The reason is not what you are expecting. It's because maybe if he had been forced to take Intro Economics, the 12th President of the Federal Reserve Bank of Minneapolis, who holds a PhD in Economics from the University of Chicago, who is a specialist in money and macro, who has a CV that creams mine 100 times over, would not be making mistakes like this. (H/T Andy Harless via Scott Sumner).
"To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation."
That could be interpreted two ways: a wrong way, and maybe, just maybe, a right way.
"When real returns are normalized, inflationary expectations could well be negative, and there may still be a considerable amount of structural unemployment. If the FOMC hews too closely to conventional thinking, it might be inclined to keep its target rate low. That kind of reaction would simply re-enforce the deflationary expectations and lead to many years of deflation."
Nope. He definitely meant it the wrong way. If the economy returns to normal, and the natural rate of interest rises, the Fed must raise its target rate of interest. (So far so good). If it doesn't, the result would be….deflation. ("Inflation" would be the right answer).
I never did understand how the Fed makes decisions. But if the President of the Minneapolis Fed, and people like him, have any sort of power over monetary policy, we ( OK, Americans especially, but probably Canadians too, getting caught by the implosion) are so totally screwed.
I notice he has an undergraduate in maths, then went straight into a PhD in economics. My conjecture: I bet he never took Intro Economics, or anything vaguely similar. I bet he waded straight into the mathematical deep end. And so he never really learned economics. So he took the Fisher identity (nominal interest rates = real interest rates + expected inflation), added monetary super-neutrality (equilibrium real rates are independent of monetary policy in the long run), and ran with it. He never distinguished between the equilibrium thought-experiment and the stability thought-experiment. If you explain this in words, as you have to in Intro Economics, you have to get it right.
We should never, ever, let students do this. Yet we do it all the time.
And this is also why we should never frame monetary policy in terms of interest rates. If this guy can't understand it, maybe some average people will get it wrong sometimes too, and have things going in the wrong direction
Sometimes I despair of my discipline. And for my economy.
Worthwhile Canadian Initiative 
Hey, look on the bright side Nick, employers aren’t stupid. They hire economists when they need regressions run, and when they need policy analysis done, they often hire someone with a master’s degree in international relations or public policy or business administration. Someone who can write a press release or a briefing note. (You doubt this is true? Watch a department of finance recruiting video, or read some of the comments about economists and the media in recent threads).
Students in all of those programs are required to have Econ 1000 – and if they’re Carleton grads, they odds are good that they’ve had 1000 from the master of economic intuition himself, i.e. you.
Nick, I was also shocked by the Kocherlakota’s speech. I was glad to see Krugman and then Harless criticising Kocherlakota. But I was very surprised when Williamson supported Kocherlakota:
http://newmonetarism.blogspot.com/2010/08/pk-froths.html
Any thoughts about why Williamson might be OK with Kocherlakota?
Forcing everyone to take Intro Econ is not enough. Quality of instruction is usually terrible – Scott Sumner once wrote a post called “Did confusion over S&D cause the crash of 2008?”.
http://www.themoneyillusion.com/?p=2006
Well Nick, as we were discussing the other day I also was math undergrad and went straight into Phd program in economics. I did however take introductory macro as an undergrad but at the time it hadn’t yet occured to me to study econ in grad school (I thought I’d be a mathemetician) so it didn’t really take.
However, I think that in large part it is also a problem of how intorductory macro is taught. In my response (just after yours) to Blik on the other thread I was trying to make the point that you have to look past a literal interpretation of the models and think through the micro mechanisms. You also have to take the models simpler models as examples to illustrate a point and not as representations of any reality. I know you could say the same of physics but there is a difference, Newtonian models do really represent reality to a good approximation at low speeds. I do think a lot of teachers might be taking their models too seriously in class.
Frances: You are probably right. But you call that the bright side? OK, I suppose it is in a way, but not for our discipline. And what happens in the long run, when we’re all dead? Who then will teach what? There’ll be noone left.
TMDB: Paul Krugman concentrates on what he had to say about structural unemployment, and Steve Williamson on structural unemployment and balance sheets. Neither seemed to notice what he said about interest rates and deflation. And that’s the really problematic part. It’s only a very short part of the speech. But if there’s one thing someone in power at a central bank ought to know, it’s the answer to this question: “Inflation looks is running too low. Which way do we move the interest rate lever to increase future inflation, up or down?”
