When economists say that something is "linear", rather than "non-linear", they normally mean it is a straight line, rather than curved. Y=a+bX is linear; Y=a+bX2 is non-linear.
That is NOT what I am going to mean by "linear" in this post.
Instead, I am going to use the words "linear" and "non-linear" in the way Artsies use those words. A "linear" plot is one that starts at the beginning, then continues with day causing following day, until it gets to the end. A "non-linear" plot curves back on itself, with simultaneity, flashbacks and flashforwards, and self-referential asides where the characters wonder if they are in a story and how it's going to end.
Economics is now, and has been for hundreds of years, a non-linear discipline, in the Artsie sense of the word.
[Update: anyone who doesn't get my point, or who wants to see the point explained by someone who understands math modelling better than me, or who wants to see it from the perspective of a real scientist (not an economist) who studies predator-prey dynamics, should read Jeremy Fox.]
The very simple story of demand and supply, as we teach it in ECON1000, is a fundamentally non-linear story. If you try to tell the demand and supply story as a linear story, you always get into deep trouble. "Bad weather causes a decrease in supply, which causes an increase in price, which causes a decrease in demand, which causes a decrease in price, which causes a decrease in supply, which causes an increase in price…."
Explaining demand and supply to first year students is difficult, precisely because it is a non-linear story. They want to know whether a change in quantity causes a change in price, or whether a change in price causes a change in quantity? And in which direction will price change if quantity changes, or will quantity change if price changes? And you can't answer that question, because it doesn't make sense. We can only answer "both".
And so we draw a supply and demand curve diagram, point to the intersection of the two curves, and say that price and quantity are co-determined simultaneously in equilibrium by the supply and demand curves. Where the supply curve is the whole relationship between price and quantity supplied; and the demand curve is the whole relationship between price and quantity demanded. And explain that supply, quantity supplied, and quantity sold are three different concepts. And explain how demand, quantity demanded, and quantity bought, are also three different concepts. And tell a story of the disequilibrium sub-plot in which an excess supply causes price to fall to the equilibrium, and excess demand causes price to rise to the equilibrium. And distinguish that disequilibrium sub-plot from the main equilibrium plot in which shifts in supply or demand curves cause the equilibrium price to rise or fall.
"Equilibrium" is economists' code-word for "this is a non-linear story".
The very simple standard story of demand and supply is a non-linear story. That's what makes it so hard to teach properly. Students really really want to hear a linear story. They like linear stories, because linear stories are so much easier to understand, remember, and explain. You can even write linear stories in point-form. "S up arrow P down arrow D up arrow Q up" would say it all, if the plot were linear. The "arrows" indicate "precedence", in both the causal and temporal sense. If the plot were linear, we could easily lay out the concrete steps through which an increase in supply caused a decrease in price and an increase in quantity, taking one causal step at a time. But it's not linear.
My car has a linear transmission. The engine turns the main shaft, which turns a cog, which turns another cog, which turns the auxilliary shaft,..which turns the axles, which turn the wheels, which make the car go forward. The monetary policy transmission mechanism, even in the very simplest and crudest version of that story, is non-linear. Even calling it the "monetary policy transmission mechanism" is a highly misleading metaphor, because it leads people to expect a linear story.
The simple story of monetary policy I teach in ECON1000 is non-linear like the demand and supply story, only more so. That's because there are more goods, more supply and demand curves, more endogenous variables that get determined simultaneously, and almost everything depends on almost everything else.
I have a shameful admission to make. A couple of times, after some students still didn't get it, I broke down. I told them that this wasn't exactly right, and then wrote down: "M up arrow r down arrow I up arrow Y up arrow P up". And the students loved it. Yes! This they could really understand! They all wrote it down in their notes, memorised it, and regurgitated it on the exam.
What I did was wrong. I linearised a non-linear story. But that's not the point of this post.
The point is that the students really really wanted a linear story of the monetary transmission mechanism. And when I gave them a linear story they thought they understood it. They didn't. They misunderstood it. They misunderstood it just as badly as a student who thinks "an increase in supply causes a decrease in price causes an increase in demand causes an increase in quantity" misunderstands demand and supply.
My students were like the people from the concrete steppes. The people from the concrete steppes want a linear story of the monetary policy transmission mechanism. Sorry, but you can't have it. If you think you understand monetary policy through a linear story, you don't understand it. The true story is non-linear. There is simultaneous causation, so endogenous variables are co-determined in equilibrium. Expectations matter, so the story has flashforwards and flashbacks, where the future affects the present. Those expectations are self-referential, because the characters in the story know the author who works at the central bank, and can anticipate the future plot he plans to write, which affects their actions today. That means a loosening of monetary policy could mean that interest rates rise, not fall. You cannot reason from an interest rate change (Scott Sumner), because interest rates are endogenous variables.
