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I'm glad you started with multiple equilibria. The existence of a relationship between current income and desired expenditure such that there can be many equilibrium levels of output with the same "fundamentals" (including the same interest rate) is one of the key insights of the Keynesian revolution, but it tends to disappear in the versions of Keynesian economics that get taught today.

On monetary policy, obviously we have two questions. First, is it in fact possible for the current decisionmakers at a central bank to change expectations about what the central bank will do in the future? I would say there are good reasons to think No. Central banks cannot make legally binding commitments about future policy, today's officials will not be in office forever, there is no guarantee that the ZLB will cease to bind over the relevant period, the actual expectations-formation process is largely backward looking, etc. There is a close parallel between claims made for expansionary expectations management today, and the claims made for disinflationary expectations management by Monetarists in the late 1970s. In that episode, despite the promises of Friedman et al., the "credible commitment" of the central banks to slower money growth did not noticeably reduce the output costs of disinflation. Not clear why central bank promises should work better today.

Second, even supposing that it is possible for the central bank to raise inflation expectations, will this in fact raise desired current expenditure? It is true that that real long-term interest rates will be lower if borrowers expect higher inflation over the life of the loan. Structures and other long-lived assets will also have a higher present value relative to financial assets. (But so will land...) These are the expenditure-raising channel. But to know if they will dominate, we need to know more about the costs of inflation. Weirdly, despite controlling inflation being the central goal of macropolicy for much of recent decades, there doesn't seem to be a good account of *why* inflation is so costly. But given that private actors clearly do find it costly, it is quite possible that the expectation of higher inflation will lead businesses to reduce investment, households to reduce purchases of durables, etc. As it happens the 1970s in the US were a period of very high fixed investment; but it would be easy to point to inflationary episodes elsewhere where investment stayed low.

So as far as I'm afraid your conclusion is right: You haven't changed my mind, at least, that the expectations channel is not a realistic transmission mechanism for monetary policy when the central bank cannot move current interest rates.

How did your expectations of failure shape your execution of this post?

More 'concretely' I think the expected length of the ZLB would be pretty critical in the effectiveness of monetary policy in the NK framework. It affects both the discounting of inflation costs (if the ZLB is expected to last 10 or 20 years as in Japan that may even be longer than my expected asset holding period) and the credibility of the CB's commitment, the longer the ZLB lasts the less credible any commitment made by current officials will be.

JW: I agree with you on multiple equilibria. I think they are really important. And not just in the (narrowly-defined) "economic bits" of society. Everything we think of as "civilisation", or "society" is one equilibrium out of many. And civilisation advances (and regresses) in large part by jumping from one equilibrium to another. And it's weird for me to see people who think they are "Keynesian" being sometimes the most likely to give a concrete steps theory of fiscal vs monetary policy, and make dismissive remarks about self-fullfilling expectations.

On your second point, you need to remember the real income channel too. If the Short Run Phillips Curve says that increasing AD will see both higher inflation and higher real income growth, I would say the effects on demand of higher expected real income growth would swamp the effects on demand of any real costs of inflation. Keynes, man, Keynes!

It doesn't need to be some cast iron legally binding commitment. As long as it changes expectations a bit, it will help. And as we approach a world of multiple equilibria, where the forces keeping the economy in one bad equilibrium get weaker and weaker, we need less and less to escape. At the limit, a new Schelling focal point will do the job. Cheap talk, or a sunspot, is enough. Think how easy it is for the government to get us to change our clocks every spring and fall.

OGT: "How did your expectations of failure shape your execution of this post?"

If I had expected certain 100% failure with every reader, I would probably not have written it. If I had been more confident of success, I would have written it sooner.

Yes. It would have been better if monetary policy had been more aggressive a lot sooner. But a P or NGDP level path target helps offset the time we expect to spend at the ZLB. Plus, if the policy is implemented, we escape the ZLB much more quickly.

Nick

Suppose the inflation expectations that do form are such that people only expect commodity inflation but do not expect their wages to go up. What does the Philips curve look like in such a scenario?

Heterogeneity of the composition of inflation expectations may itself be a great source of the existence of multiple equilibria. And real income expectations are not invariant to this heterogeneity. There are as many Philips curves as there are equilibria of inflation expectations.

I have a question.


A central bank that controls the money supply can successfully target a wide range of nominal variables (NGDP, PL, wage levels etc) simply by varying the money supply and seeing how if affects their chosen variable even without the use of expectations. Setting expectations however makes it possible to achieve the target without actually varying he money supply so much.

If I am understanding this correctly then in terms of using these nominal goals to drive real variables (RDDP, employment levels) then expectations setting is not just an easy way to achieve the nominal target but a way to make the nominal variables have a closer correlation to real ones. For example if the CB sets an NGDP target for the next period then the actual mix of inflation and RGDP growth that occurs will depend upon how effectively it communicated the target and hence controls behavior now that will influence RGDP in the future.

So my question is: Given that setting nominal targets is just a way of controlling expectations and assuming the CB knows what kind of expectations today are appropriate for achieving an optimal future why doesn't the CB target expectations and use the various nominal variables it control to achieve this, rather than targeting the variables that may have indeterminate effects on real variables ?

Ritwik: the short answer to your question is: I don't know. Given our ignorance about the short run Phillips curve, our ability to answer more complicated questions like that is very limited.

Ron: "Given that setting nominal targets is just a way of controlling expectations and assuming the CB knows what kind of expectations today are appropriate for achieving an optimal future why doesn't the CB target expectations and use the various nominal variables it control to achieve this, rather than targeting the variables that may have indeterminate effects on real variables ?"

Well, inflation targeting central banks certainly do part of this. The Bank of Canada spends a lot of time repeating that it is targeting 2% inflation, and that people really should expect 2% inflation, and that it will do whatever it takes to bring inflation back down to or back up to 2% over the "medium term". But yes, why do they still talk about adjusting an interest rate as *the* transmission mechanism via which they will hit their target? That would take a long essay in the history of thought, plus perhaps the influence of commercial bankers' way of thinking. Commercial bankers think in terms of interest rates. And so they tend to think that the Bank of Canada is a bank. Which it isn't, really.

A central bank that controls the money supply

We don't live in a world where central banks control the money supply, tho.

"Nevertheless, circumstances can develop in which even a large increase in the quantity of money may exert a comparatively small influence on the rate of interest... But if not, then, if we are to control the activity of the economic system by changing the quantity of money, it is important that opinions should differ."

"[A liquidity trap situation is one in which] a moderate increase in the quantity of money may exert an inadequate influence over the long-term rate of interest."

"A change of the quantity of money... is already within the power of most governments by open-market policy or analogous measures."

I wonder what world Keynes was living in?

W. Peden,

Keynes lived in a world where central banks did control the money supply. (Or at least where that was a reasonable first approximation.) There's a great discussion of this by Leijonhufvud in The Wicksellian Heritage.

Economic laws are not like physical laws; they are historically contingent and change as economic institutions evolve.

JW Mason,

Yes, and so do we. Private money creation was as much a feature of Keynes's world as our own. Or as Keynes puts it in the Treatise- "... we thus have side by side State money or money proper and bank money."

We just disagree. For much of the 20th century, money creation by banks was effectively limited by binding reserve requirements and related regulations, so that there was a stable relationship between high-powered money and credit money. Today, it is not and there isn't.

If you want to see where I'm coming from read the Leijonhufvud piece linked in my previous comment. I'm not going to try to improve on it here.

It seems a truism of economics that it is expectations about the future that determine decisions today. Business will invest today based on expectations about future prices and sales in the period goods starting production now will be sold.

