Fed?

In looking around to see if anyone else has noticed that the Fed seems to be violating the very statute that authorizes it to pay interest on reserves, I found the following post from April 2010 by Stephen Williamson on his blog.

The Federal Reserve Act specifies that decisions about the interest rate on reserves are made by the Board of Governors, not by the FOMC. Obviously Congress did not think through the issue properly when it amended the Act. Since the interest rate on reserves is now the key policy rate, decisions about how to set it would appropriately reside with the FOMC. An interesting section of the Act is this one:

Balances maintained at a Federal Reserve bank by or on behalf of a depository institution may receive earnings to be paid by the Federal Reserve bank at least once each calendar quarter, at a rate or rates not to exceed the general level of short-term interest r ates.

This passage may be vague, but 1-month T-bills are now trading at 0.139% and the interest rate on reserves is 0.25%. The problem is that the Fed cannot do its job and (apparently) conform to the law. The T-bill rate has to be lower now, as the marginal liquidity value of a T-bill is higher than for reserves.

So Williamson also believes that the Fed lacks the statutory authority to pay as high an interest on reserves as it is now paying banks, except that he believes that the Fed would not be discharging its other statutory responsibilities properly if it followed the letter of the law on the rate of interest it may pay on bank reserves.  But I admit to being totally unable to understand his reasoning.  How can he conclude that the marginal liquidity yield of a T-bill is higher than the liquidity yield on reserves?  Presumably in a competitive equilibrium, the pecuniary yield plus the liquidity yield on alternative assets must be equalized.  But if banks can earn a higher rate on reserves than they can on T-bills, they hold only reserves and no T-bills.  Non-banks, on the other hand, are ineligible to hold interest-bearing reserves with the Federal Reserve System, and must hold lower-yielding, less-liquid T-bills.  So the rates on T-bills and reserves held at the Fed are not consistent with competitive equilibrium, and no inference about liquidity yields, premised on the existence of competitive equilibrium, follows from current yields on reserves and T-bills.

Let’s play a little guessing game.  Who wrote the following?

A corporate income tax, which allows interest to be deducted prior to the determination of taxable income, induces debt-financing and is therefore undesirable.  A corporate income tax also allows nonproduction expenses such as advertising, marketing, and the pleasures of the executive suites to be charged against revenues in determining the taxable income.  As advertising and marketing are techniques for building market power and as ’executive style’ is a breeder of inefficiency, the corporate income tax abets market power and inefficiency just as the corporate income tax abets the use of debt-financing.  Elimination of the corporate income tax should be on the agenda.

If you couldn’t tell even before reading the quotation that I was not going to quote a typical right-wing free-market ideologue, the passage about advertising and marketing being techniques for building market power should certainly have tipped you off.  At any rate, the author of this quasi-reactionary screed against the corporate income tax is none other than Hyman Minsky (Stabilizing an Unstable Economy 1986 edition, p. 340) who has, posthumously, become a kind of cult figure among today’s progressives and anti-capitalists.  But obviously Minsky was not a simple-minded fellow, and his work, from the little of it that I have read (mainly his biography of Keynes) is the work of a sophisticated and knowledgeable thinker who had a very practical understanding of how markets, especially financial markets, operate.  That doesn’t mean that I share his general outlook on economics and finance, just that his view ought to be taken seriously, and his proposals given careful consideration.

In addition, if a left-wing cult figure like Minsky could have advocated doing away with the corporate income tax, then maybe there is some hope that a revenue-raising budget deal could be reached between Republicans and Democrats in which the corporate income tax and the employer “contribution” to social security (i.e. an employment tax) also opposed by Minsky could be traded for a Value Added Tax (with some exemptions to make its incidence somewhat progressive).  To start with the trade could be revenue-neutral, but presumably a somewhat progressive VAT would generate a faster rate of growth in revenue (both from progressivity and enhanced efficiency) than the corporate income tax and employer “contribution” to social security.

