Wrong question, wrong answer

John Cochrane has a new piece in the WSJ, criticizing the widespread concern over deflation risks, especially in Europe. I have mixed feelings about this whole enterprise.  I’ve repeatedly argued that inflation doesn’t matter, and that economists should just stop talking about inflation (and deflation.)  But they obviously won’t stop, and hence I guess I can’t blame Cochrane for responding to the often incoherent discussion. He lists 4 reasons to be skeptical about deflation fears:

1) Sticky wages. A common story is that employers are loath to cut wages, so deflation can make labor artificially expensive. With product prices falling and wages too high, employers will cut back or close down.

Sticky wages would be a problem for a sharp 20% deflation. But not for steady 2% deflation. A typical worker’s earnings rise around 2% a year as he or she gains experience, and another 1%—hopefully more—from aggregate productivity growth. So there could be 3% deflation before a typical worker would have to take a wage cut. And the typical worker also changes jobs, and wages, every 4½ years. Moreover, “typical” is the middle of a highly volatile distribution of wage changes among a churning job market. Ultimately very few additional workers would have to take nominal wage cuts to accommodate 2% deflation.

Curiously, if sticky wages are the central problem, why do we not hear any loud cries to unstick wages: lower minimum wages, less unionization, less judicial meddling in wages such as comparable worth and disparate-impact discrimination suits, fewer occupational licenses and so forth?

2) Monetary policy headroom. The Federal Reserve wants a 2% inflation rate. That’s because with “normal” 4% interest rates, the Fed will have some room to lower interest rates when it wants to stimulate the economy. This is like the argument that you should wear shoes two sizes too small, because it feels so good to take them off at night.

The weight you put on this argument depends on how much good rather than mischief you think the Fed has achieved by raising and lowering interest rates, and to what extent other measures like quantitative easing can substitute when rates are stuck at zero. In any case, establishing some headroom for stimulation in the next recession is not a big problem today.

3) Debt payments. The story here is that deflation will push debtors, and indebted governments especially, to default, causing financial crises. When prices fall unexpectedly, profits and tax revenues fall. Costs also fall, but required debt payments do not fall.

Again, a sudden, unexpected 20% deflation is one thing, but a slow slide to 2% deflation is quite another. A 100% debt-to-GDP ratio is, after a year of unexpected 2% deflation, a 102% debt-to-GDP ratio. You’d have to go decades like this before deflation causes a debt crisis.

Strangely, in the next breath deflation worriers tell governments to deliberately borrow lots of money and spend it on stimulus. This was the centerpiece of the IMF’s October World Economic Outlook antideflation advice. The IMF at least seemed to realize this apparent inconsistency, claiming that spending would be so immensely stimulative that it would pay for itself.

4) Deflation spiral. Keynesians have been warning of a “deflation spiral” since Japanese interest rates hit zero two decades ago. Here’s the story: Deflation with zero interest is the same thing as a high interest rate with moderate inflation: holding either money or zero-interest rate bonds, you can buy more next year. This incentive stymies “demand,” as people postpone consumption. Falling demand causes output to fall, more deflation, and the economy spirals downward.

It never happened. Nowhere, ever, has an economy such as ours or Europe’s, with fiat money, an interest-rate target, massive excess bank reserves and outstanding government debt, experienced the dreaded deflation spiral. Not even Japan, though it has had near-zero inflation for two decades, experienced the predicted spiral.

He’s right about point 4, there’s very little risk of a deflationary spiral.  And of course he’s right about the insanity of borrowing money to try to overcome deflation. Point 2 is a lousy metaphor, which doesn’t capture the logic of higher inflation as a way of avoiding a liquidity trap.  If Cochrane insists on shoe metaphors, here’s the right one:

Suppose you occasionally have to go out and shovel snow when it’s 40 below.  You should have one set of shoes that is 2 sizes too large, so that you can wear 4 pairs of socks with it.

Points one and three are examples how conservatives (except for the great Milton Friedman) have an unfortunately tendency to minimize the impact of demand shocks.  It’s true that inflation itself doesn’t matter, and that almost all Phillips Curve models perform really poorly.  But that’s a side issue.  When economists worry about deflation they are actually worried about falling NGDP, they just don’t realize it.  Obvious lower prices, ceteris paribus, are perfectly fine.  But when NGDP growth comes in 10% or 20% lower than workers or borrowers expected when they signed labor and debt contracts, then you have big problems.  Conservatives tend to have a blind spot for that problem (except for Milton Friedman, obviously.)

PS.  I hereby issue “loud cries to unstick wages.

PPS.  Notice to my international readers.  Keep in mind that 40 below zero fahrenheit is equivalent to 40 below zero centigrade.  

