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 
A couple of missing words in my post: “view the”
I just want to know your site’s traffic numbers after PK linked to you.
Why should people be forced to take economics 101? It’s not a science but it tries to disguise itself as one behind a wall of mathematical models. In economics if you can’t model it it doesn’t exist. But the truth is that just because you can model it doesn’t mean it exist. Didn’t Krugman warn economist not to fall in love with their mathematical models least they miss the forest for the trees the same way most economist missed the financial crisis.
And of course you have different schools of economics that in science would be considered research traditions. In science once your presuppositions are proved wrong they’re proved wrong and that tradition branches on to another research tradition that is still in tact.
Instead that tradition–I’m thinking hear of the Chicago School–treats these basic failings as abnormalities that can be explained away. And explain it does forever and ever rather than a change any part of the presuppositions their research is based on.
That the Chicago School can find wiggle room so easily in the face of the reality of what just happened and couldn’t have happened if their research tradition was correct says “this is not a science.”
Being forced to take a subject whose presuppositions are suspect, which goes for all economic schools, and that tries to pass itself off as a science or is at least ambivalent about what it wants to call itself smack of indoctrination.
That can do a lot of damage to how one sees reality. How else can one explain so many economists missing the financial crisis. Was it because theory told them that they had spread out risk so widely that catastrophic failure was next to impossible. Larry Summers certainly thought so even after being presented with a speech outlining how it was much more possible than the economic consensus would admit.
Dani Rodrik who believes that an intro to economics distorts one view when the real work is being done by those with advanced degrees, tells about the criticism he received from other economist after he published an article which free trade economist though would give ammunition to the anti-free traders. This was a dishonest way for economist to proceed but perhaps the free traders felt self assured by their rock solid law of comparative advantage.
But there was another side to proceeding thus, there was factor-price equalization side. Hardly a mention of it could be heard from economists. Could it be that it would have told labor to beware.
Free trade economist went skipping on their way to save the world while planting the seeds for our ruin. They not only destroyed labor but also our political economy. They delivered it into the tender mercies of corporations and their stockholders. Their cover story was that we were all going to find jobs in clean industries so there was no problem in letting those dirty blue collar industries go to other countries.
Our government with the encouragement of corporate money and lobbyist did just that. They turned the mid-west into a rust belt with dying towns while financial services rose to be 30% of our economy. It rose until it crashed and trillions of dollars of wealth was destroyed.
Today there are close to a million financial service guys looking for jobs. They won’t find them in manufacturing because we’ve destroyed it. Those who once practiced manufacturing are still looking for decent jobs, jobs they worked hard to make into decent jobs , jobs with pensions, health care, wage, health, and safty protections. Now what is left of unionized labor is hard pressed to hold on to the gains it has fought for because so much of the nations wealth has gone to the wealtiest that there is no blood left in the turnip for anyone, not labor or the state. (Of course the state could always tax wealth but our represenatives seem to have a problem with hurting their funding sources.)_
We were better off with a political economy in which people fight for justice rather than what we have today: one where labor’s power has been denuded and where economist pontificate. If you don’t believe just look where it has gotten our society to follow these pied pippers of psudo-science which they seem to take as gospel.
I elected to take economics many years ago when I was in college. Some years later one summer I decided to read Samuelson’s Intro on my own. No one forced me to do it.
The frist time I was impressable the second time not so much. If I would have stopped at the first time who knows what thin ice I would be basing my thinking on today. I may have been lost to those deluded souls who look to economist for answers to our political economy. It’s bad enough that you have to go search out one just to have authority when you go against the consensus.
So no, I don’t want to be forced to take introductory economics especially at an impressionable age. Considering the weakness of economic presuppositions and it’s posing as a science, stopping at intro-economics at an early age might have clowded my view of the forest forever.
Those who are first will be last to see that their principles are faulty. And, false principles are impossible to correct with any model and sophisticated detail: mathematical or otherwise. However, it’s important to understand that when those who profess do see, they’re the best equipped to correct the fault and take the lead in solving critical problems. Indeed, I think economics is key. Marx was at least correct on that point.
Nick,
Believe me, Narayana is scary smart and he knows his economics. You should probably cut him a bit of slack for the loose language he employs in speeches he delivers to the public. (Andy: I assure you that NK knows the difference between neutral and superneutral; he likely chose the former term to convey the basic idea to a lay audience).
Nick, I found it interesting that you, like many people, appear to interpret the Fisher equation as an identity. I do not. I interpret it as a theory (originally, it expressed a theory of the nominal interest rate).
