The information transfer model and the econoblogosphere

Paul Krugman has a post up that criticizes the "neo-Fisherite" view. Oddly I completely agree with his post, yet I wrote a post about agreeing with John Cochrane's post, which Krugman calls the "highest level" of  Keynesian denial. It might be confusing as to exactly where I or the information transfer model (ITM) stands.

I wrote two posts in the past that illustrate a bit of how the ITM fits in with both the history of macroeconomic thought and the debate around the current crisis. Actually, the ITM can help explain the history of macroeconomic thought. At its heart, the ITM says Paul Krugman is always right, but not necessarily for the right reasons. Anyway, this is a post fleshing that statement out with a bit more detail in fun, easy to read listicle format.

First, let me say that the ITM has a critical parameter κ (kappa, basically named after the parameter in this paper by Fielitz and Borchardt), called the information transfer index. In short, it represents the relative size of information chunks received by the supply and transmitted by the demand. Anything you say about the information transfer model has a caveat depending on the value of κ. There are two major κ regimes, and they're not very far apart numerically. When κ ~ 0.5, the ITM reduces to the quantity theory of money (and is similar to the AD/AS model with monetary offset). When κ is larger, getting towards κ ~ 0.8 to 1.0, the quantity theory stops being a good approximation to the ITM and the IS-LM model becomes a better approximation. The details are linked at this post. 

The thing is that κ can change over time and is different for different countries. That ends up muddling things a bit so I end up agreeing with Scott Sumner, Nick Rowe, Paul Krugman, David Glasner, or John Cochrane on various occasions and disagreeing with them on other occasions.

One additional detail is that the ITM says that κ tends to rise as economies get bigger and can only be reset by changing the definition of money or a monetary policy regime change. Hence you can consider old/advanced economies as generally having larger κ while younger emerging economies have lower κ. This is not always true, but can be a good guide. With that bit of background, on with the listicle!

Expectations

I personally think the way expectations are used in macroeconomics make the field unscientific. They appear to be important in microeconomics (and game theory) -- and I have no particular problem with the way they are used there. However, mainstream macroeconomics does not appear to have any kind of constraints on what form expectations take, and hence allow anything to happen in a model. This reaches an almost absurd level with e.g. Nick Rowe's insistence that if a central bank is credible with its NGDP (or inflation) target, the economy will reach that NGDP (or inflation) target ... without the central bank actually having to do anything (besides 'be credible'). I've encountered many other theories and papers in my short few years of studying economics that effectively assume the conclusion through expectations. One economist called these chameleon models (although the author does not specifically call out expectations as the source ... however the questionable assumptions in economic models are typically about expectations or human behavior).

That aside, in the information transfer model, 'expectations' as such take the specific form of probability distributions over market variables (they parameterize our ignorance of the future). Since these distributions always differ from the actual probability distributions (we do not have perfect foresight), they represent information loss and hence a drag on economic growth (relative to perfect foresight). Additionally, prices are not only lower than they would be if we knew the actual probability distribution of market variables, but frequently lower than if we parameterized our ignorance as maximal (which is what the information transfer model does).

The monetary base

The monetary base is directly related to short term interest rates in the ITM. However, only the currency component of the monetary base (I've called it M0 as they have in the UK in the past) has any impact on inflation and then only when κ is closer to 0.5. Monetary base reserves have little to do with inflation ... except in the sense that movements in reserves can sometimes cause movements in the currency base.

Liquidity trap

The ITM model has a lot of similarities with the liquidity trap when κ ~ 1.0 -- I've called it the "information trap". Monetary policy does not have strong impact -- neither raising nor lowering interest rates, nor expanding nor contracting the currency base. The "information trap" differs from the modern liquidity trap in that it doesn't have to happen at the zero lower bound (ZLB) ... it is more like Hawtrey's credit deadlock or Keynes original liquidity trap that didn't have to happen at the ZLB. 

