Paul Krugman is too kind to his intellectual opponents. Yes, I wrote that.

Here’s what Kocherlakota said in a speech after the meeting:

Whatever the source, though, it is hard to see how the Fed can do much to cure this problem. Monetary stimulus has provided conditions so that manufacturing plants want to hire new workers. But the Fed does not have a means to transform construction workers into manufacturing workers.

And this is strikingly true this time around. Kocherlakota would have us believe that there’s a big problem of mismatch because manufacturing is trying to hire, while construction has slumped. But here’s the employment reality:


This is taking it too easy. The Fed most certainly has the means to transform construction workers into manufacturing workers. Its called inflation expectations, which in turn influence the real interest rate.

There is no activity which is possible and yet still unprofitable at some real interest rate. I don’t mean this in a tautological “sufficiently low real interest rate” sense. A profitable real interest rate can be calculated. Lets crunch the numbers.

We start by asking, what is the return on investment in this activity? There is no reason this needs to be a positive number. Negative returns work just fine. Or in other words, exactly how much money does Korchelokta think manufacturing firms are going to lose by hiring former construction workers: 10%, 90%, 99.9%. Any of those numbers will do.

Lets suppose these construction workers are real idiots. They don’t know up from down. Lord only knows how they swung a hammer but apparently it was divine intervention. At manufacturing they are all but useless. So we’ll assume that by hiring these workers we will lose 99.9%.

How does that work?

We hire workers this year. We pay them $50K. However, what they produce after a year of work is only worth $50. Real knuckleheads here. Can the Fed possibly make hiring these guys worth your while? It certainly can.

You paid them $50K. Your alternative would have been to put this $50K in a trusty savings account or to buy government bonds but the yield on those are 0% nominally.

If you hire these workers you get $50 worth of real goods next year. Suppose you expected, however, 200,000% inflation. That means next year things will cost 2000 times what they cost this year. Then that $50 in real goods would sell for $100K in nominal terms.

So, you have $50K this year and if you hire these workers you will have $100K next year. Alternatively, if you save or horde your money you will have $50K next year. It is clearly twice as good to hire the knuckleheads.

Now, of course having 200,000% inflation will send people flying into real goods and an alternative medium of exchange. Though it is worth noting that as long as taxes and debt are due in US Dollars, alternative mediums have their limits.

The point, however, is that it is within the Fed’s power to make holding cash economically painful. It is within their power to make investments which would lose money in real terms, make money in nominal terms. As long as the currency is still in use, its nominal returns that we care about because you buy stuff with money, not bartered real exchange.

That’s the thing that is lost in the economic intuition of many. They are so used to canceling out inflation that they forget that we actually live in a nominal world.

You become rich by having lots of money, not by producing lots of real return. Similarly, you will be hauled into bankruptcy if you can’t meet your nominal obligations, regardless of the real value of goods and services set to change ownership.

Now, when we are away from the Zero Lower Bound, that distinction doesn’t really matter. Smoothly functioning financial markets will always incorporate inflation into the price of money. As long as nothing unexpected happens nominal concerns can be swept away in favor of the underlying real dynamics.

However, this is explicitly not the world we currently inhabit. At the Zero Lower Bound nominal becomes what matters. The real interest rate becomes a function of expected inflation and we cannot think about real profits independent of nominal ones.

Now could that possibly be a good idea? Isn’t the Fed creating massive allocative inefficiency as well as enormous pain by debasing the currency?

Well, yes 200,000% inflation would likely be ruinous. However, a world in which 200,000% inflation was required to escape the Zero Lower Bound would already be ruined.

It would be a world in which the best available use of a 50K a year worker would be producing $50 worth of value. If that is the case then ruination is already upon us.

In reality we are dealing with mildly negative real returns. Perhaps, a $50K worker can only $47.5K in goods and services. A five percent loss over the year. This requires much less inflation, 6% would do.

Even still you might think that this is inefficient. Why would we want to encourage activities which lose value? However, the relevant question is not whether an activity makes or loses value, it is whether it is the most profitable use of your resources. That is, the relevant cost is always opportunity cost. What else could you have done?

If the alternative world is one in which the 50K a year worker produces nothing of value to himself or anyone else then that’s a 100% loss. We have to always remember than unemployment – that is people who want to work at the prevailing wage but cannot find a job – is allocatively inefficient. If the worker drops out of the labor market that is another issue. However, the natural rate not withstanding, if workers are looking for work at the prevailing wage and cannot find it, then we are in an inefficient world.

I think people get sucked into a liquidationist point of view because they see the economy as analogous to a really big household. That is, they see unemployment as the necessary pain after a bout of spending because they think about a household that has overspent its credit card.

However, unemployment is not restrained consumption. That is, unemployment is not people doing with less, curtailing their desires or living within their means. It is people working and producing less. Unemployment is failure of the labor market to clear. This is not repayment for sins, it is inefficiency.

True repayment would be a contraction in consumption which lead to an immediate boom in investment. True repayment would not have workers stop working but would have workers stop making TVs and flashy cars and instead build steel mills and tractors. It would mean that we have fewer of the shinny things that make us happy today and more of the basic industrial goods that will make us richer tomorrow.

However, that is not what happens when unemployment rises. We get less of everything. Frighteningly, investment falls particularly dramatically in a recession. This is just making a bad situation worse.

Luckily there is something we can do it about. The 4% Club is still accepting nominations