The Real Flaw in Williamson’s Inflation Argument?
Wow, I don’t know if you kids have been following the blow-up over Stephen Williamson’s arguments about QE–I gave you a hint in this Potpourri when talking about Nick Rowe’s blog rage–but it has the potential to rival the Great Debt Debate of 2012. At this point we’ve got a full-blown shooting war, with Williamson, David Andolfatto, and Noah Smith on one side, arrayed against Nick Rowe, Paul Krugman, Brad DeLong, Gene Callahan, and a bunch of other people on the other side. If you click the links, you’ll see it’s hard for an Austro-libertarian economist to pick sides. They’re all dirty commie inflationists, to be sure, but you see DeLong and Krugman saying some pretty neat stuff about having a disequilibrium process to explain how the market reaches equilibrium, and Nick Rowe actually complains that Williamson’s approach throws out “methodological individualism” (!!).
Part of what’s fascinating in this whole exchange is the humility and honesty we see from two of the participants. Noah Smith says:
BUT, what Steve and I usually argue about is the general state of macro – he says macro is in fine shape, I say it hasn’t discovered much. I think this reversal supports my thesis. If a top-flight macroeconomist, who knows the whole literature backwards and forwards, can so easily change his workhorse model in one year, and reverse all of his main predictions and policy prescriptions, then good for him, but it means that macroeconomics isn’t producing a lot of reliable results.
Sure, I know that Williamson (2012) and Williamson (2013) have different sets of assumptions, and that’s why their conclusions are so opposite. But how does Williamson expect us to tell which set of assumptions corresponds to the real world, and which is just fantasy-fun-land? The papers, of course, offer no guidance, which is utterly normal for macroeconomics. A million thought experiments, and no way to tell which one to use. Is this science, or is this math-assisted daydreaming?
(I know it’s confusing that I’m saying Noah Smith is on Williamson’s side, when I just quoting him apparently giving the evil eye to Williamson. But, Noah is saying Williamson is not guilty of the specific thing that is making Rowe, Krugman, and DeLong go nuts, with DeLong saying Williamson needs to turn in his economist union card. Of course, DeLong has also told me in the past to quit my job as an economist. Is he just trying to drive up his own salary?)
Nick Rowe, upon whom I might have a man-crush at this point, actually has the courage to say, after constructing a very clever analogy, that:
I am a very amateur auto mechanic. On a good day, if it’s something simple, I can maybe diagnose and fix a problem with my car. I am a professional economist. But I understand how cars work better than I understand how economies work. I can diagnose and fix cars better than I can diagnose and fix economies.
Great stuff all around. And yet, I think everybody is flying off in tangents that miss the essential problem with Williamson’s argument. I put a question mark in the title of this post, because I’m not certain that everybody is missing the true problem, but…I’m pretty sure.
Nick Rowe’s original critique didn’t actually center on this particular passage, but Krugman made it the center of the attack. Here’s Williamson, explaining his counterintuitive claim that QE is actually reducing the rate of price inflation:
The change in monetary policy that occurs here is a permanent increase in the size of the central bank’s holdings of short-maturity government debt – in real terms – which must be balanced by an increase in the real quantity of currency held by the public. To induce people to hold more currency, its return must rise, so the inflation rate must fall. [Bold added.]
So that’s become the focal point of the attack. Krugman, DeLong, and Rowe are saying that Williamson is nutty for focusing on this necessary equilibrium condition, without worrying about how the economy will reach that new equilibrium.
In general, I’m very sympathetic to what they’re saying, and I was truly surprised by how much they sounded like Austrians who stress the market process and complain about a narrow-minded focus on equations specifying equilibrium conditions. And yet, I don’t think that’s really the problem with Williamson’s argument.
To see this, suppose we weren’t talking about a sudden surprise QE announcement. Instead, imagine we are in the midst of a Friedmanite rule where the quantity of money grows at a constant rate–let’s say it’s 2%–year after year, regardless of circumstances. Further suppose this rule has been in place for 10 years, and the public is convinced it will continue to be the rule for as far as the mind can forecast.
