Will on-tap liquidity eventually burst the bubble of fear? (bs)

In a recent post on FT Alphaville Izabella Kaminska is positive about this. She goes on explaining how the investor’s run on safe assets results in negative rates which “destroy the vital process by which economies form capital, grow and generate employment”. Skeptical on the power of monetary policy to circumvent such a bad (temporary but potentially persistent) equilibrium, Keynes envisaged fiscal policy to intervene.

"It was the government’s superior capacity to bear risk — not any inherent belief in its capacity to make better decisions — that led Keynes to advocate greater state-led investment when the economy becomes gripped by a bubble of fear."

And something else is worth noticing: financial repression, prominently criticized by the newly appointed Harvard Professor Carmen Reinhart,

“is no accident. It is the deliberate objective of a policy designed to curb the demand for liquid assets and force greater willingness to commit to less liquid forms of investment.”

So far so good!

Yet one statement struck me as pretty innovative.  Because the system is (allegedly) completely overwhelmed with capacity, we need to deploy capital by shifting demand to non-material assets like human interaction, health care, education etc. Only then, the author posits, will capital become scarce again and thus positive yields on investment will be revived.

“ Of course if that is the case, the fear bubble won’t so much burst, as eat itself out.”

Thank you for your service, Mr. Bini Smaghi (amv)

Lorenzo Bini Smaghi is going to leave the ECB's Executive Board at the end of this year. This is bad news for two reasons: First, he is an "intellectual heavyweight" as the FT correctly points out (unsurprisingly, Bini Smaghi is Chicago-trained). Second, the reason why he has to exit the Board reminds us that nationality still matters in the conduct of monetary policy. Bini Smaghi must leave since France insists on a less Italian-dominated Board, given Mario Draghi's presidency since Nov 2011. Benoît Coeuré - a Frenchman, of course - will take his place. I do not argue that Coeuré is less able than the average Board member. Yet, given that Bini Smaghi was one of the Board's most able members, it seems clear that the selection process does not sort between "competent" and "less competent" decision makers, but between nationalities - evidently able to sort out the most effective policymaker, while leaving others in place.

The most interesting statements by a central banker are probably those he makes when leaving office. Accordingly, the FT took advantage and promtly interviewed Bini Smaghi. Mr. Weidmann should listen carefully to what he has to say: "[...] not deciding, or postponing decisions, is not an option and leads to worse outcomes." Decision makers shall not "hide behind lawyers to avoid taking action." Wooha! Eat this, Bundesbank.

Bini Smaghi is in favour of QE. I like that. He also favors the ECB as Lender of Last Resort (LOLR) to sovereigns. In a short policy note, I recently made the distinction between potentially insolvent and illiquid sovereign, and only supported the ECB as a LOLR to the latter group. Now this is Bini Smaghi: "If the issue is not one of insolvency but rather illiquidity, then the ECB has room for action - one could even say that the ECB has a duty of action." For the former group, I'm still in favor of haircuts and of the ECB to act as the Owner of Last Resort (OLR) to the European banking sector. I'm pretty sure that Smaghi wouldn't buy in as he still opposes Private Sector Involvement (PSI). He is quite honest: "No central bank in the world would consider the default of its sovereign desirable or possible."

I also disagree with another point he makes: "[T]he lender of last resort function is typically characterised by constructive ambiguity. Central banks try to avoid committing themselves in advance on the specific conditions in which they will intervene. [...] Central banks should use as much constructive ambiguity as possible and avoid committing to act – or not to act – at a time of high uncertainty." How can he say that? Modern monetary policy boils down to the control of market expectations. The expectation channel is key! Also when it comes to the LOLR-function. Without a credible commitment to a potentially unlimited swap line - exchanging sovereign bonds for central bank liabilities -, the ECB actually has to purchase sovereign bonds in significant amounts. Also QE will prove ineffective, if the ECB refuses to control/determine market expectations.

Nevertheless, thank you for your service!

Nobel Laureates 2011: Chris Sims and Thomas Sargent (ls)

Find the official statement here. You may also be interested in a more detailed review of their work.