The theory behind the use of nominal targets seems to be as follows: CBs use nominal targets to influence these expectations about the future that drive investment. It turns out that setting expectations on what nominal targets the CB is going to fulfill makes it easier for them to achieve them (ie: they can reach the target without changing the money supply so much as without the use of expectations). Further: The use of expectations to achieve a nominal target actually helps change the kind expectations that drive investment. A credible commitment to meet an NGDP tomorrow will drive investment today as it increases confidence about sales and prices tomorrow.

My concern with the above is that it only works as long as the nominal targets work on expectations in the way that the CB hopes it will. If an NGDP target doesn't inspire more investment it may just raise inflation fears and cause people to swap money (that they otherwise would have invested) for gold and other safe assets and hence reduce RGDP compared to the situation with no NGDP target. In this situation an inflation target would have been better even if it led to lower NGDP in the short run.

So given that a CB can never really know the real effects of a nominal target should they not target expectations of real variables? For example supposing that there is a correlation between expectations of RGDP growth and actual RGDP growth - could not the CB target an expectation of 3% RGDP growth by manipulating the various nominal variables it has available (NGDP, inflation and interest rates etc)? It could use a RGDP futures market or a just a survey of business to ascertain what RGDP expectations actually were.

J. W. Mason,

That a causal relationship has become unpredictable does not mean that it has ceased to exist. A monopoly supplier of base money can still hit any nominal target it likes over the medium-term, provided it's willing and legally able to utterly destroy the economy. Hitting a target for the price of broad money (the price level) is no easier than controlling the quantity of broad money. Indeed, central banks only control the former insofar as they can adjust the latter.

Of course, a hardcore endogenous money type can deny that the central bank can control either, and I don't think either of us is going to provide the other with an argument tonight that will change the other's mind. Nevertheless, I do think that it's interesting and useful to consider one's position on these matters and also to consider the position of Keynes. In particular, it's worthwhile to note that Keynes's liquidity trap is very different from that of New Keynesians or Post-Keynesians. I'm not sure if anyone still believes in the liquidity trap in the GT, though monetarists and Keynesians and Robertsonians will all disagree among each other on WHY it's wrong!

I like the liquidity trap in the GT. I've written a bunch of blog posts defending it, in fact.

I agree with you that neither of us will change the other's mind!

Nick,

Basic stuff:

I find it concretely obvious that when a Canadian mortgage borrower takes out a variable rate mortgage, in making that decision he/she typically ponders the risk of rates rising in the future and the timing of that risk. And that risk is directly affected by the expected timing of Bank of Canada interest rate policy. And that is a consideration that holds equally true at the zero bound, or at any policy rate of interest. Are you suggesting there are thinking people who don’t understand or consider that?

And when people buy a stock or a bond, they implicitly or explicitly discount the value of expected future cash flows to the present. What is the general problem about expectations here? At its broadest level of generality, which also applies to monetary policy, it seems to be a trivial issue. Are there people who actually don’t think about translating potential future consequences to present action? What am I missing about the premise of the importance of this basic concept of expectation as it applies to monetary policy, because some people certainly seem to make a huge deal about it?

The problem being that the central bank cannot commit "to delaying the time at which it would otherwise increase the nominal interest rate. It could commit to keeping interest rates "too low for too long". "

We don't even know if Bernanke will be re-elected. We don't know who will be president. We don't know what cutting edge macro research will be in the future.

The very fact that we are talking about changing monetary policy today means that we can also change it to tomorrow.

So it is very difficult for me to believe that the CB will keep rates too low in the future merely because it would be in the interest of the CB to make such a promise today. In the future, we will be beyond the ZLB. If the ZLB happens once every 60 years, it is far too easy for the CB to forget those promises and start fighting inflation in the future.

And IIRC, economists are blaming the CB for keeping rates too low in the 1950s and 1960s, even though we were in a ZLB in the 1930s and 1940s. I don't believe we are looking back at that period today, saying, well, they needed to keep rates low because investors assumed rates would be low for an extended period of time and this got us out of the Great Depression. What can the CB do today that would force it to adopt a certain monetary stance two decades from now?

The above should read "re-appointed" instead of "re-elected" :) But you get my point, I hope.

Nick, speaking for at least some of us out here in the Concrete Steppes I would just like to report that many of us understand how these a priori models based on rational expectations are supposed to work. We just don't believe that the world we live in is correctly represented by the models. (And I'm not even talking about the fact that some of us don't believe that people have rational expectations.)

Here's a simple model describing a class of possible worlds: in this world there are two people: Master and Servant. Servant has a fixed psychological disposition to form comprehensive expectations of the future based on the statements of Master about the future. Servant also has a fixed behavioral habit of acting in the way Servant's comprehensive expectations of the future say Servant will act. Master also has a fixed psychological disposition to form comprehensive expectations of the future based on the statements of Master about the future. And Master also has a fixed behavioral habit of acting in the way Master's comprehensive expectations of the future say Master will act.

There are multiple outcomes consistent with these assumptions:

1. Master says, "Five minutes from now, you and I will be doing the Tango"; and indeed, five minutes later Master and Servant are doing he Tango.

2. Master says, "Five minutes from now, you and I will be making mud pies"; and indeed, five minutes later Master and Servant are making mud pies.

Etc. etc.

Now here are my neighbors, Bob and Carol. Five minutes ago, Bob said. "Five minutes from now, you and I will be doing the Tango." And yet, Bob and Carol are not doing the Tango. What went wrong???!

Nothing went wrong. It's just that the actual circumstance of the household in which Bob and Carol live is not adequately represented by the logically possible model of the Master and Servant worlds. That a priori conceivable model is not a correct description of the actual household in the actual world.

And there is no suggestion here that Bob and Carol don't have expectations that are rational through and through. Instead, they are simply lacking the kinds of dispositions and habits described in the account of the Mater and Servant worlds.

I understand the forward guidance story about people whose expectations of future interest rates are determined in part by their expectations of various kinds of actions the central bank might take in response to various kinds of changes in the inflation rate; and whose economic decisions now are based on their expectations of future interest rates. I just don't think the universe of people whom that story accurately represents is, in a US economy of 300 million people, a very significant number of people.

The challenge from the Concrete Steps is an empirical challenge about the actual behavioral facts, psychological facts and institutional facts of the actual economy we live in. That's why our steppes are called "concrete". It's not a challenge about the bare theoretical intelligibility of descriptions of various kinds of economically possible worlds.

Good post about an underappreciated issue!

The very fact that we are talking about changing monetary policy today means that we can also change it to tomorrow.

Exactly. The fact -- if it is a fact -- that central bank A's commitment to some rule produces economic effect X, does not mean that central bank B could commit to a similar rule and get a similar outcome. The fact that A is committed to the rule means precisely that does not have a choice about it. As soon as we say that central bank B is choosing whether to adopt the same rule as A, we have ruled out the possibility of it being committed in the way A is, because that commitment is defined precisely by not having (or not being believed to have) a choice.

(This goes back to the Chuck Norris posts here a few months ago.)

And IIRC, economists are blaming the CB for keeping rates too low in the 1950s and 1960s, even though we were in a ZLB in the 1930s and 1940s.

This is a really good point. Looking retrospectively, nobody explains economic outcomes in terms of the monetary policy 10 or 20 years later. Nobody. And of course to define "rational expectations" in a way that says people in 1935 knew the true expected value of the short interest rate a decade after World War II (which presumably implies that they knew there would be a war, what its outcome would be, etc.) is to define the term in a way that's lost all contact with any recognizable human reason.

Dan Kervick's comment is good too.

If the Short Run Phillips Curve says that increasing AD will see both higher inflation and higher real income growth, I would say the effects on demand of higher expected real income growth would swamp the effects on demand of any real costs of inflation.