Thus, there is no question that we are bouncing from one equilibrium to another. We are in the long-run equilibrium (in terms of any standard way you are going to model such a situation). Now, within this long-run equilibrium path, Williamson could still make his claim: Each year, the rate of inflation has to perpetually fall, because each year you have to convince the public to hold more cash than they held the previous year. Thus, for any positive growth in the quantity of money, the rate of price inflation must constantly fall. Perhaps it asymptotically approaches some lower bound, rather than turning into outright deflation, but the return to holding a dollar bill has to keep increasing, year after year, otherwise the public would refuse to accept the new money that the government tried to put into circulation.
OK, does anyone like Williamson’s argument now that I’ve placed it in the context of a decades-long equilibrium that everybody sees coming? Of course not. Something is still totally screwy with the argument, and the problem is not one of “stability.”
Rather, what Williamson’s argument leaves out is the fact that, other things equal, you want to hold more money when its purchasing power falls. This is because people want to hold a certain amount of real cash balances. Just focusing on this effect, you would think that as price inflation occurs, people want to hold more money. So this effect works in the opposite direction from the effect that Williamson isolates.
Look, you can whip up a cute little model–with all the bells and whistles, and without worrying about the “story” behind it–where the long run equilibrium outcome has a constant rate of positive price inflation, and in which the stock of money is constantly growing, even per capita. In fact, we would expect the two to be positively related in equilibrium: The faster the stock of money is growing, the higher the (constant) price inflation rate. Williamson’s logic–insofar as it goes–is still “right” in such an outcome, but it’s clearly being offset by other forces. Thus, I don’t think his fundamental problem is that he’s failing to draw little green arrows funneling the economy into his equilibrium (as Krugman suggests).
This is such a basic point I’m making, that I’m a little bit afraid that Noah will send me a private email explaining that DeLong was right–I really do need to find another job. But I call ’em like I see ’em, and the above seems to me to be the true problem with Williamson’s argument about QE causing low price inflation.
Bob: “Each year, the rate of inflation has to perpetually fall, because each year you have to convince the public to hold more cash than they held the previous year. Thus, for any positive growth in the quantity of money, the rate of price inflation must constantly fall.”
That’s a beautifully clear reductio ad absurdam.
Consider the man-crush returned!
I had to re-read that statement six times when I came to it.
Ryan that’s because Nick and I are each 6x the economist you are. Zing!
Wait a minute,
If a central bank wants to convince the public to hold more cash this year than last year, then all they have to do is print however much more they want the public to hold this year versus last year (as long as the additional quantity is within the bounds of no hyperinflation and no rejection of the currency).
For example, if last year the public held $500 billion in cash, and a central bank wants the public to hold 10% more this year, or $550 billion in cash, then they just have to print $50 billion more. After all, the public will more than likely accept this much more money without rejecting the currency altogether.
In other words, there is no requirement that prices have to rise or fall this year versus last year. The only implication of what happens to prices is what happens to productivity. If productivity is greater than 10% this year (and we assume total spending is a linear function of total money supply), then prices will fall this year. If productivity is less than 10% this year (and we again assume a linear relationship between money supply and total spending), then prices will rise this year. Regardless of what happens to prices, the public will be holding a collective $550 billion in cash, or $50 billion more this year than last year.
We can all agree that Williamson’s statement is wrong, but I just wanted to explain a reason why it is wrong. There may be more reasons.
Murphy’s response here:
“Rather, what Williamson’s argument leaves out is the fact that, other things equal, you want to hold more money when its purchasing power falls. This is because people want to hold a certain amount of real cash balances. Just focusing on this effect, you would think that as price inflation occurs, people want to hold more money. So this effect works in the opposite direction from the effect that Williamson isolates.”
I am not sure that “fact” is right, at how it is stated. The argument that other things equal, people want to hold more money when its purchasing power falls, seems to me to be a tautology. The meaning of “fall in purchasing power” is either a fall in production, or a rise in the quantity of money, or a combination of the two. I am assuming we’re holding productivity constant since nobody mentioned otherwise, so that means a fall in purchasing power is being tacitly based on a rise in the quantity of money. But given there is a rise in the quantity of money, it follows (from my initial arguments above) that people are already holding more money!
