Money/macro needs to go back to basics - InvestingChannel

Money/macro needs to go back to basics

Imagine an island with 100,000 people who are all self-employed. They produce 43 commodities, such as food, clothing and shelter, and exchange the commodities with each other. There is no financial system and obviously there is 0% unemployment—how could a self-employed person be unemployed? To avoid the inconvenience of barter, they adopt some form of money—it might be silver coins or it might be a crate of Monopoly money that washed up on the beach.

How do we model the price level? Certainly not with interest rates or a Phillips curve!  There are no interest rates and there is no unemployment.

It’s easiest to start with NGDP, and then work backwards to prices. Suppose people prefer to hold 12.5% of their annual output/income in the form of money balances. That 12.5% represents the inverse of velocity (i.e. 1/V). In that case, V will be 8 and NGDP will be 8 times the money supply. Thus if the money supply is $1 billion, then NGDP will be $8 billion, or $80,000 per person. Now let’s model the rate of inflation:

Inflation equals NGDP growth minus RGDP growth

NGDP growth will be growth in the money supply plus growth in velocity. RGDP growth is determined by non-monetary factors. There’s your basic model of inflation in the simple island economy.

Now let me immediately acknowledge that the real world is very complicated, and this makes it hard to model V. Workers are usually not self-employed–they work for companies and have sticky wages. Labor markets don’t always clear. There are also financial markets, and the nominal interest rate can have a big impact on velocity (especially at the zero bound). But no matter how important these extra factors, they are still basically epiphenomena—the core of monetary economics is all about shifts in the supply and demand for money—it has nothing to do with the Phillips Curve or the liquidity effect from interest rate changes. Call the supply and demand transmission mechanism in my simple model, “Mechanism X”. That’s still the core transmission mechanism in our modern economy; it doesn’t go away just because you add sticky wages and interest rates. It’s just harder to see.

Where did modern macro go wrong? Perhaps when they made these liquidity effect/Phillips curve epiphenomena into the center of their models of the transmission mechanism. We don’t need Phillips curves or interest rates to explain why more supply of peaches and/or less demand for peaches reduces the relative value of peaches, nor do we need Phillips Curves or interest rates to explain why more money supply and/or less money demand reduces the relative value of money. We need to go back to basics.

Matthew Klein has a good article in the FT, pointing to the fact that modern macroeconomists are floundering around, unable to explain recent trends in inflation. He begins by quoting Olivier Blanchard, who states the conventional New Keynesian view:

I have absolutely no doubt that if you keep interest rates very low for long enough the unemployment rate will go to 3.5, then 3, then 2.5, and I promise you at some point that you will have the rate of inflation that you want.

-Former International Monetary Fund Chief Economist Olivier Blanchard

Japan has kept rates very low for a very long time, and still has low inflation. Their unemployment rate is only 2.8%. Sorry, but interest rates and the Phillips curve are not reliable models of inflation.

Now of course these elite NKs are very smart guys, and they did not develop these models for no reason at all. In the short run an easy money policy often (not always) leads to lower short-term interest rates. But over longer periods of time it often leads to higher nominal interest rates. The point here is that it’s the easy money policy that matters, not the interest rates. An easy money policy will lead to higher inflation regardless of when it causes lower or higher interest rates. The easy money policy of 1965-81 led to both higher interest rates and higher inflation. Switzerland’s tight money policy of January 2015 led to lower inflation and lower interest rates–even in the short run. (Yes, the NeoFisherians are occasionally correct.)

The same is true of the Phillips curve. It worked OK for many years, especially under the gold standard.  The Phillips curve still “works” in places like Hong Kong. A low rate of unemployment is indeed often associated with higher inflation. But it did not work during the 1970s in America, when unemployment and inflation rose at the same time, or in the last few years when inflation has stayed low despite unemployment falling to 4.2%. And that’s because it’s not the core transmission mechanism for inflation, the core mechanism is the supply and demand for money. Changes in inflation may or may not be related to interest rates or unemployment, but they are always related to what’s going on with the supply and demand for money.

Unfortunately, this confusion has led Blanchard’s opponents to go even further off base:

Blanchard was prompted to recite his faith in the power of the Phillips Curve by former Fed governor Jeremy Stein, who wondered how central banks were supposed to raise their inflation target to 4 per cent when they are still undershooting the current target of 2 per cent. Blanchard seemed to think the answer was easy: keep rates low, unemployment will fall, and inflation will necessarily accelerate.

Larry Summers — Blanchard’s co-host at the conference and co-author of one of the papers — found this hopelessly inadequate. He pointed to Japan’s long experience with full employment, large government budget deficits, aggressive monetary expansion…and total price stability. If they haven’t managed to get inflation, how could anyone? Blanchard had no answer but to repeat his catechism.

This literally makes me want to pull my hair out. Indeed Stein’s argument is not even logical. Suppose someone were halfway between Baltimore and DC, driving south, and the passenger said “What makes you think you’d be capable of driving this car to New York, when you haven’t even reached Baltimore”. My response would be “Umm, I’m not trying to reach Baltimore. If I wanted to reach New York I’d turn around and drive north. I’m driving south.” My response to Stein would be to point out that if the Fed wanted higher inflation it would not be raising interest rates with the publicly expressed purpose of holding inflation down. Rightly or wrongly, the Fed believes that if it raises interest rates it will achieve 2% inflation, and if it does not raise them then inflation will overshoot 2%. They may be wrong, but this has nothing to do with monetary policy being impotent. It’s a question of whether they are steering in the right direction.

I could have also responded, “I have decades of experience driving cars, I’m pretty sure I’m capable of driving this car to New York.”

I’m not sure if people realize just how radical 2% trend inflation is. If you had told Keynes that central banks could target inflation at 2% in the long run he would have laughed—he would have regard you as a fool. Throughout almost all of human history the long-term trend rate of inflation was either near-zero (commodity money) or wildly gyrating (German hyperinflation, post-Bretton Woods “Great Inflation”, etc.) Then around 1990 the Fed started trying to stabilize inflation at about 2%. Since that time, inflation has averaged about 1.9%, amazingly close to 2%. This isn’t some sort of weird miracle; it’s happened because the Fed controls the long-term trend rate of inflation.

If the Fed wants 4% trend inflation, they’d go back to Volcker’s policy from 1982-90, when inflation averaged 4%. This is not rocket science; other countries have also been able to target inflation.

Japan can’t create inflation? Really? What if they devalued the yen from 112 to the dollar to 600 to the dollar? No inflation? Then what about 6000 yen to the dollar?

Inflation is always and everywhere a money supply and demand phenomenon.  (I prefer that to Friedman’s, “Persistent inflation is always and everywhere a money supply phenomenon.”  Which is basically what he meant in the quote often attributed to him)

HT:  Caroline Baum