The people from the concrete steppes find this all very frustrating. They want a story with a linear plot, because a linear plot is what they understand. And if they think the linear plot cannot work at the Zero Lower Bound on nominal interest rates, they conclude there must be no plot in which monetary policy works. And they think that any non-linear story is just handwaving and mystification.
Here is a very simple non-linear story, which the people from the concrete steppes won't like. We know that for any equilibrium time-path there exists a second equilibrium time-path along which all nominal variables (like NGDP, and the money supply) are higher or lower. This means that a permanent loosening of monetary policy will eventually move the economy towards one of those time-paths along which all nominal variables are higher. This means that the expectation of a permanent loosening of monetary policy will mean the expectation of an eventual permanent increase in all nominal variables like NGDP. (This is how monetary policy always works, regardless of the ZLB, because interest rate changes are an endogenous symptom of monetary policy changes, not an integral step in a linear causal chain.) An increase in expected future NGDP will increase demand today, and increase current NGDP. It would really help people to expect a permanent loosening of monetary policy and a permanent increase in future NGDP if the central bank announced a commitment to a higher future NGDG target, because hitting that target would require the central bank to loosen monetary policy permanently.
Not very linear, is it? But then economics isn't a linear subject, and hasn't been for hundreds of years. So what did you expect?
Worthwhile Canadian Initiative 
I agree with you about the Fed, W. Peden. This is supposed to be a Worthwhile Canadian Initiative, after all.
@ W. Peden
“The ECB’s holdings of private debt have not been problematic, as far as I know.”
YET.
If you throw a trillion euros or two (or three) at a bunch of insolvent banks, there is a certain amount of repayment risk.
The ECB is entering new territory (at least in modern times) of central bank risk for a major state with its own currency. This could blow up in their faces. The Fed may have unlimited ammunition (or not), but the ECB probably doesn’t anymore (if it ever did).
It’s confusing, unnecessary and imprecise to create your own terminology and repurpose existing terminology. Possible terms to choose among:
Non-monotonic
Multivalued
feedback and feedforward with and without delays and nonlinear feedback functions
differential equations including nonlinear and delay and matrices thereof
sensitivity
distinctions of equilibria including multiple, unstable, and nonexistent
stability and criteria for same
distinctions between steady state, finite difference and differential models and their possible nonequivalence.
The difference between uncertainty and risk and its economic effects
The effects of different risk distributions (acual and assumed) on the behavior of the financial system
continuity
phase space
bifurcation, attractors, chaos, randomness, and the concept of chaotic control
domains of validity for models
and from economics stocks, flows and integrated flows and the problems from confusing them, with reference to the use and abuse of GDP
There is an abundance of useful terminology and correct representation available from mathematics, physics and engineering, if you choose to use it. If your representations don’t serve to communicate, maybe they’re the wrong representations.
“… as simple as possible, but not simpler”
Prakash: “However, if market monetarists believe in expectations setting overriding eveything, then the central bank should target something that has the distributional aspect also taken care of. Targetting the median wage or even better the 25th percentile wage should be what they aim for. Do you disagree?”
Some MMs do sometimes wonder about targeting (the time-path of) average nominal wages, instead of NGDP. It probably wouldn’t make a lot of difference if we targeted the median wage instead of the average (unless the skewness of the wage distribution changed a lot over time for other reasons, which I expect it might).
I think (and I’m pretty sure other MMs would agree on this) that targeting the median wage rather than NGDP would probably have no effect on the long run distribution of income. It would probably have some effect on short run cyclical fluctuations in the distribution of income, but I can’t figure out whether it would make inequality more procyclical or countercyclical (maybe I could if I spent a lot of time thinking about it). But it would probably not reduce long run inequality relative to an NGDP target.
News flash from zerohedge:
“Fortress Paper Ltd. announces that its wholly-owned subsidiary, Landqart AG, a leading manufacturer of banknote and security papers, has had a material banknote order reinstated. This order was unexpectedly suspended in the fourth quarter of 2011 which negatively impacted the financial results of Landqart’s operations in the first half of 2012.”
Step by step to a crackup.
Determinant,
That raises a further question: are there any parallel restrictions on the Bank of Canada? Does it hold private debts? (I confess a lack of knowledge about Canadian monetary institutions- I only did Canadian Studies for one year and while there was a bit of economics we didn’t get all the way to monetary policy!)
Peter N,
Even then, with the exception perhaps of the Spanish banks, the problems for most European banks are their holdings of sovereign debts, because in an important sense (monetary sovereignty) the eurozone states are not sovereign.