As always, the forecasts failed. ;-)

Rethinking Central Banking (ls)

Eichengreen, Rajan, Rodrik, di Mauro, Shin, Rogoff and other leading economists have released a brillant report on the future of Central Banking. The report can be downloaded here, a summary can be found on vox.

They especially focus on the debate of whether central banks should pursue a financial stability goal. They reach a conclusion which I fully share. Here are their key points (my emphasis, originally taken from the vox summary):

It is time to move beyond dissatisfaction with the prevailing framework and properly flesh out an alternative. In our view [...] that alternative should have the following elements:

• Financial stability should be an explicit mandate of central banks.

Other micro- and macroprudential policies should be deployed first, wherever possible, in the pursuit of financial stability, but monetary policy should be regarded a legitimate part of the macroprudential supervisors’ toolkit.

• When rapid credit growth or other indicators of financial excess accompany asset price increases, the authorities should employ stress tests to measure the effects of changes in credit conditions on asset prices, economic activity, and financial stability.

Instead of seeking to identify bubbles, the authorities should simply ask whether current financing conditions are raising the likelihood of sharp reversals in asset prices that are disruptive to economic activity.

• Where the answer to the aforementioned question is yes, central bankers should then lean against the wind using a combination of the tools at their disposal, turning first to non-monetary micro- and macroprudential tools, but also to monetary policy tools when necessary.

If this results in periods when, in the interests of financial stability, the central bank sets policies that could result in deviations from its inflation target, then so be it.

• Responsibility for the maintenance of financial stability can be assigned either to the central bank or to a self-standing financial supervisory authority. But in both setups, close coordination between the central bank and other agencies that contribute to ensuring the stability of financial conditions is essential.

This is particularly important when policymakers have to evaluate the tradeoffs between the use of monetary tools and prudential measures and make decisions on the appropriate mix.

• Central banks already require substantial operational independence in order to pursue their mandates. They will require even greater independence when a financial-stability objective is added to those mandates.

They will, in turn, have to establish the legitimacy of their actions in circumstances where the nature of threats to financial stability is poorly understood.
[...] Independence is politically viable only with accountability, and the best way to enhance accountability is for central banks to become more transparent and forthright about their objectives and tactics.

• The spillover effects of a central bank’s policies in other countries are a legitimate concern.

At present, central banks do little to internalise these effects. Admittedly, they may have difficulty in justifying actions taken in the effort to do so to domestic political authorities.
This tension points to the need for further changes in prevailing policy framework. Specifically, domestic political authorities should be persuaded to allow such considerations to play an explicit role in the central bank’s monetary policy framework in large economies. Large-country central banks should pay more attention to their collective policy stance and its global implications. Where appropriate, they should consider coordinated action to help stabilise the global economy in times of stress.

Rogoff on Europe and the IMF (amv)

Click here for a very insightful article by Kenneth Rogoff. Teasers:

The IMF needs to bring much more of this brand of skepticism to its assessment of eurozone debt dynamics, instead of constantly seeking strained assumptions that would make the debt appear sustainable. Anyone looking closely at Europe’s complex options for extricating itself from its debt straightjacket should realize that political constraints will be a huge obstacle no matter which route Europe takes. 

Even outside Europe, the IMF has long given too much credence to sitting governments, rather than focusing on the long-term interests of the country and its people. The Fund is doing Europe’s people no favor by failing to push aggressively for a more realistic solution, including dramatic debt write-downs for peripheral eurozone countries and re-allocating core-country guarantees elsewhere. 

Now that the Fund has squarely acknowledged the huge capital holes in many European banks, it should start pressing forcefully for a comprehensiveand credible solution to the eurozone debt crisis, a solution that will involve either partial breakup of the eurozone or fundamental constitutional reform. Europe’s future, not to mention the future of the IMF, depends on it.

Since I don't see how the current incentive system can bring about a beneficial constitutional reform, we are left with Rogoff's other proposal: a partial breakup (check also Henry Kaspar @ Kantoos). 