The ITM is, in a sense, identical to Paul Krugman's mental model (or what seems to be his mental model) if you replace "normal times" with κ ~ 0.5 and "liquidity trap" with κ ~ 1.0.

The Phillips curve

This sounds reasonable, but doesn't appear to have a strong signal in the data using the ITM. The two variables (inflation and unemployment) have a complicated relationship and the ITM doesn't describe the fluctuations leading to unemployment -- unemployment seems to be the result of, for lack of a better set of words, irrational panic that could only be modeled by modeling human behavior.

(New) Keynesianism

Essentially, the ITM is well-approximated by the ISLM model when κ ~ 1.0, but not when κ ~ 0.5. So the ITM is sometimes Keynesian inasmuch as the ISLM model is Keynesian. New Keynesianism is based on the expectations-augmented Phillips curve. Given what I've said about expectations and the Phillips curve above, you can guess that the ITM probably doesn't agree with new Keynesian methodology. This isn't to say the models are wrong or won't outperform the ITM against data -- just that methodologically they represent completely different viewpoints. 

Also, since in the US κ has been close to 1.0 both today and during the 1920s-30s, the ITM basically says Keynesianism has been the right theory at those times ... as Paul Krugman says, our world today (and Japan in the 90s) represents the return of depression economics.

(Market) Monetarism

If you take out the expectations piece (the "market" in market monetarism) ... and instead of M2 or MB use M0 ... and give a specific form for the velocity of money, the ITM basically agrees with monetarism ... when κ ~ 0.5. That is to say that Milton Friedman was (almost) right about the US during the 1960s and 70s (but wrong about Japan and the Great Depression). Scott Sumner and Nick Rowe are also right about the 1970s. Additionally, κ < 1.0 for Canada, Australia, China, Russia and Sweden (currently), so monetarism gets those right. However monetarists frequently try to appeal to data from these countries to prove their point about the US, Japan or the EU; in the ITM this is comparing apples and oranges.

Neo-Fisherite model

The only two things that the ITM has in common with this idea/model is that lower interest rates run you into low inflation faster than higher interest rates, and, if κ gets too large, the dependence of the price level on M0 (currency base) becomes an inverse relationship ... i.e. deflationary monetary expansion (as evidenced by Japan). This latter mechanism will lead to even lower interest rates over time.

However! An economy with a constant rate of inflation and a constant interest rate is impossible (unless RGDP grows at an increasingly exponential rate), and the mechanism has nothing to do with expectations, but rather is closely related to the liquidity trap. This makes it different from the typical neo-Fisherite view.

Fiscal policy

Debt-financed fiscal policy always boosts NGDP as it represents an independent process from economic growth. It also raises interest rates (aka 'crowding out'). However, when κ ~ 0.5, if the central bank is targeting inflation or NGDP, fiscal policy will fail to produce inflation (or NGDP) due to monetary offset (q.v. Scott Sumner). When κ ~ 1.0, then there is no monetary offset and the impact on interest rates is minimal. Again this view almost perfectly matches up with Paul Krugman's views, except that "liquidity trap conditions" mean κ ~ 1.0.

(My personal politics on this issue say that even if e.g. unemployment insurance negatively impacted NGDP, we should still do it because we are human beings not heartless automatons optimizing economic variables.)

Coordination failures

David Glasner and Nick Rowe have several posts that present the idea that coordination failures are the cause of recessions (Nick Rowe tends to put the onus on monetary policy, while David Glasner does not). The ITM motivates the idea that coordination causes the recession in the first place (i.e. people en masse becoming pessimistic about the economy) and that the economy does not naturally re-coordinate (create the 'inverse coordination' of the original pessimism) in order to undo that loss in NGDP. That re-coordination would require resources (e.g. debt financed fiscal policy) comparable to the original NGDP loss ... basically the idea that government spending should approximately equal the output gap per Keynesian analysis.

Other ideas?

...