He just wrote down “i=r+p”, and “r is exogenous”, and like a good little math student, concluded “if we want to raise p, we must raise i”. It’s very simple math, and wrong.
Adam: I was wondering how you would respond. Let me say straight out that you obviously do understand economics, somehow! Maybe it’s that old intro econ course you took; maybe it’s what you learned going out into the world, when you had to think about it all and apply it, or maybe it’s just you. (I don’t have an economics undergrad degree either, BTW, though I did do sort of the equivalent to a minor, or a bit more. And I took Intro twice, for A-levels, and again at uni.
Maybe it’s the teaching of intro macro, as you say (and what you say there makes sense). I just don’t know.
But we can’t afford the risk. Make em all take Intro.
@The money demanda blog
Easy, Williamson (a Canadian) also went from math to graduate econ!
It´s the math in them…
Nick, I was referring to (newer) posts where Krugman and Williamson were discussing Kocherlakota on interest rates. I was very disturbed by Kocherlakota on interest rates, but initially there was a total silence in the blogosphere (Scott Sumner was on a holiday) so I had no idea what others were thinking, but finally Krugman briefly mentioned Kocherlakota on interest rates. But then for some deeply mysterious reason Williamson started defending Kocherlakota on interest rates.
I would recommend that anyone interested in studying economics seriously take a math major/econ minor at undergrad. Or math major/Econ 1000 at undergrad. It’s not just because a strong background in math is a huge help in graduate school. There’s another reason.
Econ 1000 is where the big concepts in econ are taught. The 2000 level introduces some new big concepts and refines old ones.
You can get a very long way in terms of policy analysis with no more 2nd year econ concepts.
Advanced undergrad and grad courses spend a lot of time teaching those same basic concepts with a greater degree of technical sophistication. If you went through a BA/MA/PhD at Carleton, you would take Intro to Econ, and then five further courses called micro theory and another five courses called macro theory (2 of each @ 2nd year, 1 at 4th year, 1 at MA level, 1 at PhD level). It ends up being the same ideas with greater and greater degrees of technical sophistication.
An undergrad degree in something other than econ makes grad school much more interesting.
(Personally I avoided much of this by having a very unconventional undergrad at Simon Fraser University where advanced micro theory was Coase, Hayek and Popper and by doing a PhD at LSE where the conventional course sequence was replaced by a series of state of the art mini-courses Larry Summers, Nick Stern etc).
I’m not quite satisfied with my blog post, because I don’t think it gets at what’s really wrong with Kocherlakota’s argument. I can’t believe that he’s as ignorant of basic economic reasoning as you conclude (and as I implicitly assume, with my umbrella analogy). There is some hypothetical world — one with the same logic as ours but very different empirical facts — in which Kocherlakota’s argument is valid. I’m frustrated by not being smart or diligent enough to ascertain that world’s characteristics with any precision, so I could explain how they are different from ours. The general idea, I think, is that the zero nominal interest rate is a sunspot that gets people to fixate on a deflationary equilibrium. What you need for that to work, I’m not sure. Wild guess: flexible prices, rational expectations, bounded uncertainty (possibly at zero), definite knowledge of certain aspects of the Fed’s reaction function, certain constraints on that function, discontinuous shocks. (Think: if I were a Martian come to earth, and I observed a zero nominal interest rate, and my Martian X-ray vision allowed me to observe that the risk-adjusted marginal product of capital was exactly 1%, then I would conclude that people must be expecting deflation, and I would get a job and hoard money. If you can get enough people to act like Martians, then the zero interest rate becomes a self-fulfilling prophecy of deflation.)
TMDB: Sorry. I had missed those bits. It’s just a one-liner in PK. I can’t think why SW should think that passage is unobjectionable, unless he missed that bit I’m objecting to, or somehow interprets it very differently. God only knows.
Andy: Just over a year ago, I did a post arguing that the Bank of Canada should loosen monetary policy and thereby “rise” interest rates. http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/07/why-the-bank-of-canada-should-rise-interest-rates.html
Maybe, just maybe, that’s what he is trying to say. But Jeez, if you are trying to say something like that, and you are President of the Minn Fed, and not some no-name blogger like me, and if you know that people currently frame monetary policy as setting an interest rate, and you know that people frame tightening monetary policy as raising interest rates, you make damn sure to be very very explicit, even more so than I was in that post, that you are adopting a very unconventional way of framing monetary policy. You make damn sure that people understand clearly what you are saying. He doesn’t.