On the subject of corporations, I would also like to mention a great little book (unfortunately long out of print) written by my late friend, Harvey Segal, at one time an editorial writer for the Washington Post and later chief economist for Citi Bank in the Walter Wriston era, Corporate Makeover.  The automatic identification of free-market capitalism with a system of business organization dominated by corporate ownership, which sprang up almost overnight in the late nineteenth century, deserves more critical attention than free-marketers are usually willing to give it.  Perhaps anti-corporate rhetoric from the left produces a compensating defensiveness on the part of free-marketers, causing them to defend corporations against all negative criticism, but even Hayek expressed considerable unease with the extent to which the corporate model separates corporate decision-making from the interests of the (nominal) owners.

HT:  June Flanders

Update:  As an anonymous commenter points out below, there is no reason to restrict the trade to corporate taxes for VAT, pollution taxes and certain other kinds of taxes on rent-producing activities could also be part of the mix.

IS-LM is quite the rage this week.  Perhaps I will come back with some further observations another time, IS-LM being a perpetual object of argumentation among monetary theorists and macroeconomists, but here are some of my own, mostly critical, observations about that old standby of Keynesian economics.

Everyone recognizes that, in its original Hicksian form, IS-LM is a static one-period model, which sharply limits its practical application unless it is augmented to give it some dynamic features.  But augmenting it in the standard fashion doesn’t address, much less fix, its basic deficiency.  What is the nature of a static one-period equilibrium in which there is positive investment and saving and a rate of interest?  The model doesn’t have a coherent intuitive economic interpretation even in its one-period form.  Merely adding some dynamics doesn’t address the disconnect between the model and basic economic concepts.

For example, does anyone outside of Cambridge England actually think of the rate of interest as the price of holding money?  In the IS-LM model, the rate of interest is determined by the demand for money and a fixed supply of money (though in more up-to-date versions the interest rate is chosen by monetary authority).  The demand for money depends on income, so investment spending and consumption spending do affect the interest rate by way of their influence on the demand for money.  Now it’s true that there are bonds in the IS-LM model, otherwise there would be no way to measure the cost of holding money, but the presence of bonds doesn’t fix the underlying problem.  Even though a bond market is included, it can be kept in the background out of sight inasmuch as you only have to solve for equilibrium in two of the markets in a three-good system to find the equilibrium for the third market as well (Walras’s Law).

The trouble is that the bond market, reflecting the supply of and the demand for loanable funds, is an epiphenomenon.  There is a mismatch between the money market (demand for and supply of a stock) and the market for loanable funds (demand for and supply of a flow).  In the real world, interest rates are not equilibrating the supply of and demand for loanable funds; interest rates emerge out of the process of evaluating all durable assets, which are nothing but claims to either fixed or variable future cash flows of various durations and risk characteristics.  The structure of interest rates and risk and liquidity factors must adjust to bring about equilibrium between the demand for and the fixed supply of the current stock of physical assets.  The interest rates on the subset of financial assets that we call bonds are determined as part of the process of valuing all durable assets, the valuation of bonds being constrained by the valuations placed on the entire range of durable assets.  One of the good things about Milton Friedman’s 1956 restatement of the quantity theory of money was his explicit recognition that interest rates are determined not in a narrow subset of markets for fixed income financial assets, but in the complete spectrum of interrelated markets for long-lived physical and financial assets.

One way to handle this would have been to make explicit the consumption/investment tradeoff by defining a purchase price (for consumption) and a rental or hire price for current use of the output as an input in producing units of output for the next period.  The rental price over the purchase price represents a real interest rate and allows in an obvious way for both expected inflation and a consistent distinction between the real and the nominal interest rate.  (In the General Theory, Keynes explicitly rejected that distinction, based on reasoning implicitly assuming the existence of a liquidity trap, but in fact, using a comparative-statics approach, you can derive an effect on the interest rate in IS-LM from expected inflation when there is no liquidity trap.  And if you start from full employment equilibrium, the comparative-statics exercise increases the interest rate by as much as expected inflation.  Allyn Cottrell showed this in a paper some years ago, “Keynes and the Keynesians on the Fisher Effect,” Scottish Journal of Political Economy 41:416-33, 1994.

