Instrumental beliefs, prediction and reality
Note: Feel free to skim past the philosophy to the discussion of monetary policy at the end.
In a recent podcast, Penn Jillette said something to the effect that people don’t believe conspiracy theories because they are true, rather because they are entertaining, like a good story or a good song.
The term ‘entertaining’ has a rather frivolous connotation, so lets make the concept more general and include beliefs that add deep and profound meaning to life, in areas such as art, religion, and politics.
There is another set of beliefs about the world that are more instrumental. If I believe the two objects in front of my eye are a hammer and nail, it’s not because I enjoy this belief, rather because this belief is useful. I know (or “predict”) that if I pick up the hammer I can drive the nail through a piece of wood. Similarly, I believe that New York City exists in the sense that I predict that if I traveled to that spot I’d see tall buildings, art galleries and yellow taxis.
So you might say that our view of reality is a set of beliefs that we find either directly rewarding or at least instrumentally useful. In the rest of this post I’ll mostly focus on the latter.
The sciences contain the most famous examples of instrumental beliefs. In principle, the laws of “physics” should be able to explain the behavior of the entire physical universe, or at least the non-random portion. But in practice, people use the term ‘physics’ to refer to the subset of physics problems that are very simple and easy to model. The term ‘chemistry’ refers to physics problems that are slightly messier and more complex, whereas geology, meteorology, ecology and economics refers to highly complex areas of physics—the motion of molecules in complex and chaotic environments.
In the simpler branches of science, it is possible to do controlled experiments and reach a broad consensus about cause and effect. Two physicists will have similar predictions about the speed at which an object will fall if dropped in a vacuum at sea level. In contrast, in the more complex sciences even the experts will often disagree, as it is tough to do controlled experiments that replicate the specific empirical question you want answered. What controlled experiment would tell you the odds of an 8.0 earthquake in LA next year, or the odds of global temps rising by 2 degrees by 2100, or the odds of rhinos going extinct in the wild by 2100, or the odds of a recession in 2021?
So this raises an important question. How should “we” decide what to believe about reality in the areas where the systems are complex? If the “we” is policymakers, then Robin Hanson has argued that prediction markets are the best way to ascertain the truth. I agree.
But most people disagree and are skeptical of market forecasts; they would rather import the methods of the “hard sciences”. Let the experts decide. Let experts set monetary policy. If not all experts agree, then let a panel of 12 experts vote on the policy, majority rules. (Actually, not all FOMC members are experts.)
People often define fault lines in economics in terms of left/right, Keynesian/classical, Austrian/Marxist, etc. But the fault line that really matters is methodological. How do we decide what we know?
The standard view is that reality is best understood in terms of what the experts believe to be true. I see reality as what the markets believe to be true. Expert opinion is an input, but only one of many inputs, into market forecasts.
In the past, the Fed has tended to rely on the experts. (Albeit not exclusively, they have always paid some attention to markets.)
You might wonder why I spend so much time fighting against the asset price bubble view of markets. If bubbles exist, if they are a part of reality, then they are useful for making forecasts. (I’m ignoring the fact that people might get utility merely from believing in bubbles.) If they are useful, then market forecasts are not reliable, and that makes expert opinion relatively more valuable. The fight over bubbles is a fight over the future of macroeconomics.
I’m actually not ideologically opposed to rule by experts—after all, I’m an expert on monetary policy. I’d like to be a ruler, to have others ask me where the Fed should set interest rates. But my reading of the evidence suggests that market forecasts are superior. Thus I try to infer the market prediction of the interest rate most likely to achieve the Fed’s policy goal.
Robert Shiller is one of the most famous proponents of the view that asset price bubbles are important. Thus you’d also expect him to be skeptical of the view that markets can guide monetary policy. And that seems to be the case.
Consider the past 12 months, a good example of the difference between expertise and markets. Monetary policy experts tend to rely on Phillips curve type models, which suggest that very low unemployment is a sign the economy is in danger of overheating. Here’s a discussion of Robert Shiller’s ideas from July of this year:
Nobel-prize winning economist Robert Shiller sees justification for a quarter-point interest rate hike.