Instead, he is saying exactly what a math student would say, if you showed him the Fisher identity and told him that money was long run super-neutral. And he does indeed state the Fisher identity, and the super-neutrality (OK, he calls it neutrality) of money.
The hypothesis that he doesn’t have a clue (despite the CV) fits the facts.
Today, Williamson elaborates further…
Deflation
I argued here that we should not be worried about deflation. In part, this was a backward-looking argument, based on the behavior of the stock of currency, along with observations about the implied inflation premium on long-term Treasuries. Now, if you have been watching bond yields recently, you will have observed two things: (i) The yields on both nominal Treasuries, and inflation-indexed Treasuries (TIPS) have both fallen; (ii) The difference in those yields (a measure of the inflation premium on long Treasuries) has also fallen. This may reflect the view of the market that, given the last Fed statement, and public statements by Jim Bullard, among others, the Fed knows something the market cannot see directly, which is that inflation is going to be much lower for an extended period, if not negative.
In this case, I agree with Kocherlakota, that the market has it wrong. As Kocherlakota argued, most of our monetary models tell us that, if the Fed maintains a constant nominal interest rate target forever, that will essentially determine the inflation rate, by way of the Fisher relation. If the Fed keeps the short-term overnight rate at 0.25% forever, and if the long-run real interest rate is 2%, the inflation rate must be -1.75%, which would be supported (roughly) by long-run growth in some monetary quantity of -1.75% plus the long-run growth rate in real GDP.
This makes deflation seem like a real possibility if the Fed maintains a target nominal interest rate of 0.25% for an “extended period,” as specified in the FOMC statements since all the trouble started. However, consider this. Suppose, as seems to be implied by the last FOMC statement, that the Fed intends to hold the size of the balance sheet constant, in nominal terms, for the immediate future. Suppose that what they mean by this is that the balance sheet will remain constant until the stock of excess reserves “runs off,” at which time we will go back to a “normal” policy regime. By normal policy, I mean an implicit inflation target of 2% supported by a nominal fed funds target, recalibrated at each FOMC meeting.
Now, what happens between now and the time at which excess reserves go to zero? Suppose over that period that the interest rate on reserves (the relevant policy rate when excess reserves are positive) stays at 0.25%. Suppose that the inflation rate over that period is 2% and that real GDP grows at 3%. Also suppose that the quantity of currency relative to nominal GDP is constant, implying that the stock of currency outstanding is growing at 5% per year. At this rate, excess reserves will run off in about 18 years. By that time, the majority of the MBS on the Fed’s balance sheet will have disappeared, and the Fed will be back to having mainly Treasuries in its portfolio. Could this be an equilibrium path for the economy? Well, given what I specified here, it seems unlikely that banks will wish to hold excess reserves for 18 years given a real return of -1.75%. Somewhere in that 18-year period, the Fed will have to raise the interest rate on reserves, otherwise the stock of currency will be growing in excess of 5% per year, and the inflation rate will rise above 2%. Thus, if anything, the inflation risk appears to be on the up side, given stated policy. I don’t see the deflation risk.
Kocherlakota does a poor job explaining why “conventional thinking” is wrong. Maybe he is relying on Bullard’s “7 faces of peril” paper with a flawed model of zero inflation expectations trap. Bullard’s conclusion is OK (more QE is needed), but underlying model is not.
SW (as quoted by Marcus):
“In this case, I agree with Kocherlakota, that the market has it wrong. As Kocherlakota argued, most of our monetary models tell us that, if the Fed maintains a constant nominal interest rate target forever, that will essentially determine the inflation rate, by way of the Fisher relation.”
Oh Christ. Oh Christ. Oh Christ.
SW interprets Kocherlakota the same way I do, and thinks he’s right. Oh Christ.
We’ve been at near zero for quite a while now and we are heading for deflation. There is some correlation but not necessarily causation. Doesnt this speak to the over all ineffectiveness of monetary policy in the first place? While he may be missing some basic macro teaching I think basic macro teaching is missing some attachment to the real world as well. As I understand it, monetary policy assumes the fed can increase money supply. That seems a specious claim since loans (the only way interest rates gets money into peoples hands) are driven by customers applying for them, not banks making money available for them.
Maybe if interest rates were 20% and I was getting that much income off my passbook savings, Id spend a lot more money. If my 401k was getting 20% I’d probably put a lot less into it and spend more. Yes this seems counter to monetarist thinking but maybe that is exactly how e should be thinking seeing as monetarists have been in charge for a while.
