January 1, 2017The Priority Resolution
December 31, 2016Gary Cohn on the Chinese currency
December 31, 2016Covenants without the Sword?
December 31, 2016Reading Bastiat's Economic Sophism
December 30, 2016Scott Alexander Calls Out the New York Times
December 30, 2016Growth, or jobs for Americans?
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Frequently Asked Questions
Saturos directed me to a comment by Eliezer Yudkowsky:
He is referring to a paradox described as follows in Wikipedia:
That second case might bother some people, but if you think about it your annoyance with the idea of causation going back in time is actually irritation with the concept of a perfect predictor. Something most people believe is impossible. But if one did exist . . . think about it.
OK, even if you think what I just wrote is nonsense, the application to markets and monetary policy is interesting. I've frequently talked about "long and variable leads" in monetary policy. This was a play on the "long and variable lags" claimed by Milton Friedman, who thought that changes in the money supply had a peak impact perhaps 18 months later. I claim that changes in the money supply affect prices and output before they occur, at least in most cases. That's because policy is at least partly forecastable, and hence (as Yudkowsky notes) asset markets (and the economy) should be impacted by expected future policy.
But here's where things get interesting. Policymakers also care about markets, which leads to the Bernanke/Woodford circularity problem. Markets are intensely focused on every twitch in Janet Yellen's face during Congressional testimony, and Janet Yellen is focused on what markets are doing, as an indication as to whether money is too tight. Markets are the "predictors", and Yellen is like the person trying to win a million dollars, only in her case it's a sound economy that is the goal (say 4% NGDP growth).
But of course the market predictor is far from perfect, and indeed is also responding to other shocks like corporate profitability, so even if it were perfect you'd need an NGDP futures market, not a stock market as a predictor. And yet it is also clear that it has some useful information. Which reminds me of this fascinating Financial Times story from a few weeks back:
It may seem like market crashes cause a weaker economy, but in fact it is more likely that they predict it. Markets that crash are essentially predicting Fed failure. To make things even more complicated, the Fed uses market information in an attempt to avoid failure. A week before the FT article cited above, I wrote the following:
. . . the Fed knows that equity markets (and bond markets and commodity markets) often provide the first clue of an economy that is about to tank. Not a particularly reliable clue---recall the famous joke about the stock market predicting 11 of the past 6 recessions, but nonetheless an important clue.
When the FT talks about "air pockets" they are essentially talking about the extent to which central banks are willing to write off market warnings as "noise". Beyond that point you have the famous central bank "put". Ot at least they try to exercise a put; in 2008 they obviously failed. Fed policy seems like a stock market to monomaniacal Wall Street types, who confuse the markets with the macroeconomy. But Fed policy is actually a NGDP put exercised very clumsily by looking at noisy stock data.
The markets don't know exactly where the central bank has set their put, so prices plunge lower and lower until they see signs from the central bank that it will boost NGDP growth. What looks like a stock crash causing an NGDP slowdown, is actually a stock market predicting that central bank passivity will fail to stop an NGDP slowdown. Markets also know that central banks prefer fed funds targeting to QE and negative IOR. And they know that central banks are "only human" and don't like to admit mistakes by suddenly reversing course. That's what caused the recession in 1937, and if there is one this year (still far from certain) that stubbornness will again be the cause.
The thing that has always frightened me about asset market plunges is that they already incorporate the Fed's expected response. That should be as frightening to the Fed as the Newcomb Paradox game player contemplating the predictor's uncanny predictive ability. You don't just need to act; you need to do more than the market expected. Obviously that's hard to do consistently, which means ideally you don't want to allow NGDP expectations to plunge in the first place. In other words, "If I was headed for 4% NGDP growth, I wouldn't start from here".
The solution is for central banks to set up policy regimes that cause "The Predictors" to consistently predict success, i.e. to predict steady NGDP growth at 4% or 5% or whatever is the target. Did I mention NGDP futures markets?
PS. This post also relates to Paul Krugman's famous "promise to be irresponsible" monetary stimulus at the zero bound. This idea is to promise to do something in the future that will cause the markets and the economy to behave better today. It's called "irresponsible" because when the future actually arrives you may not want to honor that promise (economists call this 'time inconsistency'), but if you have made it, then fear of losing your reputation leads you to honor it. Thus before Newcomb's game begins you could promise to the predictor that you'd predict box B only. The idea is that $1,000,000 plus a good reputation for honesty is worth more than $1,001,000 and a reputation for dishonesty.
PPS. I'm in way over my head here, but doesn't Calvinist predestination imply that by choosing to be good you cause (many decades earlier) God to select you as one of the chosen few to go to Heaven? It's hard for me to wrap my mind around the idea that little old me could change God's mind, but then I'm a fatalist that doesn't believe in free will, so I guess I'll just continue occasionally being bad. (But only in TheMoneyIllusion comment section, not this one.)
PPPS. Eliezer Yudkowsky has a wonderful introduction to market monetarist ideas, over at Facebook.
HT: Don Geddis