I agree about new territory. Of course, the ECB has always been a pioneer institution: never before have we had a central bank without a state. It was created to facilitate the formation of a European state, rather than to help the politics of an existing state (like a normal central bank). Cart before the horse, as it turns out. However, it’s only been in tough times that the ECB’s peculiarities have become important.
Anyway, apart from the fact that a government can’t suffer losses from its holdings of its own debts (I am no poorer if I write a $1 trillion IOU to myself and then burn it, except from one piece of paper and one match) the eurozone crisis shows us that government debts can be just as dangerous as private debts and that this isn’t just a problem of third-world defaulter nations like Argentina and Zimbabwe. If we’re going to have central banks, then they should generally choose the assets they buy on the basis of independent ratings. That would give an incentive to end some of the monopolistic elements in the ratings agency business, which would benefit parties quite apart from the central bank.
Peter N: “It’s confusing, unnecessary and imprecise to create your own terminology and repurpose existing terminology.”
Agreed. And I did wonder about using at least one of those alternative terms, “non-monotonic”, but I thought that wasn’t exactly right either, and it might be even more confusing. In this case, since a large part of the population are non-economists, and non-scientists, and do use “non-linear” in roughly the Artsie sense, and we do hear complaints from those people that “economics is linear”, I thought it best to go with their existing usage.
My guess is that a greater part of the whole population uses “linear” in something like the Artsie sense than in the Y=bX sense. Even if I’m wrong on that guess, it’s not a trivial proportion of the population.
The public may be a lost cause at the moment, but economy begins at home. Students deserve better.
For instance, how does supply and demand work in the automobile market? Here you have a rich but well understood pattern of supply and demand. Students would see economics as it actually works. For instance, past a certain point automobile inventories are a wasting asset. Why do manufacturers overproduce, fill dealers’ lots with 120 days of inventory and end up having to give rebates? What exactly does retail price mean? What effect does lobbying have on the market (the dealer market is not free).
A lot of the confusion is of economists’ own making. The imprecision of undergraduate education pollutes the whole system. After all, today’s students are tomorrow’s economists, businesspeople, politicians…
Especially to be avoided is appeal to obviously true general principles that are not obvious, general, provable or sometimes even true. Rational expectations would be a case in point. Its only defense is that it makes modeling easier (though not more correct). Is it an emergent phenomenon of large numbers of irrational agents? How would you prove (or even plausibly demonstrate) this?
W Peden:
“If we’re going to have central banks, then they should generally choose the assets they buy on the basis of independent ratings.”
Why are you talking about buying risky assets? None of the central banks under consideration (Fed, ECB, BoC) can buy private assets. Only government guaranteed ones. I’m not sure what you are talking about. The ECB can’t even do QE. The only literal buying they are allowed to do is limited to the demand for paper money. Anything else is banned as debt monetization.
There are good reasons why this is done, as rsj has explained. There are also good reasons why we should clearly delineate the boundaries of the CB for the purposes of our discussion. Otherwise it’s pointless. The question you seem to be discussing is “what are the limits of the power of expectations management for a central bank that has the ability to do whatever it wants”. Or perhaps, that has the ability to purchase assets of a quality only known to W Peden. Or how about, allowed to do just enough to make the claim that they are omnipotent true, whatever that happens to be. The rest of us should be excused for thinking that that is not a terribly interesting conversation.
The trouble with permitting risky asset purchases is that you can securitize just about any risk you want, including almost any imaginable fiscal action. How about the CB buys loans to people whose unemployment benefits have expired? That should work.
@K
“The only literal buying they are allowed to do is limited to the demand for paper money. Anything else is banned as debt monetization. ”
What was that last 900 billion euros of LTR, then?
K,
I was under the impression that the ECB had been buying covered bonds and the Fed had been buying mortgage-backed securities. Perhaps I’m mistaken.
I often run into this problem teaching American Politics to undergraduates. Explaining to students that the relationship between interest groups, congress, and the bureaucracy is a complex interplay of interests, information, and power is something they find deeply unsatisfying. If you reduce it down to some kind of vulgar exchange they perk right up.
W Peden,
No, actually you’re right on both counts. They both have limited abilities to buy some private assets. But it doesn’t change the rest of my points. It’s fiscal powers that have the potential to rescue the economy from the liquidity trap. We actually do have to understand the institutional constraints and the extent to which the CBs have fiscal powers in order to understand the limits of central bank powers. And it’s not “monetary policy” because the quantity of money has nothing to do with it. It’s only about the asset side.
K,
Money is an asset, so changing the mix of assets between base money and private sector assets has everything to do with the quantity of money.