HT:  Ramesh Ponnuru

iPredict donations

We finally have a way of donating money to iPredict.  I will soon contact each person who offered a donation, and provide the contact person at the Victoria University of Wellington.  I will ask each person to donate at least 75% of the amount originally promised, if possible.  You may donate the full amount promised if you wish–it would help to sustain the market, but isn’t needed to get it off the ground.  The only exception is one large donor, who will be donating to Hypermind instead.

Thanks again for your support, and patience.

Update:  I should probably mention that the proposal evolved as time went by.  The initial plan called for funding of $31,500, but we later evolved to a different strategy, where the total cost is more contingent on how long the market runs.  Also, Hypermind later contacted us with a different plan, which we are already arranging funding for from a big donor.  The promised donations were considerably more than the amount the iPredict plan originally called for, but some of the donations were rather vague (“if needed”), or no specific amount promised. Some of the funds will be directed to Hypermind.   I believe that 75% of the amount promised should be enough to get a decent NGDP market off the ground with iPredict, even if one or two donors fail to come through.

Update#2:  I told that the US Friends of Victoria University is a US registered 501 c 3.

I’m no expert on taxes, but I believe that is good news.

Please respond to our arguments

Saturos sent me a IEA paper on monetary policy , by Pascal Salin.  There’s a section discussing market monetarism:

Let us assume that, because of excessive taxation and regulation, there is a real rate of growth of -2 per cent in a country. If, because of monetary growth of 3 per cent, there is a 5 per cent inflation rate, the growth rate of nominal GDP will be 3 per cent. If the target for nominal GDP is equal to 5 per cent, monetary authorities will increase the rate of growth of the quantity of money in order to reach the target. This will lead to inflation of 7 per cent. Once again, we cannot solve a problem without knowing its causes. If the low rate of real growth is due to non-monetary factors, one cannot change it just by manipulating monetary instruments.

It is impossible to reach two targets of economic policy with only one instrument (monetary policy) and the NGDP measure combines together two variables which tend to be affected by different types of policy (monetary policy and policies that affect the real economy).

These things make me want to pull my hair out.  We are told that bad policies that reduce trend RGDP growth to minus 2% will result in 7% inflation under NGDP targeting?  With absolutely no boost to RGDP? That’s the claim?  My response is “hell yes” that’s exactly why we need NGDP targeting!  If you target inflation in that scenario then RGDP growth would be well below minus 2%, and you’ll have mass unemployment.  Indeed the (supposedly awful) outcome he describes is exactly why we need MM.

It doesn’t bother me when someone disagrees with market monetarist ideas.  But tell us why! When it’s clear they’ve never read any of our proposals, and are not responding to any of our claims, then there can be no meaningful debate.  I looked at the references at the end of the paper to try to figure out which market monetarist papers he had read.  The references contained a total of three items.  A 1968 paper by Milton Friedman, and 2 papers by the author himself.  That’s it. No wonder he seemed completely unaware of the logic behind market monetarism.

The second paragraph is even worse.  No, NGDP is not two variables, it’s a single variable.  It’s not even debatable.  His logic would imply that inflation is also two variables, as it can be partitioned into goods price inflation and services price inflation.  In any case, even if for some strange reason you were able to convince me that NGDP were two variables, the standard argument that one monetary policy tool can’t hit two variables would have no relevance.  A single monetary policy tool can obviously hit any nominal composite of two variables that represents a weighted average boiled down to a single number.

BTW, here are some odd points about the article:

1.  He seems Austrian, but ignores the fact that Hayek favored NGDP targeting.

2.  He has nice things to say about money supply targeting, and rejects the claim that velocity is quite unstable.  Yes it seems that way (he argues), but just wait until we stabilize the money supply–then velocity will be much more stable.  OK, so he likes money supply targeting and thinks it would lead to stable V.  And if it was as successful as he anticipates then we would end up with . . .

. . . we’d end up with that awful NGDP targeting!

Other things equal, lower prices cause consumers to buy less of a good

I still see confusion about the never reason from a price change concept.  So let’s try again, looking to see whether “other things equal” helps.

Most people accept that fact that lower prices caused by less demand means something different from lower prices caused by more supply.  But what about lower prices, “other things equal?”

Screen Shot 2014-11-12 at 8.30.25 AMAs you can see the quantity demanded exceeds the quantity supplied. In that case the actual quantity bought and sold and consumed equals the quantity supplied, unless demanders put a gun to the head of suppliers.  So “other things equal” lower prices will reduce the amount that consumers purchase.  If either supply or demand shifts, then other things are not equal.  My “never reason from a price change” refers to equilibrium movements, you certainly can reason from a price or wage control set by the government, which moves prices away from equilibrium.  But as this case shows, not necessarily in the direction that you might assume.