That’s right: A hike — not the cut Wall Street is expecting Wednesday from the Federal Reserve.
“We still have a very low unemployment rate. The economy is hot,” the Yale University professor told CNBC’s “Trading Nation” on Monday. “One could easily make a case for staying the course and doing another interest rate increase at this meeting to cool this economy.”
That’s an almost perfect example of the methodological split that I described earlier. “Nobel-prize winning” vs. “Wall Street”. The financial markets were suggesting that inflation would stay low even if the Fed cut interest rates; whereas Shiller worried that the economy would overheat, even without a rate cut. Olivier Blanchard recently expressed similar concerns, although he later backed off a bit.
This year, the Fed decided to follow the markets and ignore the models constructed by experts. That’s partly because even the experts are losing a bit of faith in Phillips curve models as a policy tool. Even some of the experts are beginning to follow the markets.
The view that markets should guide monetary policy is just one part of a much broader agenda—markets should determine what is true, what is reality.
Consider the following two cases:
Los Angeles policymakers decide to spend $300 million in a new high school, believing it will make LA better off.
A small town in New Hampshire holds a town meeting, and decides to spend $2 million remodeling an elementary school, believing if will make the small town better off.
I would argue that while neither decision is, strictly speaking, a market outcome, the New Hampshire town more closely mimics a market. That’s because the decision-makers in LA have almost no personal stake in what happens. They are engaged in “expressive voting”. It makes them feel good to build a shiny new high school for mostly low-income students. Sort of like when Penn Jillette’s acquaintances believe in conspiracy theories. In the New Hampshire town, the residents who vote at the town meeting have a real stakes in the decision. It will affect their property taxes and their children’s education.
[Yes, even LA policymakers pay property taxes, but the gains they personally derive from “big government” far outweigh the cost of their taxes going up.]
This also explains why Switzerland is more successful than most other countries; its policymaking apparatus more closely resembles a market outcome.
At the Fed, some people feel good when they vote in a “dovish” or “hawkish” direction. They have a lot invested in their ideology. Contrast that with Wall Street. In 1932, New York financiers voted for Herbert Hoover. But in 1933, the financial markets “voted” that FDR’s policies were likely to boost prices and output. Markets are unsentimental, and hence more likely to produce useful predictions, useful maps of “reality”.
Unlike markets, Fed officials are reluctant to reverse course soon after a major decision, as it makes them look bad—to most people, not to me. I have a higher opinion of Powell after he reversed course on interest rates. I believe the Fed was right to raise rates in 2017-18, and right to cut them this year. Why? Because the outcome was good.
PS. The question of whether reality is actually “out there” or is merely a mental construct is not important for the purposes of this post, or indeed for any other purpose.
Tags:
15. November 2019 at 11:39
Superb. Any thoughts on crazy maverick Nassim Taleb, who offends across the spectrum with his unorthodox ideas and basically hates all economists not named Russ Roberts? He’s always going on about “skin in the game”.
15. November 2019 at 12:52
The next step should be obvious: policy makers need to come up with a way for academic experts to have more tangible skin in the monetary prediction game. Maybe we tie their 401k to successfully predicting market outcomes? Maybe the FOMC members are given bonuses or fines depending on market outcomes?
15. November 2019 at 13:40
Summers called it “inflation lurking in the background”. What does the Fed do about “inflation lurking in the background”? The consensus among economists is nothing. That seems to be Sumner’s view, although his preceding blog post distinguished between the “financial cycle” and the “business cycle”. What does one do with the “financial cycle”? Feed the beast? Starve the beast? Or do nothing and risk being devoured by the beast?
15. November 2019 at 13:42
Scott you say “You might wonder why I spend so much time fighting against the asset price bubble view of markets. If bubbles exist, if they are a part of reality, then they are useful for making forecasts. (I’m ignoring the fact that people might get utility merely from believing in bubbles.) If they are useful, then market forecasts are not reliable, and that makes expert opinion relatively more valuable. The fight over bubbles is a fight over the future of macroeconomics.”