Whether central banks’ capacity to get out of liquidity traps is ‘fiscal policy’ or ‘monetary policy’ is entirely a matter of the words one chooses to use. Yours is about the third definition of ‘monetary policy’ offered so far and there are probably a dozen we haven’t used yet. The important point is that classical fiscal stimulus of the type that Keynesians dream about is unnecessary, even if one makes the assumption that treasuries and base money can be perfect substitutes.
I wouldn’t mind if monetary policy was entirely conducted through postive/negative IOR, if possible. It’s just, as it happens, central banks can always increase demand and the Keynesian liquidity trap has no application to real world economies. That’s distinct from Keynes’s liquidity trap; whether Keynes was right depends on your theory of liquidity preference. (Like ‘monetary policy’, there are about a dozen meanings of ‘liquidity trap’.)
Feedback is compatible with causal precedence and temporal precedence.
Nonlinearity is compatible with causal precedence and temporal precedence.
It is a mistake to regard systems as acausal or regard the causal relations as temporally indifferent simply because the distances in the causal-temporal sequencing of events in these systems might in some cases lie below the threshold that can be practically measured, or that the inquirer has chosen to measure.
It can be useful to approximate systems with a level of description in which some macro-parameters are in a steady state. But one can almost always ascend to a more detailed description of the system in which that parameter is refined into one that is no longer steady. Just think about the predator-prey example Fox used.
Crude global measures and descriptions can be useful – until they aren’t. When the debates concern the causal details, different accounts of which generate different predictions about results, then it is not a sufficient response to say that you are attached to temporally indifferent and acausal equilibrium models that only approximate.
There is nothing in the world of human affairs which is analogous to the atemporal causal dependence of systems such as those studied in classical Newtonian dynamics.
This looks to me like a lot of pop scientific hand-waving fluff for not wanting to think about challenging causal questions.
W Peden: “Money is an asset, so changing the mix of assets between base money and private sector assets has everything to do with the quantity of money.”
No, nothing. Treasury can get the identical effect by swapping t-bills for the same real assets. If the quantity of the medium of exchange has nothing to do with it, then it’s odd to call it monetary policy.
“classical fiscal stimulus of the type that Keynesians dream about is unnecessary, even if one makes the assumption that treasuries and base money can be perfect substitutes.”
Of course, to the extent that the central bank digs out of the liquidity trap via fiscal policy, it’s exactly as distortionary as when treasury does it. Just without the democracy bit.
Dan: “It is a mistake to regard systems as acausal…”
I am certainly not saying it’s acausal. The supply and demand curves cause price and quantity. The mistake is made by those who confuse the absence of a uni-directional uni-temporal causal sequence with the absence of causality. Not every type of causation is like billiard balls.
K,
They can, but they don’t, so it isn’t. If someone kills someone else by clubbing them over a head with a cricket bat, it’s puerile to say that cricket bats have nothing to do with it because they could have used a baseball bat instead.
“Of course, to the extent that the central bank digs out of the liquidity trap via fiscal policy, it’s exactly as distortionary as when treasury does it.”
No, unless the treasury conducts the fiscal stimulus simply by buying highly rated assets. That would actually avoid many of the distortionary problems of fiscal stimulus, but if you’re going to have a fiscal stimulus then the least distortionary way to do it is simply to underfund existing expenditure (since changes in M = PSBR – sales of gilts + bank lending to the non-bank private sector – non-deposit liabilities – the external balance) to the extent that is needed, which will probably be enough to do the job all by itself.
If exposing the Fed to risk was the real rationale, then why is it able to conduct other risky activities, including its LOLR function? Arguably, because these activities are necessary to perform its function adequately. So why is effective demand management at the zero level bound less worthwhile than lending to banks who can’t borrow on the market? (If we make the assumption that treasuries and base money are indeed perfect substitutes under current circumstances.)
Because the central bank was not created to be a economic agent, nor a demand management agent.
It was created at the urging of the banks to ensure the stability of the banking system. They needed a reserve bank (a bank that could settle payments between other banks and lend to other banks) that could always deliver in times of crisis. The previous reserve banks, such as the Bank of Suffolk, weren’t always big enough to guarantee an end to bank runs.
There was no larger economic role at all, other than the role of preventing bank runs. The residual, and difficult to detect “demand management” role of monetary policy came much later.
The government, then as well as know, primarily manages demand via fiscal policy. That is why, for example, we have unemployment insurance, food stamps, and other fiscal stabilizers, without which we would be in a depression.
Nick’s brand of monetarism died long ago when it was tried and failed. There are no plausible mechanisms by which the CB can target (or even control) the higher monetary aggregates, and no evidence of these aggregates playing any structural role in the economy, we are left with fairies, tinkerbells, and pure obstinance. Everyone else has moved to viewing the central bank as setting the OIR, rather than quantities.