The conditions of factor-market equilibrium and money-market equilibrium can then be used to derive an equilibrium time path for the economy with the Keynesian spending (consumption and investment) functions suppressed instead of a meaningless bond market which can be discarded.  Earl Thompson developed such a model nearly 40 years ago, but never published it.  The 1977 version of his working paper deriving and applying the model is available here.  He also modeled the monetary sector in a way that can be made consistent either with the competitive nature of a modern banking system or with the fixed money-supply approach of the General Theory.

Earl’s paper is tough to follow in a number of places, which may have something to do with its lack of influence.  His earlier papers were not always written in the most accessible style, as he tended to leave out too many steps in his argument that were obvious to him, but not so obvious to his readers.  To achieve a level of aggregation comparable to IS-LM requires some heroic assumptions, and making them explicit, as Earl did, underscored the unrealistic nature of his model, a characteristic that Hicks’s matter-of-fact presentation of IS-LM tended to obscure in his presentation.  Also carrying out the analysis in terms of spending functions imparts a certain appearance of realism that is lacking from characterizing factor-market equilibrium in terms of a single labor input and the rental rate for using the single output as in input into its own production.  That is probably why IS-LM, for all its faults, remains popular with people with a moderate degree of economic sophistication when trying to get a handle on economic policy.  The fact that, despite its many shortcomings, some recognized some not, so many economists and policy makers are still using it is a sad commentary on the deplorable lack of progress made by macroeconomics over the past 40 years than on the virtues of IS-LM, a lack of progress for which both Keynesians and non-Keynesians alike can take the blame in roughly equal shares.

Our very own redoubtable Benjamin Cole ventured onto Stephen Williamson’s blog to argue the case for an aggressive monetary policy after Williamson’s admiring post about Charles Plosser’s recent speech which prompted my own, less than admiring, post about the speech.  As you might expect Benjamin was received less than cordially, but he stood his ground and gave as good as he got.  Way to go, Benjamin!

I am not going to review the details of the exchange between Benjamin, Williamson, and an anonymous interlocutor (you can go there and read it for yourselves), but I was struck by what appears (to me at any rate) to be an inconsistency in Williamson’s position.

Replying to Benjamin’s call for a more aggressively expansionary monetary policy, Williamson replied as follows:

[Quoting Benjamin] “I am flabbergasted anyone thinks the Fed is doing enough. Really? Inflation is dead, unemployment is at 9 percent, and we are 10-15 percent below GDP growth trend.”

I am flabbergasted to know that you think there is any action the Fed can take now that would increase aggregate activity and/or increase the inflation rate.

Lest you think that that was a slip of the pen, Williamson makes the same point again, even more explicitly, in response to Benjamin’s reference to Milton Friedman’s advice to the Bank of Japan:

[Quoting Benjamin] “The Fed could announce it is targeting 7 percent nominal GDP growth, and follow Milton Friedman’s advice to Japan, and start printing money.”

The Fed can announce whatever it wants. If it can’t actually accomplish what it announces, what good is the announcement? “Printing money” would be, I assume, exchanging reserves for some Treasury debt. That will be essentially neutral – no effect on any prices or quantities.

Then when Benjamin invokes John Taylor’s 2006 advocacy that the Bank of Japan engage in QE, Williamson dismisses Taylor with the a wave of his hand, while dismissing the idea of any trade-off between inflation and unemployment as akin to a belief in the Phillips Curve, as if that were like believing that the earth is flat or that the sun revolves around the earth.

I would not call Taylor’s 2006 paper serious science. You seem to have a firm belief in a Phillips curve tradeoff. I’m not sure why.

Here is where things start to get tricky.  Why does Williamson think that the Phillips Curve is so off the wall?  Based on his earlier responses, you might think that it is because he rejects the notion that policymakers (i.e. the Fed) can control the rate of inflation.  If you can’t control the rate of inflation, the Phillips Curve is useless.  There is another possibility, however, which is that the rate of unemployment is unaffected by whatever rate of inflation the Fed chooses, because the Phillips Curve is vertical.  Now either view is defensible, but, as far as I can tell, they are mutually exclusive.  Either the Fed is powerless to affect the rate of inflation, or it isn’t.