Oh Christ.
Central banks can’t keep the price level and inflation rate determinate by pegging the nominal (or even real) rate of interest forever. We’ve known that was wrong at least since Wicksell’s cumulative process. I assumed that everyone (except a few hopeless lefties and funny money guys) knew that was wrong. Nobody’s monetary model tells us that (except a few hopeless Post Keynesian types, who are at least logically consistent, because they assume very sticky prices that don’t respond to AD at all).
Oh Christ.
This is much worse than Cochrane getting Say’s Law wrong. Say’s Law is very nearly right, and very few people understand precisely why say’s Law is wrong, and that it’s money, and only money, and not any other asset, that makes Say’s Law wrong.
I give up.
This isn’t New Monetarism. It’s got nothing to do with Monetarism at all. It’s the exact opposite of Monetarism. Somebody resurrect Milton Friedman.
Gizzard: sorry. I’m in far too much despair to try to explain it to you. I’ve got to gather up my strength to try to explain it to people who are, by any objective measure, by far my intellectual superiors in their economic education.
Paul Krugman reads WCI. Why? Because of the comments.
Oh dear! I must clean up my language (could have been worse, I expect). I was just writing another post on this. Think I will leave it now.
I guess Kocherlakota (and Williamson) made a wonderful discovery — the fed can keep the inflation rate constant by just holding the fed funds rate constant, since the rate of real interest is constant. It’s a mathematical certainty! And makes the job so much simpler… wonder why we never thought of it.
Don’t leave it. More 2x4s to the head of the dumbkoffs is a good thing.
Such a tease, Nick
Let’s have it out. The false monetarists must be purged.
Karl Smith does it best – Kocherlakotaean deflation in Zimbabwe:
http://modeledbehavior.com/2010/08/25/bang-bang-kocherlokta-on-deflation/
I would suggest Williamson should try to exlain why a deflationary spiral is eventually created by pegging the nominal interest rate at the near zero level without using a mathematical equation which is valid ex-post. He should first describe what happens during a deflation, that is, define the broader deflationary environment and, then, try to explain what will be the real processes under way, especially at the macro level: excess supply in all economic sectors, falling demand? The more I read Williamson’s reply, the more it looks like the general level of prices is determined exclusively by monetary variables which sounds quite different from any sort of hypothesis about the neutrality of money, it looks more like the neutrality of everything which is not money (expectations) on the general level of price (velocity of circulation? credit creation? market confidence?, productivity?).
Probably, Williamson read too carefully Keynes on expectations 🙂
By the way, the only way out of this recession is raising taxes on the very very wealthy -I mean income, but especially, non-physical entities- and try to devaluate the dollar -even if it won’t be so easy in the ingenious way the German used to manage it, that is, creating 15 years before an unbalanced currency area.
Oh Christ.
The all-math no-basics principles demon strikes again.
I feel sad when I remember how Pierre Fortin taught us macro at Laval in the 70’s. If that math master didn’t told us “Remember that each equation must represent a behavior” followed ( just in case we young doofus didn’t catch it the first time) by “Never write an equation if you don’t understand the behavior” at least three times each course period, he didn’t told us once…
Today, I warn my students that they must understand two things : the difference between a monetary and non-monetary economy ( why Say’s law is wrong in the presence of money) and what is the relationship of money and goods flowing in the balance of payments account.( I don’t know a single financial journalist or minister of financeor trade that gets it) Not that the rest is meaningless but because without that,there is no hope of sound reasoning. And that “Never write an equation” thing.
In the name of simple humanity ,can I exchange my Cegep post for a Fed presidency? Or at least just give them a couple hours of basic macro?
Oh Christ!
I would describe the problem as too much focus on equilibrium, and not enough of processes that would bring about equilibrium.
“We should never, ever, let students do this. Yet we do it all the time.”
I think you’re on to something. I’m a math guy who read Romer’s Macro text, and even though I was reading a saltwater textbook with a saltwater professor, who reinforced at every point the little voice saying ‘but wait…’, my main reaction in the RBC model section was ‘this is so cool!’ It was only later, with a bit more perspective and a bit more thought about the economics of the situation that it struck me how truly off the rails RBC theory was.