Murphy seems to be arguing a sequential events form of argument, where a fall in purchasing power is supposed to “lead to” a rise in the quantity of money people are wanting to hold. But wait a minute, a fall in purchasing power is another way of saying there has been a rise in the quantity of money held by the public! Or else it’s another way of saying production declined, but we assumed that is constant.
It seems he is arguing something like “Melted iron leads to iron turning into liquid.”
Any help?
Murphy wrote:
“Thus, there is no question that we are bouncing from one equilibrium to another. We are in the long-run equilibrium (in terms of any standard way you are going to model such a situation).”
YES! Thank you for mentioning that we are IN the long equilibrium of past events. For some reason so many people think we’re not experiencing the long run effects of past policy changes in the long run past. As if the only long run effects are those that haven’t happened yet.
I will only add that we are always IN the effects of short run policy changes as well. Such as money changes, which is assumed by many to be “long run neutral.” I think that long run neutrality of money only has a kernel of truth if there is a one time change in money, and then nothing. But if money is constantly changing, we are always living in a world of money NON-neutrality.
MF I totally get what you’re saying, and I agree, but I think I’m making a different point in the quotation you grabbed. I’m saying that if people know the currency is going to be gradually rising over time, and they know this several years ahead of time, then Williamson’s logic still fails. So when Krugman, DeLong, et al. try to say Williamson is wrong because his equilibrium is unstable, I don’t think that’s really the issue.
OK, that makes sense.
Even if people expected prices to fall every by say 2% or whatever, and this results in people holding a higher ratio of cash to assets, then this does not imply any necessity to keep increasing one’s cash to assets ratio.
There might be a one time 10% rise, say, in the ratio of cash to assets on the basis of a continuous 2% price deflation, say.
5 years ago Ron Paul and Peter Schiff said the dollar was going to collapse. The dollar has not collapsed. Inflation is very low. These are facts. All the talking in the world will not change this reality. Accept it.
You could have said the same thing in 2006, at least about Ron Paul, about the housing market. Those were facts, and all the talking in the world was not able to change this reality in 2006.
What is inflation? How do you come to the conclusion that it is very low?
Good question Bala. I am not holding my breath for good answers but I will check back.
Answer: Money supply expansion greater than real production expansion.
Does that mean it has to be the same now?
No! It just means that this is a bullshit argument. Stop thinking linear! The human economy is a complex, chaotic, non-linear and adaptive system.
joe, thread-jack penalty, 15 yards!
The dollar hasn’t collapsed yet. Five years is like ten minutes when it comes to economic transitions, Joe. Be patient. When the taper never comes, the markets will eventually get the message that the printing will never stop until it is forced to. Then the dollar will collapse. All that QE money is going into the bond and stock markets right now. Those markets are getting expensive, and when they top out, the money will flow into other things.
joe,
I know where you are coming from but what is inflation? Currently the market is above the peak of 2007 at the rate of 3.1% per year. The rate of inflation has been 2% over this time period.
The number of people working is still below where it was in 2007 by several million people.
This shows a growing disconnect of markets, inflation, and jobs. This is not a good thing. Since I think we can all agree that the market value of 1560 in 2007 was the height of the bubble, this also leads me to question where we are now with the market.
Now as for ‘inflation’ Okay there are like three factors that are keeping inflation in check. First the investment communities money has not ‘worked’ its way into the man on the streets life. It is nestled in investments in companies that ALREADY exist and their share prices are pushing ahead just fine. Not new investments that require capital investment. Hence the money is lacked up fine and aggregate demand is sleeping the deep slumber. Most of the inflation you are currently seeing has mostly to do with foreign trade divestment. The race to the bottom we are participating in right now, but this is slow going because lets face it we are basically the healthiest looking horse in the glue factory.
So what does all this mean. It means things are going to seem like they are getting better until the crap hits the fan… And that makes a huge mess I tell you what.
So yes you are right, nothing that was believed to happen, namely that the economy actually improved significantly has WORKED. had the money actually moved as the Fed had hoped it would QE 1 and QE 2 would have been enough, but no we decided on perpetual QE3… How do you come back from it? Honestly how can the Fed regulate anything in the future when it comes to monetary policy… I am interested to see it.
“To induce people to hold more currency, its return must rise, so the inflation rate must fall.”