Macro Markets and Risk Sharing (fg)

I highly recommend a set of readings of Bob Shiller on creating new market segments that allow to truely insure and hedge aggregate home country and global economic risk:

Shiller proposes a new set of markets that could in theory provide much better diversification opportunities. These so-called macro markets would be large international markets trading, in the form of futures contracts, long-term claims on major components of incomes shared by a large number of people or organizations. For example, in a macro market for the United States, an investor could buy a claim on the U.S. national income and then receive, for as long as the claim is held, dividends equal to a specified fraction of U.S. national income. Such a claim is comparable to a share in a corporation, except that the dividend would equal a share of national income rather than a share of corporate profits. Such markets might exist for entire countries— the United States, Japan, and Brazil—or for regions— such as the European Union and North America. Even a market for claims on the combined incomes of the entire world could be formed. Prices would rise and fall in these markets as new information about national, regional, or global economies became available, just as prices rise and fall in the stock market as new information
about corporate profits is revealed. The potential future importance of these markets is supported by the most basic principle of finance diversification. People could use macro markets to hedge their own national income risks and to invest in the rest of the world. This investment strategy would reduce income growth uncertainty and lead to a more secure financial future

Good to know Bob Shiller already has a patent on a specification on macro markets with nominal GDP securities ;) . The work on this subject includes

• Bob Shiller (1993), Macro Markets. Creating Institutions for for Mangaing Society's Largest Economic Risk, Oxford.
• Bob Shiller (2003), The New Financial Order. Risk in the 21th Century. Princeton.
• Bob Shiller et al (1999), Macro Markets and Financial Security, FRBNY Economic Policy.

I also refer to the idea of Scott Sumner on using nominal GDP futures to extract market expectations on future nominal GDP as both information and target variable for monetary policy.

Irving Fisher and Debt (fg)

Every student of Economics, at least one time during her studies, has stumbled over Irving Fisher's theory of debt deflation. One passage in his book, The Purchasing Power of Money (1911), resembles a behavioral approach to explain the build-up of debt:

The public psychology of going into debt for gain passes through several more or less distinct phases: (a) the lure of big prospective dividends or gains in income in the remote future; (b) the hope of selling at a profit, and realizing a capital gain in the immediate future; (c) the vogue of reckless promotions, taking advantage of the habituation of the public to great expectations; (d) the development of downright fraud, imposing on a public which had grown credulous and gullible (p.349)

Gerlach/Moretti vs. Taylor (amv)

Stefan Gerlach and Laura Moretti provide a very suggestive analysis of monetary policy before the crisis (© voxEU.org). They essentially argue that - in contrast to what John Taylor wants us to believe - low policy rates during 2002-5 do not indicate an expansive stance of monetary policy. Rather, the Fed simply responded (sluggishly) to a fall in the Wicksellian rate (determined by real data alone). As a theorist and historian of economics, and since I make this point repeatedly,  I especially welcome the following statements:

"Furthermore, standard macroeconomic models hold that monetary policy has, at most, temporary effects on real variables, and thus they have a difficult time explaining this decline [the decline in 10y TIPS-yields]. Hence, a reduction in the federal funds rate – a nominal overnight rate – cannot have depressed 10-year real interest rates over a decade. In turn, this suggests that monetary policy played at most a limited role in setting the stage for the crisis." [my emphasis]

"[T]he Wicksellian interest rate is independent of monetary policy but may change in response to real economic disturbances, such as to changes in economic growth. Since deviations of the real interest rate from the Wicksellian interest rate are temporary, long-term real interest rates, represented by the yields on TIPS in the empirical analysis above, are largely driven by expectations of the Wicksellian rate." [my emphasis]

See also: Michael Woodford about his distaste for QE3, his hopes for better Fed-communication in general, and his advice to Bernanke with respect to his Jackson Hole speech today. 

Nobel Laureate Meeting at Lindau (fg)

Please find some enlightening speeches of Nobel Laureates at this year's meeting at Lindau including R. Mundell, J. Nash, R. Auman, E. Prescott, M. Scholes, W. Sharpe.

Mundell: Curreny Wars, Euro Mania, and the Price of Gold; he proposes an international Dollar/Euro fixed exchange rate system

UPDATE: The Financial Times (FTD) reports on Mundell's idea of a new exchange rate system.

Auman: Challenging Nash Equilibrium and the Role of Rational Expectations in Games; why the Nash equilibrium is flawed

Prescott: The Current State of Aggregate Economics; he reviews aggregate modeling and the role of disutility from work.