Here is an example of billiard balls — e.g. actually looking at what people are doing and how the institutions work in order to try to understand the economy — from the Fed!
http://www.ny.frb.org/aboutthefed/fedpoint/fed49.html:
“Following the introduction of NOW accounts nationally in 1981, however, the relationship between M1 growth and measures of economic activity, such as Gross Domestic Product, broke down. Depositors moved funds from savings accounts—which are included in M2 but not in M1—into NOW accounts, which are part of M1. As a result, M1 growth exceeded the Fed’s target range in 1982, even though the economy experienced its worst recession in decades. The Fed de-emphasized M1 as a guide for monetary policy in late 1982, and it stopped announcing growth ranges for M1 in 1987.
By the early 1990s, the relationship between M2 growth and the performance of the economy also had weakened. Interest rates were at the lowest levels in more than three decades, prompting some savers to move funds out of the savings and time deposits that are part of M2 into stock and bond mutual funds, which are not included in any of the money supply measures. Thus, in July 1993, when the economy had been growing for more than two years, Fed Chairman Alan Greenspan remarked in Congressional testimony that “if the historical relationships between M2 and nominal income had remained intact, the behavior of M2 in recent years would have been consistent with an economy in severe contraction.” Chairman Greenspan added, “The historical relationships between money and income, and between money and the price level have largely broken down, depriving the aggregates of much of their usefulness as guides to policy. At least for the time being, M2 has been downgraded as a reliable indicator of financial conditions in the economy, and no single variable has yet been identified to take its place.”
A variety of factors continue to complicate the relationship between money supply growth and U.S. macroeconomic performance. For example, the amount of currency in circulation rose rapidly in late 1999, as fears of Y2K-related problems led people to build up their holdings of the most liquid form of money, and then it showed no increase (even on a seasonally adjusted basis) in the first half of 2000. Also, the size of the M1 aggregate has been held down in recent years by “sweeps”—the practice that banks have adopted of shifting funds out of checking accounts that are subject to reserve requirements into savings accounts that are not subject to reserve requirements.
In 2000, when the Humphrey-Hawkins legislation requiring the Fed to set target ranges for money supply growth expired, the Fed announced that it was no longer setting such targets, because money supply growth does not provide a useful benchmark for the conduct of monetary policy. However, the Fed said, too, that “…the FOMC believes that the behavior of money and credit will continue to have value for gauging economic and financial conditions.” Moreover, M2, adjusted for changes in the price level, remains a component of the Index of Leading Economic Indicators, which some market analysts use to forecast economic recessions and recoveries.
In March 2006, the Federal Reserve Board of Governors ceased publication of the M3 monetary aggregate. M3 did not appear to convey any additional information about economic activity that was not already embodied in M2. Consequently, the Board judged that the costs of collecting the data and publishing M3 outweigh the benefits.”
W Peden,
90% treasury bond + 10% junk bond = 100% highly rated asset. Assuming purchases of treasury bonds is irrelevant, then the purchase of $1Tn highly rated assets is equivalent to the purchase of $100Bn of junk bonds. The only thing that matters to the economy is the beta of the asset, ie the equivalent quantity of whole market exposure. And of course, targeting any specific sector/asset class is a direct subsidy to that sector. Marking an asset as AAA is a great way to fool people into believing that you aren’t taking any risk. Then you buy 10 times as much of it.
Wall Street could repackage the entire junk bond market as AAA if the Fed incentivized them to do it.
K,
90% treasury bond + 10% junk bond = 100% highly rated asset.
Assuming this logic, the optimal policy is for Treasury to sell 1 Trillion of treasury bonds, allowing the transformation of $100 B of junk bonds into AAA assets, no?
In other words, fiscal policy.
rsj: you can’t have the central bank do monetary policy to manage AD when it’s on the gold standard. The gold standard is the monetary policy. So of course the Fed wasn’t created to use monetary policy to control AD. That all changed (for the Fed) when FDR decided to raise the price of gold, to target a higher price level. Oh, and FDR didn’t say “lets cut interest rates to hit our target of a higher price level”. He raised the price of gold instead. And it worked.
And that dismissal of monetary aggregates might have been a little premature. Have a look, just as an example, at David Beckworth’s charts. If you had no other measure of monetary policy to work with, and no other information, which would tell you that there’s been a recession happening recently? David’s charts, which suggest tight monetary policy and recession? Or the ultra low interest rates, suggesting loose monetary policy and an inflationary boom?
“Neither” of course is the right answer, because everything is determined simultaneously. But if I were someone from the concrete steppes, who wanted a simple billiard ball causal theory, I would look at David’s charts and go “Hmmm. I bet that reduction in the money supply is what caused the recession!”
