Friday, May 9, 2014

Adventures in circular reasoning

"[Market monetarists] have a coherent model that incorporates rational expectations and efficient markets."
... Scott Sumner

Efficient markets require rational expectations which is the assumption that expectations are coherent with the model. He goes on to add "We have a model that can explain market responses ..." ... wait, I thought the EMH means that you can't know what the market will do?

Now I actually have learned a lot over the years from Sumner and agree with a lot of stuff that's on his blog. Actually the biggest difference between the information transfer model (ITM) and what seem to be Sumner's views is that many of the things Sumner thinks can happen at any time, the ITM says happens either when the base is low relative to NGDP or high relative to NGDP. Actually that's true of me and about any economist. High interest rates are a sign money's been loose? Yes, but only when the base is small relative to NGDP. Liquidity traps? Yes, but only when the base is large relative to NGDP. Any time there are arguments that derive from the 1970s, they seem to follow in the ITM when the base is small compared to NGDP. Anytime there are arguments that derive from the Depression or Japan since the 1990s, they seem to follow from from the ITM when the base is large compared to NGDP.

In any case, the ITM is a coherent model that incorporates maximally uninformative markets and makes no restriction on expectations.  The ITM distinguishes between the monetary base and currency and understands the temporal aspects of each. The ITM gives an explicit function for the price level and the rate of inflation, unlike Market Monetarists or New Keynesians. It explains the liquidity trap and diminishing effect of monetary expansion. It explains Abenomics. In fact, it gives a coherent view of the history of economic thought and economic performance in the US from before the Great Depression to the present. [1]

What it doesn't have is support [2] from anyone with an economics degree :)

[1] If you read Sumner's linked post, it'll explain the joke.
[2] Noah Smith favoriting my tweets doesn't count.


  1. Jason, another great post. I'm disappointed that Sumner didn't respond to you (or Rowe or Glasner... or Sadowski for that matter... I left another comment directly addressed to Sadowski concerning your posts): Sumner's usually pretty thorough about responding to everyone (except for Major_Freedom). He explained to me one day why he doesn't respond to commentators like Major_Freedom: You have to be all of the following to be on his ignore list:

    1. Rude
    2. Verbose
    3. Foolish

    He said I'm in no danger there as I'm never rude and seldom foolish. :D

    I can't imagine you'd be in the same category as MF!!... maybe he just didn't know what to make of your comment.

    1. Mike Sax says that he must stay off the ignore list by keeping his comments brief.

    2. Maybe Sumner ignored you because you didn't directly address him... he probably saves time by just responding to the ones that start off with "Scott, ..."

    3. Thanks!

      I imagine he didn't respond because I asked if anyone else thought it was circular and obvious Sumner did not :)

  2. Jason, O/T: do you think the ITM allows you to determine if the conditions are ripe for hyperinflation or not?

    1. Hyperinflation seems to be a choice (i.e. a political issue). As long as the central bank pays attention to market indicators and the government doesn't literally print dollars to pay for stuff, there seems to be no danger of even high inflation unless the currency in circulation is very small relative to NGDP.

      I've put forward the idea is that we actually need a little bit of hyperinflation to get us out of our current situation:

  3. I found your post here (actuallly I'd seen it a while ago and directed Vincent Cate's attention to it):
    I'm glad you got back to him! I'll comment there.

  4. Redundant, perhaps, but not circular:

    Rational Expectations -> EMH -> MM Model

    So, yes, MM model incorporates EMH, and by extension, Rational Expectations.

    Further, """We have a model that can explain market responses ..." ... wait, I thought the EMH means that you can't know what the market will do?"

    Actually, EMH asserts predictable market responses to unpredictable events. Ex: we don't know if Acme Company will exceed earnings expectations in the future, but you can be damn sure the market will instantly bid the price of Acme shares up if that occurs (barring some exceptions...)

    1. I was being a bit cheeky in taking EMH to mean strong EMH. If one allows expectations to price in an announcement (earnings, Fed interest rates, QE) the model explanation of market responses becomes: it was a surprise vs it wasn't a surprise. We've just moved our ignorance around: "Can the model explain market responses?" becomes "Can the model explain why a piece of information is a surprise?"

      Regarding the circular reasoning, rational expectations is the assumption expectations of prices are on average consistent with your model; the expected price is the model result plus random noise E(P) = P* = P + ε.

      So the circularity is (where the parentheses define logical dependence, and can be read "depends on"):

      MM model(EMH(rational expectations(MM model)))

      Now one could be charitable and say this implicitly defines the MM model, but that would require that the MM model is the only model that incorporates rational expectations and the EMH.

      By the way, I do think the MM model is a real and consistent model -- I actually build a mathematical version of it in this post:

      I was just poking fun at this particular explanation of it :)


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