Selgin on 'Skidelsky's Late Punch' (amv)

This post is just a follow-up on fg's hint at Skidelsky's 'Keynes-Hayek Rematch'. Here is George Selgin's reaction.

How to get out of a Recession - or the Keynes-Hayek Rematch (fg)

I really do not want to get into another debate on the origins (mal-investment, low articifal interest rates, bad luck, lack of transparency that contributed to the build of systemic risk, etc???), the trigger of the crisis (Lehman, loss in confidence, reduction in expected GDP???) and the ways how to get out of it (stabilizing spending expectations vs. austerity???). For the sake of completeness, I just want to link a recent contribution of Robert Skidelsky on the different views of Keynes and Hayek about how to produce a recovery (see also a recent amv's post in our blog). According to him,

Whereas for Hayek recovery requires the liquidation of excessive investments and an increase in consumer saving, for Keynes it consists in reducing the propensity to save and increasing consumption in order to sustain companies’ profit expectations. Hayek demands more austerity, Keynes more spending.

Nick Rowe strikes back (amv)

Nick Rowe sent me his response and gave me the permission to post it. You find my remarks at the end of his reply. So here we go:

Thanks for your response. I've got several different things I want to say in response, so i will just number them for clarity:

1. Yes, you understood what I'm saying. That's always a relief. I wasn't sure if I was clear enough. 

2. As you say, my critique about fragility in the limit is different from Peter Howitt's critique about dynamic instability under learning. But my intuition (OK, my "gut") tells me that the two are closely related. That if a model is very fragile in my sense it will be unlearnable in Peter's sense. Because if they haven't learned it yet that will cause big changes in how the model behaves, so what they learn from observing the model will be very different from the RE equilibrium.

3. OK, if half the agents make one mistake, and the other half make the exact opposite mistake, the model might behave exactly like an RE model in aggregate. But what if 49.9% make one mistake, and the other 50.1 make the exact opposite mistake? If it's a robust model, that's no big deal. The predictions will be almost identical to full RE. But if the model is "fragile in the limit", that small difference will cause a big bang in the predictions.

4. OK, I concede your main point! A model that is "fragile in the limit" might still be a "useful" model in some sense. But that's a very different sense from the one that we usually have in mind when we talk about models being "useful". Normally we mean something like "there's some sort of rough correspondence between the world and the model". But models can sometimes be "useful" in another way. The Modigliani Miller Theorem would be my favourite example. Someone could argue that the MM model is totally useless as a theory of how the world works, but is still a really useful theory because it tells us what assumptions we need to reject if we want to understand firms' financing.

5. Now I want to go totally off-topic. Well, not totally, but close. Whatever are you guys doing learning that stuff about stability of equilibrium in a Walrasian (OK, Arrow-Debreu, but same difference) economy? We live in a monetary exchange economy with n-1 markets (2 goods each, one of which is the medium of exchange), not a Walrasian economy with one big market where all n goods are traded simultaneously. So Walras' Law is misspecified, because there are n-1 different excess demands for money. Plus, if prices are at disequilibrium levels, either buyers or sellers will be rationed (they won't be able to buy or sell as much as they want), so will reformulate their notional demands and supplies taking those quantity constraints into account. So Walras' Law can't apply anyway, because their demands and supplies in each market are based on the quantity constraints in all the *other* markets, so the sum of the excess demands don't conform to any unified decision-making process based on a single (budget) constraint. We (old) guys learned that in the 1980's. It was called "disequilibrium macro". Then Lucas came along, and (almost) everyone forgot it. But doing stability proofs in a non-monetary economy with a Walrasian auctioneer with "notional" excess demand functions that ignore quantity constraints....now that really is useless. As well as "fragile in the limit"! ;-)

Since it's quite late in good old Germany, I will only comment on #5. Well, perhaps my recourse to the SMD results becomes more comprehensible if I tell you that I'm a historian of economics. So my job is to cope with the 'wrong ideas of dead men' (or at least quite old men). That may explain my focus on Arrow-Debreu models. Yet note that I used the SMD results only as an example to make my point. You could find other frameworks to make the same point. I'm just writing about SMD, so it seemed natural to use it. Actually, I would be pleased if SMD results would figure more prominently in our curricula. Since it is a highly negative result, applied economists should be aware of it. In particular when you are a Arrow-Debreu sceptic, you should welcome higher awareness of the generic impossibility to establish global uniqueness and stability by means of 'proper microfoundations'. This is because Arrow-Debreu reasoning is not as dead as perhaps it should be. Be it as it may, I'm happy that you concede my main argument (#4).