Sure, if the central bank is believed to be able to stabilize real output, then that expectation will itself help stabilize real output. This is undoubtedly one of the reasons that the quantitatively trivial operations in monetary policy can be effective at maintaining full employment. But it's a different story when you're no longer talking about stabilizing the existing level of output, but closing a large output gap - especially when the central bank has been unsuccessfully trying to close that gap for years. If the current effectiveness of policy depends on the beliefs about its future effectiveness, seems to me we're back in multiple equilibria land. If we can only have jam today if we have jam tomorrow, then we always have jam or we never do.

Monetary policy is better for preventing depressions than for ending them.

It's even worse, I think, actually. If future expansionary policy would raise output today, and if output today nonetheless remains depressed, then rational agents should adjust their priors about the likelihood of future expansionary policy downward. So the longer the depression goes on, the harder it gets for the expectations channel to work.

Sorry -- one more comment. I think some of the confusion here comes from importing model-logic into analysis of actual economies.

If I'm making a macro model, I'll write down some structural equations (say, an IS relationship linking the output to interest rates and a Phillips Curve linking inflation to the output gap), and then write a monetary policy rule linking interest rates to inflation and/or output. Once I've written those, and specified the distribution of shocks my economy is subject to, I can then ask what the expected value at time t is of some variable at time t+n. I can try this out with different monetary policy rules, and each will imply a different set of expectations.

It's natural to imagine actual monetary policy the same way -- just like the economist can choose what monetary policy rule to put in the model, the central banker can choose what monetary policy rule to follow, and in either case, people being rational, an appropriate set of expectations will follow. But in the case of the real economy this is logically incoherent. Either people have true knowledge of the distribution of future monetary policy, in which case that distribution already exists and is not available as a choice for the monetary authorities. Or else the authority really is free to choose a rule, in which case there is no rational basis for knowledge of future policy and expectations must be nonrational.

"If the ZLB happens once every 60 years, it is far too easy for the CB to forget those promises and start fighting inflation in the future."

It could also forget the promise to fight inflation when the target is reached. The commitment problem is two sided, and people will also worry about overshooting the target.

Nick

I agree, my question was a complicated one. But my positive argument is that the expectations formations process might itself depend on which concrete steppe transmission mechanism is dominant. For example, if monetary easing is being funnelled into commodity speculation, people will not expect their wages to go up, while commodity prices will. This will probably be stagflationary. If it is being funnelled into mortgages, we should expect new construction or at least improved balance sheets due to mortgage refi. If it is a generic interest rate cut, we should expect more consumption and investment. But we may even expect less investment if we have a model where there are two types of businesses - those that need to borrow to invest (entrepreneurs) and those that don't (incumbents), and the relative advantage of incumbents is higher when rates are higher, so that aggregate investment is higher when rates are higher. And so on and so forth.

Essentially, my points are :

1) The AS/Philips curve is not invariant to the monetary regime
2) De-aggregating and then re-aggregating might be helpful in understanding why expectations can be/ are being frustrated despite 'mattering'.

I agree that monetary policy can be loosened at the ZLB. My contention is that the question of 'which' monetary policy is always important, but especially important at the ZLB. And that the effectiveness of expectations policy is not invariant to the concrete steppes that form the substrate on the basis of which these expectations will be formed.

I would like to endorse and follow up on Ritwik's statement:

... my positive argument is that the expectations formations process might itself depend on which concrete steppe transmission mechanism is dominant.

Consider again my example of Master and Servant, but change the assumption that Servant has a fixed psychological disposition to form comprehensive expectations of the future based on the statements of Master about the future. Assume instead that Servant has a variety of conditional dispositions to form expectations of the future based on statements of Master about the future when those statements are accompanied by certain other actions that Servant believes are causally related to the future event Master describes.

So for example, suppose every year Master plows either the Front Field or the Back Field. The Front Field is perfect for raising pumpkins but won't yield grapes. The Back Field is perfect for producing grapes but won't yield pumpkins. Servant knows these facts. Servant might have the following conditional dispositions:

1. If Master plows the Front Field and says "We will be harvesting pumpkins this year," Servant will form the expectation that they will be harvesting pumpkins.

2. If Master plows the Back Field and says "We will be harvesting grapes this year," Servant will form the expectation that they will be harvesting grapes.

3. If Master plows the Front Field and says "We will be harvesting grapes this year," Servant will not form the expectation that they will be harvesting grapes.

4. If Master plows the Back Field and says "We will be harvesting pumpkins this year," Servant will not form the expectation that they will be harvesting pumpkins.

I think this is relevant to a lot of the discussion about central banks and expectations. My hypothesis would be that few people form their expectations about future variables - inflation, nominal spending, the unemployment rate, etc. - on the basis of statements about central bank expectations alone. But a somewhat larger number of people might form their expectations about those variables from central bank statements that are coupled with other central bank actions that those people believe to be causally connected, in ways that operate independently of expectations-related influences, with the outcome the central bank says it expects.

For a given observer X of central bank statements and actions, it could be that if the central banker says "We expect higher inflation this year", and that statement is accompanied by a helicopter drop, X will expect higher inflation. But if the statement is not accompanied by a helicopter drop, X will not expect higher inflation.

Now suppose the central banker accompanies the statement with, not a helicopter drop, but a round of something the central banker calls "quantitative easing". How will X respond? It might depend on what X thinks the term "quantitative easing" refers to. If X thinks it refers to a helicopter drop, then X might form new expectations in the same way as if the central banker had notified the public of a helicopter drop. But suppose X believes that the term "quantitative easing" refers to the purchase of limited types of financial assets, and understands that when it occurs, the financial assets that are injected into the economy in the form of money are offset by the purchased financial assets that are removed from the economy. The psychological response is unlikely to be the same. What the response will be depends on what other beliefs X has about the ways in which different variables in the economy are and are not connected.

And then, of course, in our actual economy, there are a large number of people who, unlike X, pay little or no attention to central bank statements and actions in any way.

Here is my 3 different ways expectations can matter;

Workers, their income and spending/saving habits;

Do people think that people actually expect higher future incomes to go along with their expectations of higher inflation? Is the income channel driven by the inflation expectations channel? I can tell you that most people working for someone else, people who rely on a paycheck from someone (most people) do NOT believe that their paycheck will rise in tandem with inflation. They feel poorer as inflation expectations rise (and they are in real terms quite often) and they will NOT spend more today because they fear high future prices.

Now the owners of a business and their hiring decisions;

Do they behave in a way that induces them to spend/invest as their expectations of future inflation increases? Doubtful. If they think future costs will be higher, they will likely cut present costs, and it looks as if the story of the last few years bears that out.


The entrepreneurs ;
I have come to the conclusion that what these inflation expectations economists really believe is that they see the drivers of our economies as those that take the big risks (true to a degree for sure), those that shoot big….. and they see our economies fate as tied to these "benevolent dictators" so to speak. We must rely on these extremely successful entrepreneurs to do the right thing and protect their investments and not get in their way. Its these guys’ inflation expectations that drive things because these guys are real sensitive to the erosion of inflation on their investments. If they see inflation in the future they will spend now to get the best deal they can.

This may be how a small segment of the population sees things and we will see if rising inflation expectations gives them a sense of urgency to do something productive now.

As a "concrete steppes" guy I dont think monetary policy is completely ineffective, I just think its clumsy, fraught with very bad side affects and too top down. I see it as actually more top down than fiscal policy, which interestingly is the criticism of fiscal policy by the monetarists. Just a different view of things? Or is there an actual definition of “top down” that can be discerned ?