Your view here doesn’t surprise me based on other stuff I’ve read from you. However, I would push back against it.
When we think about bubbles, it is helpful to keep in mind that bubbles typically do not happen in short-lived assets. Bubbles typically happen in assets where 1) they have a long duration, the payouts are typically far in the future (consider internet stocks), 2) there is a high degree of uncertainty surrounding those payouts.
If you try to model assets like this, then you will see that small changes in the assumptions have large impacts on price. Think of the response to a change in interest rates for a perpetuity versus a 1 month T-bill.
What you are talking about for NGDP targeting is relatively short-dated instruments, probably 1 year, maybe longer. There is some uncertainty in what the payouts will be, but we aren’t talking about the same kind as with internet companies or other assets.
So long as they have liquidity and the ability to go long and short, I wouldn’t worry so much about NGDP futures having bubbles in them.
That some assets may have bubble-like behavior does not mean all of them will. Or, that market forecasts are sometimes wrong and this can have a significant impact on some market prices, does not mean that when markets are wrong in their forecasts for other assets that it will have a significant impact on market prices.
15. November 2019 at 13:56
Another great post.
15. November 2019 at 15:05
So to the extent that the United States has political markets, and we have chosen our Representatives based on a variety of factors — including our opinion about the relative importance of AGW mitigating policies — do you feel like the United States is taking a relatively optimal policy approach with respect to AGW?
15. November 2019 at 15:07
@John Hall, Amazon traded for $1.73 a share on 5/16/1997 and $107.13 a share on 12/10/1999. Is that the idea of a bubble you have in mind?
15. November 2019 at 16:50
Interesting post. There could still be a problem in defining what will be Federal Reserve reaction to market stimuli. In brief, The tight-money myrmidons could always devise a plan for extremely limited response to market signals.
On scale of government, New Hampshire Town versus Los Angeles. I think this is right— bigger is badder.
For example, the scale of the federal government is obviously vast. Most people do not know they spend per resident about $3,600 for our war-making apparatus (Department of Defense, VA, black budget, prorated interest on national debt). So the average family of four spends $14,500 annually on “national security.”
I wonder what percent of the US population would vote to pay such sums of money.
15. November 2019 at 17:47
Brian, I don’t know much about him other than the “black swan” thesis, which seems sound.
Derrick, You said:
“Maybe the FOMC members are given bonuses or fines depending on market outcomes?”
Yes, then expand the FOMC from 12 members to 7.4 billion members. I.e., tie monetary policy to a NGDP futures market.
John, I agree, and have made that argument in my NGDP futures papers.
Rajat, Thanks.
Scott, No, for several reasons. Our political markets are not all that efficient, and even if they were I’m not sure they’d come up with a sound carbon policy. Global externalities are difficult to address.
15. November 2019 at 18:40
rayward, it is easier to talk about when being more precise: increased variance in future inflation expectations. I too have long been curious about this aspect of policy, and have a hard time finding much analysis of it. Well, there are people who model it numerically for lots of things obviously, but I mean macro level discussion of how we should think about it, which models have historically performed better and why that might be, etc.
15. November 2019 at 18:53
I still think that bubbles exist, based on what happened to real estate values in Florida. If market prices are being set by idiots, while experts are skeptical of those prices and can explain why folks in the future won’t pay that much money for the asset, then I would go with the experts. Not that by experts that I don’t mean academics, but rather people who make their living based on those assets. Such that Wall Street professionals would be considered experts on financial product prices, while professors and government officials and day traders would not be.
Granted, this is probably a more limited definition of a bubble than most people use.
15. November 2019 at 20:21
A good post, but your statement that “markets should determine what is true, what is reality,” is much too sweeping. You should say instead that markets should determine our expectations (about future reality). Many factors other than markets go into determining—i.e., causing—actual conditions (= reality).