What do I mean by this? Consider two debt instruments with identical risk characteristics. One is a real bond that yields a real rate of return r. The other is a nominal bond that yields a nominal rate of return i. Now here comes the theory part: I impose a no-arbitrage-condition (what must be true if both instruments are to be held in wealth portfolios). The NAC is i – p = r, where p is the inflation rate.
Now, to say anything more than this, one should properly write down (or have at their disposal) a complete economic theory, preferably written in a mathematical language (Joseph Conrad is said to have preferred English for his novels because this language is so deliciously ambiguous), with assumptions made explicit, etc. etc. Obviously, NK was not going to do this for his audience. But let’s see what he’s getting at.
Rearrange the NAC above and we get the Fisher equation: i = r + p. We can use the quantity theory (with stable velocity) as a theory of inflation; i.e., p = m – g, where m is the money growth rate and g is the growth rate in the demand for real money balances. And so, together, we have:
i = r + m – g.
Now, one might take (r,m,g) as exogenous, in which case, you have a theory of the nominal interest rate. Alternatively, we might take (r,g) as exogenous, and note the equivalence between i and m. If the Fed picks i and commits to it, it is implicitly committing to a money growth rate m. The implicit assumption here is that agents adjust their expectations in line with actual Fed policy. So if i=0 and r>0, then inflation (m-g) must necessarily be negative (according to this theory).
Nick, I must have missed your point. I think you may have been trying to argue that the Fisher equation is an identity (theory free) and that NK was being stupid-silly in trying to deduce conclusions from an identity. If this was your point, I think you are wrong. One may legitimately disagree with the theory NK was proposing, but it would be wrong to suggest that there is not an underlying logic to what he was trying to say.
And by the way, the theory and scenario he brings forth reminds me a bit of Japan. Why can we not interpret the deflation in Japan as the outcome of a credible policy to maintain interest rates close to zero? And by the way Nick, when you speak of the impossibility of pegging the nominal interest rate (re: Wicksell), how do you think the Japanese have managed to do so without the predicted instability in inflation/deflation?
Finally, I have to say that when Paul Krugman revels in your dispair, egging you on for more emotional outbursts…well, you know you’ve done something wrong!
David,
I think that Adam P has pretty much nailed it. His point bears repeating:
“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.”
I am really tired of hearing that people who say (and/or do) remarkably silly things are scary smart.
Rob,
With all due respect, why do you repeat that bullshit? In what sense do you say he has “nailed it?” What makes this guy somehow know what THE mechanism is? I have no idea what model of the world this guy has in his head. His conclusions may be correct or not. If they are correct, it would be of some interest to have the assumptions spelled out precisely.
I can write down a precise economic model where raising interest rates now has any one of the following effects on the price-level and inflation: [1] An immediate drop in the price-level, with no inflation effect; [2] A one-for-one increase in the inflation rate; [3] etc. etc.
What is predicted to happen depends on many things, not the least of which is how the fiscal authority interacts with the monetary authority in paying interest on money and bonds. In more elaborate models where agents have to learn about things, the dynamics can become more complicated.
I have no idea what you think he “nailed.” What you are really saying, I think, is that his interpretation/explanation squares with your own. If so, that’s wonderful. But this does not imply that there is no logical coherence (or, indeed, empirical relevance) to the argument put forth by NK.
Cheers, DA
When I took Macro Econ, I was also becoming familiar with the mathematics of optimization. I was incredulous at the Macro-Econ assumptions made: no fixed costs, no transaction costs, homogeneous agents. I decided that Econ must be more about politics than science, and that I didn’t have the stomach to deal with the likes of Milton Friedman, et al.
Recently I have seen two papers that deal directly with these fixed costs and heterogenous beliefs — and surprise! If you do model fixed costs (Gomory and Baumol) and heterogeneous agents (Geankoplos) you get some rather surprising results. For instance: there are infinitely many ways of distributing gains from trade; and: asset price bubbles are endogenous whenever you have a spectrum of opinions and investors with access to leverage.
Given these pretty fundamental results about equilibrium processes, it seems that there is a whole lot more work to do in macro-economics. We know far too little about the dynamics to criticize each other about high-level inflation vs deflation comments.
“What you are really saying, I think, is that his interpretation/explanation squares with your own.”
In a certain sense, yes, that is what I was thinking. I simply took his point to mean that in the short term, pegging the interest rate below the natural rate would lead to accelerating inflation. Am I mistaken in thinking that it is a common feature of most mainstream models of monetary policy? I thought (up until the current argument) that this was well accepted. I’m pretty sure that Nick thinks the same thing.
