Archive for the 'Tony Yates' Category

Repeat after Me: Inflation’s the Cure not the Disease

Last week Martin Feldstein triggered a fascinating four-way exchange with a post explaining yet again why we still need to be worried about inflation. Tony Yates responded first with an explanation of why money printing doesn’t work at the zero lower bound (aka liquidity trap), leading Paul Krugman to comment wearily about the obtuseness of all those right-wingers who just can’t stop obsessing about the non-existent inflation threat when, all along, it was crystal clear that in a liquidity trap, printing money is useless.

I’m still not sure why relatively moderate conservatives like Feldstein didn’t find all this convincing back in 2009. I get, I think, why politics might predispose them to see inflation risks everywhere, but this was as crystal-clear a proposition as I’ve ever seen. Still, even if you managed to convince yourself that the liquidity-trap analysis was wrong six years ago, by now you should surely have realized that Bernanke, Woodford, Eggertsson, and, yes, me got it right.

But no — it’s a complete puzzle. Maybe it’s because those tricksy Fed officials started paying all of 25 basis points on reserves (Japan never paid such interest). Anyway, inflation is just around the corner, the same way it has been all these years.

Which surprisingly (not least to Krugman) led Brad DeLong to rise to Feldstein’s defense (well, sort of), pointing out that there is a respectable argument to be made for why even if money printing is not immediately effective at the zero lower bound, it could still be effective down the road, so that the mere fact that inflation has been consistently below 2% since the crash (except for a short blip when oil prices spiked in 2011-12) doesn’t mean that inflation might not pick up quickly once inflation expectations pick up a bit, triggering an accelerating and self-sustaining inflation as all those hitherto idle balances start gushing into circulation.

That argument drew a slightly dyspeptic response from Krugman who again pointed out, as had Tony Yates, that at the zero lower bound, the demand for cash is virtually unlimited so that there is no tendency for monetary expansion to raise prices, as if DeLong did not already know that. For some reason, Krugman seems unwilling to accept the implication of the argument in his own 1998 paper that he cites frequently: that for an increase in the money stock to raise the price level – note that there is an implicit assumption that the real demand for money does not change – the increase must be expected to be permanent. (I also note that the argument had been made almost 20 years earlier by Jack Hirshleifer, in his Fisherian text on capital theory, Capital Interest and Investment.) Thus, on Krugman’s own analysis, the effect of an increase in the money stock is expectations-dependent. A change in monetary policy will be inflationary if it is expected to be inflationary, and it will not be inflationary if it is not expected to be inflationary. And Krugman even quotes himself on the point, referring to

my call for the Bank of Japan to “credibly promise to be irresponsible” — to make the expansion of the base permanent, by committing to a relatively high inflation target. That was the main point of my 1998 paper!

So the question whether the monetary expansion since 2008 will ever turn out to be inflationary depends not on an abstract argument about the shape of the LM curve, but about the evolution of inflation expectations over time. I’m not sure that I’m persuaded by DeLong’s backward induction argument – an argument that I like enough to have used myself on occasion while conceding that the logic may not hold in the real word – but there is no logical inconsistency between the backward-induction argument and Krugman’s credibility argument; they simply reflect different conjectures about the evolution of inflation expectations in a world in which there is uncertainty about what the future monetary policy of the central bank is going to be (in other words, a world like the one we inhabit).

Which brings me to the real point of this post: the problem with monetary policy since 2008 has been that the Fed has credibly adopted a 2% inflation target, a target that, it is generally understood, the Fed prefers to undershoot rather than overshoot. Thus, in operational terms, the actual goal is really less than 2%. As long as the inflation target credibly remains less than 2%, the argument about inflation risk is about the risk that the Fed will credibly revise its target upwards.

With the both Wickselian natural real and natural nominal short-term rates of interest probably below zero, it would have made sense to raise the inflation target to get the natural nominal short-term rate above zero. There were other reasons to raise the inflation target as well, e.g., providing debt relief to debtors, thereby benefitting not only debtors but also those creditors whose debtors simply defaulted.

Krugman takes it for granted that monetary policy is impotent at the zero lower bound, but that impotence is not inherent; it is self-imposed by the credibility of the Fed’s own inflation target. To be sure, changing the inflation target is not a decision that we would want the Fed to take lightly, because it opens up some very tricky time-inconsistency problems. However, in a crisis, you may have to take a chance and hope that credibility can be restored by future responsible behavior once things get back to normal.

In this vein, I am reminded of the 1930 exchange between Hawtrey and Hugh Pattison Macmillan, chairman of the Committee on Finance and Industry, when Hawtrey, testifying before the Committee, suggested that the Bank of England reduce Bank Rate even at the risk of endangering the convertibility of sterling into gold (England eventually left the gold standard a little over a year later)

MACMILLAN. . . . the course you suggest would not have been consistent with what one may call orthodox Central Banking, would it?

HAWTREY. I do not know what orthodox Central Banking is.

MACMILLAN. . . . when gold ebbs away you must restrict credit as a general principle?

