A slightly off-center perspective on monetary problems.
[I should first explain the “part 1.” The hope is that you will read this before the political art post which follows. They are separate issues, but the second is easier to understand if you read this first. Mankiw visitors: I do off-topic posts every Sunday, early next week I’ll do a monetary post that gives you an idea of my views on the crisis.]
I use the efficient markets hypothesis in my research and in my blog. Once I started looking at the world through the EMH lens, I found it much easier to understand the relationship between policy and the financial markets—particularly in my research on the Depression. Here I’d like to do three things; indicate why I believe markets are more efficient than they seem, acknowledge that there are events that look like market inefficiency, and then argue that those perceived inefficiencies, even if real, don’t have the policy implications that many people assume they have.
If markets are efficient then the expected loss on Fed purchases of long term debt is roughly zero. On the other hand if the Fed has inside information about its future policy, then the Fed could use that information to make expected profits or losses. In a post today, Krugman argues that the Fed may be using the inside information in a perverse way, to generate expected losses. His argument (which is technically correct and which I discussed here in an earlier post) is that the Fed might actually persevere and produce more inflation (and I would add more real spending growth as well) than the markets currently expect. Because markets are skeptical about the ability or willingness (probably the latter) of the Fed to carry through on a reflationary policy, long bond yields do not currently price in the sort of inflation or nominal spending growth that the Fed presumably wants. What do we make of this?
I haven’t had a chance to fully digest yesterday’s Fed action. However since I have received many comments from people who think I should be enthused, I feel obligated to throw a little cold water on the celebration.
Soren asked why I don’t think predictive accuracy is necessarily the best way to test whether someone is a good economist. First let me point out that economic theory itself predicts that it should almost impossible to make unconditional predictions of asset prices, or to predict the business cycle beyond a few months. So the fact that Irving Fisher didn’t predict the stock market crash, for instance, is totally irrelevant to his ability as an economist. But there is certainly something to Soren’s point. If economic models cannot make at least conditional predictions, what use are they?