I viewed as more of a conciliatory argument than you did, evidently. The reason I saw Adam P’s argument as conciliatory is that he is basically agreeing with NK’s statement, which did include the “long term” caveat. All he was saying is that the effects in the short run (hyperinflation and deflation) were being ignored. While continuing to hold the interest rate constant, these short-term processes naturally reach an end point, and give way to the long term equilibrium that NK identified. Say under sustained deflation, the capital stock would eventually fall to the point where the marginal product of capital, which is equivalent to the natural real interest rate, becomes equal to the real natural rate, restoring full employment. At this point you would start to see the long-term inflation associated with the high rate, but only after that period of deflation.
It sounds about right to me. I’m sure that Adam P could explain it better than I have, but I certainly don’t see how it constitutes bullshit.
uh, equivalent may not be the right term there, but I think you can see the point
Rob,
Perhaps “bullshit” was too strong a word. But maybe not. The theoretical properties of macroeconomic variables (which is what we are arguing here) depend critically on the underlying assumptions being made. It is hard to lay out all of one’s assumptions in a forum like this (or in a talk like the one NK gave). This is why we have academic journals.
I am not sure what you have in mind by “mainstream” economic models. (Again, it would have been helpful for you to cite an example). In the models I work with, pegging the nominal interest rate below its “natural” rate is not, in itself, inflationary. Of course, I also tend to work with rational expectations models, and this makes a big difference to the theoretical feasibility of pegging interest rates. The best paper on this, I think, is by Peter Howitt’s “Interest Rate Control and Nonconvergence to Rational Expectations,” JPE 1992.
With respect to your comment on a sustained deflation leading to a fall in the capital stock to the point where the MPK = r and “full employment” is restored. I suspect you meant an increase in the capital stock (to drive down the MPK)? And in any case, MPK = r does not guarantee “full employment.” For example, we have models of multiple equilibria where MPK = r, and yet, the economy is “stuck” at a low-level equilibrium.
http://en.wikipedia.org/wiki/Real_business_cycle_theory
Table 1 says investment goes sky high in booms and busts in busts. If you combine that with Alan King’s observation you get finance bubbles crowding out any postulated tech shocks.
This is all just a variation on the “bomb line” fallacy from Catch-22, in which the pilots believe that if the thread line on the map showing Allied forward positions is moved, they won’t have to bomb Bologna. So in the middle of the night someone sneaks in and moves the line.
Of course, in the novel, that means they don’t have to bomb Bologna. But I don’t think the real world works like that (usually).
DA et al:
Why the Thomas Aquinas routine? If I, or any other mere mortal, had come out with a whopper like NK did, you wouldn’t hesitate point out that I didn’t know what I was talking about, and probably none too gently either. So why does NK get a pass?
As for Nick despairing over the implications: You seriously can’t imagine the aparently screwed-up ass backwards view leading to some really horrendous policy? I think Nick (and PK) are right to make a big deal of this. It’s appalling and terrifying.
Of course, I’m just a nobody in the peanut gallery. What I think doesn’t matter in the least.
…capital stock, the freshwater school postulated cause of booms and busts, is the least cyclical variable! The captured economists don’t suggest forcing banks to retool car plants to wind turbines or R+D or clean up pollution, in booms. Main reason no self-consistency is funded by profits of booms, whereas Keynesian economists no conflict-of-interest. There is no human capital component or externalities in RBC wiki, so unemployment (and demographics) ignored and probably the biggest awaiting productivity gain in USA, Canada and 3rd world; pollution is ignored.
Thx Peter, was 1/2 way through novel.
My post said: “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?”
Then Nick’s post said: “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.)”
If I’m remembering correctly when you talked about haircuts (or post(s) near then), you talked about saving in the medium of exchange. I tried to specify no savings. That would include the currency. Granted that may be unrealistic, but I believe my point still stands.
David, the funny thing is I was ascribing to Kocherlakota a model pretty similar to what you’ve spelled out but I, in my mind, distinguished the “short-run” from the “long-run” he refers to try to give it a small toehold on reality.
You seem to be saying that you believe Kocherlakota was recomending a policy based on reasoning from a stable velocity quantity theory with exogenously fixed real rate? Notice in the model as you’ve written it if the fed ever wants to raise i it has to raise m (since r and g are fixed exogenously). Thus raising i can only be accomplished by raising inflation.
You consider this an empirically relevent model? I’m pretty sure constant velocity quantity theory models have long been understood to have no bearing on reality. When the Fed raised its target intrest rate over 5% in 2007 whyd didn’t it result in an increase in the inflation rate? I would suggest that if Kocherlakota was actually suggesting the Fed raise rates soon based on this reasoning then he’s even stupider than Nick has said.