HAWTREY. . . . that kind of orthodoxy is like conventions at bridge; you have to break them when the circumstances call for it. I think that a gold reserve exists to be used. . . . Perhaps once in a century the time comes when you can use your gold reserve for the governing purpose, provided you have the courage to use practically all of it.

Of course the best evidence for the effectiveness of monetary policy at the zero lower bound was provided three years later, in April 1933, when FDR suspended the gold standard in the US, causing the dollar to depreciate against gold, triggering an immediate rise in US prices (wholesale prices rising 14% from April through July) and the fastest real recovery in US history (industrial output rising by over 50% over the same period). A recent paper by Andrew Jalil and Gisela Rua documents this amazing recovery from the depths of the Great Depression and the crucial role that changing inflation expectations played in stimulating the recovery. They also make a further important point: that by announcing a price level target, FDR both accelerated the recovery and prevented expectations of inflation from increasing without limit. The 1933 episode suggests that a sharp, but limited, increase in the price-level target would generate a faster and more powerful output response than an incremental increase in the inflation target. Unfortunately, after the 2008 downturn we got neither.

Maybe it’s too much to expect that an unelected central bank would take upon itself to adopt as a policy goal a substantial increase in the price level. Had the Fed announced such a goal after the 2008 crisis, it would have invited a potentially fatal attack, and not just from the usual right-wing suspects, on its institutional independence. Price stability, is after all, part of dual mandate that Fed is legally bound to pursue. And it was FDR, not the Fed, that took the US off the gold standard.

But even so, we at least ought to be clear that if monetary policy is impotent at the zero lower bound, the impotence is not caused by any inherent weakness, but by the institutional and political constraints under which it operates in a constitutional system. And maybe there is no better argument for nominal GDP level targeting than that it offers a practical and civilly reverent way of allowing monetary policy to be effective at the zero lower bound.

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The Microfoundations Wars Continue

I see belatedly that the battle over microfoundations continues on the blogosphere, with Paul Krugman, Noah Smith, Adam Posen, and Nick Rowe all challenging the microfoundations position, while Tony Yates and Stephen Williamson defend it with Simon Wren-Lewis trying to serve as a peacemaker of sorts. I agree with most of the criticisms, but what I found most striking was the defense of microfoundations offered by Tony Yates, who expresses the mentality of the microfoundations school so well that I thought that some further commentary on his post would be worthwhile.

Yates’s post was prompted by a Twitter exchange between Yates and Adam Posen after Posen tweeted that microfoundations have no merit, an exaggeration no doubt, but not an unreasonable one. Noah Smith chimed in with a challenge to Yates to defend the proposition that microfoundations do have merit. Hence, the title (“Why Microfoundations Have Merit.”) of Yates’s post. What really caught my attention in Yates’s post is that, in trying to defend the proposition that microfounded models do have merit, Yates offers the following methodological, or perhaps aesthetic, pronouncement .

The merit in any economic thinking or knowledge must lie in it at some point producing an insight, a prediction, a prediction of the consequence of a policy action, that helps someone, or a government, or a society to make their lives better.

Microfounded models are models which tell an explicit story about what the people, firms, and large agents in a model do, and why.  What do they want to achieve, what constraints do they face in going about it?  My own position is that these are the ONLY models that have anything genuinely economic to say about anything.  It’s contestable whether they have any merit or not.

Paraphrasing, I would say that Yates defines merit as a useful insight or prediction into the way the world works. Fair enough. He then defines microfounded models as those models that tell an explicit story about what the agents populating the model are trying to do and the resulting outcomes of their efforts. This strikes me as a definition that includes more than just microfounded models, but let that pass, at least for the moment. Then comes the key point. These models “are the ONLY models that have anything genuinely economic to say about anything.” A breathtaking claim.

In other words, Yates believes that unless an insight, a proposition, or a conjecture, can be logically deduced from microfoundations, it is not economics. So whatever the merits of microfounded models, a non-microfounded model is not, as a matter of principle, an economic model. Talk about methodological authoritarianism.

Having established, to his own satisfaction at any rate, that only microfounded models have a legitimate claim to be considered economic, Yates defends the claim that microfounded models have merit by citing the Lucas critique as an early example of a meritorious insight derived from the “microfoundations project.” Now there is something a bit odd about this claim, because Yates neglects to mention that the Lucas critique, as Lucas himself acknowledged, had been anticipated by earlier economists, including both Keynes and Tinbergen. So if the microfoundations project does indeed have merit, the example chosen to illustrate that merit does nothing to show that the merit is in any way peculiar to the microfoundations project. It is also bears repeating (see my earlier post on the Lucas critique) that the Lucas critique only tells us about steady states, so it provides no useful information, insight, prediction or guidance about using monetary policy to speed up the recovery to a new steady state. So we should be careful not to attribute more merit to the Lucas critique than it actually possesses.