JW Mason,

One additional interesting thing about Keynes's liquidity trap is that, unlike the New Keynesian and Post-Keynesian traps, it's immune to Tim Congdon's ideal solution* to our current problems, which is to expand broad money by the government selling its debt to commercial banks rather than the public ("debt-market operations" as opposed to OMOs). However, like me, Congdon is of the opinion that Friedman gave us reasons to dismiss such dangers in 1956.

* Congdon is a monetarist, but he thinks that expanding central bank asset sheets is needlessly controversial and risky.

Dan K.,

While I'm totally with the spirit of your comments, I think that having just two agents obscures one of the main points, which is the role of the central bank in solving the coordination problem *among private actors* by providing a focal point for expectations.

On the inflation expectations channel, the important thing is not that households desire higher current consumption when inflation expectations rise, but that businesses and asset-woners desire more physical assets as opposed to financial assets. Production of physical assets requires current labor and other inputs, and thus raises incomes. I'm skeptical about this too, but we need to be clear what story we are criticizing.

(Also, to be clear, in modern economies higher (but still moderate) inflation is almost always associated with higher real wages, not lower.)

Also, this statement makes no sense to me at all:

If they think future costs will be higher, they will likely cut present costs, and it looks as if the story of the last few years bears that out.

Are you saying that in a deflationary environment businesses don't care about their costs? And how do "the last few years" support this? Inflation expectations have been very low. In any case, inflation means both costs and sale prices will be higher, so margins will be the same. The important thing is that financial commitments taken on now will be less burdensome.

Again, it actually is a historical fact that the period of maximum inflation in the postwar US was also the period with the highest levels of business fixed investment.

I don't think the expectations channel works -- I don't think that the central bank can change people's beliefs in that way, for reasons similar to yours. But if we actually did experience a period of elevated inflation it seems pretty likely that output, employment and real incomes would be higher as a result.

Oh, sorry, second part of my comment was in response to Gizzard. (Somehow I thought his/her comment was also from Dan K.)

All Ill say is that most owners of businesses really dont give a crap about what some monetary expert says the "inflation expectations" level is or might be. Most guys running businesses think the costs of their future input materials and health insurance premiums are going to rise. THAT is inflation to them. Not some number released by the fed. And as a result of not seeing any more customers coming through the door to meet those costs they are cutting. That is the reality of how businesses react to higher future costs without the expectations of higher future sales.

I think most businesses know intuitively that if every businesses costs are going up they will NOT pay more in salaries as a response, since salaries are one of the costs they are trying to cut.

I dont think periods of inflation lead to high output, employment and incomes, I think periods of high income, employment and output will lead to inflation eventually.

W Peden

1) How are you differentiating between PK, NK and Keynes's liquidity traps?

2) In Congdon's solution, the govt should expand its debt to commercial banks and do what with the proceeds? Does he want a helicopter drop of bonds on banks?

Thanks JW Mason. I don't think anything essential would be changed if I used a three-person model with two servants and a "ringmaster" who doesn't participate in the economy, but who only makes statements that set the servants' expectations because both of the servants have have dispositions to form expectations about their own and the other servant's behavior based on the ringmaster's statements about what that behavior will be. Do you think it would make a difference?

Also, in the case of the Fed, wouldn't we want to model them as a participant of some kind in the actual economy, and not just an expectations-setter? After all, they are buying and selling assets of the same kind as many other participants in the private financial sector.

Ritwik,

I'd say that, approximately-

1. Keynes's liquidity trap is a situation where an increase in the quantity of broad money cannot reduce the yield on long-term government bonds.

2. The Post-Keynesian liquidity trap is when short-term interest rates cannot be cut any further.

3. The New Keynesian liquidity trap is the ZLB.

The Post-Keynesian liquidity trap is superficially similar to Keynes's, but there are two important differences: (i) the shift from focusing on long-term to short-term interest rates; and particularly (ii) the move from exogenous money (Keynes) to endogenous money (every(?) Post-Keynesian). Nicholas Kaldor (1982) is very good on the difference between the two and very critical of Keynes on this issue.

As for Tim Congdon: the government just spends as it did previously. So instead of financing public borrowing through debt sales to the non-bank public, the government borrows new money from commercial banks; instead of banks being the first private sector recipients of the new money, suppliers to the government would receive the new money. It's a change in the funding of expenditure, rather in the level of expenditure. To illustrate with an identity-

Broad money growth = ((A - B) + C) + D

Where A is public sector borrowing, B is debt sales to the non-bank public, C is bank lending to the private sector, and D is the overseas influence on the money supply. Congdon's policy is to shift borrowing from B to A, thereby increasing broad money growth.

I think he understands that it isn't really practical in current circumstances, because of the current fashion for independent central banks.

the shift from focusing on long-term to short-term interest rates

Why do you see this as progress? I would think the case that long-term rates matter more for output and employment than short-term rates do, is pretty strong.

JW Mason,

I don't think it's progress, at least insofar as Keynesian analysis goes. Short-term rates are interesting for their effects on private lending, but Keynes was right (given his assumptions) to focus on the long-term rate, which is the important rate for large capital projects and therefore (as you say) output and employment.

I prefer Keynes to the Post-Keynesians, the New Keynesians to Keynes, and the monetarists to the New Keynesians (New Keynesianism is mostly monetarism without an appropriate focus on money and a lot of dodgy ratex stuff).

JW: Good find on Leijonhufvud on Wicksell. I can't remember if I have read it before, or just something similar. It's funny how we are all still debating Ricardo vs Tooke!

Everyone: there's something very puzzling about this government commitment thing.

There are theses things called government bonds, where the government makes a commitment to pay a certain amount to whoever owns them, sometimes 30 years in the future. Some of those bonds are even supposed to be indexed to inflation!!! I can't see any reason why anybody would believe that commitment. Would it actually be in the government's interest to do what it said it would do, 30 years previously? That would be most unlikely. After all, it will be a totally different government 30 years from now, and it won't care what a government 30 years previously had said it wanted it do do. Those government "bonds" must be worthless, right?

Nick Rowe,

A very interesting analogy. The UK Treasury issued a 51 year bond last year...

Nick, it seems to me that even 30 years from now the government will have an interest in making good on 30-year old commitments, to preserve its reputation as a borrower and preserve the value of similar commitments it will probably want to make at that time. Also, in the US there is actually a passage in the 14th Amendment to the Constitution that says the validity of the public debt of the United States shall not be questioned. One reading is that even Congress is not permitted to undo the debt obligations that it, itself, has made.

Nick, it seems to me that even 30 years from now the government will have an interest in making good on 30-year old commitments, to preserve its reputation as a borrower and preserve the value of similar commitments it will probably want to make at that time.

Then why not the same of central bankers and their NGDP level target...?

W Peden: "The UK Treasury issued a 51 year bond last year..."

I just can't see those things possibly finding any buyers! But, of course, I bet they got snapped up. And 51 years is nothing. In the good old days, when the sun never set on the British Empire, they issued consuls. And some of those consuls are still out there, I think, despite government efforts to buy them back!

Dan: you are right, of course. But why couldn't the same reputational argument be made for monetary policy, as well as fiscal policy? How did the fiscal confidence fairy get reified into a cast-iron bond, while the monetary confidence fairy gets dismissed as just Tinkerbell, who only exists if we all believe in her?

Some in Canada speak of the 2% inflation target as "quasi-constitutional".

Alex beat me to it!