I think what we need is an intro economics class for people who already have graduate-level mathematical sophistication. It does us no good to sit in a classroom full of people who don’t know calculus and are uncomfortable with algebra. But it also does us no good to start right up with the modeling without thinking about how it applies. We need something that makes explicit the manner in which our math is brought to bear on observation.
Nick,
Wrong. He actually took principles of economics from Alan Blinder at Princeton. What I’m wondering is whether you were on vacation when they did Irving Fisher in macro class.
Steve Williamson
Bill: that is a better way of describing it. Except there’s zero, rather than not enough, on the process that would (or, in this case, would not) bring about equilibrium. It was what I meant by distinguishing the equilibrium thought-experiment from the stability thought-experiment.
Jacques: I have to confess, “the relationship of money and goods flowing in the balance of payments account” is something I wish my head were a little bit clearer on. Lovely story about Pierre Fortin. Yes, Pierre’s way of putting it, “Remember that each equation must represent a behavior” is a very good way to try to understand what the math is telling you.
bruce: I read your comment as making a similar argument to bill woolsey. Yes, we need to know the process.
TMDB: Karl’s “bang-bang” interpretation is interesting. But, even if the process bringing us to the new equilibrium happened instantly, in this case it wouldn’t bring us to the new equilibrium but away from it (under any reasonable behavioural assumptions). It’s more like “bang-monetary system explodes”. I like to think of the infinite adjustment speed as the limiting case of the slow process. With a fixed nominal interest rate, there is no nominal anchor. The monetary units are indeterminate. The only question is whether the system explodes slowly or immediately.
Rob, Jim: on reflection. my new post wasn’t really saying anything I hadn’t already said here. Just laid out the Wicksellian process a little more fully.
Jed: even if the real natural rate were constant, it still wouldn’t really work. (But it’s easy to explain why if you suppose it changes, and since it does change, there’s no harm in supposing it does).
Steve: So my conjecture was wrong about him missing intro? What then happened? You can’t go from the Fisher equation to the statement that if the Fed pegs the nominal interest rate, the price level is determinate. The units are all wrong. There’s no nominal anchor. Start in one equilibrium, double the time paths of all prices, (I’m assuming neutrality), and you’re still in equilibrium.
Or, start in equilibrium. Let the Fed raise the whole announced time-path of nominal interest rates. By what process does this create excess demand for goods at the existing price vector, and so cause a higher rate of inflation?
Don Patinkin taught me Fisher. And David Laidler. And I read more myself.
Seems the professor in question has a practical problem of overspecialization with no generalization compounded by a mastery of a theoretical part without any vision of the whole.
In higher hemispheric learning I suspect Nick has double mastery: being the master of economic intuition, as Francis relates, as well as a master of economic analysis (sensible and thoughtful mind functioning). Perhaps he has a third mastery being among the best at economical economic education with his intro course – if he balances his masteries in his teaching.
In higher hemispheric learning an educator will first provide an intuitive picture so students get a feel for the whole: a pre-analytic vision. Then they’d bring in sensible and thoughtful analysis.
Please notice, “intuitive”; “feel”; “sensible”; “thoughtful” (thinking). Who knows where this “whole”, typology of four-folded ideal types, comes from?
“Paul Krugman reads WCI. Why? Because of the comments.”
Oh my. More lurking it is then.
No, no! Just act natural, and don’t look at the camera.
Nick’s post said: “This is much worse than Cochrane getting Say’s Law wrong. Say’s Law is very nearly right, and very few people understand precisely why say’s Law is wrong, and that it’s money, and only money, and not any other asset, that makes Say’s Law wrong.”
I think I’m going to actually agree with Nick. Let me put that in my terms. If an economy was all currency (basically, no currency denominated debt) and no one saved, including corporations, then Say’s Law would hold. Correct?
Funny, I know a bunch of Post-Keynesian types and none of them think anything like what Nick Rowe attributes to them.
Why are you folks so down on mathematics? I like to tell people that there were two useful things I learned in high school – calculus, and how to type. I’m applying the second skill right now.
Steve
I studied economics at LSE 1961-64. My teachers were world leaders in their fields (R G Lipsey, Lord Robbins, Phelps-Brown etc); and all were advisers to governments and/or business. I understood economics as a tool to change the world rather than an abstruse academic or mathematical activity, and later was an economic policy adviser to UK and Australian Prime Ministers.
I dropped maths when I was 15, not because of lack of ability or interest but because the system and small school size (420 pupils over seven grades) limited my options. Interestingly, from 1962 UK Advanced-Level maths was a requirement for LSE economics course.