Furthermore, I don’t think your really doing a great job defending him here since what your suggesting makes him, and you, appear completely idiotic.
David: “Believe me, Narayana is scary smart and he knows his economics.”
I believe you. But, being really smart never stopped anyone from making daft mistakes, sometimes. But I think there’s more to it than that. This is not just some random, inexplicable mistake. (And it’s not, in my opinion, some “deliberate ideological” mistake either. Because he could have done much better than this, if that’s what he wanted, for starters.) And the fact that Steve, and now you(?), and Jesus Fernandez-Villaverde on Mark Thoma’s blog, agree with him, definitely confirms it’s not random. There real big systemic problems with the economics that some people are learning (or not learning). And that Steve should be surprised that others find this controversial, is really surprising. Didn’t he know what everyone else thinks, even if he does disagree?
“Nick, I found it interesting that you, like many people, appear to interpret the Fisher equation as an identity. I do not. I interpret it as a theory (originally, it expressed a theory of the nominal interest rate).”
I can interpret it either way. To my mind, Fisher identity + superneutrality = Fisher relation. I used the LHS in this post, and the RHS in my next post. (Actually, superneutrality is sufficient, but not strictly necessary, for the Fisher relation).
“Nick, I must have missed your point. I think you may have been trying to argue that the Fisher equation is an identity (theory free) and that NK was being stupid-silly in trying to deduce conclusions from an identity.”
That wasn’t my point. My point, which I make clearer in my next post, and which I (falsely) assumed every macroeconomist understood, was that there is a big difference between asserting the Fisher relation (superneutrality) as a (long-run) equilibrium condition, and assuming that the economy will actually move towards that equilibrium where the Fisher relation holds. If you peg the nominal interest rate forever, you certainly will not move towards equilibrium. You will move away from it. Wicksell knew that. It is assumed in every discussion of the Taylor rule. Every central banker I’ve ever spoken to says you have to lower nominal interest rates initially if you want to raise inflation, and then raise them again, and raise them higher than before, when you get inflation up to the new higher equilibrium. In other words, what central bankers say makes no sense whatsoever unless they understood my point.
I am still stunned that NK’s speech got approval. (Or, maybe as Pres, he doesn’t need it?). There are a lot of eyebrows to be collected along Sparks street.
“And by the way Nick, when you speak of the impossibility of pegging the nominal interest rate (re: Wicksell), how do you think the Japanese have managed to do so without the predicted instability in inflation/deflation?” good question. I have been asking myself the same thing. I did a post on this: http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/12/why-dont-we-observe-macroeconomic-black-holes.html I don’t know the answer. Yes, something is wrong with standard theory. No surprise.
But when you are a Fed Pres, and you say something that so totally contradicts standard theory, to the extent of turning the Fed’s one steering wheel in the opposite direction to what every other central banker says you need to turn it to get the same results, then you really do need to know that you are saying something very radically different. He clearly didn’t.
Nick: “there is a big difference between asserting the Fisher relation (superneutrality) as a (long-run) equilibrium condition, and assuming that the economy will actually move towards that equilibrium where the Fisher relation holds”
Well put mate.
Adam P:
Do you actually read what I have written before crafting your comments?
First off, I am more accustomed to reading NK’s journal articles, where he carefully spells out all of his assumptions. I am not precisely sure what he meant by some of his remarks in a speech whose language was constrained by time and the nature of the audience. Perhaps because I know him, I am willing to cut him some slack. I know that he is not an idiot or ill-schooled, even if such a thought seems brings some people a peverse form of pleasure.
Second, you ask about the empirical evidence about the “model” I wrote down. (I do not consider it much of a model, it is just undergrad short-hand with tons of implicit assumptions built in). I guess this means you accept the logical validity of the argument, in which case, the defense of NK’s loosely stated opinion is complete (i.e., there exists an underlying logic to his argument). To answer your question, no, I do not take the “model” overly serious. On the other hand, it is not inconsistent with what we have observed in Japan, for example. Would you care to address this point?
Third, as I make clear in my response to Rob, NK is likely disciplining his reasoning by applying the standard “rational expectations” solution concept. As Peter Howitt (JPE 1992) has shown, even a mild departure from this assumption can lead to the Wicksellian cumulative process that Nick (and others, including you, I suppose) are worried about. I have a lot of sympathy for this line of reasoning (but again, I wonder about how Japan squares with this prediction).