There is one problem. It's the problem with all laws, where you want both to give people a commitment about the future, so they can plan, and invest (understood very broadly) today, but at the same time you recognise that sometimes you change your views on what the best law would be, or circumstances change in an unforeseen way. It's the old problem of rules vs discretion. But most people more or less handle this problem most of the time. You recognise the weight of past commitments, but at the same time recognise that unforeseen stuff happens, and you work out some messy compromise. All you need is a bit of innate conservatism, coupled with a bit of (dare I say "Anglo Saxon"?) pragmatism, and an unwritten constitution works more or less OK.

There are theses things called government bonds, where the government makes a commitment to pay a certain amount to whoever owns them, sometimes 30 years in the future. Some of those bonds are even supposed to be indexed to inflation!!! I can't see any reason why anybody would believe that commitment. Would it actually be in the government's interest to do what it said it would do, 30 years previously? That would be most unlikely. After all, it will be a totally different government 30 years from now, and it won't care what a government 30 years previously had said it wanted it do do. Those government "bonds" must be worthless, right?

Ha! Very nice.

But, it should be noticed that there are lots of governments that are *not* trusted to honor their commitments in 30 years, and hence cannot issue 30 year bonds. And governments that can issue 30 year bonds, cannot necessarily make other commitments at the same horizon.

Yes, the US constitution says that federal debt must be honored. It also says that confederate debt may *not* be honored. US bonds are not worthless. Confederate bonds turned out to be. The types of commitments governments can credibly make about future policy are historically and institutionally specific. They can't be treated in an axiomatic way.

So i disagree with Dan K. here -- the fact that governments issue long bonds and honor them cannot be derived from any simple premises. It's a fact about the world, that could be otherwise. In fact we see multiple equilibria of this kind al the time. A government that *could* issue 30 year bonds, would not face liquidity constraints and would honor those bonds. but if it can't, in general, issue 30 year bonds, then if it does manage to sell some, it would be likely to face liquidity constraints before they mature and may well suspend payment. So people are right not to buy them. Both the will-honor and won't-honr equilibria are stable, and rational agents will choose to behave in a way that maintains whichever one you are in. (We're seeing a bit of this in Europe right now.)

The fact that (some) government are believed very, very unlikely to default on their bonds is a product of a very long history, of a whole set of institutions gradually developing that reinforce that belief. It's the very gradualness that makes the commitment credible and the equilibrium stable. Many (most?) governments in the world *cannot* issue 30 year bonds, let alone consols, certainly not in their own currency. And you can't change that just by announcing it.

Nick, I think you are right to make an analogy with law and other social norms that have to both be regarded as binding, and be allowed to change over time. But I think you underestimate how hard a problem that is. The fact that after a great deal of social evolution it's been sort-of solved for some aspects of social life in some parts of the world, does not mean that it has been solved in general

JW: "Many (most?) governments in the world *cannot* issue 30 year bonds, let alone consols, certainly not in their own currency. And you can't change that just by announcing it."

Agreed. But notice the one asymmetry in my analogy: the fear with bonds is always in one direction: that the government will "pay" the debt by inflating the currency. The commitment is always to resist the temptation to inflate. Right now, for the US, for monetary policy, we want a commitment to print more money/create a higher level-path of NGDP/create more seigniorage revenue than people currently expect. "I'm going to be a (slightly) bad boy, I swear!" That's a lot more credible. (Paul Krugman's words....damn, I've forgotten.....irresponsible.)

"The fact that after a great deal of social evolution it's been sort-of solved for some aspects of social life in some parts of the world, does not mean that it has been solved in general"

Yep. Agreed. Watch the news. Some societies are really.....not at a good focal point.

Nick, I see what you're saying, but I have never said that central bank stimulus policy is ineffective - in the places where I think it is ineffective - because the bank's commitments are not credible. It's more that I don't think the actions they are committing to are all that important, and I don't think the number of people who hear and care about those commitments are all that numerous. If my neighbor says he is going to keep the rate he charges for plowing driveways at $35 for the next 5 years, I might find his commitment 100% credible, but its not going to affect my economic behavior much. Now Ben Bernanke's most totally believable commitments fall somewhere between the commitments of my neighbor and the covenants of God in their impact. But where exactly they fall is the issue.

I know that the latest wrinkle in thinking - spurred in part by the reaction to Woodford's paper I guess - is that even though the Fed had already given a fair amount of forward guidance about their expectations of keeping interest rates extremely low, the guidance was long-termed enough, and wasn't backed up with enough other talk to make people really, really, really believe it. Fair enough. So they have now been even more forward and committed in the guidance. But we're talking here about interest rates that are already extremely low, and about the difference between an extra year or so. How much more charge does this new statement add to the cattle prod? It seems to me we're talking about microvolts at this point.

Maybe the added commitment has a marginal impact. Who can say? Or maybe the companies and consumers are actually waiting until they know interest rates have hit bottom, and won't move until they catch a whiff of a soon-to-come rise in interest rates. In that case, couldn't the promise of extremely low interest rates further into the future be counterproductive? Beats me. I just wish we could make policy on the basis of something less speculative than these mind-game models where, for every model that points in one direction, there is a similar model pointing in another direction.

I suspect we'll never really know what the effect of all this Fed communications business really is. The CEO from some giant corporation could take a happy pill tomorrow - completely unrelated to any Fed press conferences or whatnot - and announce that the company is hiring 3000 people to accommodate all the new business it is expecting next year. If the company is prominent enough, the confidence fairy might take wing as others follow the leader, and all the hiring might generate the additional demand needed to self-validate the investment decisions.

Then why not the same of central bankers and their NGDP level target...?

Alex, we seem to be talking at cross-purposes here. It is no part of my line that the Fed's commitments are not sincere, or that future Fed's will not be determined live up as best they can to the promises of past Feds. Whether that is the case or not is neither here nor there for me.

I just don't think the central bank by itself can hit an NGDP target with any degree of accuracy, so I don't think it matters how sincere and committed the Fed is to hitting such a target, or how concerned future Feds will be to keep the promises of past Feds. To me, its something like the National Weather service announcing a rainfall target. It doesn't matter how sincere, committed and institutionally stable they are.

... the fact that governments issue long bonds and honor them cannot be derived from any simple premises. It's a fact about the world, that could be otherwise.

I agree JW. But I believe the US has a track record of paying its debts, going all the way back to Hamilton. So it has hard won credibility, and every time it pays another debt it invests further in that credibility.

There are theses things called government bonds, where the government makes a commitment to pay a certain amount to whoever owns them, sometimes 30 years in the future. Some of those bonds are even supposed to be indexed to inflation!!! I can't see any reason why anybody would believe that commitment. Would it actually be in the government's interest to do what it said it would do, 30 years previously?

Congress passes laws allowing the government to formally issue a debt obligation. That debt obligation is backed by "the full faith and credit of the United States".

When a Congress person loses his seat, the law remains, as does the obligation.

There is a big difference between a financial obligation made into law and backed by the full faith and credit of the U.S. government, and the announcement of a policy stance by someone who will be replaced with possibly a different policy stance.

Nick, don't you see the difference between a debt obligation of the government written on paper and owned by someone with a legal right to redeem, and a "policy" obligation? The current sitting session of congress can force the U.S. to incur a debt obligation, but it cannot force future sessions of congress to incur policy obligations. There is no mechanism to constrain future legislators this way, and if there was, it wouldn't make sense to prioritize one session of congress of another, reserving policy making rights to only one period of time.

Or, put another way, in 20 years, our knowledge of how the economy works will be different. We will, hopefully, understand that the central bank does not control the money supply! (had to get that jab in).

