Like physics, modern macroeconomic theory predicts the possibility of "black holes". The analogy with physics is close, but not exact. Because unlike physics, where it's not easy to see a black hole, there should be no difficulty in macroeconomists seeing a black hole, if one exists. At the very least, we should certainly see any economy being sucked into one. So where are they? Why don't we ever see any?
If the economy gets too close to a black hole, it can't escape, and is sucked into a deflationary death-spiral. If nominal interest rates are at or near zero, and so at their lower bound, any deficiency of aggregate demand causes increased deflation, which in turn causes increased expected deflation, which in turn causes higher real interest rates, which in turn reduce aggregate demand, which in turn causes increased deflation...and so on. The price level and real output should both fall to vanishing point. Money in a black hole should have infinite value, yet nobody will buy anything with it.
Theory does not predict that black holes will happen. But it does predict that they can happen. And commonsense (backed up by Murphy's Law, in this case) says that, sooner or later, anything that can happen will happen.
So where are they? Why can't we see them? We sure have sailed our macroeconomic spaceships close enough to the boundaries of predicted black holes plenty of times. Why didn't any economy ever get sucked into one, and collapse into an infinitely valuable pinpoint?
Either somebody up there likes us. Or there's something wrong with macroeconomic theory.
JKH, I have one other question.
What is the difference between a 100% reserve requirement and a 100% capital requirement?
Posted by: Too Much Fed | January 04, 2010 at 01:49 AM