Yet that is exactly where Williamson is headed, because in his next response to Benjamin, Williamson says the following:

[Quoting Benjamin] “No one suggests that inflation cannot be tamped down at some point–if we were so lucky as to have five years of robust growth, we could then start tightening the money supply.”[

It’s costly to reduce inflation once it gets going, right? What if all your inflation does not produce the robust growth you are expecting. Now everyone is complaining, not only about being unemployed, but about the high inflation rate, just as they were in 1980. Then you have to put them through the wringer again to get the high inflation out of the system. Do you think that will go over well?

So Williamson is no longer flabbergasted at the thought that the Fed might be able to increase the rate of inflation; it’s perfectly doable.  The problem now is that the Phillips Curve is vertical, so even if you raise the rate of inflation, it won’t get you the reduction in unemployment that you thought you would get.

There are two points to make about this.  First, on substance.  The argument that a vertical Phillips Curve means that monetary policy is useless only works if we assume that the natural rate of unemployment is a constant of nature in the sense that the actual rate of unemployment must always equal the natural rate.  If the actual rate of unemployment can exceed the natural rate, then monetary policy can hasten the return of the actual unemployment rate to the natural rate, though, to be sure, there is a risk of overshooting the natural rate.  Opponents of using monetary policy to reduce unemployment like to suggest, but without saying so explicitly, that the natural rate of unemployment has risen sharply so that monetary policy can’t reduce unemployment below its current level.  But to my knowledge, no one has come out and actually said in so many words that the natural rate of unemployment is now 9%.

Second, sliding effortlessly back and forth between an argument that says that the Fed is powerless and an argument that says that although the Fed can indeed raise the rate of inflation, doing so would be bad policy, because higher inflation would drive up unemployment to an even higher level in the endwhen inflation eventually had to be reduced does seem a tad, shall we say, ad hoc.  And, as we all know, serious scientists never engage in ad hocery.  (Query:  but isn’t the Phillips Curve vertical?  Answer: Well, it’s vertical when you increase the rate of inflation, but it’s negatively sloped when you reduce the rate of inflation.  Go figure.)

The stock market apparently took heart from Chairman Bernanke’s testimony today to the Joint Economic Committee of Congress, rising 4% from its low for the day and 2% from yesterday’s close.  I fear that this is just the market whistling past the graveyard, because Bernanke said very little – actually almost nothing — that he has not said before.  Why the market would have taken any comfort from his remarks is a mystery to me.

What is even more ominous is how closely Bernanke’s testimony tracks the recent message of Jeffrey M. Lacker, President of the Federal Reserve Bank of Richmond whose recent contribution to the second quarter 2011 issue of Region Focus, a publication of the Richmond Federal Reserve Bank, can be found here.

I offer a few of Mr. Lacker’s juicier morsels for your reading pleasure.

Typically following a recession, the economy rebounds strongly, growing more rapidly than the long-run trend for a few years, and then settles back to its more traditional growth path. . . . Occasionally this process has taken a bit longer than one might have expected.  For instance, following the recessions of 1990-1991 and 2001, it was a while before growth exceeded its long-run average of 3 percent. . . . And we may see a similar growth curve this time as well. . . .

[T]here is another possible path the economy might take. . . . We may not see that faster, catch-up level of growth that has followed most recessions.  Instead, we may simply settle into a growth rate of 3 percent.  In short, we may not gain back the ground we lost during the recession.

There are many reasons why this scenario might occur, among them changes in public policuy.  New tax and regulatory policies – including both the recent health care and financial reform bills – could have significant persistent effects on output and consumption.  Moreover, there remains considerable policy uncertainty surrounding such issues – for instance, how fiscal balance will be achieved over the long run.

Nobel Prize winning economist Robert Lucas, among others, has argued that the United States may be headed toward an overall policy regime similar to that of many other developed countries, especially those of continental Europe.  On balance, these countries have more regulated labor markets, higher tax rates, and larger social safety net programs.  While they have roughly the same average rate of growth as the United States, they generally employ less labor and produce less output per capita.  Although these countries are rich by global standards, they typically have been less economically dynamic and are poorer than the United States.