But whatever that knowledge is, it will cause policy to change. Policy will always change. We will not adopt a bad policy in 20 years in order to fulfill a "policy debt" set today. But we will continue to service our debt. We are not know debating not servicing our debt. We are now debating adopting a new policy. One of these is a policy variable, while the other is a real obligation that people can count on being fulfilled.

rsj: "bonds" are just ink marks on paper. Is it magic ink and magic paper? Laws are more ink marks on paper. Only superstitious people believe they have any magic power. "Bonds" and "laws" are just the government's communications strategy. They only work if we believe they work. They aren't concrete steps to anywhere.

Everything rests on fairies. It's fairies, all the way down.

Nick, this is why economics, try as much as it might to pretend otherwise, is a social science. We have rules. The rules change. The models need to capture the rules. The models need to change. So everything is either subject to the Lucas critique or vacuous, because the rules themselves are changing, and there are no invariants.

In our world, we are debating policies, because policies change. In 10 years, a 10 year bond will be paid in full, but the 10 year old policy promises of central bankers will have only comical value.

And revolutionaries use models to change the way we see the world, and so to change the rules. Will Americans still see monetary policy as interest rates 10 years from now? I don't know, but I wouldn't count on it.

"Nick, this is why economics, try as much as it might to pretend otherwise, is a social science."

I can't think of an economist who would want to pretend otherwise. (Maybe some would say it's a branch of biology, but I'm not sure they are mutually exclusive?) Most (all?) economists I know say that economics is a social science. Some say it is the queen of the social sciences. Some say it is the only right way to do social science.

I don't think this applies much to the issue of debt repayment, but its worth noting that laws are not the same things as conventions, standards, rules or norms. They are rules enforced by sanctions. Governments don't succeed in getting people to conform, by and large, to the laws simply by communicating those laws. A government is not a mere facilitator of coordination. Governments also communicate their standing commitment to enforcing the laws by punishing violations. And they demonstrate the credibility of that commitment not just by stating the commitment in a firm voice, but by investing massive amounts of resources, day after day, in the apprehension, prosecution and punishment of violators of the laws, and by publicizing these investments and results so that everyone is aware of them. So the proof is in the pudding.

A country's debt commitments are not really made more credible because it has passed a law binding itself to paying the debt, since it can always change the laws later. But the commitment is made more credible by an enduring track record of repaying debts. Debts can be difficult to pay and there is always at least some incentive for not paying them. So if one sees that a country has a long track record of consistently paying its debts over many generations, one has some evidence that there is something in the institutions and mental habits of the people of that country that seems consistent over time and that the people apparently successfully pass down from generation to generation. It's by no means an infallible conclusion to draw, but it does grow more solid the longer the practice endures.

Dan: " Governments don't succeed in getting people to conform, by and large, to the laws simply by communicating those laws. A government is not a mere facilitator of coordination."

I don't look at it that way. Those people we call "Prime ministers", "presidents", and "queens", are usually not any more powerful, in concrete terms, than anyone else. They can only communicate those things we call "laws" to those people we call "police" and "judges". The people we call "police" usually choose to obey, because they think other police and everybody else will obey too. The "police" are usually a little bit more powerful than ordinary people, but not much. And there are very few of them. But their uniforms and badges are a focal point, so we usually obey them, and they are trained to coordinate on focal points better than a mob of individuals, which helps them win when it does come down to concrete stuff.

Again, it's fairies all the way down, once you disaggregate "government".

it's fairies all the way down

I agree with this, actually.

Nick

When making your purchase decisions without first inferring the objective function of the central bank would be a sign of moral turpitude (or would make woe befall you), I'd agree with this monetary policy and law analogy. Until then, let's acknowledge that we're dealing with very shaky territory here.

If one was to believe everything you say, we're better off searching for the roots of monetary policy in political philosophers and psychologists, proper ones at that. Fisher & Friedman are useless and monetary economics courses should be scrapped or reduced to footnotes in sociology classes.

At the very least, this is sufficient case for subsuming monetary economics under the ambit of public finance.

"How did the fiscal confidence fairy get reified into a cast-iron bond, while the monetary confidence fairy gets dismissed as just Tinkerbell, who only exists if we all believe in her?"


Maybe this has something to do with the source of the institution asking for the confidence. A body like Congress that has very transparent codes, readable and changeable by the people, will necessarily be trusted more than a body which most people understand to have been created in secret ways (on an island off the coast of Georgia), with nefarious intent (to put banks in a special wealth stealing position relative to the electorate). While contempt of Congress is high it doesnt approach the level of contempt for all Central Bankers around the world, and with good reason I think. In the United States at least, they meet regularly, do not openly discuss the specific content of their meetings, CSpan never shows us a blow by blow of the nature of their debates and all we get at the end is a very nebulous five minute proclamation by Bernanke at the end. Most of the time its simply unnecessary words concluded with "We intend to keep rates at x for the forseeable future". CBs are the least trusted people on the planet, so regardless of their intent and abiliites to affect things, everything they do which requires a level of coordination with and trust from the general population will be negatively affected. There is really not anything of importance in this world that doesnt require a significant amount of collective will to get accomplished and collective will requires thoughtful and trusted communicators (maybe not first and foremost but certainly important to the process). Sorry to burst your bubble Nick but most people see CBers as scheisters.

We all know thtat CBs are FOR the banks first and public purpose is waaaaaaay down the list if even on the list.

Nick, the difference between the government and the fed is the government is a legally mandated monopoly that has wide spread support. Are you suggesting that the fed should have greater monopoly powers? Should the American government outlaw the acquisition of gold or currency exchange?

Again, it's fairies all the way down, once you disaggregate "government".

Isn't that a little bit like saying, "It's atoms all the way down, once you disaggregate nuclear bombs"?

The motives people have for conforming to laws are very different from the motives they have for conforming to norms articulated by a facilitator.

Suppose we had a norm which said: "you must do X, and you must punish those who do not follow this norm". (please note the infinite regress due to the self-referential bit, so the norm says we punish those who do not punish those....who do not do X.) If people actually follow that norm, we call it a law.

Some people do try to analyse this sort of stuff. They come from lots of different disciplinary backgrounds, economics included. My guess is that sociology and psychology are if anything under-represented in this field. But when you read this sort of stuff, it's often very difficult to guess the author's disciplinary background.

Ian: "...the government is a legally mandated monopoly..."

At least, that's what the government says it has. But that's just another way of saying that there's a bunch of people who call themselves "the government".

"Are you suggesting that the fed should have greater monopoly powers? Should the American government outlaw the acquisition of gold or currency exchange?"

Nope. I have no idea why you might think I'm saying that.

Suppose we had a norm which said: "you must do X, and you must punish those who do not follow this norm". (please note the infinite regress due to the self-referential bit, so the norm says we punish those who do not punish those....who do not do X.) If people actually follow that norm, we call it a law.

Few such norms exist. That describes life in something not far removed from a Lockean state of nature with the private enforcement of justice.

In our society, we have professional classes of punishers. They punish people because it is their job to do so; and like most people, they do their job not because it is part of a broad social convention, but because they are incentivized to do so.

Dan, I think Nick is right here. "Laws" and "incentives" are just conventions. The only reason laws have moral force and are obeyed, is that they are widely believed to have moral fore and to be obeyed. On a formal, abstract level there really is no difference between changing a law and changing an expectation of future policy.

The difference is the practical one. In a modern liberal society, the belief that the law will be followed is very strong, so that it can be a convenient shorthand to just say "people have incentives" as if it were a physical fact, like "people have two kidneys." But it isn't really. On a fundamental level, there really is no difference between central bank guidance and law.