Nick,
the charts are M4. But the Fed does not control M4. It has never been able to hit a monetary aggregate. Therefore M* is not a measure of monetary policy at all according to the Fed. That was the quote I just posted.
All it controls is the quantity of bank reserves, and even then, it only controls this quantity when the OIR is zero. It is a far cry to go from the quantity of reserves to M4 — or even M2! This is where your billiard ball assumption comes in — whether it be fixed ratios or other mechanisms. You need these mechanisms to go from what the CB does control to what you want it to control.
When we point out that your proposed mechanisms don’t exist, you respond with “I don’t need any mechanisms. It just works”. Why not have the CB target youth and sunshine? It has as much control over these as it does over M2, M3, or M4.
The future does not affect the present. There is no information from the future. So, all action is based on expectations, so expectations about the future profoundly affect the present. But the future doesn’t, except in its unknowability, its complete information opaqueness which requires us to develop expectations so we can act.
rsj: “When we point out that your proposed mechanisms don’t exist, you respond with “I don’t need any mechanisms. It just works”.”
Stop making up quotes.
Stop pretending that I have not explained why I believe that monetary policy can work. You know damned well I have done this. You may disagree with my explanations, or not understand them, but you cannot repeatedly insist I have not explained my belief. Like at the end of the above post.
And stop attributing beliefs to me I do not hold. Of course central banks do not have perfect control over all nominal variables.
Or, just stop altogether.
Lorenzo: agreed. But I think promises of future actions count for something. And even “cheaptalk”, which isn’t even a promise to do anything, can have effects in a coordination game, like the cox in a racing eight.
This is rather sad. It seems that failing freshman calculus is a prerequisite for ECON 100. Do you actually check the transcripts? The whole supply / demand interdependence thing is right out of freshman year calculus and physics – a depends on b, b depends on a. Hey, it’s the 18th century now. We know how to deal with this what with exp(a+bi)=exp(a)(cos(b)+isin(b)) and all that. Expect oscillations, expect damping, expect explosive growth. Equilibrium is just one behavior among many possible and you can’t assert it, you have to prove it.
I usually blame the failings of our economists on a Soviet era like ideological blinding, but it might just be basic innumeracy. Surely it is time to move the field, or at least its mathematical underpinnings, into the 18th century.
And stop attributing beliefs to me I do not hold. Of course central banks do not have perfect control over all nominal variables.
OK, Nick, that is fair.
You did not say “I don’t need any mechanism”. I caricatured your arguments. God forbid that someone from the steppes would do that 😛
But your approach suggests this. In your blog posts, you at least suggest that the central bank controls the quantity of “money”, which would correspond to the control of the higher aggregates. Maybe not perfect control, but at least a strong influence.
The whole notion of “targeting”, at least in the crude form presented here, is one without mechanisms. You see a box in which there is pressure. You have two buttons, red and blue. You press one and the pressure rises. You press another and the pressure drops. You don’t need to know or care how it works, it just works. You then run some regressions, etc.
But at some point, further presses of the button stop working — something has changed inside the box. Here, the mechanisms are important. It makes a big difference whether there really is a structural relationship that is being exploited. The quote I cited suggests that there isn’t.
You and I have (I believe) a fundamental disagreement about how the channels operate. And therefore what the CB can successfully target.
When the CB tries to target something that it does not control — what happens? It wants more NGDP, so it cuts rates. That doesn’t work, so it cuts rates again. That doesn’t work, so it finally hits the zero bound. Is the CB ineffective because it has hit the zero bound, or because it was trying to target something that it cannot successfully target?
It gets more interesting if the CB can only conditionally target a nominal, dependent on other aspects (e.g. the belief that house prices will rise) that it does not control. Or, if it can only asymetrically target — e.g. it needs to cut by more than it raises rates, to have the same effect. Then you can only target, but for a limited period of time, and must always hit the zero bound at some point.
And at the same time, what about the ability of fiscal policy to affect NGDP? Do you think if we eliminated food stamps, unemployment insurance, aid to states, and started running budget surpluses “to pay down debt”, that this may effect NGDP?
@Lorenzo from Oz
The word expectations has too much baggage. Some expectations are of such high probability that they are knowledge of the future and others are much less so. The nature of the economic system determines the difference. Since the mathematics is unfavorable to future knowledge (high sensitivity, high dispersion, feedback, delays, bifurcations, chaos and poor information concerning the nature and values of boundary conditions), only our isolated immediate local future is sufficiently likely to be considered knowledge.
OTOH my knowledge of the present and past is extremely limited and inexact. We see and hear with our imaginations, not with our eyes and ears, which are themselves rather limited. It’s endlessly amazing what we can accomplish with such poor quality inputs.
I usually blame the failings of our economists on a Soviet era like ideological blinding, but it might just be basic innumeracy. Surely it is time to move the field, or at least its mathematical underpinnings, into the 18th century.