Actually, I concede your point about Walras' Law. Right because I'm a historian of economics, I'm well aware of the precious results by Clower and Leijonhuvfud that you "(old) guys" studied some hundred years ago (more or less), and that unfortunately disappeared from modern curricula. In concrete, I concede that in a monetary economy it is crucial to distinguish between notational and effective demand and, hence, to know of Clower's dual decision hypothesis. Consequently, I do accept that Walras' Law applies if and only if effective demands coincide with notational demands and that this do not have to be the case. So you preach to the converted!

A response to Nick Rowe: Fragility at the limit (amv)

I promised Nick Rowe to respond to his post on what he calls "fragility at the limit'. It is a follow-up on the debate on Kocherlakota's argument that it is possible to determine long-run inflation expectations by setting nominal yields according to the Fisher relation. Let me start with a disclaimer: I do not believe that central banking is or should be using nominal yields in the way Kocherlakota suggests. I am interested in the theoretical model underlying Kocherlakota's argument. I further believe there is a grain of truth in his statement, since I 'believe' in long-run neutrality. As I mentioned many times before, I side with Sumner & his allies on NGDP- or (at least) price-level targeting.

Nick introduces an interesting argument. If I got him right, he accepts that Kocherlakota's argument is a sound REE-prediction. He however argues that the model is 'fragile'. To show what he means, he partitions the set of agents by defining a fraction f of adaptive agents on [0,1] (and, accordingly, a fraction (1-f) of RE-agents). The same fraction partitions the bahavior of firms, that is, f gives the fraction of sluggish price setters, while (1-f) gives the set of instantaneous price setters.

He starts with f=1 and argues, correctly, that an 1% increase in nominal yields suggests a 1% increase in real yields and, thus, initiates a sluggish deflationary (or disinflationary) process. As f approaches zero, that is, as the fraction of RE-agents who adjust prices instantaneously increases, the same 1% increase in nominal yields results in ever faster deflationary processes. As f approaches zero, increasing nominal yields suggests "instant explosive deflation". At the limit, however, that is, for f=0, Kocherlakota's model applies, that is, a 1% increase in nominal yields suggest 1% higher inflation expectations.

Nick concludes: "Suppose that the predictions in the limit (as the assumptions approached the model's assumptions) were totally different from the predictions at the limit. That would be a model that is fragile in the limit. And that, to my mind, would be a totally useless model."

Now, in this post I do not want to talk about monetary policy. As I mentioned before (in some comment section), I dislike DeGrauwe-type models, because they suggest that RE is a restriction on individual behavior. I rather side with Arrow, who convincingly argues that RE as an individual assumption is prohibitively restrictive. RE is a general equilibrium notion; REE defines a class of GE models; REE-price systems reflect information as if agents had the super-human capabilities Arrow is referring to. What is needed, of course, is some kind of mechanism, like Sandroni's market selection process, that establishes convergence in case of agents with bounded cognitive and information-processing capabilities. In case of monetary macro models, other learning processes are relevant, like Howitt's, who argues that if QTM-logic applies, and if central banks can manipulate nominal interest rates only by adjusting monetary base in the inverse direction, then a Kocherlakota-type REE is unlearnable. Note, however, that this is about the REE's dynamic stability and not about Nick's concept of 'fragility at the limit'.

To show what I mean, let me take an example that is totally unrelated to monetary policy. Let me talk about the Sonnenschein-Mantel-Debreu results (SMD). The Debreu version (1974) claims that given any function, say g, from the unit price simplex to a k-dimensional commodity space satisfying continuity, homogeneity, Walras's Law, and a boundary condition, then for every compact subset of the price simplex there exists an exchange economy with k 'well-behaved' agents such that the aggregate excess demand of that economy is equal to g(p) on the compact subset. Thus, if structure is imposed by restrictions on individuals (those restrictions that suggest utility and profit maximization),  most of it is lost by aggregation (only continuity, homogeneity, and Walras' Law survive the adding-up of individual demands). Thus, sufficiency conditions for global uniqueness and global stability imposed on the system like gross substitutionality do not have microfoundations.