They are not trying to convince the public as a single self-conscious being to hold more money, right? They convince primary dealers by overpaying for the assets they own, therefore relatively increasing their financial situation compared to the rest of the society. Why would they say no?
*…relatively improve their financial situation …*
It was my metaphor 5 years ago:
http://clubtroppo.com.au/2008/09/18/how-to-fix-the-financial-crisis/#comment-319683
From Brad DeLong:
http://www.paulormerod.com/wp-content/uploads/2012/07/book_thumb_2.jpg
Can’t remember which chapter because I gave away my copy; but at any rate there’s a lot of other people who understand that convergence is quite difficult to guarantee within any particular time frame. I would hazard a guess that it gets worse when the people making good money on arbitrage understand that convergence to equilibrium would but them out of business. It’s a good book, glad to see those ideas have done one full cycle at least.
I’ve never quite understood why Austrians think the market process is unique to them. I’ve always said – to Pete Boettke for example – that the market process is in the dynamics, which is essentially what you are acknowledging here.
Of course if you want to approach it in a literary way and come up with a stream of interest words like “groping” or “alertness”, of course that’s not going to satisfy you. But that’s not the same thing as not thinking about market process.issues.
Thanks for this – I haven’t been following the debate really and this highlights some important points I think.
I guess you actually don’t think that pump priming does impede the market process, or do you?
Geez, if he did think that pump priming impedes the market, he would not be a Keynesian, so your question answers itself.
Well if the difference in the understanding (between Keynesians and Austrians) of the market process and how it actually works and how it interplays with pump priming is so obvious then I don’t understand his comment..
And if this is actually your view that the market process is assisted by pump priming then I would love to read a book that in detail describes how the market process works from a Keynesian point of view. In which book is it described best?
If you had a good system, the pump would self prime.
Why is your system constantly broke and need of repair?
I say scrap your Keynes system for something more reliable that requires less maintenance and adjustments.
Keynesian money is simply garbage from an electro/mechanical engineer perspective.
skylien, I guess you think in any discussion of anything whatsoever it is ok to bring up your pet peeves.
So you’re saying he’s a libertarian?
Funny that you make this (typical) snarky comment, when you are a person that feels the need to interject your comments anywhere you damn well please.
Only where it says “Reply”.
Gene,
1: It was Daniel wondering why Austrians bring the market process up all the time. While it earned me a “Geez” from LK because I have to be aware where a Keynesian comes from, it seems for Daniel the same standard does not count…
2: You exaggerate. I am usually not starting it out of nowhere. Though I am using opportunities that come up. Unfortunately there was so far not one attempt to help me out with that question. Not even a reaction. Yours is the first. It seems that it must really be a stupid question to ask how pump priming assists the market process in translating subjective valuations of market participants into proper market prices.
3: Thanks that you notice.
Daniel: Thanks for this – I haven’t been following the debate really and this highlights some important points I think.”
It does more than that. It nails *the* important point.
See my latest post. http://worthwhile.typepad.com/worthwhile_canadian_initi/2013/12/helicopter-money-does-not-cause-deflation.html
This is Game Over. All that’s left is the mopping up.
And all you other commenters are talking about trivial crap, and missing the Big Story.
Nick Rowe wrote:
And all you other commenters are talking about trivial crap, and missing the Big Story.
Nick did you throw your back out or something? It seems you are particularly ornery lately. I’m not complaining, just observing.
Bob: you are right. This SW stuff upsets me. Because it means the teaching of basic economics has gone to hell in a handbasket. SW is not some random idiot posting random crap on the internet. This is the future of our discipline. This is what the best and brightest of the next generation are learning. It’s not just arguing about details. This stuff is basic. This isn’t a Dark Age. This is back to the Stone Age. Except the math is fancier, so we can’t see it.
Personally I think the whole direction in education needs to change. How do you think students would react to a programming competition where autonomous agents battle it out in a trading scenario? Put economic theory to the test, learn a useful skill, brush up on math, and feel good when you win. Reputations to be made and lost…
I’m sure your typical student would talk about that in their spare time more than boring liquidity preference.
“This isn’t a Dark Age. This is back to the Stone Age. Except the math is fancier, so we can’t see it.”
What, did you pick up the General Theory today? Because that’s precisely the reaction I had to it!