Given that we can’t be sure which recovery path the U.S. economy will take, what should the Federal Reserve do? . . . I think the direction we should take is roughly the same in either case.  Monetary policy is highly accommodative right now.  While inflation trends are currently well-contained at around 2 percent, we need to be alert to the risk that the monetary stimulus now in place might set off an inflationary surge.  [Time out for a comment from the peanut gallery:  Excuse me, but how alert were you (i.e. the FOMC) to the risk of a recession and a financial meltdown in the spring and summer of 2008 when the economy began contracting rapidly while you (the FOMC) were obsessed with preventing inflation expectations from becoming unanchored because of rising oil and food prices?  Does the FOMC have any less obligation to be alert to deflationary surges than to inflationary ones?]  More broadly, it is important that people recognize that, as Chairman Bernanke recently noted, monetary policy is not a panacea.  Monetary policy determines the inflation rate over time, and has only a transitory effect on real economic growth.  Further monetary stimulus is unlikely to alleviate the impediments to more rapid growth, but could raise inflation to undesirably high levels.

The U.S. economy is remarkably resilient.  But . . . we must face the possibility that we  may never fully regain what was lost during the downturn, especially if policymakers do not squarely address those issues that have long loomed over the U.S. economy but can no longer be ignored.

Now for the closing paragraph of Chairman Bernanke’s testimony before the Joint Economic Committee:

Monetary policy can be a powerful tool, but it is not a panacea for the problems currently faced by the U.S. economy. Fostering healthy growth and job creation is a shared responsibility of all economic policymakers, in close cooperation with the private sector. Fiscal policy is of critical importance, as I have noted today, but a wide range of other policies–pertaining to labor markets, housing, trade, taxation, and regulation, for example–also have important roles to play. For our part, we at the Federal Reserve will continue to work to help create an environment that provides the greatest possible economic opportunity for all Americans.

Downright scary.

On his blog, Steve Williamson discusses the recent (September 29, 2011) speech by Charles Plosser, President of the Federal Reserve Bank of Philadelphia, to the Business Leaders’ Forum at the Villanova School of Business.  Plosser explains why he disagrees with recent moves by the Fed such as forward guidance about keeping short-term interest rates at current low levels, and operation twist to lengthen the maturity structure of the Fed’s asset holdings.  Williamson likes the speech; I don’t.  So let’s explore my reasons for disagreeing with Plosser and Williamson.

The first half of the speech reviews the current economics situation, the slow recovery from the 2008-09 downturn and financial crisis, and the deteriorating economic situation since the beginning of the year, despite what Plosser calls “the extraordinary degree of monetary accommodation” provided by the Fed, resulting in a tripling of the size of the Fed’s balance sheet, and a shift in holdings “from mostly short- to medium-term Treasuries to longer-term Treasuries, mortgage-backed securities, and agency debt.”  Furthermore,

In August, the FOMC changed its guidance about its expectations for the future path of the federal funds rate. In particular, it stated that economic conditions were “likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.” At its meeting last week, the FOMC announced additional accommodative action. In an effort to reduce long-term Treasury yields from already historically low levels, the FOMC intends to purchase $400 billion of longer-term Treasury securities and to sell an equal amount of shorter-term Treasuries by the end of June 2012.

Plosser goes on to defend his dissent from the recent FOMC decisions, arguing that the ineffectiveness of past monetary stimulus in reducing unemployment should serve as a warning to “be cautious and vigilant that our previous accommodative policies do not translate into a steady rise in inflation over the medium term even while the unemployment rate remains elevated.”  In other words, monetary accommodation has proven ineffective in reducing unemployment, but it may cause inflation in the future, and without reducing unemployment in the process. 

How is that possible?  Wouldn’t an increase in aggregate demand resulting from an easy money policy tend to increase inflation while reducing unemployment?  Plosser thinks not, because monetary expansion could create “an environment of stagflation, reminiscent of the 1970s [that] will not help businesses, the unemployed, or the consumer.” 