So, at the end of the day, NK may be right or wrong. Perhaps he hasn’t heard of Wicksell. Or maybe he has and has chosen to discount it. A respectful post on Nick’s part reminding NK (and the rest of us) of Wicksell and of its empirical relevance would have been entirely appropriate. Instead, he goes crazy…and with Krugman’s blessings. That’s embarrassing (the latter, not the former…lol).
Cheers, DA
Nick’s post said: “Every central banker I’ve ever spoken to says you have to lower nominal interest rates initially if you want to raise inflation, and then raise them again, and raise them higher than before, when you get inflation up to the new higher equilibrium.”
Does that assume an aggregate demand shock instead of an aggregate supply shock?
Nick,
As usual, you raise several good points. (You could have expressed them better in your post, but this is a different matter).
Yes, you are right that SW appears unaware of how others approach this issue. We all have a lot to learn, I guess. (I see that you have started a fruitful discussion with Steve on his blog).
Yes, Wicksell knew about the theoretical pitfalls of interest rate targeting. (Again, I am curious to see how the predictions do not seem consistent with Japan, but maybe something strange going on in Japan).
I’m not sure about relying on the “conventional wisdom” of the world’s central bankers, however. What makes you so sure that they (oops, we…I guess) have it right?
I look forward to reading your next post.
Cheers,
DA
Yes I read your comment, did you?
The issue after all is not at all whether or not there exists an underlying logic to the argument in the context of some model. Kocherlakota was not giving a counter-example in a theoretical debate, he was advocating for a particular policy.
Second, that sort of “undergrad” shorthand was exactly how I read your model and what I was ascribing to Kocherlakota. I see nothing wrong with that if you yourself would understand the implications of those “tons of implicit assumptions”. Clearly neither you nor Kocherlakota understand your own model.
I was giving you a hint when I pointed out that your “model”, the part you wrote down, implied that the way to raise i was to raise m. You didn’t find that a strange implication?
Perhaps the problem is that you left out the money market. We’re thinking in undergrad shorthand remember, the usual story in such models is that increasing m lowers i and in order to raise i the Fed lowers m.
Was Kocherlakota advocating for the fed to raise i by raising m? If that is the case then then he should at least indicate how that is supposed to work given how non-standard that argument is, that is not how your undergrad shorthand model works. On the other hand, if he was saying that the Fed should raise i by lowering m then when we plug the lower m into your long-run equilibrium you get even more deflation.
The point being that raising i now is not helpful in your standard undergrad shorthand model so if that is what he is reasoning from then he’s reached a completely incorrect conclusion from that model, as apparently have you. And again, he was advocating a policy so the empirical relevance of the model that he’s reasoning from is of paramount importance.
Finally, I do think your “model” is inconsistent with the Japanese experience exactly because they didn’t follow the path the model implies in transitioning to this “long-run” equilibrium. On the other hand, the idea that simply r < 0 in the US now and in Japan I think is consistent with observation and is consistent with a coherent theory (and by that I don’t mean your “model”).
David,
“it is not inconsistent with what we have observed in Japan”
I disagree. On two occasions, the BoJ started to raise interest rates (just as, presumably, the natural real rate was starting to rise toward its long-run value). On both occasions, what happened was exactly the opposite of what Kocherlakota’s argument would suggest: instead of allowing Japan to make its way out of deflation, the interest rate increases were followed by declines in the inflation rate back into deflationary territory.
David,
An example of what I would consider a mainstream model is the Neo-Wicksellian model presented by Woodford in Ch. 4 of Interest and Prices.
“With respect to your comment on a sustained deflation leading to a fall in the capital stock to the point where the MPK = r and “full employment” is restored. I suspect you meant an increase in the capital stock (to drive down the MPK)?”
No, I meant a decrease in the capital stock due to depreciation and lack of investment, say in a situation where you have deflation and the interest rate is stuck at the zero bound. The interest rate couldn’t be lowered enough to stimulate investment due to a low MPK. Eventually lack of investment results in a declining capital stock, and MPK increases.
There may be some flaws in there but that is what I meant. Increasing capital stock and declining MPK would be more consistent with the opposite situation of an investment bubble approaching the point where it pops
Andy Harless said: “I disagree. On two occasions, the BoJ started to raise interest rates (just as, presumably, the natural real rate was starting to rise toward its long-run value). On both occasions, what happened was exactly the opposite of what Kocherlakota’s argument would suggest: instead of allowing Japan to make its way out of deflation, the interest rate increases were followed by declines in the inflation rate back into deflationary territory.”
The underlying imbalance was not corrected?
