Saturday, July 13, 2013

The fragility of expectations

Monetary stimulus advocates appear to be discounting empirical evidence and reconfirming their strong priors by appealing to expectations. The Nikkei took off on what appeared to be hints that the government wanted monetary expansion, which based on, say, a quantity theory of money should lead to increased inflation in the long run and pull Japan out of its low inflation lost decade. Unfortunately this has since led to nothing but a fall in the Nikkei.

The explanation given by monetary stimulus advocates is that subsequent comments by the Bank of Japan made these expectations evaporate. This view is adopted even by people skeptical of monetary stimulus; this is a good reference. Here is Paul Krugman talking about the effect of Federal Reserve's tapering comments. His argument to exiting a liquidity trap is that the Fed must "promise to be irresponsible", which is hard therefore fiscal stimulus is preferable. This is the first form of what I mean by the fragility of expectations in the title. Different individuals talking about monetary policy in the public sphere affects monetary policy.

There is another explanation of a failure of monetary policy: a lack of "concrete steps" by the BOJ to set monetary policy. Nick Rowe calls this set the People of the Concrete Steppes (I liked the post I linked to, though it is not the defining post). Scott Sumner has a very good argument and collection of evidence against this view and in favor of the expectations mechanism (in reference to US monetary policy).

The model presented in this blog, while it may not be correct, raises some interesting questions. First, the Quantity Theory of Money in the Information Transfer Model framework (ITM + QTM) independent of expectations. If $NGDP = x$ and $MB = y$, then the price level is $P = f(x,y)$. The QTM is also independent of expectations in the long run, i.e. regardless of whether you think increasing the monetary base will create inflation expectations in the short run, it leads to a quasi-deterministic increase in the price level in the long run. The ITM + QTM is even more deterministic. Changes in the monetary base lead immediately to direct changes in the price level. Allowing for noise in the empirical data, the model nails the price level and its derivative.

Therein lies the a second form of the fragility of expectations: model dependence. The ITM + QTM predicts that monetary policy should not be helping the US or Japan regardless of expectations. The price surface in the US is flat in both directions and in Japan the price surface actually decreases for increases in the monetary base in the short run (in the long run NGDP growth would eventually cause the price level to increase). If the ITM + QTM theory takes the world by storm, then the expectations following a monetary base increase would be the opposite of the the expectations resulting from a traditional QTM (under present conditions).

We return to the first sentence of this post; monetary stimulus advocates appear to be discounting empirical evidence and reconfirming their strong priors by appealing to expectations. The theoretical priors in this case are a quantity theory** and an expectations mechanism for the short run effects of monetary policy ... but the latter derives its explanatory power from the former quantity theory. That means there really is a single prior -- the efficacy of monetary policy in the short run. Therein lies a third form of fragility: a lack of theoretical robustness. A model that is ostensibly a mathematical relationship between aggregate economic variables becomes philosophical musings about how humans behave.

[I do want to say it's not that I don't believe expectations can have effects on markets in the short run. If a buyout is announced, the stock price of the purchased company rapidly converges on the buyout target price. In our discussion here, the Nikkei likely rose because people believed that the BOJ would loosen monetary policy and that looser policy would lead to economic growth. In the QTM, this rise would have been sustained in the long run if the monetary base actually did increase; in the ITM +QTM, this rise would have eventually evaporated as the increase in the monetary base led to deflation.]

** This could also be some kind of more complicated quantity theory like new Keynesian models.