But there is a very big practical difference. People actually do hold very strongly rooted expectations that law will be obeyed, that debts will be paid, etc., in a way they do not about central bank announcements changing the expected economic conditions years from now. That's a contingent fact about the world -- it's perfectly possible that after years at the ZLB, and a big intellectual victory by market monetarists, etc., announcements about policy N years from now would become a main tool of central banks, and experience would eventually confirm that you should make economic choices today based on what the central bank says policy will be five years from now. There's no reason in principle why that could't be the case. It just doesn't happen to be the case now.

I don't know if you identify as an MMTer or not. But my criticism of MMT has always been that they take a set of true, and important historical-empirical claims, and then mistakenly try to derive them deductively.

Just to make the grounds of *substantive* agreement with Dan K. clearer, here's Gillian Tett in today's FT, reporting that on a recent survey of CFOs that finds the vast majority of businesses would not change their business plans at all even if interest rates fell by as much as two percent. But "optimists add, QE3 also provides a wider general psychological boost. ... The crucial problem ... is that the psychology of this is still so uncertain. With anything between $2,000bn and $4,000bn of unused liquidity now swirling around the US financial system (depending on how you measure it), consumers and CFOs alike can sense that monetary policy is becoming less effective."

As a practical matter, QE is not expected to work, which means that if it depends on the expectations channel, it won't.

(link fail, sorry.)

The quote is from Gillian Tett in today's Financial Times.

Link fixed.

JW

"On a formal, abstract level there really is no difference between changing a law and changing an expectation of future policy."

Correct, with an important caveat. Changing expectation of future policy is equivalent to *successfully* changing the law.

Every year in India, thousands of female foetuses are aborted, despite strict laws banning sex determination of pregnancies. Every year in India, billions of rupees are demanded and offered as daughters' dowries, despite strict laws banning this as well. Every year in India, we are reminded of how little the government can matter for social conventions.

Every year, economists write thousands of articles about how this or that government policy failed because it failed to take into account people's tastes, preferences and incentives.

The question is, are nominal macroeconomic expectations as fluid, as well understood and as effortless as the effortless switching of clocks during DST, or are they more analogous to the rigid social conventions and private preferences over which non-despotic fiat regimes have relatively little power.

Nick somehow believes that the answer is clear. I'm not sure what gives him this confidence.

JW: what that FT article missed is this: suppose only 9% of firms respond to the interest rate cut. But another (say) 9% of the firms (or their customers) respond to the increased demand from that original 9%. And so on. Good old fashioned Old Keynesian multiplier analysis. Now the central bank announces a focal point to help the firms solve the very short run coordination problem. All you need is one firm.

Ritwik: people used to think of monetary policy in terms of the gold price. Then they thought of interest rates. Now they think of inflation targets. What gives me confidence? Roosevelt did it.

"Nope. I have no idea why you might think I'm saying that."

You are making an argument for the reputation of the federal reserve and its ability to stick with its comittment are you not? People view government debt with high levels of trust because when it comes time to pay the debt off, the government can force people to pay it. If the fed commits to inflation its a lot less obvious what is going to happen since it is hard to force people to support the decisions of the fed, the only way would be to outlaw gold or currency trading.

Of course, in the long run government collapse all the time but the long run to government collapse is much longer than the long run to monetary regime collapse.

"But there is a very big practical difference. People actually do hold very strongly rooted expectations that law will be obeyed, that debts will be paid, etc., in a way they do not about central bank announcements changing the expected economic conditions years from now. That's a contingent fact about the world -- it's perfectly possible that after years at the ZLB, and a big intellectual victory by market monetarists, etc., announcements about policy N years from now would become a main tool of central banks, and experience would eventually confirm that you should make economic choices today based on what the central bank says policy will be five years from now. There's no reason in principle why that could't be the case. It just doesn't happen to be the case now."

The difference is that it is harder to enforce inflation on people without completely monopolizing the currency within a geographical area in a similar way that our legal system does. If it becomes a custom then you dont have to enforce it, laws are not customs since they are enforced on those that disagree with them.

If people have reason to believe that policy announcements will have beneficial outcomes in the future then it might become customary for policy announcements to affect current economic conditions. If NGDP targetting policies require everyone to share the same customary expectation for it to have an effect on current economic conditions then it is hard to see how you are going to get millions of people to agree on policy without enforcing it onto large groups of people.

"Dont steal other peoples stuff" is a lot easier to agree upon then "Lets inflate away your savings". The government has broad support for the former but its hard to see how a central bank will be allowed the later through a democratically elected government.

laws are not customs since they are enforced on those that disagree with them.

What Nick keeps saying, which seems completely clear to me but apparently not to others, is that enforcement is itself just a custom.

JW: you said it clearer than I did. That's perhaps why it wasn't clear to others.

All you need is one firm.

One interest-sensitive firm plus an arbitrarily large change in interest rates, you mean?

But even if the Fed can genuinely affect both real interest rates and people's expectations of them, that doesn't mean it can do so without limit. It's much more likely that it can establish expectations that inflation will be 3 percent at some point in the future, than that it will be 30 percent. Right?

Also, this is a somewhat separate issue, but the narrower the range of activities that are sensitive to the interest rate, the more changes in the composition and not just the level of activity you get from monetary policy. E.g. it's a pretty well established argument that if monetary policy operates almost exclusively through the housing market, stabilizing overall output may require booms and busts in housing, with all the disruption that implies. Even aside form all the issues we're debating here, for monetarism to work as a *policy* argument, demand for whatever form of liquidity the central bank controls, should be stably associated with the whole range of activity.

(OK, yes, the larger are multipliers, the less of a problem this is. But you can't assume they are arbitrarily large.)

JW: "One interest-sensitive firm plus an arbitrarily large change in interest rates, you mean?"

No! One arbitrarily small interest-sensitive firm, one arbitrarily small change in interest rates, and a positive feedback parameter greater than or equal to one. Keynesians called that positive feedback parameter the "marginal propensity to consume". OK, but add in the marginal propensity to invest, plus an additional factor for the propensity for raising prices and so lowering the real rate of interest for any given nominal rate. And it can easily be bigger than one (if the central bank lets it be). And the multiplier is infinite.

This is why I keep yammering on about upward-sloping IS curves.

Yes, it's all about credibility. I refer to the poker-game model. Do governments bluff? Generally not, or when they do we get an election soon enough and get a more credible player to sit at the table and play better.

Is it wise to bet against the government? Generally not, the consequences are transparent and well-known.

Do central bankers bluff? They do, and people like George Soros call their bluffs. We don't like central bankers bluffing because we hate making George Soros rich.

All the Concrete Steppes (and why are we stuck in a concrete field in the Ukraine?) people are saying is that when the cards are down, the Central Bank can be shown to be bluffing and lose the hand. So the expectations channel is weak to bluff-calling unless you can magically give the Central Bank an automatic, ever-present ace in the hole.

"What Nick keeps saying, which seems completely clear to me but apparently not to others, is that enforcement is itself just a custom."

I understand this, what I am saying is that customs that are not enforced (acceptance of fed policy) are not as credible long term as those that are (government bonds). At this moment in time if people adjust their expectations to future output based on policy set by the fed then this is a custom but it is one that is not enforced. If I think the majority is wrong in their expectation I can protect myself from the inflation by investing in other assets. If the government wants to pay back it's debt then I have no choice but to pay taxes which are enforced by law.

Yes these laws are also customs that can change which is why I asked nick if he was talking about enforcing by law the quality of fed notes. He asked why fed commitment wasnt questioned more than the commitment to pay back government bonds, government bonds are questioned less than fed commitment because we know that other people will be forced to pay them back. The fed can only be committed as long as people continue to voluntarily hold on to fed currency which is hard to believe given the massive number of competitive options currency users have in our modern societies.