David, actually I should modify what I said above, Kocherlakota wasn’t quite advocationg raising rates now so I take that back.
However, he was suggesting that low i leads to deflation which does appear to imply that he believes raising i is necessary to avoid getting stuck in a deflationary equilibrium and on this my points above apply:
1) He is advocating a policy so the empirical relevance of the model he is reasoning from matters.
2) He is drawing a completely incorrect conclusion from the type model that you and I are ascribing to him. Thus your defence of him isn’t so good.
What’s so strange about Japan? BoJ’s goal is zero inflation. They do QE/ZIRP in order to raise the natural rate when deflationary pressures emerge. They raise rates when positive inflation threatens.
David,
what Rob is saying above makes sense. Rob is using r to be the real interest rate prevailing in the economy, the whole problem is that the natural rate (call it r) is lower than r and so the economy doesn’t invest enough. The equilibrium condition is MPK = r, not r. The slump is due to r* < r.
Thus, if the capital stock falls then MPK increases until we have MPK = r* = r and full-employment is restored.
Rob,
The mainstream model you cite assumes perfect financial markets, no money, and sticky prices. Even Woodford has abandoned it. Nevertheless, I see where you’re coming from now. However, I stand by my earlier point that the condition MPK = r* is no guarantee of “full employment” equilibrium. I can write down a model, for example, where MPK = r* at two (or more) levels of capital, one which Pareto dominates the other. (A simple way to do this would be to assume some form of increasing returns in the production function). Such a model has a “Keynesian” flavor to it; i.e., where a “depression” is the outcome of expectations coordinated on a low-level of activity.
Regards,
David
Adam P:
I like your comment: “Clearly neither you nor Kocherlakota understand your own model.”
O.K., so maybe I truly am clueless. I do, however, fancy myself as someone with an open mind. And so, in the interest of possibly learning something significant, allow me to an extend the following offer to you.
I am willing to invite you to give a seminar on this topic at the St. Louis Fed sometime this fall. All expenses paid. Time limit: 1 hr. Audience: myself and various members of our research department. I am willing to accept instruction throughout the day (before and after the seminar). Afterward, I offer my impressions of what I have learned (we can do this at the bar). Beer purchases financed by the loser of sequential foosball games (optional).
What say you?
Email me: andolfatto@stls.frb.org
David: Oh Christ! You realise that Adam lives oceans away, is very good at fuBball, and drinks beer like a fish?
Nick,
So much for my rational expectation! 😉
I’ll have to live with my commitment, however (subject to
our travel budget, of course).
And please let me know whether you’d like to visit the Fed one day!
I’d love to see you and Steve in a room, duking it out…
David
Here’s a thought: we ask for WCI session at the CEAs in Ottawa next year. We all kick in a certain amount for beer.
I’ll briefly explain what I mean by “economical economic education” to frame an education system – which you already have really (nothing new, just refreshing with two eyes) – to teach intro economics with higher hemispheric learning. By “economical” is simply meant efficient: ability to teach more in less time with better results.
I did an action research project about 20 years ago that addresses the problem of so many 10 to 12 yr olds loosing love of learning at that age. I used Ockham’s razor (“law of economy”) in two principle ways: “entities must not be multiplied beyond necessity” as well as recognizing that simplicity is an aspect of structure: for depth perception the right higher hemisphere synthetic picture of the whole ideally mesh with the left hemisphere’s analytical assumptions.
First, the established teaching curriculum for Grade Four students was set to spend 80% of the time on reading, writing, math and science. I was able to reduce the time taught on these subjects to 50% with better learning outcomes. The proof was with the Canadian Test of Basic Skills administered at the beginning and end of the year.
Example of one program: built an observation beehive for students to observe and get a feel for the synthetic whole, then developed lesson plans for analysis with reading, writing, math and science around those observations. This opened up 50% of the school day (after lunch) for daily PE; drama; gardening (lesson plans like the beehive) and group dynamics in general (I do socio-metric testing to determine leadership, followers, alienates and isolates). I submit, it was a very economical and highly successful. The students loved to learn.
Onto university education in economics, where actually you already have such a system and probably use it as standard economics in your intro class: the famous circular flow diagram (“beehive”) of Household and Firm with the flow of Factors of Production and Goods & Services. Who originated it? Its brilliant!
As an isolated up-in-the-air system, it’s heavenly. The main problem is coming to ground in reality, which you can’t do if your assumptions are off the mark. Frankly, I see a form of Gresham’s law at work, not economically where quantities of bad money drive good money but philosophically where bad qualities (selfishness) drives out good qualities (enlightened self-interest of ego and empathy).