To be sure, in his Twitter exchange with Adam Posen, Yates mentioned several other meritorious contributions from the microfoundations project, each of which Posen rejected because the merit of those contributions lies in the intuition behind the one line idea. To which Yates responded:

This statement is highly perplexing to me.  Economic ideas are claims about what people and firms and governments do, and why, and what unfolds as a consequence.  The models are the ideas.  ‘Intuition’, the verbal counterpart to the models, are not separate things, the origins of the models.  They are utterances to ourselves that arise from us comprehending the logical object of the model, in the same way that our account to ourselves of an equation arises from the model.  One could make an argument for the separateness of ‘intuition’ at best, I think, as classifying it in some cases to be a conjecture about what a possible economic world [a microfounded model] would look like.  Intuition as story-telling to oneself can sometimes be a good check on whether what we have done is nonsense.  But not always.  Lots of results are not immediately intuitive.  That’s not a reason to dismiss it.  (Just like most of modern physics is not intuitive.)  Just a reason to have another think and read through your code carefully.

And Yates’s response is highly perplexing to me. An economic model is usually the product of some thought process intended to construct a coherent model from some mental raw materials (ideas) and resources (knowledge and techniques). The thought process is an attempt to embody some idea or ideas about a posited causal mechanism or about a posited mutual interdependency among variables of interest. The intuition is the idea or insight that some such causal mechanism or mutual interdependency exists. A model is one particular implementation (out of many other possible implementations) of the idea in a way that allows further implications of the idea to be deduced, thereby achieving an enhanced and deeper understanding of the original insight. The “microfoundations project” does not directly determine what kinds of ideas can be modeled, but it does require that models have certain properties to be considered acceptable implementations of any idea. In particular the model must incorporate a dynamic stochastic general equilibrium system with rational expectations and a unique equilibrium. Ideas not tractable given those modeling constraints are excluded. Posen’s point, it seems to me, is not that no worthwhile, meritorious ideas have been modeled within the modeling constraints imposed by the microfoundations project, but that the microfoundations project has done nothing to create or propagate those ideas; it has just forced those ideas to be implemented within the template of the microfoundations project.

None of the characteristic properties of the microfoundations project are assumptions for which there is compelling empirical or theoretical justification. We know how to prove the existence of a general equilibrium for economic models populated by agents satisfying certain rationality assumptions (assumptions for which there is no compelling a priori argument and whose primary justifications are tractability and the accuracy of the empirical implications deduced from them), but the conditions for a unique general equilibrium are way more stringent than the standard convexity assumptions required to prove existence. Moreover, even given the existence of a unique general equilibrium, there is no proof that an economy not in general equilibrium will reach the general equilibrium under the standard rules of price adjustment. Nor is there any empirical evidence to suggest that actual economies are in any sense in a general equilibrium, though one might reasonably suppose that actual economies are from time to time in the neighborhood of a general equilibrium. The rationality of expectations is in one sense an entirely ad hoc assumption, though an inconsistency between the predictions of a model, under the assumption of rational expectations, with the rationally expectations of the agents in the model is surely a sign that there is a problem in the structure of the model. But just because rational expectations can be used to check for latent design flaws in a model, it does not follow that assuming rational expectations leads to empirical implications that are generally, or even occasionally, empirically valid.

Thus, the key assumptions of microfounded models are not logically entailed by any deep axioms; they are imposed by methodological fiat, a philosophically and pragmatically unfounded insistence that certain modeling conventions be adhered to in order to count as “scientific.” Now it would be one thing if these modeling conventions were generating new, previously unknown, empirical relationships or generating more accurate predictions than those generated by non-microfounded models, but evidence that the predictions of microfounded models are better than the predictions of non-microfounded models is notably lacking. Indeed, Carlaw and Lipsey have shown that micro-founded models generate predictions that are less accurate than those generated by non-micofounded models. If microfounded theories represent scientific progress, they ought to be producing an increase, not a decrease, in explanatory power.

The microfoundations project is predicated on a gigantic leap of faith that the existing economy has an underlying structure that corresponds closely enough to the assumptions of the Arrow-Debreu model, suitably adjusted for stochastic elements and a variety of frictions (e.g., Calvo pricing) that may be introduced into the models depending on the modeler’s judgment about what constitutes an allowable friction. This is classic question-begging with a vengeance: arriving at a conclusion by assuming what needs to be proved. Such question begging is not necessarily illegitimate; every research program is based on some degree of faith or optimism that results not yet in hand will justify the effort required to generate those results. What is not legitimate is the claim that ONLY the models based on such question-begging assumptions are genuinely scientific.

This question-begging mentality masquerading as science is actually not unique to the microfoundations school. It is not uncommon among those with an exaggerated belief in the powers of science, a mentality that Hayek called scientism. It is akin to physicalism, the philosophical doctrine that all phenomena are physical. According to physicalism, there are no mental phenomena. What we perceive as mental phenomena, e.g., consciousness, is not real, but an illusion. Our mental states are really nothing but physical states. I do not say that physicalism is false, just that it is a philosophical position, not a proposition derived from science, and certainly not a fact that is, or can be, established by the currently available tools of science. It is a faith that some day — some day probably very, very far off into the future — science will demonstrate that our mental processes can be reduced to, and derived from, the laws of physics. Similarly, given the inability to account for observed fluctuations of output and employment in terms of microfoundations, the assertion that only microfounded models are scientific is simply an expression of faith in some, as yet unknown, future discovery, not a claim supported by any available scientific proof or evidence.


About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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