No! One arbitrarily small interest-sensitive firm, one arbitrarily small change in interest rates, and a positive feedback parameter greater than or equal to one. Keynesians called that positive feedback parameter the "marginal propensity to consume". OK, but add in the marginal propensity to invest, plus an additional factor for the propensity for raising prices and so lowering the real rate of interest for any given nominal rate. And it can easily be bigger than one (if the central bank lets it be). And the multiplier is infinite. This is why I keep yammering on about upward-sloping IS curves.

Ah, ok, now I see what your argument is. Huh. I think I still don't agree, but will need time to formulate a response.

Nick Rowe: "How did the fiscal confidence fairy get reified into a cast-iron bond, while the monetary confidence fairy gets dismissed as just Tinkerbell, who only exists if we all believe in her?"

Isn't it the other way around?

I was interpreting the monetary confidence fairy as confidence in the CB, not as the nebulous Confidence Fairy who will tap businessmen with here wand.

I was interpreting the fiscal confidence fairy as confidence in the legislature.

JW: "Ah, ok, now I see what your argument is."

Which makes me realise just how bad I've been at explaining my argument.

Min: Yep. Sometimes people talk about the fiscal confidence fairy as the belief that cutting the deficit will increase demand. Here I was talking about the opposite case -- the belief that increasing the deficit would increase demand. (Or just the belief that bonds would be paid). I wasn't clear.

Thanks, Nick. So many fairies, so little time! ;)

"Y = 0.5E(Y) + 0.5X. What people choose to do depends partly on some exogenous variable X, and partly on what they expect other people to do. But there is only one level of Y, given X, at which people's actions will confirm their expectations of others' actions. Most static economic models are like that.

"Now lets complicate that model slightly, by introducing time. Y(t) = 0.5E(Y(t+1)) + 0.5X(t). What people do today depends partly on X today, and partly on what people expect people to do tomorrow. Most dynamic economic models are like that. And you need to say something about how people form their expectations in order to solve those models.

"One assumption is rational expectations. People's expectations are consistent with the model. Taking that same equation and leading it forward one period gives you Y(t+1) = 0.5E(Y(t+2)) + 0.5X(t+1). If people expect that that is how people will choose tomorrow, then E(Y(t+1)) = 0.5E(E(Y(t+2))) + 0.5E(X(t+1))."

Why should we believe that E(X(t+1)) even exists? After all, X is exogenous.

And the whole system is non-causal anyway.

On this business of laws, I believe the claim that laws are just a particular kind of convention is incorrect.

The most important feature of behavior rule that is a convention, as it is now generally analyzed, is that the reason self-interested people have for obeying it is their belief or expectation that everyone else generally conforms to the rule. The classic example is driving on the right (or left). Suppose there is a country X with no law governing which side of the road one should drive on, but a convention that one is to drive on the right hand side of the road. A self-interested driver Y wants to get from point A to point B with minimum hassle. The fact that Y expects that everyone else in X will drive on the right is, all by itself, a reason for Y to drive on the right.

But now consider paying taxes. Suppose X is a country with no tax laws, but a suggested voluntary tax that everyone in X generally pays. Does the self-interested person Y's belief that almost everyone else in X will pay taxes give Y a reason to pay taxes? No, not at all. The self-interested person has every reason to defect from the norm of tax-paying. Driving on the left will get Y into trouble if there is general conformity to right-hand driving. Not paying taxes will cause Y no trouble at all. At least, not unless there are sanctions regimes in place.

So suppose there are some enforcers with a known disposition to punish people who don't pay taxes, and the existence of these enforcers and their general success in punishing tax dodgers is generally known. Should we say at least that among the enforcers, punishing tax dodgers is a a convention? I don't thing so. Punishing tax dodgers is not some kind of mutually convenient solution to a coordination problem among the enforcers. The enforcers punish tax dodgers because they are also subject to positive and negative sanctions in the forms of rewards and punishments meted out by others.

A system of law depends on network of generally known dispositions to sanction.

Thanks for that FT link, JW.

Queen of the social sciences? IIRC, Marx tried to inject some class consciousness and his work was not well received.

As long as you model people as atomistic individuals who are only trying to maximize their own individual consumption while minimizing their own labor effort, economics will remain the blind step-child of the social sciences.

J.W.

What Nick keeps saying, which seems completely clear to me but apparently not to others, is that enforcement is itself just a custom.

Of course, but I am saying that these customs need to be baked into the models, and changed as the customs change. So federal debts are real obligations -- you buy a bond for $1 and get back $(1+r). That goes into the model. But policy promises are not obligations, so that does not go into the model.

If you really believe that economics is a social science, you cant make up whatever customs you want in your model and assume the model has relevance. You cannot invent "policy bonds" and talk about them in the same way that you talk about real bonds, because the repayment of bonds "is just a custom".

... and a the focusing example here is money, which is itself a social construction. All the pushback against the notion that the CB controls the money is supply is because Nick has his own unique social constructions that are not the general social constructions of our economy. Just as you can't invent social constructions for policy bonds, you can't invent constructions for money. You have to get the social rules right in order for the model to be relevant.

rsj: "As long as you model people as atomistic individuals who are only trying to maximize their own individual consumption while minimizing their own labor effort, economics will remain the blind step-child of the social sciences."

Durkheim said something similar. But then many (not all) sociologists simply assume social propensities, which begs the question. Some of us have tried to tackle the question.

Here is an example from David Friedman.

Here is my own (slightly pathetic) attempt. (But I'm still proud I tried, so please don't laugh. Friedman is better.)

There are others like that. Those are 20 years old. The literature has moved on since, but I haven't kept up with it.

David Hume: "As FORCE is always on the side of the governed, the governors have nothing to support them but opinion. ‘Tis therefore on opinion only that government is founded; and this maxim extends to the most despotic and military governments, as all as the most free and popular. The soldan of Egypt, or the emperor of Rome, might drive his harmless subjects like brute beasts, against their sentiments and inclination: but he must at least have led his mamalukes or praetorian bands like men, by their opinion."

rsj,

"IIRC, Marx tried to inject some class consciousness and his work was not well received."

Had Marx not personally been a blatant counterexample (among many) to class consciousness, people might have taken the idea a little more seriously.

@Nick Rowe

Nick, this is ad hominem, but in a nice way. :)

Fairly often you ask us to suppose that all of a sudden people change their beliefs, desires, or behavior. In a world in which that happens often enough, doesn't it become difficult for people to form rational expectations, much less expectations far into the future?

Min,

FORMING (implicit) expectations far into the future is easy. Forming CORRECT expectations of what will happen tomorrow seems almost impossible sometimes! Hence saving, hedging, contingency planning etc.

If economics is a social science, then why do we so often use the word 'social' to mean 'not economic'?

W Peden: because we stupidly let our enemies appropriate the word "social". Which is why my gut reaction, when I hear the word "social", is to reach for my shovel.

Min: yes. But when I say "what will happen if X changes" that is often shorthand for "what would be different if X were different".

JW: I really like Hume on this subject. He has another good one somewhere about 2 guys rowing a boat without having made a social contract. Their rowing in time *is* their social contract. On that particular passage though: even if nobody liked the emperor, no individual would go first to disobey. Or second. Stalin held meetings where he asked people to stand up and say what they really thought. Whoever stood up first was shot. It's not quite that bad in universities, but it's usually imprudent to express some views, or not to criticise people for expressing those views, whether you agree or not. Economist Timur Kuran (sp?) has some good stuff on "preference falsification", with equilibria where everyone pretends to like something they don't.

Nick Rowe: "But when I say "what will happen if X changes" that is often shorthand for "what would be different if X were different".

Thanks. :)

Actually, that clears a good bit up. :)

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