Who is “we?” (never reason from a quantity change)

Nick Rowe has a new post asking why we were so clueless:

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?

Then he translates into monetary economics:

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).

Here’s what I said back on November 30th:

Let me illustrate this with a specific example.  We start at the Australian position, near the bottom of the U-shaped graph.  Now the central bank contemplates three possible policies: status quo, the Japanese option, and the Zimbabwe option.  (No idea why they’d want to move.)  Assume policy is 100% credible.  My claim is that a move toward the Japanese option would actually require a larger monetary base, as the slowdown in NGDP growth would be trivial compared to the jump in demand for base money as a share of GDP, from 4% to 20%. Moving that way would force the central bank to print lots more base money, despite the slower NGDP growth and inflation. Sound far-fetched?  Check out the US since 2008.  We’ve seen the slowest NGDP growth since Herbert Hoover, and a big surge in the base.

My only regret is not explicitly spelling out that once you get to the Japanese position the expected change in the monetary base would have to turn negative, to insure that NGDP would fall over time.  I guess I thought that was obvious.

Milton Friedman discussed all this back around 1970.

PS.  This is an example of never reason from a quantity change.  Quantity can rise due to more demand for base money, or more supply of base money.



10 Responses to “Who is “we?” (never reason from a quantity change)”

  1. Gravatar of Geoff Geoff
    7. December 2013 at 06:36

    “…never reason from a quantity change.”

    Poof goes market monetarist theory of NGDP “explaining” anything that occurs on the side of production or employment.

  2. Gravatar of Kevin Donoghue Kevin Donoghue
    7. December 2013 at 06:40

    (1) Never reason from a price change, (2) never reason from a quantity change.

    Aren’t these just special cases of the general rule, don’t reason from an endogenous variable? Or is there a more subtle point that I’m missing?

  3. Gravatar of ssumner ssumner
    7. December 2013 at 06:48

    Kevin, No, that’s all I’m saying. Nothing more.

    But how often do you see people say “The interest rate fell ergo . . .” or “the currency depreciated ergo . . . ”

    And I include myself in that group, although I’d like to think I at least have at the back of my mind the factor causing the price change.

  4. Gravatar of jknarr jknarr
    7. December 2013 at 08:27

    Nick has displayed a penchant for using very bad analogies. I hope people do not call him out using the same degree of overwrought snark. His points stand by themselves, and would be listened to better without the noise.

    Instead of tautological post-hoc “permanent or temporary” base money causality, these arguments require a positive theory of why households vary in their willingness to hold base money.

    I think liabilities matter. Japan at 240x debt to NGDP — pent up tax liabilities — might have different cash holding tendency than Australia at 27x, where a new dollar of base money has fewer preexisting claims.

  5. Gravatar of Geoff Geoff
    7. December 2013 at 08:56

    Central bank + Market economy = Hampered market economy

    This is a “system” where one ought not reason from anything endogenous to it, such as an NGDP change.

    Sumner believes that observations of a hampered market economy reveals a cause and effect relationship between “exogenous” central banking and “endogenous” market economies, such that we are entitled to “reason from exogenous variable changes”, but not entitled to “reason from endogenous variable changes.”

    The problem with this, of course, is that we can only ever observe a fully “endogenous system”. As a result, if Sumner is going to reason from an observable NGDP change, he is reasoning from an endogenous quantity change, which he argues we should not do.

    The fundamental problem in his worldview is that he believes economic laws don’t apply to the central bank, or inflation. Hence the various “effects” and “paradoxes”.

  6. Gravatar of flow5 flow5
    7. December 2013 at 13:12

    You all went to the wrong schools.

    Between 1942 & up to the introduction of the payment of interest on excess reserve balances, the CBs responded immediately to any injection of new excess reserves (e.g., via open market operations of the buying type). I.e., the CBs always minimized their non-earning balances during this period.

    A spectacular example of this mechanical modus operandi occurred when Paul Volcker was Chairman:

    (1) when he drained legal reserves (instantly lowering both short & long-term rates – T-bills fell from 16.00% on 3/25/1980 to 6.18% on 6/13/1980), &

    (2) then as he reversing policy – dramatically injecting reserves (instantly raising both short & long-term rates – T-bills rose back to 17.01% on 5/13/1981).

    I.e., as roc’s in MVt fell (roc’s in MVt = aggregate demand), so did market interest rates. As roc’s in MVt rose, so did market interest rates.

    The Fed’s transmission mechanism (interest rates) has little (if any thing), to do with aggregate demand.

    I.e., despite 17 raises in the FFR, -every single rate increase was “behind the curve”). I.e., Greenspan NEVER tightened monetary policy.

    And Bankrupt you Bernanke (after 29 consecutive months of negative roc’s in MVt, continued to drain liquidity despite the 7 reductions in the FFR (which began on 9/18/07).

    I.e., the money stock can never be managed by any attempt to control the cost of credit.

  7. Gravatar of ssumner ssumner
    7. December 2013 at 13:50

    jknarr, I like his analogies.

  8. Gravatar of Saturos Saturos
    8. December 2013 at 07:12

    Huh? How does more demand for base money increase the quantity of base money if the supply doesn’t change?

  9. Gravatar of ssumner ssumner
    8. December 2013 at 07:54

    Saturos, It sharply increases the real demand, at which point an inflation targeting central bank adjusts the supply to prevent severe deflation. Consider a drop in the inflation target from 2% to 0%, the rate in Japan prior to 2013.

  10. Gravatar of c8to c8to
    9. December 2013 at 23:53

    IOR – never reason from a base quantity change stuck under the feds ‘mattress’

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