“Thus, there is no question that we are bouncing from one equilibrium to another. We are in the long-run equilibrium (in terms of any standard way you are going to model such a situation). Now, within this long-run equilibrium path, Williamson could still make his claim: Each year, the rate of inflation has to perpetually fall, because each year you have to convince the public to hold more cash than they held the previous year. Thus, for any positive growth in the quantity of money, the rate of price inflation must constantly fall.”
I haven’t been following that closely, but I thought that part of the argument was the assumption of a liquidity trap. I was under the impression (perhaps erroneously) this was a special case.
Tom: yes. But Steve’s reasoning applies equally well outside of a liquidity trap. If the money supply increases, something must adjust so that people want to hold more money, to restore equilibrium between demand and supply. The normal answer is that the price level increases. But Steve’s answer is that the inflation rate *must* fall.
This explains why Zimbabwe had hyperdeflation, something that had always puzzled me before.
Let me ask a question that I think is related. In this example I am assuming that the inflation rate effects the nominal interest rate. If The Fed has a stated goal of raising inflation to 2% and the current rate is 0%, why would you make a loan of any duration when inflation hits 1%? If the Fed is able to raise the rate to 2% and you make a 30 year loan at 1% the only way you made a smart decision not waiting for inflation to reach its target before making the loan is if it took many years for this to pass. To take it back a step further you would be an even bigger fool to make a loan while the inflation rate was 0%.
If the Fed is credible and they promise to hit an inflation target then the effect should either be immediate or nothing at all.
” QE causing low price inflation.”
“, so the inflation rate must fall.”
Neither of these implies the other. One is I, one is dI/dt. There’s something missing here.
Right Ken, the “missing” thing is that price inflation was higher before the crisis and QE. Now it all fits…
Ok. Nice to see what’s missing is something empirical, not numbered axioms.
Haha, no angry emails from me!
“Rather, what Williamson’s argument leaves out is the fact that, other things equal, you want to hold more money when its purchasing power falls”
isn’t Williamson whole point that the purchasing power will sometimes not fall but rise following an increase in the money supply? He presumably would claim that what you say is (at least sometimes) untrue.
This is an unusual position to hold but it can’t be defeated by simply assuming inflation. The whole argument is a challenge to that assumption being always true.
Correction:
“He presumably would claim that what you say is (at least sometimes) untrue.”
He wouldn’t need to claim this but simply that sometimes an increase in the money supply doesn’t cause its PP to fall.
[…] Kudos to Bob Murphy for getting there before I did. I wonder if the quickness someone gets to the problem with […]
I suppose someone should at least mention the standing Austrian dislike of homogeneous macro-economic models, where prices move as a whole rather than relative to each other. Throw in Cantillon effects for good measure. I understand that Nick Rowe wants the intellectual challenge of beating Keynesians under their own rules, but if the other stuff doesn’t even get mentioned then onlookers will forget this is an Austrian blog.
Even when you do have a homogeneous macro-economic model, you can still have debt deflation. Debt deflation is compatible with both Keynesian theory and Austrian theory, but so often gets ignored. Not one of the economists linked above even bothered to mention it. Here’s the total mortgage debt in the USA (cut-n-paste from the Fed website):
2009: 14,299 billion
2010: 13,656 billion
2011: 13,340 billion
2012Q2: 13,158 billion
2012Q3: 13,062 billion
2012Q4: 13,072 billion
2013Q1: 13,013 billion
2013Q2: 13,003 billion
Thus about 1.3 trillion dollars of debt just vanished in the last 4 years. None of the models even give this a moment’s thought. Weird huh? If a helicopter had dumped 1.3 trillion dollars into the economy they would have all been talking about it.
“cut-n-paste from the Fed website”
I am not sure if Yellen likes it if you remove data from their website.
😉
The data is more useful to them here… surrounded by appropriate theory to help them understand it.
Williamson has made another post:
newmonetarism.blogspot.ca/2013/12/intuition-part-ii.html
At the risk of a 15 yard penalty aside comment to Lord Keynes. Since I updated my Mercury browser I can no longer leave comments at your website. There may be something amiss with your website. Either that or Bob Roddis has powers I never suspected.
On my blog? That is strange. I just tested the comments mechanism and it seem fine.