The SMD results are true for arbitrary dispersions of individual characteristics like preference and endowments. Imagine a convergent sequence of Arrow-Debreu exchange economies with a large but finite number of agents and commodities, decreasing in the dispersions of such primitives. States differently: for any sufficiently large n in the index set we have arbitrary dispersions of primitives; as n increases, dispersion decreases; in the limit, all agents have identical preferences and endowments. The last such economy in the sequence before we reach the limit is one with identical preferences and collinear endowments. As shown by Kirman and Koch (1986), the SMD results still apply. Up to this economy, there is no hope for global uniqueness and stability. But this is evidently not true for the limit economy, which in fact is a quasi-Crusoe economy. Global uniqueness and stability is trivial. Thus, as in Nick's framework, the sequence is discontinuous, that is, it jumps at the limit.

According to Nick's definition, we can say that the SMD results are 'fragile at the limit'. But his core statements that this implies 'uselessness' does not follow. It just tells us if we find an economy with strictly identical agents, we can hope for global uniqueness and stability. Otherwise, we have to make other restrictions than those on individuals (see Werner Hildenbrand on this). What this shows is that Nick's argument is not generically true as it is implied to be. An even though the SMD results tell us something about global stability of each economy in our sequence (or rather the lack thereof), Nick's notion of 'fragility at the limit' is about the continuity properties of a sequence of models (or rather about the lack thereof). As he insists, many economist do not pay enough attention to stability properties. I also believe that this is important. But as I tried to argue, his notion of 'fragility at the limit' is not concerned with dynamic stability issues.

Kocherlakota vs. Selgin (amv)

I am currently engaged in a discussion with George Selgin and Nick Rowe on two only partly related subjects (check the comment section of Sumner's post):

The discussion emerged in reaction to Kocherlakota's (K in the following) controversial statement exactly a year ago. There he states the following: 

It is conventional for central banks to attribute deflationary outcomes to temporary shortfalls in aggregate demand. Given that interpretation, central banks then respond to deflation by easing monetary policy in order to generate extra demand. Unfortunately, this conventional response leads to problems if followed for too long. The fed funds rate is roughly the sum of two components: the real, net-of-inflation, return on safe short-term investments and anticipated inflation. Monetary policy does affect the real return on safe investments over short periods of time. But over the long run, money is, as we economists like to say,neutral. This means that no matter what the inflation rate is and no matter what the FOMC does, the real return on safe short-term investments averages about 1-2 percent over the long run.

Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition. In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative. Why? It’s simple arithmetic. Let’s say that the real rate of return on safe investments is 1 percent and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25 percent. The only way to get that is to add a negative number—in this case, –0.75 percent. [...] To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation.

My position is that, if you accept K's premises, then his statement is fundamentally correct (no inconsistencies). I argue further that if you accept modern modelling practices, then K's premises are quite conventional. The reason for the outlandish flavor of his prediction may follow from a discrepancy between the representative economist's believe of how the real world behaves and the world described by their own models.


I entered the debate  not to defend K. I entered it to debate Selgin's use of Wicksell's concept of interest spead. In concrete, Selgin argues that - given the FOMC's promise to hold FFR close to zero up to mid-2013 - if for whatever reason Wicksell's natural or equilibrium rate turns positive before mid-2013, then (1) either will the Fed engage in open market operations to keep FFR at the promised level and, thus, will act inflationary, (2) or the Fed will tighten policy to depress the natural rate to the zero level to keep its promise without allowing for inflation, (3) or the Fed has to break its promise (see also the comment section here).


(1) Let me begin with Wicksell. I entered the comment section by arguing that - given Wicksell's own premise of perfectly flexible prices - his framework is not robust for alternative assumptions of how agents form expectations. In contrast to NK models, Wicksell induces persistency no by price rigidities, but by assuming adaptive expectations. If you substitute rational for adaptive expectations, you get rid of all persistency. You have an essentially frictionsless model. Then, of course, the entire notion of Wicksell's interest rate spread breaks down.