On the economic analysis side work for an intro course I’d use Jevons: simply defining economic analysis as the “mechanics of self-interest and utility”. Self-interest is the centering principle; utility (ordinal preference function) the marginal principle. This is status quo standard economics eh. Just keep it simple for your students in the intro class. For methodology little math is fine but more analytical reasoning (excluded middle) is better and synthetic reasoning (dialectic which includes the middle) has a place too. Interestingly, when teaching arithmetic (i.e. drilling multiple tables) in the above action research project, the carrot after hard work was to play logic games and puzzles. They loved it.
Now, in applying the law of economy to gain depth perception meshing the two sides. Personally, I’ve never seen a circular flow chart with something in the middle. Self-interest is quite a phenomenon there; as is utility at the margin, though both principles have flaws that need revision in my worldview. Self-interest (natural) is not selfishness (cultural); and, revising preferences can wait. I had quite a battle with Herb Gintis in the 90s on the topic.
I don’t think that you can say that Woodford has abandoned it. He still refers to it as the “canonical” and “basic New Keynesian model” and refers to his more recent models as “extensions” of that model (w/ Curdia Aug & Oct 2009, 2010). My understanding is that he argues that the extended models (with credit spreads, etc.) give similar results as the basic model, and that the basic model is still valid
If there has been some radical paradigm shift, then I am unaware of it.
Well David, that’s a friendly offer and in principle I’d like that. However, I don’t think you really expect or want me to come to talk about the mechanics and implications of undergrad shorthand models so I can only assume the offer is somewhat disingenuous.
So I guess we’ll just leave the conversation there, no point talking past each other any more. Sorry if you think I didn’t give your point its due consideration.
As for the comment about not understanding your own model, as far as I can see it’s no different, just less tactful, than what Nick said in the post so better just bring Nick to give a talk. I imagine Nick and I are anyway saying something similar.
“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”
In Introductory Macro or International Trade, there is barely a week ( well a term) without a student bringing a series of articles from a well-known financial journalist either about his own reflexions ( such as they are ) or commenting on some ministers or Chamber of Commerce type interpreting trade figures, Usually it begins by ” We have a trade surplus so let’s be proud of our competitivenes” followed a few days later by ” We have a negative capital account so investors are fleeing” or ” Our businesses are bold and forward-looking and invest outside”. A few months later, a negative trade figures start the thread in reverse.
In other words, they have no understanding of what’s going on. They know the arithmetical results but have no clue about the behavior. They have no understanding of why the trade and capital numbers must be equal and of opposite sign..
That’s why in my course basic points it’s next in importance to Say’s Law in a money economy.
Third, and so related to the first it is almost the same thing, is why in a money economy there is no difference between a capitalized ans a pay-as-you-go retirement system at the macro level. (At the micro level it is of course a different story) Nobody reads “Capital accumulation with or without the social contrivance of money” anymore?
And fourth is why at the macro level of a central gov’t, taxation has almost nothing to do with funding gov’t expenditures but is about regulating aggregate demand.( In a century, at least one minister of finance in the western world will get it. In two centuries , the financial press…in five or six , the fresh-waterians.)
As for my students, if they get 2 out of four,it is a year well-spent.
Rob: Would you really expect Woodford to come out and say, after all these years, and in front of all his disciples, that “oops…I guess assuming frictionless financial markets and cashless economies kind of missed something?” Now, he suddenly has models with cash, banks, balance sheets, debt constraints, etc. You do not think this is a radical paradigm shift? Maybe not so radical, but pretty significant, in my view. (A New Monetarist might say that he has finally seen the light…or “a” light, at least — evidently NMs have blind spots too).
AdamP: You’ve wimped out on me. And I was getting a little worried after Nick pumped you up like that! I think that Nick and I are largely reconciled on this matter (see comments on Williamson’s blog).
Stephen: A WCI session at the CEAs? Brilliant! Where do I contribute? 🙂
David, Stephen, are you thinking of a macro-guys-fight-it-out-session or a talk-about-blogging session?
Like I said David, if I thought the offer was at all serious I’d absolutely come.
A WCI session absolutely needs to happen. How do we make it so?
On a WCI session at next year’s CEA meetings. They’re in Ottawa at the beginning of June this year, info can be found at economics.ca/2010/en. This is how to get a session on the program:
The conference organizer is Professor Mike Veall, Department of Economics, McMaster University, who can be reached at veall@mcmaster.ca. He welcomes suggestions for special sessions any tine, but no later than January 28, 2011. It is expected that the conference web interface for individual submissions will open December 1, 2010 and close on February 18, 2011.