This seems to me a most remarkable assertion.  The experience of the 1970s used to be viewed as evidence that the long-run Phillips Curve is vertical, so that monetary policy can’t force the unemployment rate down permanently below its “natural” level, because ultimately, when the price level effects are foreseen, workers will not let themselves be fooled into accepting lower real wages than they are really willing to work for.  From this proposition, Plosser apparently infers that even if there is unemployment, because (in a Phillips-curve framework) real wages are too high to allow a full-employment equilibrium, you can’t use monetary policy to reduce the real wage, because workers won’t let their real wage be reduced by inflation even when the real wage is above its equilibrium level. 

This is actually a curious inversion of Keynes’s argument about the futility of nominal wage reductions as a method or eliminating unemployment.  Keynes held that falling nominal wages would simply be passed through by employers to customers in the form of lower prices, negating the nominal wage cut.  The logic by which Keynes concluded that falling nominal wages would cause a proportionate fall in prices rather than a less than proportionate fall in prices to restore equilibrium was far from ironclad; one could argue at least as plausibly that firms would not be quite so obliging as to pass forward their full savings from reduced money wages to consumers without trying to increase their depressed profit margins even a smidgen.  Similarly, Plosser seems to be suggesting that workers, despite high levels of unemployment, are so determined to preserve their current above-equilibrium real wage that any increase in prices tending to reduce real wages would elicit immediate and effective demands by workers for increased nominal wages thereby negating the incentive to hire additional workers otherwise following from an increase in prices relative to wages.  If this is the lesson Plosser draws from 1970s stagflation, it is a very different lesson from the one that Friedman and Phelps thought that they were teaching when they formulated the natural rate hypothesis 40 years ago. 

The only other possibility is that Plosser thinks that the natural rate of unemployment is now approximately 9%.  Perhaps it is, but if that is what he thinks, he ought to be willing to make that argument explicitly and not pretend that he is simply applying the lessons of the 1970s.

But Plosser seems to be making just that suggestion in the next paragraph of his speech (quoted approvingly by Williamson).

In my view, the actions taken in August and September tend to undermine the Fed’s credibility by giving the impression that we think such policies can have a major impact on the speed of the recovery. It is my assessment that they will not. We should not take certain actions simply because we can. . . . The ills we currently face are not readily resolved through ever more accommodative monetary policy. If we act as if the Fed has the ability to solve all our economic problems, the credibility of the institution is undermined. The loss of that credibility and confidence could be costly to the economy because it will make it much harder for the Fed to implement effective monetary policy in the future.

Plosser offers an assessment that the actions taken by the FOMC in August and September cannot affect the speed of the recovery.  I agree with that assessment, because monetary policy has failed to change pessimistic expectations about the course of future prices and nominal incomes.  Plosser, however, apparently believes that monetary policy could not under any circumstances do any more than it already has.  But he seems unwilling to defend his assessment that monetary policy cannot reduce the current rate of unemployment in terms of any commonly understood macroeconomic model.  We are supposed to just take his word that monetary policy cannot help speed the adjustment of an unemployment rate above its natural level back to its natural level.  So unless Plosser believes that the current unemployment rate is already at its natural level, I cannot understand how he could suggest that a policy of moving the unemployment rate down toward its natural level is tantamount to asking the Fed to “solve all our economic problems.”  And if he thinks that the unemployment rate is now at the natural rate of unemployment, he ought to say that that is what he thinks and explain why he thinks that is the case.

Steve Williamson supports Plosser with the following observation:

A large fraction of the population is significantly worse off than they were in 2007. But there are no monetary policy actions available currently that will make them better off. However, by continuing to engage in unconventional policy actions – QE1, QE2, “forward guidance,” and Operation Twist, the Fed is acting as if it knows what it is doing, and can actually reduce unemployment by taking those actions. Further, public statements by some Fed officials, particularly Bernanke, express confidence that these actions actually work. Bernanke, and like-minded people such as Charles Evans, Chicago Fed President, are unfortunately engaged in wishful thinking.

What is the wishful thinking here?  Is it that speeding the adjustment of unemployment toward the natural rate will make the reduction in unemployment unsustainable?  What is the theory that explains why speeding a reduction in unemployment to the natural level is unsustainable?  What evidence supports such a view?  Or is that the natural rate of  unemployment is now at 9%.  And again I ask, what is the basis for believing that the current natural rate is now at 9%?