Why is this? In Wicksell's pure credit economy (or cashless economy, if you wish) - given passive monetary policy - a shock to the natural real rate of interest is accommodated by an increase of the consolidated balance sheet of the banking system such that the inflation-adjusted monetary rate remains constant. Thus, we have an interest spread indicating an increase in AD. Since Wicksell assumes neutrality, the real output level remains constant in his deterministic, stationary model. Thus, a positive shock to the natural rate suggests a positive aggregate excess demand and, thus, a rising price level (vice versa for negative shocks to the natural rate). Evidently, Wicksell's cumulative process is disequilibrium analysis, because - in contrast to modern theorists - he is endowed with a static long-run notion of equilibrium only. He recommends monetary policy to increase the inflation-adjusted rate of interest as soon as the central bank observes inflation. Optimal policy sets the policy rate equal to the natural rate (implicit target: zero inflation).


What happens in case of RE in Wicksell's otherwise frictionless economy? RE suggests that agents know the true model; they understand that inflation is a function of aggregate excess demand. Further, actual inflation equals expected inflation. It follows that the inflation-adjusted monetary rate always and by necessity equals the natural rate (a real rate, of course). Further, monetary policy cannot influence the inflation-adjusted money rate of interest; money is neutral even in the short-run. Thus, Wicksell's concept of the spread between the real money rate and the natural rate breaks down if you substitute rational for adaptive expectations. 


Note that Selgin applies Wicksell's aggregate excess demand concept to the case of frictionless RE models (see item (5) in his last comment here). As argued above, this is illegitimate. 

(2) Now that I have clarified my position, let us turn to Kocherlakota. Before, however, I bring in some theory. In contrast to K, let me maintain the assumption that our reference model is frictionless and that it predicts REE. I will relax the former assumption later. In concrete, I assume a RBC model that implements Arrow-Debreu allocations and, thus, predicts optimal sequences. Of course, there is no medium of exchange in our model; but this is also true for NK-variations (see Woodford's cashless economy). Thus, Selgin's OMO-based story does not apply. In fact, we are faced with Say's Identity, that is, aggregate purchasing power is determined by aggregate supply, always and by necessity. RBC does not house Wicksellian processes; monetary disequilibria are ruled out. 


There is, however, a role for money as a unit of account! Choose a commodity as numeraire. The role of the central bank is not to control AD, but to fix nominal values by determining the relative price of the unit of account over time. One way to do so is by making use of the Fisher relation. Since the inflation-adjusted interest rate is an intertemporal price relation determined by primitives, the central bank determines the expected time path of the relative price of the numeraire-commodity by communicating its preferred nominal yield curve. This, essentially, is K's logic.

(3) Finally, I have to show how the unit-of-account model relates to NK models: RBC is at the core of the NK model that allows us to measure the deviation from optimal time-series due to sticky prices (or information). Such persistency is implemented by adjustung a forward-looking Phillips-curve. Some Taylor-rule accounts for the central banks ability to alter the representative household's intertemporal consumption plan such that welfare-losses are minimized.

K effectively argues (see the bold emphasis above)  that - in contrast to standard Calvo-pricing - persistency fades out in the long-run. If, for instance, persistency is due to the average length of contracts, a promise of the central bank at an initial date to hold nominal rates at zero for a period extending the average length of contracts, markets rationally apply the unit-of-account model to predict inflation rates beyond that average length. For earlier periods, markets apply the NK model. It is this deviation from standard theory that accounts for so much confusion with K's statement.

I'm still surprised by Sumner who sides with Selgin and Rowe. After all, he often refers to Friedman's correct observation:

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

Certainly, the high interest rates in the 70s were not due to high natural rates of interest (due to positive growth prospects), but due to high inflation expectations. Likewise, falling nominal yields in the 80s cannot be explained by falling growth expectations only, but by expected disinflation.

Disclaimer: All this does not mean that I prefer interest-based monetary policy. I prefer some kind of level-targeting making use of whatever instruments necessary to control expectations.