I left economics to travel in 1972, the break extended to 1985 and in 1986 I took some courses at the Australian National University as a refresher. By then the content was almost all mathematical techniques and analysis rather than policy-relevant, and I’ve found the situation even worse in Queensland since 1991. I recruited a number of new economics graduates and students to my policy section, all said they learned more in three months with me than in 3-4 years at well-regarded universities.
I’m not an economic modeller, but since 1966 have worked with many modellers and directed modelling. In every case, the assumptions and interpretation of results were crucial, and depended for their validity not on the technical aspects but the understanding of economics per se. In my experience, over the last 50 years the profession has moved from the primacy of a grasp of economics – how things work – to over-elaborate mathematical techniques which do not aid understanding.
I made this point in reply to Scott:
“If the Fed can peg a low-rate with little to no open-market activity, then the public believes that the Fed is communicating that the inflation rate will low for the period over which rates are held low.”
Jawboning can create the disinflation. This matches the empirical facts very well. The Fed has been performing OMOs but they’ve been sterilized. Ergo, the the Fed moved the market with words not money. Ergo, there has not been inflation only disinflation.
Similarly, if the Fed raises the FF rate by declaring a new higher target, and achieves that end without OMO, they’ve convinced everyone that the future will have higher inflation.
Kocherlakota is right–within the confines of a reasonable counterfactual. So, now, all three of you are being too presumptuous.
The thin reed in his statements is about the stability of the real-rate.
Steve: I confess I’m bad at maths, and it scares me. But I do agree it’s useful (I once fixed my car with the aid of the envelope theorem, seriously!). Leaving cars aside, I was trying to model one of my thesis papers, and couldn’t get the math to work. Then I realised it was my intuition that was wrong, and the math was trying to tell me that. But people can make the opposite mistake too. I’m only really confident about something when the math, diagrams, and intuition, all line up and say the same thing.
But I am genuinely worried about overemphasis on math in graduate economics courses. I have anecdotes of students getting totally misled by their math, and missing things that would be obvious if they had been required to explain things verbally, or in graphs. Like a model of competitive equilibrium with increasing returns to scale. He didn’t see the problem.
They never taught typing in English schools. Good calculus though, if I had paid more attention.
By the way, I’ve done a new post on how I interpret standard economic theory, and what it has to say about the Fisher relation. See what you think. I hope it might clarify things, one way or the other.
Too Much Fed: Nope, sorry, we disagree on that. If you’ve got currency, as a medium of exchange, then Say’s Law is wrong, regardless of whether there’s debt. And if you don’t have a medium of exchange, then Say’s Law is right, even if you do have savings and debt. (I’m probably alone in thinking this.)
JamesH: yes, Post Keynesians are more varied than I let on. Some are not that different from New Keynesians. It depends on their IS curve (does it slope down wrt real interest rates?) and their Phillips Curve (does it get affected by AD?)
Hey, I know how to make this crazy stuff work: The Fed plays the role of “Confidence Ferry”. If the Fed keep interest rates to low it stifles demand by ruining confidence; if the Fed raises rates it show the Man On Top knows things will get better, inspiring people to lend and spend.
I don’t need evidence. I don’t need it.
Steve, no one is down on mathematics. The criticism is that mathematics cannot be a substitute for economics, defined as a discipline that studies actual human behavior. If economics is a science, then it is far more than math, just as physics is far more than math even though it intimately relies on mathematics. Kocherlakota is being accused of treating theories naively as mathematical equations, divorced from empirical common sense (or uncommon sense, as the case may be).
In my finance PhD program we took most of the same courses as the econ PhD students the first two years. I had a bachelors in economics, but most of the econ PhD students didn’t, and I saw they could get As in the econ PhD courses with little economics intuition just by being good at learning math.
I always thought maybe they’ll actually really learn the econ when they have to teach it, but perhaps teaching in econ tends to be superspecialized just like research is, so many profs at top universities still don’t understand intuitively giant amounts of even basic economics.