When I said price changes have no effect, I should have said “other than to subjective states of mind.”  A price change, in and of itself, will change the amounts that people prefer to buy and sell. But a price change doesn’t affect any observable economic variable, unless it is an artificial price change that moves you away from equilibrium.

Ditto for interest rate changes and investment.  Many people stubbornly refuse to stop thinking in terms of “interest rate change equals interest rate change caused by the Fed,” and even worse, “interest rate change equals interest rate change caused by the liquidity effect of a Fed action.”  The latter claim isn’t even close to be true.  It’s not even true 20% of the time.  But it seems to be what many of my commenters and most economists assume is the case.  Here’s a typical comment from my previous post:

If interest rate rises stifle investment . . .

Stop right there; interest rate rises do not stifle investment.

I’m not sure why so many economists are confused on this point.  Perhaps they think: “The liquidity effect impacts rates in the short run.  The term ‘short run’ means roughly what’s going on right now.  And a long time series is just a long series of ‘right nows.’”  If that’s not what they are thinking, I’d love to hear alternative theories.

PS. The term “short run” does not in any way mean “what’s going on right now.”

In economics, price changes don’t have any effect, they are effects

I don’t know how many times I have to keep saying this before the rest of the profession figures it out.  Never reason from a price change.  [Update:  I mean an equilibrium price change.] It makes no sense to argue whether a higher price will increase or decrease quantity.  Here is a S&D diagram.  I dare you to show me how price changes affect quantity.

Screen Shot 2014-11-11 at 10.56.48 AM

And here is an IS-LM diagram.  Interest rates are the price of credit.  Changes in interest rates do not have any effect on quantity of output, price of output, or any other variable.  It’s not even an “other things equal” deal; price changes have no effect.

Screen Shot 2014-11-11 at 10.57.43 AM

At this point some economists will say; “I meant an interest rate change caused by a change in monetary policy.”  The problem is that higher interest rates can be produced by both easier and tighter monetary policy.  And easier and tighter monetary policy have opposite effects on prices and output.  So I’m sorry, but it’s still a meaningless debate.  It’s not that there is a right or wrong answer; there is no coherent question.  Monetary policy can shift the LM curve, the IS curve, or both.

Consider this analogy:  A debate over whether high oil prices increase or decrease global oil consumption.  The debate is meaningless.  Price has no effect.  Here’s how the issue should be discussed:

A.  An Arab oil embargo caused higher prices and lower consumption in 1974.

B.  Booming Chinese auto sales caused higher oil prices and higher consumption in 2007.

Prices are not a cause of anything; they are an effect.  And interest rates are a price.  So please stop these silly posts discussing the impact of a change in interest rates.  Talk about the effect of expansionary and contractionary monetary policies—that’s an interesting question.

This criticism applies to both sides of the debate.  John Cochrane and Noah Smith should not be discussing the possibility that higher rates lead to higher inflation, and Paul Krugman should not be claiming that the standard model suggests that higher rates lead to lower inflation.  Actually, both claims are true in specific situations.  But without specifying the specific situations in which each claim is true (especially the path of the money supply and IOR) the claims becomes utterly meaningless.

Truly a debate about NOTHING.

PS.  If you are still having trouble with this, consider the following.  A 1/4% rise in the fed funds rate today can be accompanied by a near infinite number of simultaneous expected changes in the future expected path of variables like the fed funds target, the monetary base, the interest rate on reserves, the reserve requirement, and all sorts of other policy levers.  Those variables in turn have a near infinite number of effects on all sorts on market variables other than short term interest rates, including TIPS spreads, commodity prices, forex prices, future expected real estate prices, stock prices, corporate bond risk spreads, etc., etc.  And all that happens immediately.

Here’s another example.  Assume Japan has run zero percent inflation for 20 years while the US has a credible 2% inflation target.  Zero inflation is expected to continue in Japan.  Suddenly they depreciate the yen 17% and set up a rigid currency board with the US.  PPP tends to hold in the very long run; so long term Japanese inflation expectations immediately rise from 0% to 2%. Interest parity holds even in the short run, so Japanese interest rates immediately rise to US levels. That’s a case where Cochrane is right, and it’s 100% consistent with IS-LM.  In contrast, in January 2001 the Fed cuts rates more than expected, and TIPS spreads rise sharply on the news.  That’s a case where Krugman was correct, and it’s 100% consistent with IS-LM.

The correct answer is “it depends.”

PPS.  Question for Nick Rowe.  Does my yen/dollar peg solve the coordination problem you discuss in this post?

HT:  TravisV.