I agree. I’ve talked about damping, causality, and forward-looking systems before. Didn’t get very far.
rsj,
“It was created at the urging of the banks to ensure the stability of the banking system. They needed a reserve bank (a bank that could settle payments between other banks and lend to other banks) that could always deliver in times of crisis. The previous reserve banks, such as the Bank of Suffolk, weren’t always big enough to guarantee an end to bank runs.
There was no larger economic role at all, other than the role of preventing bank runs.”
Ahem banker to the government.
A thought has just crossed my mind. A very puzzling thought.
I had always understood that uniqueness of equilibrium could only be proven under very stringent assumptions, and then only in Walrasian General Equilibrium theory. Once we relax those very stringent assumptions, or move away from Walrasian General Equilibrium theory, we cannot be assured of uniqueness. Many examples exist of models where equilibrium is not unique. And these models are not at all new. Philosophers like Hume and Rousseau can be interpreted as putting forward (implicit) models of multiple equilibria, or what might nowadays be called sunspot equilibria.
To my mind, only the most dogmatic or ignorant of orthodox economists would insist on uniqueness of equilibrium.
Why then is it that those economists who are currently in this debate most dogmatically insisting on uniqueness of equilibrium also those who think of themselves as heterodox?
Not that I think the equilibrium might not be unique. But we can’t be sure it’s unique.
I’m convinced it’s not unique. We don’t know the model of the economy. We know nothing about the distribution of possible events in the future. It’s questionably even meaningful to say that there exists an objective set of probabilities. Where are they? So the equilibrium is a result of our collective subjective expectations, which could be pretty well anything and which are subject to shifting drastically and unpredictably. The idea of a unique equilibrium is a bias that economists (myself included) exhibit as a result of spending too much time in their simplistic model worlds.
‘”Equilibrium” is economists’ code-word for “this is a non-linear story”.’
Except when you are talking about general equilibrium, which is the only true equilibrium state.
Partial equilibrium is, well, partial.
All the ‘non-linear’ story telling has trained macroeconomists to falsely understand the world in the sense that they mistake as the actual world a fake world lacking many of the actual core causal mechanisms at the heart of the economic organism, eg ever aspect of the coordination, pricing, lengthening and shortening of heterogeneous production processes inter-related with heterogeneous labor and heterogeneous financial instruments and monies and near monies.
Most heterodox economists I know of don’t believe the economy is ever in any equilibrium of the sort mapped out in Arrow-Debreu, etc.
An old John Hicks footnote seems apt here
Some of the most serious fallacies of traditional economics have been
due to confusion between optimum and equilibrium conditions; the
apparent influence of Dr. Pangloss upon the development of economic
thought is for the most part nothing but pure intellectual error.
—J. R. Hicks, “The rehabilitation of consumers’ surplus,” Review of
Economic Studies 8(2), February 1941, pp. 108-116, footnote 1, p. 112.
Keynes certainly believed in multiple unemployment equilibria. But to him, government policy could select among them. If you believe government cannot do that, then yes, it is sunspots.
To the degree that economic outcomes are the results of our collective choices, then of course the future is indeterminate. The belief that there is some epistemological end-point that the free market will carry us to is just, at its heart, an attempt to discourage public participation and deny our freedom to shape our future with collective action.
Which is not to say that the economists who believe that are motivated by the same factors, they are motivated by the traditions of discourse as shaped by the professional institutions. But don’t forget the root of that discourse.
It’s questionably even meaningful to say that there exists an objective set of probabilities.
The probability distribution must be endogenous, right?
I mean, the probability that you will get laid off is not independent of your consumption demand, which is supposedly determined by the probability that you will get laid off, etc. By choosing a priori that the probability distribution is a random walk around some mean and then solving for the mean, you are already closing the door to a lot of interesting dynamics.
rsj:
“The belief that there is some epistemological end-point that the free market will carry us to is just, at its heart, an attempt to discourage public participation and deny our freedom to shape our future with collective action.”
Beautiful.
“The probability distribution must be endogenous, right?”
The probabilities, and even the space of the dynamics (the support of the probability space) are certainly dependent on the intrinsically unpredictable decisions of the agents in the world. I suppose that the decisions of most of the agents in the economy are largely noise, but ideas do spread and some agents’ decisions are pivotal, so you cannot dismiss the systemic importance of reasoning and conscious processing. In a world as complex and unknown as the one we live in, those decisions can no longer be viewed as a necessary consequence of rational expectations of the (totally unknown) system dynamics, and instead need to be viewed as exogenous (i.e. uncomputable, unpredictable) risk factors in their own right. Human decisions are every bit as exogenous as new technology in your favourite RBC model, which is to say not predictable by the laws of economics, even in aggregate. We are free to shape our world.
rsj,
“The belief that there is some epistemological end-point that the free market will carry us to is just, at its heart, an attempt to discourage public participation and deny our freedom to shape our future with collective action.”