I think I might have been the first to bring up this issue (I’m not sure) and now I see I’ve missed all the fun. It seems to me that there are 100 ways that the Fed could raise interest rates and simulaneously raise inflation. I would be thrilled if they would do one of those things. And there is one way they could raise interest rates and reduce inflation expectations. As a matter of fact (from the TIPS spreads responses to fed funds surprises) we know that when the Fed raises the fed funds target they happen to use the one method that reduces inflation expectations. This happens at precisely 2:15 in the afternoon, so I really doubt there is any dispute over this empirical regularity. They rely on a liquidity effect (less base money means higher fed funds rates in the short run due to sticky prices.) Because that is the method they actually use, people get very nervous when Fed officials talk about raising rates in the middle of the biggest recession since the 1930s. Am I right? If not, where have I gone off base?
BTW, in a model w/o sticky prices Steve Williamson would be right. But prices are sticky, and hence short term interest rate changes are not best explained via the Fisher equation. With a liquidity effect real rates are moving by more than nominal rates.
You have made the important point — Kocherlakota is assuming that there is a unique equilibrium and it is stable. As I mentioned over at Angrybear, I don’t think this assumption is due to ignorance of basic economics. Kocherlakota definitely knows better. The falseness of his assumption is one of the results of the sort of mathy economic theory which is on his very impressive CV.
In his academic work, he demonstrates that he is very well aware that there are always two equilibria in monetary models one of which is the non-monetary equilibrium in which money is worthless. He knows this (in spite of not taking introductory economics).
There is yet another aspect of the Kocherlakota train wreck. He seems to assume that it is undesirable to have deflation when real interest rates are normal. A balanced growth path with normal real interest rates corresponds to unemployment at the natural rate (generally assumed to be zero in Kocherlakota’s academic work). In that case, according to Kocherlakota’s academic work, the optimal rate of inflation is -r, that is the optimal nominal interest rate is zero.
Somehow Kocherlakota is mixing a Keynesian belief that unemployment might be lower (permanently) if the real interest rate were lower and an analysis in which unemployment is assumed to be equal to a constant (usually set to zero for simplicity).
The point is that Kocherlakota’s awesome CV includes many many articles in which he argues that in the very long run, the safe short term nominal interest rate should be as close as possible to zero (the Friedman rule) yet he uses much of that equilibrium analysis to argue that the optimal safe short term nominal interest rate is higher than 0.25%.
You are right that Kocherlakota made an error which should prevent him from getting an A in economics 101. Your theory as to what went wrong doesn’t fit the papers on his CV (OK I haven’t read them but I know some of the closely related literature). My theory is that he thinks there are two ways of talking about economics — rigorous math and total anything goes BS. My guess is that, since the FOMC doesn’t want math, he considers BS arguments which he knows are invalid to be par for the
coursedebate. But of course I can’t read his mind.“Why are you folks so down on mathematics? I like to tell people that there were two useful things I learned in high school – calculus, and how to type. I’m applying the second skill right now.”
Others have asked who exactly is down on math. I ask: whose association of mathematics is with high school calculus? High school was about precursors to mathematics — symbol pushing and inchoate intuition. The people being complained about are way more mathematically sophisticated.
scott sumner, you boxed krugman in, so i don’t know if you will get a link from him anytime soon. or he boxed himself in. either way, glad you and nick are back from vacation.
The natural rate of interest is zero. http://bilbo.economicoutlook.net/blog/?p=4656
Low interest rates can be deflationary for a few reasons. Lower interest payments, say on car and house loans could make wages less sticky. In fact many borrower’s costs are lowered. Conversely, high interest rates can add to supply side inflation, and yes to some degree decreased demand for credit.
There is the Gibson paradox as Keynes put it, low interest rates decrease inflationary pressure, house buyers feel less buying pressure, housing prices stagnate or decline despite the low interest rate. There is a lot of empirical evidence to support this now.
Do not despair, Nick. As long as the vast majority of economists continue to economy as more important than the finite world, it doesn’t really matter if they believe inflation or deflation results from low interest rates. In fact it doesn’t even matter whether inflation or deflation results from low interest rates. It’s all angels dancing on the head of a pin.
Well Nick, I’m way late here but I’m actually gonna have to agree with Woolsey. What Williamson and Kocherlakota are doing is relying on a single equation without thinking through how it’s supposed to work, a big no-no. (Of course I think Sumner does the same thing but…)
I mean, what Williamson says is what the models imply but that’s because the models also imply an eventual, automatic, return to full employment. The mechansim by which holding the short rate low forever would cause deflation is that prices will rise so high in the short-run that they’re later expected to fall.
Raising rates now does imply a higher long-run inflation rate but only because we get MORE deflation now until prices are so low that once full-employment is restored it must be that prices will rise.