15. November 2019 at 22:59
Scott – this post touches on similar matters (epistemology) as Scott Alexanders recent post – https://slatestarcodex.com/2019/11/06/building-intuitions-on-non-empirical-arguments-in-science/
I shared a book recommendation there; – The Beginning of Infinity by David Deutsch. I don’t know if you have read it, but (simplifying) he believes truth is in good explanations, and empirical data follows explanation not the other way round. In the case of monetary policy, I believe you and other monetarists have a good explanation of how modern economies work (at least in the short term) and that is why I support your ideas. In contrast the ideas of other economists often seem internally contradictory, or even incoherent like the bubble theory. So I would differ slightly on your statement that “markets should guide monetary policy is just one part of a much broader agenda—markets should determine what is true, what is reality.” Explanations should be the starting point about what is true, making them clear and consistent should be the goal, and the market test is a verification of that. To illustrate – the bubble proponents often point to historical market trends and use those to support their idea. What proves them wrong is not history, but that their idea is a bad explanation (you do this very well actually).
16. November 2019 at 08:35
“I’d like to be a ruler, to have others ask me where the Fed should set interest rates.”
Scott, from previous reading I thought if you were a “ruler”, you would abolish a focus on interest rates in favor of a NGDP market with guardrails.
Did I misunderstand? If so, please help me.
If you are still in favor of the guardrail model, please don’t write about manipulating interest rates. You have made and are making great progress towards adoption of better monetary policy. Don’t dilute the message.
16. November 2019 at 11:04
How does algorithmic trading factor into your evaluation of the wisdom of markets? Do you see it making markets more “truthful”, less “truthful” or neither?
16. November 2019 at 21:31
Philo, I meant “determine” in the sense of “ascertain”, not “cause”.
ChrisA, I read a Deutsch book a few years ago–he’s very good.
I think I mostly agree with you. I wasn’t suggesting that market would develop models, rather that they could provide numerical estimates of important variables.
Todd, Yes, you are correct. I was half joking, pointing out that my self-interest (from an “ego” point of view) is against my actual policy preferences. Yes, I would turn it over to the markets.
Carl, I really don’t know.
17. November 2019 at 07:32
> I believe the Fed was right to raise rates in 2017-18, and right to cut them this year.
Weren’t they still under their inflation target?
17. November 2019 at 07:36
Scott,
Speaking of beliefs, do you think it’s silly to believe that tight monetary policy can cause r* to fall for decades? What if velocity fell over that same period, and what if it did so continuously faster than sticky prices could adjust? In other words, does a long-term decline in r* necessarily imply there are real factors at work?
17. November 2019 at 11:44
Scott have you read this (and similar) https://aeon.co/essays/what-if-your-consciousness-is-an-illusion-created-by-your-brain ?
viz: Phenomenal consciousness is a fiction written by our brains to help us track the impact that the world makes on us
17. November 2019 at 13:28
Matthias, Yes, and for that reason they should have raised rates more slowly.
Michael, I believe money is neutral in the long run. So “yes” to both questions.
wlb, I have not read that, but I do believe that consciousness creates a sort of fiction, or “story”. That doesn’t mean that what we believe is false, but it is a story.
17. November 2019 at 16:42
Three things happened in Japan’s two lost decades.
Population growth slowed.
Monetary policy was probably too tight. Fiscal stimulus was tried.
Also, after the 1985 Plaza Accord, Japanese industry flooded offshore to escape a too strong Yen. More than 5,000 companies set up operations in Thailand, so income in Japan was reduced.
This was also the period in which the Thailand GDP increased by 10% a year and their economy was referred to as a tiger economy. Incomes in Thailand rose.
17. November 2019 at 17:41
Scott,
So, what am I missing regarding long-run money neutrality. I’m aware of and accept the claim that sticky prices, including especially wages, adjust in the long run, ceteris paribus. Am I wrong to qualify it at the end?