Kenneth Rogoff on the Great Contraction (fg)

Kenneth Rogoff writes on the recent uncertainties surrounding a possible second fall down in world economic growth within 4 years. He comments:

Moreover, too many policymakers have relied on the belief that, at the end of the day, this is just a deep recession that can be subdued by a generous helping of conventional policy tools, whether fiscal policy or massive bailouts. But the real problem is that the global economy is badly overleveraged, and there is no quick escape without a scheme to transfer wealth from creditors to debtors, either through defaults, financial repression, or inflation.

Some observers regard any suggestion of even modestly elevated inflation as a form of heresy. But Great Contractions, as opposed to recessions, are very infrequent events, occurring perhaps once every 70 or 80 years. These are times when central banks need to spend some of the credibility that they accumulate in normal times. The big rush to jump on the “Great Recession” bandwagon happened because most analysts and policymakers simply had the wrong framework in mind. Unfortunately, by now it is far too clear how wrong they were.

I do not feel happy with such kind of proposal. O. Blanchard and others similarly called for higher inflation targets in order to escape the `lower-bound' of short-term policy rates. Rogoff, instead, makes a point in favor of higher medium-term inflation in order to transfer wealth and to reduce both leverage and debt burdens - a quite different logic.

BBC's Keynes vs. Hayek Debate (amv)

Check it out. Good stuff. The 'Yo Hayek!' crowd is evidently larger and more enthusiastic than the 'Yo Keynes!' crowd.

Sumner is back and rocks the boat (amv)

The opportunity costs of blogging are extremely high at the moment. This explains my absence in the last couple of weeks. The good news is that a much more able economists has returned to the blogosphere after endless months of absence:

Scott Sumner provides a very suggestive summary of his viewpoint on the GFC. As regular readers of 'the coffeehouse' know, I usually share his theory-based perspective. This time is not different. I especially like this: "The hero is the EMH [...]." I could not agree more.

A nice portrait of Akerlof the Great (ls)

Find it here. (HT Mankiw)

Some teasers:

While unemployment is the topic that has motivated him the most, it is his 1970 article showing how markets might break down in the presence of asymmetric (or unequal) information that won him the Nobel Prize. Indeed, if you play a game of word association with an economics PhD and say “Akerlof,” chances are the response will be “lemons.”

Hmmm... probably true. ;-)
 

This is because the example Akerlof gave was of used car markets, where sellers have better knowledge of whether their car is a good one or a “lemon.” The buyers’ best guess is that the car is of average quality, so they will only be willing to pay the price of a car of average quality. This means, however, that owners of good cars will not place their cars in the used car market. But that in turn lowers the average quality of cars on the market, causing buyers to revise downward their expectations of quality. Now even owners of moderately good cars are unable to sell, and so the market spirals toward collapse. Akerlof says that the problem dates back to one that has confronted horse traders over the ages: “If he wants to sell that horse, do I really want to buy it?” But problems of asymmetric information are present in most markets, particularly in financial markets. “This [recent financial] crisis gave us glaring examples,” says Akerlof. “Ordinary people thought they were buying homes, not the complex derivatives that they later realized they had ended up buying.”Akerlof says he chose the example of used cars to make his paper “more palatable” to U.S. readers. But his interest in the subject had been triggered when, during his stay in India in 1967–68, he noticed people’s difficulty obtaining credit. He kept this example in the paper, along with sections on how the “lemons principle” could also explain why the elderly had trouble obtaining insurance and why minorities had difficulty obtaining employment. All this proved too exotic for much of the academic market of the time; the paper was turned down by three leading journals before it was finally published [...]

Find the paper here. It is a must-read for students. In my humble opinion it's one of the most brillant papers ever written, since it introduces the extremely powerful concept of adverse selection in a way which is really easy to understand.   

 

The profession's favorite economic thinkers (amv)

Check out William L. Davis et al. on Economics Professors’ Favorite Economic Thinkers, Journals, and Blogs (along with Party and Policy Views). Teaser:

Favorite Pre-Twentieth Century economists 

Favorite Twentieth-Century economists, deceased

Favorite Living economists Age 60 or Older

HT Mankiw

Robert W. Clower 1926-2011 (amv)

I am sorry to inform you that the great Robert W. Clower passed away earlier this week.