Since it’s in Ottawa there will probably be a large number of submission.
Sorry, wrong link, it should be economics.ca/2011/en
I agree with you, Nick, about math having to make sense, but I learned that from a math professor.
I took Econ 101 as an undergrad – I found it to be nonsense, really. I was a math/physics double major, and the single thing I most remember was what one math professor called “The Reasonableness Test.” You can imagine what it was.
Those were the days not just before personal computing, but at the dawn of personal calculators. One of my physics profs allowed the use of calculators for a test (it had been forbidden before), but included one problem whose only calculation resulted in a trivial answer. The one student in the class who had a calculator – a TI SR-10 – was the one student who got it wrong.
I have a PhD in computer science, and I think my own discipline differs from economics in a fundamental way: our assumptions are tested against the reality of a machine that must execute them. Mathematics is an a priori discipline, economics should be empirical. When folks start relying on untestable a priori models, and rely on assumptions to avoid the need for empirical grounding, what one ends up with is worse than nonsense – it’s nonsense that doesn’t manifest as such. In CS, we call that “Byzantine error.” There’s nothing worse than error that hides in the confounding of unknown factors, but that kind of confounding seems to get ignored entirely in economics. I don’t get that, and I don’t see how the resulting discipline could possibly do more good than harm.
Something else, if you’ll allow me a serial comment.
You may have heard about the Millennium Prize problems. One of those is a computer science problem, known as “P ?= NP.” I think that problem’s very existence speaks to your concern about economics.
Within computer science (and more broadly, mathematical logic) there’s the area of computation theory, and within that, the area of decidability theory. Broadly, the issue is what is reasonably computable and what is not. Reasonably computable problems generally have deterministic algorithms that take (small) polynomial time and space to compute. Problems with only known exponential algorithms, or only non-deterministic polynomial algorithms (thus, technically, not algorithms at all) are not considered reasonably computable.
It seems to me that computer science and theology share this concern, of what is reasonably decidable or computable, and that a similar concern is missing from economics. Yes, theology, and my point in that reference is that in many respects, the modern discipline of economics appears to me even less rigorous than theology – it’s more a religion than a scientific discipline, despite its apparent reliance on mathematics. Theology, like computer science, takes seriously the question of standards of proof and practicality. I seems that what economics relies upon has nothing whatsoever to do with what mathematics would consider valid standards of proof.
Economics as a profession needs to be far more than just the priesthood of the religion of capitalism, but that’s how it looks to folks like me, who know what science is and know what religion is. Economics is far more the latter than the former, by my own standards of measure.
The conceptual substance of modern economics is social science – both psychology and sociology – but I see little evidence (admittedly as an outsider) that those foundational disciplines and their methods and results are taken seriously by the discipline of economics itself. I’ve never seen mention of a single economics “law” that isn’t at its core an unproven/unprovable hypothesis about human behavior that just happens to be taken as axiom within the discipline of economics. That makes it little better than religion, and not good religion at that.
Continuing the post at August 26, 2010 at 01:15 PM …
Here is the haircut economy “post”:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/11/accounting-and-economics-and-money.html
part of Nick’s post:
“Lets start with a very simple model. No foreigners, no government. No investment. The only two goods are haircuts and money. There are no inventories of haircuts. They get produced and sold at the same time. You can’t cut your own hair, and there’s a tabu on cutting the hair of someone who has cut your hair recently, so you must use money as a medium of exchange. Money is a fixed stock of currency. No banks.
Start in equilibrium: demand for haircuts=haircuts produced=haircuts supplied. Desired saving=0 …”
And, “For antiques, substitute bonds, bank loans, whatever. It doesn’t matter, unless it’s the medium of exchange.
The only form of excess desired savings that does the damage is an excess desire to save in the form of the medium of exchange.
Is that what you were trying to say Winterspeak? If so, you were absolutely right!”
Am I confusing the “haircut” economy with Say’s law?
part of Nick’s post is a comment at
November 19, 2009 at 07:55 PM
from that link
Someone asked how the Japanese were able to peg rates for so long, without the price level exploding. Andy Harless got part of it, they raised rates any time price stability was reached. But the other part is QE. Once rates hit zero the Japanese used QE. That won’t work at positive rates because QE will cause the overnight rate to fall. But at zero it can’t fall, so the central bank can still peg inflation at negative 0.5% by using QE to prevent runaway deflation, and by raising rates whenever price stability rears its ugly head. And that is precisely what the BOJ did. There is no mystery to be explained.