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.
Potpourri
==> Josie the Outlaw saunters into town, and lays her gold piece on the bar countertop. When the sheriff shows up, I hope he’s articulate and has really thought through his life choices.
==> More Bitcoin battling. Gary North is skeptical, Jeff Tucker is enthusiastic, and Roger Ver is loaded.
==> I’m a big Glenn Greenwald fan but if this blog post is accurate, my admiration is tempered.
==> Did y’all catch this line from Obama? “Obviously my most recent concern has been that my website’s not working…We’re evaluating why it is exactly that I didn’t know soon enough that it wasn’t going to work the way it needed to.”
==> Last thing: I can’t remember if I’ve already plugged it here, but I highly recommend the current Hunger Games movie. However, you really need to have seen the first one (or read the books) to appreciate it.
Why They Can’t Run Government Like a Business
I discuss this topic at EconLib this month, giving both the theory and many illustrations. As if to motivate my article, Paul Krugman today explains why we shouldn’t be too hard on the ObamaCare website:
Healthcare.gov is much better. It’s not running like, say, Amazon — but remember, mainly the government is trying to give you money, namely subsidized insurance, rather than to sell you something, so it doesn’t have to match commercial performance right away.
Respecting Sacred Cows
There is a strain of libertarians who revel in their atheism, such that they actively go out of their way to offend theists. They might explain their consistency along the lines of, “I respect no rulers or gods.” Or they might say, “At this blog (Facebook page etc.), there are no sacred cows.”
That has never been my approach, even when I was an atheist. When my Jewish neighbors invited me over for a meal that had religious overtones, I was constantly asking (discreetly) things like, “Is it OK for me to drink that?” to make sure I didn’t unintentionally offend their guests.
Even taking the metaphor literally, if I were in a group of devout Hindus, I would do my best not to disrespect cows in front of them.
People might respond to the above by saying, “But you need to confront error wherever you find it!” OK, but I don’t think insulting people is the way to change their minds. I have literally had agnostics email me and say words to the effect, “I don’t believe in God, but the Sunday comments at your blog are so obnoxious when atheists gang up on you, it almost makes me.”
Even When I (Sorta) Agree With Him, Dean Baker Gives Me the Creeps
In terms of the underlying policy stance, I think I agree with Dean Baker in this post about immigration restrictions on foreign doctors. (HT2 Chris Rossini at EPJ) But holy cow does this give anybody else the creeps?
We have deliberately changed immigration rules and standards to make it easier for foreign computer engineers, nurses, and even teachers to enter the country and meet demand in these occupations.There is no economic reason why we would not do the same for doctors. The potential savings to consumers and the government and gains to economy would be several times larger for each qualified doctor that we brought into the country than for every nurse or teacher.
…[R]egularizing a flow of doctors, with foreign students trained to U.S. standards, would be a major focus of trade agreements like the Trans-Pacific Partnership. (We could design a mechanism to ensure that earnings of foreign doctors are taxed and repatriated to home countries so that developing countries could train 2-3 doctors for every one that comes to the United States. Even an economist could figure out how to design such a mechanism.)
Potpourri
==> The erudite von Pepe notified me that John Taylor has been blogging about Summers/Krugman as well; here’s a good example.
==> Here’s me with Tom Woods talking on this topic.
==> Speaking of Summers/Krugman, apparently the Onion anticipated their stance.
==> Mark Spitznagel is not on the Bitcoin bandwagon.
==> Danny Sanchez has a long article on Mises, concerning “mind and method.”
==> Oakland residents turn to private “cops.” The NPR coverage is pretty funny.
==> Salim Furth decomposes (some of) the European data and argues that Paul Krugman’s frequent scatterplots–in which Krugman tries to show the “obvious” negative effects from cutting deficits–are actually showing how bad raising taxes can be in a recession. (HT2 Landsburg) If we break out the data into spending cuts versus tax hikes, then you see a different story. Note, this is exactly what I said, when Krugman was going ballistic about the phony-baloney deficit hawks who didn’t endorse the French tax hike. Remember Krugman said there was no evidence that raising taxes in a recession would hurt growth? Oops.
==> Bob Roddis grabbed a funny screen shot of the ads he saw at Mike Norman’s blog.
==> An interview with me about teaching at Mises Academy.
==> Nick Rowe lets loose with some blog rage:
Something somewhere went very deeply wrong with the way macroeconomics is done in some places. I do not know why it went wrong like that.
This is not about politics or ideology. Explaining everything in terms of politics or ideology is one of those witchcraft explanations that only ignorant people use, who practice witchcraft themselves, and so think everyone else is a witch. I am pretty sure I am more right-wing than Steve [Williamson] is. This is about how we do economics.
This is not about sticky or flexible prices either. With sticky prices, the truck would fall slowly if it went over the edge of the cliff. With perfectly flexible prices it would fall instantly if it went over the edge of the cliff. But it could still fall over the edge of the cliff, regardless of whether prices are sticky or flexible (unless prices were completely stuck, of course, because then the truck can’t move at all).
And it’s not about who is more intelligent either. Steve probably is.
