What we have just witnessed is the economics equivalent of the Sokal hoax. It wasn't a hoax, just a mistake, but the effect was the same. We all make mistakes. What matters is that the rest of us didn't all spot that mistake immediately. Even those of us who did see that something was wrong didn't immediately identify what exactly was wrong. We need to ask ourselves why. We can't blame the person who made the mistake if we didn't immediately see it either.
Many economists have been puzzled by recent house price inflation. My theory shows that house price inflation was caused by too many houses being built....Loadsa theory.....Let me give you the intuition with a simple thought-experiment. Suppose builders suddenly increase the stock of houses on the market. The rate of house price inflation must increase for people to be willing to hold those extra houses, because people demand more houses when they expect rising house prices.
If you believe my explanation makes sense, you will also understand why Zimbabwe had hyperdeflation. There needed to be ever-accelerating deflation, so that people would willingly hold all that extra money.
But why didn't we immediately see what was wrong?
Take any asset. It could be houses, or it could be money. The only difference (in this case) is that the price of money is the reciprocal of the price of other goods, so the rate of increase of the price of money is the rate of decrease in the price of other goods (i.e. the deflation rate).
The quantity of houses demanded is a negative function of the price of houses and a positive function of the expected rate of increase of the price of houses.
The quantity of money demanded is a positive function of the price level and a negative function of the expected rate of inflation.
Ignore anything else that might affect the demand for houses, or money, just to keep it simple. And assume perfectly flexible prices and continuous market-clearing, just to keep it simple. And assume actual and expected inflation are the same, just to keep it simple.
Assuming a simple log-linear demand function for the stock of houses, the supply=demand equilibrium condition is:
H(t) = a - P(t) + b.Pdot(t)
The equivalent for money is (remembering the price of money is the reciprocal of the price level);
M(t) = a + P(t) - b.Pdot(t)
It is well-understood, at least since Brock (1975) "A simple perfect foresight monetary model"(pdf) , that this equilibrium condition permits an infinite number of solutions. There is the "fundamental" solution, where the equilibrium time-path depends only on the time path of M(t). And then there are an infinite number of "bubble" solutions. Even if M(t) is constant for all time, P(t) can rise without limit at an ever-increasing rate, or fall without limit at an ever-increasing rate, along any one of these bubble paths.
Economists normally adopt the "fundamental" solution, but some economists think we might sometimes observe "bubble" solutions.
If there is an upward jump in M(t), that was not foreseen, and if people expect that increase to be permanent, the fundamental solution says that P(t) must jump too to restore equilibrium. A permanent increase in the money supply causes a permanent increase in the price level. If the theorist forgets that P(t) can jump up, the only way to restore equilibrium is to assume that Pdot(t) jumps down. A permanent increase in the money supply causes a fall in the inflation rate. But that means the theorist is assuming the economy has moved from the fundamental equilibrium path onto one of the bubble equilibrium paths.
There is an alternative way to get an increase in the money supply to cause deflation, while sticking to the fundamental equilibrium. You need to ensure that when M(t) jumps up, Mdot(t) jumps down at the same time. The money supply increases, but is expected to start declining from now on. The jump up in M(t) causes the P(t) to rise. The jump down in Mdot(t) causes Pdot(t) to fall, which in turn causes P(t) to fall. If you rig it just right, so the two changes have just the right relative magnitudes, the net effect is no change in P(t), and a fall in Pdot(t).
[Update: Here's the above paragraph in math. Assume A=0, and initially M=1 and Mdot=0. So people expect P to stay constant at 1. Suddenly M jumps to 2, but the central bank also announces that M will decline at rate 1/b from now on. There is no jump in P, but Pdot is now -(1/b).]
But note one thing very well. This fundamental solution, where an increase in the money supply causes no rise in the price level but a fall in the inflation rate, requires people expect that the money supply will eventually be lower than if it had never increased in the first place. QE causes inflation to fall because QE causes people to expect a bigger negative QE in future than the original positive QE. That seems implausible to me.
The proper way to discuss questions like this is to talk about the extent to which QE is expected to be permanent or temporary. Scott Sumner, to give just one example, has been saying that QE has little effect because it is expected to be mostly temporary, given the failure of the Fed to announce a sensible target. You talk about the central bank's monetary policy target, and how that influences people's expectations of future prices (or NGDP, if prices are sticky). And you discuss the effects of QE within the context of that monetary policy framework.
Instead, Steve Williamson's posts have served only as a Rorschach test (I forget who said that) for far too many people, who read into it what they wanted to read. Read Izabella Kaminska for example. (Her post would work as a Sokal hoax in its own right. It's unintelligible.)
So, what went wrong? How come even those of us who did get that something was wrong didn't immediately figure out what exactly was wrong?
I blame maths. Only when Steve said it clearly in words (for which he deserves credit), could I clearly see what the problem was.
(Perhaps I should have written a slightly different post, a real hoax, arguing that rising house prices are indeed caused by building too many houses, just to see how many people would fall for it? But a hoax post on money would be much easier to pull off.)