What’s wrong with the notion that velocity, for example, can fall for decades, and consistently fall more quickly than sticky prices can adjust, thus cutting into real growth over that period? But, it usually doesn’t cut real growth enough to send it negative. The exceptions are the recessions.
In other words, in that scenario, you never really get to long-run neutrality, because policy is always running too tight. RGDP is always under potential.
By the way, I obtained a copy of that Fed paper I mentioned in a previous thread. Here’s the link:
https://www.federalreserve.gov/econres/feds/files/2019076pap.pdf
17. November 2019 at 17:43
Oh, and in case you don’t recall the mention of that paper, in it, a Fed economist argues that the neutral interest rate in the US may be significantly lower than most believe.
18. November 2019 at 05:46
Apropos to nothing perhaps, I have mentioned before that I like to read Ed Yardeni——in part because he was an ex-teacher of mine and in part because I have always liked his way of viewing the fair price of the equity market. In other words, he has a view on whether market pricing is “rational” or at least within historical bounds. While I do think that “fair value” is one of the stories we must tell ourselves to have markets function——I realized on 10/19/87 that “value” and “markets” are in fact a convention that “collectively” we have chosen to believe in (I.e., believe in the sense that I can exchange securities for money in a relatively stable environment)——-but in “rational” terms——“today’s” value plus or minus 30% cannot be distinguished from each other——(I put rational in scare quotes because of my previous observation that beneath it all is a faith of some kind)
Okay——sorry for the long intro. I bring up Yardeni because I realize how much you have impacted my view of the world. Yardeni——who has been “remarkably accurate” over the last 5 years on earnings growth and equity prices——has seemed to change his tune—-or at least added a few arrangements.
He has just completed a book on the Fed. His view is the Fed has been “easing too much” and free with money. He thinks they do not have the ability to hit a 2% inflation target—-and have been easing in a futile attempt to do so——and that somehow this will lead to bad outcomes. He mentions that Powell’s “symmetry” is an unachievable outcome. But I think he makes no sense in saying that. I am disappointed—in him.
18. November 2019 at 12:22
Michael, Velocity doesn’t really matter, what matters is NGDP growth. The Fed offsets most changes in velocity, certainly over a period of decades.
18. November 2019 at 16:12
Scott,
I apologize for not getting my messages across. Too often I don’t express myself clearly enough, so I’m sure that adds to frustration when reading my questions and comments. And then, there are times I’m just sloppy or wrong.
What I failed to convey clearly above, is that long run money neutrality doesn’t apply to the question I’m asking.
The reason is, I see the situation as being that velocity falling year after year, with the rate at which it is falling consistently outpacing the adjustment of sticky wages.
For example, let’s say wages take 3 years to fully adjust after as velocity falls for a year. Then, say velocity falls the next year as well, and then does so for several years. V can fall at a slow enough rate that wage adjustment can catch up, or fast enough that wage adjustment does not catch up entirely, but not fast enough to completely kill economic growth.
Another way of putting it is that money supply grows, but is offset by somewhat slower simultaneous money demand growth. This cuts the RGDP growth rate and rate of inflation. It’s why the Fed often has trouble hitting its inflation target.
So, in this clearer context, V matters.
18. November 2019 at 16:30
[(1 + change in Sm) / (1 + change in Dm) – 1] = change in NGDP,
where Sm is the supply of money and Dm is the demand for money.
For example, [(1 + .06)/(1 + .02) – 1] = `.04, or 4% NGDP growth, with some combination of a cut in the inflation rate and rate of RGDP growth.
18. November 2019 at 16:47
Just to try to be crystal clear, in that last example above with the simple equation, imagine wages adjust at, say 1% or less over the course of each year, so you have trailing wage adjustment that cannot keep up with lower growth each year, due to year-by-year falling velocity.
And indeed, after an initial spike in velocity in early 2010, it fell year-after-year until mid-2017.
10. October 2020 at 11:27
[…] the money too easy or too tight? Again, it is market expectations that will ultimately provide the most appropriate forecast: “The view that markets should guide monetary policy is just one part of a much broader […]