I despair of my ability to explain to Steve why I think his post is so horribly wrong. Why can’t he just see it! It’s obvious to my eyes. It’s staring me straight in the face!
Blowback: Krugman Endorses Summers’ Critique of Freshwater Economists on Financial Infrastructure
We were all distracted by the stuff about never ending bubbles and whatnot, but Larry Summers in his recent IMF speech had a pretty funny bit where he said:
Now think about the period after the financial crisis. You know, I always like to think of these crises as analogous to a power failure, or analogous to what would happen if all the telephones were shut off for a time. The network would collapse, the connections would go away, and output would of course drop very rapidly. There’d be a set of economists who’d sit around explaining that electricity was only four percent of the economy, and so if you lost eighty percent of electricity you couldn’t possibly have lost more than three percent of the economy, and there’d be people in Minnesota and Chicago and stuff who’d be writing that paper… but it would be stupid. It would be stupid.
In context, Summers is poking fun at the “freshwater macro” guys, who were arguing in 2008 that the shock to the financial sector shouldn’t affect real GDP too much. In this post, Krugman explains the broader argument, and of course endorses Summers’ critique of this silly guys.
It’s a great critique. It reminds me of the time I busted a different economist, a saltwater one it just so happens, who had made the same mistake in the context of international trade (rather than the financial sector). This economist (whose identity for the moment I will keep a mystery) had argued:
There are a lot of good things you can say about international trade. But it does not, repeat not, do anything to alleviate a shortage of overall demand. Yes, if you liberalize trade countries will export more. But they will also import more. If you’re worried about C+I+G+X−M, it’s a wash, because X and M rise equally.
Which makes this WaPo editorial on things Obama should be doing about jobs truly bizarre. Even if the proposed trade deals with Korea and Colombia were remotely big enough to bear mentioning in the context of the crisis — which they aren’t — they wouldn’t be job creation measures.
To show how silly this was, I explained:
Imagine a small but productive island nation, similar to Hong Kong, which has an enormous export sector. Its Keynesian parameters have the following values:
C = $74 billion
I = $10 billion
G = $15 billion
X = $100 billion (exports)
M = $99 billion (imports)Thus the GDP of our island nation is $100 billion, which is consumption plus investment plus government spending, plus the $1 billion in net exports.
Y = C + I + G + (X − M)
100 = 74 + 10 + 15 + (100 − 99)Now suppose that a rival nation surrounds the island with warships and completely seals it off from international trade. According to [the mystery economist’s] logic, we should expect GDP to fall 1 percent, down to $99 billion. Now some of the islanders might say, “Huh?! How the heck are we supposed to even eat if we lose our access to the world economy? We have no oil or other natural resources, and we import most of our food. If we can’t trade, our cars and trains will come to a standstill and everyone will have to cut meat out of his diet.”
[The mystery economist] would laugh at such medieval, verbal reasoning. He would patiently explain to the frightened islanders that the numbers don’t lie. Yes the economy would lose $100 billion in exports, throwing all those people out of work, but domestic consumers would have to switch their demands away from the $99 billion they previously spent on foreign goods. Net exports only contributed $1 billion to GDP before the blockade, so the complete cessation of trade wouldn’t have much of an impact. Right?
No, of course that’s not right. After the blockade is put into place, we ask macroeconomists (before they starve) to tabulate the national accounting identity one last time. This is what they report:
C = $15 billion
I = $0 billion
G = $5 billion
X = $0 billion (exports)
M = $0 billion (imports)Rather than the 1 percent drop [the mystery economist] had forecasted, GDP actually fell a shocking 80 percent, down to $20 billion. No businessperson in his right mind is investing in this environment; the government has had to slash its spending because of the collapse in revenues; and consumers have scaled back their purchases to an extreme austerity budget. The island is devastated by the naval blockade. Duh! Of course it is: that’s why warring countries blockade each other.
So you see, our mystery economist had committed the exact same fallacy as the freshwater guys–a mistake that Summers called “stupid” (a label Krugman endorsed) by deploying their argument in the context of electricity. I instead made the point with a small island that imports a lot of its food, but it was the same critique, and the underlying “stupid” mistake was the same.
At this point, I’m sure no one needs to click the link to learn the identity of my mystery economist.
Chinese Officials Are Backing Off Dollar Purchases
From Bloomberg:
The People’s Bank of China said the country does not benefit any more from increases in its foreign-currency holdings, adding to signs policy makers will rein in dollar purchases that limit the yuan’s appreciation.
“It’s no longer in China’s favor to accumulate foreign-exchange reserves,” Yi Gang, a deputy governor at the central bank, said in a speech organized by China Economists 50 Forum at Tsinghua University yesterday. The monetary authority will “basically” end normal intervention in the currency market and broaden the yuan’s daily trading range, Governor Zhou Xiaochuan wrote in an article in a guidebook explaining reforms outlined last week following a Communist Party meeting. Neither Yi nor Zhou gave a timeframe for any changes.
If Scooby Doo were a blogger, I think he would say, “Ruh roh.”
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