Bob I’m confused-not uncommon for me. The idea that inflation would make people want to hold more money seems totally ccounteruntuitive to me. Certainly that’s not the rationale of why the Fed would increase the money supply?
I thought the idea was the Monetarist HPE where enough money is printed to exceed demand for it whereby everyone wants to get rid of it?
If you’re right about inflation making people want to hold onto more money then this is the opposite of what the Fed thinks it’s doing
“The idea that inflation would make people want to hold more money seems totally ccounteruntuitive to me.”
Put it this way Mike:
Suppose tomorrow you expected prices to rise by ten-fold. Bread will cost $30 a loaf, gasoline would cost $40 a gallon, hamburgers at McDonald’s will cost $45. And so on.
Ask yourself if you would be content with your existing money, or if you think it would be a good idea to hold more money to finance your future expenditures, so that your standard of living doesn’t fall too much…
Major do you agree that the HPE expects the total opposite effect? If the prices I have to pay goes up ten-fold this is not a problem for me if my wages also go up the same amount.
Suppose your current employer is not willing to give you a raise. The question is would you DESIRE more or less cash on hand?
In the case of money printing the level of wage prices is going to up at least some-it may be the same as prices, maybe less, maybe more.
Very unlikely you would see prices go u by 10 times and wages nothing.
Incidentally Bob I couldn’t help but smile at your comment on SW that you’re naturally sympathetic to anyone Krugman attacks.
I’d love you to show me how many times Krugman has attacked SW-or indeed said a word about him-the last 4 years and how many of the opposite.
An alien who read SW’s blog would have no idea there is anything in the world but the fiendish Krumgan whereas they wouldn’t have any idea who SW was by reading Krugman.
You aren’t just sympathetic to those who Krugman attacks you’re also pretty sympathetic to those who attack Krugman.
It’s inconsequential to Bob’s point about being sympathetic to anyone Krugman attacks, to insist that he show you how many times Krugman has attacked SW. They’re two different things.
If I said I am sympathetic towards anyone you attack, and today you just so happen to attack a guy named Steven W., and I do become sympathetic towards Steven W., does it matter if this is your first or 10th time attacking him?
“You aren’t just sympathetic to those who Krugman attacks you’re also pretty sympathetic to those who attack Krugman.”
Actually he isn’t. If you read his blog regularly, you’ll see that he tends to take arguments against Krugman with a far more discerning and critical eye. He wants the criticism to be legitimate, and not just a smear.
My point is that Krugman hasn’t attacked It’s not even close-on whom attacks who. SW attacks Krugman constantly and Krugman mentions him maybe once a year.
I don’t think you can say that his criticism in this case is an ‘attack’ as many are perplexed by SW’s arguments rightly or not.
Nick Rowe describes that I thought is supposed to happen when there’s more money:
“Start in equilibrium. Suppose the helicopters drop more money on the population. People do not wish to hold more money. Because there are diminishing marginal benefits to liquidity, and those marginal benefits are now below the opportunity cost of holding money. So people will try to spend their excess supply of money. This creates an excess demand for goods. This causes the price level to rise. In the new equilibrium, the real value of the total stock of money is the same as it was in the old equilibrium. If the money supply doubles, the equilibrium price level doubles too. And so the marginal benefits of holding money are the same as they were in the old equilibrium.”
http://worthwhile.typepad.com/worthwhile_canadian_initi/2013/12/helicopter-money-does-not-cause-deflation.html#more
[…] my post about Williamson’s QE argument left some people confused. It sounded like I was saying that price inflation causes people to want […]
CPI measures a market basket of goods.
On the other hand, 85B per month goes to items not in this market basket.
My bread and milk may be a similar price, but that pink diamond I always wanted is now 70M. That 10 acres I wanted is now 1 million dollars when it used to be 10,000 dollars.
There is massive price increase the moment you look outside of the bogus market basket and it is not because of scarcity or demand….
“Bernanke’s first goal is to get people to understand that there will be no tightening in the rate of purchases. And since there are acceptable signs of growth in the economy, investors with a medium or longer-term horizon are happy to be buying in this environment,” said Jim McDonald, chief investment strategist at Chicago-based Northern Trust Global Investments.