Curious. Do you think that economics is so simple that people have to have suspicious intents if they disagree with you?
W Peden,
No, when people are wrong there are other possible explanations. For example, they could be stupid.
🙂
K,
Oddly enough, those are exactly the two explanations of disagreement that Thomas Sowell argues that left-wing people will tend to return to again and again, because they fall naturally out of their foundational epistemological views. Similarly, that term used by right-wing people like Ronald Reagan and Milton Friedman, “well-meaning” and its synonyms (a term I used to hate when I was on the left) makes a lot of sense if you take your epistemological views from people like Hayek, Smith, Popper and Hume.
J.V. Dubois
“Market Monetarists disagree – the problem is not with CB (and the monetary policy it conducts) not being credible – it is that it is credible in its goal not to expand demand. It is DeLong who is horribly wrong. He assumes that CB will just watch by as fiscal stimulus “mechanically” does its magic to restore the economy.”
I must say I found this comment very disappointing – I generally find J.V. Dubois comments incisive. But this comment only makes sense if we we ignore the effect of the zero lower bound, and the effect of policy uncertainty. If there is no danger of crowding out, there is no danger of deflationary central bank intervention. And the effect of monetary policy in those circumstances remains uncertain, the effect of direct government expenditure is much more certain and direct. That relative difference in certainty is important.
rjs seems to me (but I’m biased) to be winning the argument here. But he is missing something important (and so is everybody else). Path dependence! Surely when we start with an analogy from ecology it must immediately come to mind! The starting point might matter!
“The belief that there is some epistemological end-point that the free market will carry us to”
is a perfectly reasonable comment upon the assumption that “free markets” (as if we really had any) will always produce results that are not only more efficient but morally superior and do so regardless about the assumed initial facts.
“is just, at its heart, an attempt to discourage public participation”
however is an abridgment that has to produce more heat than light.
The dynamic seems to be that
1) some participants who claim to be on the free market side hold that as a logical and necessary consequence derivable (in their view) from unassailable moral and economic principles, any opposing arguments must be some combination of incorrect, misinformed, politically radical, dangerous and evil.
This is a particularly pernicious development of an unfortunate tendency among some economists to run the scientific method backwards.
2) As an unsurprising consequence of the human tendency to think well of ourselves and or motives and justify our actions, the rich attribute their success to hard work and intelligent decisions, rather than occupation of a position that allows the extraction of rents, or starting with an advantage.
3) People naturally want to pass their favorable circumstances on to their children
4) Free speech (in practice and in definition) has always been in tension with the old saw “Freedom of the press is limited to those who own one.” The current controversy being Citizens United.
5) Legislatures have usually been subject to corruption for some part of their histories. State legislatures in the 19th century US far surpassed the worst abuses of today. A society must deal with the problem or suffer the consequences.
6) With more regulation, you have more opportunities for regulatory capture.
7) The tendency of bureaucracy to expand and entrench itself applies not just to government and industry, but also to political organizations.
This dynamic is certainly opposed to the (effective) participation of that part of the public that opposes these forces (which needn’t be the same part for every issue)
“deny our freedom to shape our future with collective action.”
This rhetorical flourish just confuses the issue since it has a politically slanted tone, while being too vague to be arguable.
So economics may not be particularly simple, but people espousing certain views often have suspect or self-serving intents. It should be noted that there is a distinction to be made between the motives of the particular proponent making the argument, and the political baggage attached to the argument.
Neither side has an answer to the question: “Are people whose actions or their consequences are evil, but who are acting for reasons they believe are moral or just, good or evil?” And we can ask how useful it is to dwell on the question.
Peter N
Excellent comments all. I particularly like the fact that you identify “Bureaucracy” as being not confined to government.
Nick Rowe
“We know that for any equilibrium time-path there exists a second equilibrium time-path along which all nominal variables (like NGDP, and the money supply) are higher or lower. This means that a permanent loosening of monetary policy will eventually move the economy towards one of those time-paths along which all nominal variables are higher. This means that the expectation of a permanent loosening of monetary policy will mean the expectation of an eventual permanent increase in all nominal variables like NGDP.”
Nick, even if I accept the conditional logic, I don’t see how it is possible for the Fed today to make any binding and credible commitments as to the behaviour of the Fed in the future. Just like I don’t see how a democratic government (e.g. Greece) can make binding and credible committments as to the behaviour of their successors (who just might be their political opponents).
reason – Nick’s off-line for a few days, Frances