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Paul Krugman is at it again with his calls, using a model based on what I believe to be an entirely flawed conception of monetary policy at the zero bound, to argue that China’s currency policy is harming the US:

So again, the Fed is moving in the right direction, both for US interests and for the sake of the world as a whole. China is beggaring its neighbors, which in this case means everyone else.

Krugman is continuing his call that we begin threatening to engage in protectionism through legislation aimed at Chinese products. Of course, this is wholly unnecessary. Matt Yglesias has the money quote:

The Chinese government’s discomfort with monetary stimulus is understandable. Monetary stimulus plus Chinese currency policy will equal an undesirably large amount of inflation in China. That means that in order to avoid an undesirably large amount of inflation, Chinese leaders will need to engage in a more rapid currency readjustment than they want to. That, however, merely underscores that unilateral monetary action is the right way for the US government to handle our concerns about China’s currency policy. We don’t need to threaten them, or bribe them, or cajole them, or go to “currency war” or anything. What we need to do is to adopt monetary policies that are appropriate for our economic situation. The Chinese will learn to deal with it, and in the longer term we’ll all be better off.

Which highlights the idea that beggar-thy-neighbor policies are anything but zero-sum games when it comes to money. All currencies can’t devalue against each other simultaneously, but all currencies can depreciate relative to goods and services…and that has a stimulative effect. Depending on the relative slope of your economy’s SRAS curve that either means higher inflation or higher real output. Monetary easing in the United States would likely mean higher real output in the US…but it would likely mean higher inflation in China.

What exactly does that do? It gives China cover to adjust their exchange rate policy. A policy of easy money in the US actually benefits both the US and China (assuming that China will follow an optimal policy regime).

What is embarrassing is that we live in a rich country, with a fiat currency, and we are still having a conversation about how to get the economy off the ground…and furthermore contemplating highly detrimental policies in order to do so.

Will make our lives less worth living until our eventual death anyway.

Paul Krugman complains that its not only the Austerity crowd but the Tight Money crowd that’s switching its tune on the bond markets

So will the OECD call for a drastic shift toward expansionary [monetary] policies, since the clear and present danger, at least according to the bond market, is disinflation (and possibly deflation)?

No, it won’t. The bond market only rules if it tells people what they want to hear.

The odd thing isn’t that people only hear what they want. Confirmation bias is ubiquitous. The odd thing is that so many in positions of authority only want to hear that which justifies greater indifference to human suffering.

Others will see more cynical causes but, my current explanation is that this is a transfer of logic from the way certain body tissues operate. Its clearly the case that skin, muscle and connective tissue respond to stress by growing:  a process known as hypertrophy. This might also be the case with nervous tissue and some other, though importantly not all, tissues. This is an interesting and important phenomenon that details the power of highly complex evolutionary systems. Yet, it is a fool’s errand to apply this to the world writ large.

When you stress most things they don’t grow back stronger, they break. When you apply job losses to an economy people don’t become hardier, they become poorer.  The idea that tough love will lead to a better economy in the long run is just wrong. Not mean. Not heartless. Not insensitive. Wrong.

Monetary policy doesn’t work that way. Fiscal stimulus doesn’t work that way.

More importantly, I want people to question whether or not you believe in economic toughness primarily because you are extrapolating from your experience with muscle fatigue. Human bias is elusive and works in mysterious ways. You may have learned from an early age that “no pain means no gain” and at a minimum that’s a good rule of thumb when dealing with sarcoplasm. However, this phenomenon is deeply dependent on the nature of sarcoplasm and the metabolic process generally. It does not carry over to the world or equilibrium systems on the whole. You will make deep logical errors if you believe that it does.

And getting the right answer matters. What’s important is not whether what you are saying “feels” true. Unlike Paul, I don’t doubt your sincerity. What matters is whether it is true. The world operates on objective facts and their relationships. The world does not operate on whether you subjectively feel like you did the right or responsible thing. We can talk more later about how responsibility  – or compassion for that matter – are mental interpretations. Real world events are the result of the interaction of subatomic particles. Responsibility or irresponsibility can’t cause anything to happen they can only provide an interpretation of events that have actual physical causes. But, like I said more on that later.

The issue today is: what series of logical steps is telling you that we should listen to bond markets when they suggest tighter polices but not when they suggest loose ones?

In a blog post today, Paul Krugman outlines a hypothetical situation that we could find ourselves in:

And this raises the specter what I think of as the price stability trap: suppose that it’s early 2012, the US unemployment rate is around 10 percent, and core inflation is running at 0.3 percent. The Fed should be moving heaven and earth to do something about the economy — but what you see instead is many people at the Fed, especially at the regional banks, saying “Look, we don’t have actual deflation, or anyway not much, so we’re achieving price stability. What’s the problem?”

I wonder if, on a particularly lazy day when Paul Krugman finds it difficult walk upstairs, he claims that he is in the “main floor trap”? But I digress. There is only one culprit in this situation: the dual mandate.

I’m not an expert on the history of the dual mandate, but I would venture a guess that it was the result of a grand bargain in which “price stability” came from the “hawkish” right, and “unemployment” came from the “dovish” left. The nature of the Fed’s dual mandate is such that it allows the central bank to wiggle out of nearly any situation if finds itself in with little consequence. Since the Fed is aiming at two diametrically opposed targets at once (price stability and full employment), it has large discretion upon which it can draw to justify its policy actions.

Is unemployment 9.5% with core CPI inflation falling below 1% and future expected inflation well below target as well? Well, that’s price stability!

How about persistent inflation rates bordering on double-digits while employment booms? Pat yourselves on the back guys!

In reality, and much to the chagrin of leftists everywhere, the modern Fed (1980’s+) has mostly erred on the side of price stability, which in the recent context has meant 5% NGDP growth with a rough average of 3% real growth and 2% inflation. This has allowed for a NAIRU of around 4-5% for the United States as a whole. Of course, that is a rate…and as long as the unemployed are continually in flux — that is, as long as hires outpaces quits and fires — that rate isn’t much of a problem. What is a problem is that the same dual mandate that was praised by some economists during the Great Moderation is now enabling the Fed to shirk its duties (and perhaps even worse, providing cover for “leveling down” with an implicit policy of opportunistic deflation…which is what Krugman implies above).

The Federal Reserve’s mandate is unique in the world. Most other central banks operate under a “hierarchical mandate” which generally stipulates an inflation target. It is hierarchical, because the central bank can set any target other targets it wants, and pursue them in order as long as they have hit their mandated target. The results of this kind of target vary from country to country.

In my opinion, Congress should scrap the Fed’s dual mandate, and instead mandate that the Federal Reserve set an explicit nominal target, and do everything in their power to hit that target (level targeting). If they’re feeling generous, they can give the Fed discretion as to which target they would like to set. If not, I would specify NGDP. I don’t think that the monetary policymaking body of the Federal Reserve should even look at a single unemployment number. They should focus like a laser on their keeping their nominal target in a very narrow range and leave the question of unemployment (which is a real variable) to other policymakers.

Stabilize monetary policy around a nominal aggregate, and I would wager that unemployment would find a way to work itself out with minimal intervention.


P.S. I kind of smile when I think about the Fed “moving heaven and earth to do something about the economy”. I suppose that is because 1) I think that monetary policy can do so and 2) I’m a huge nerd.

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