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Hoisted from the Archives from a Year Two Years Ago: John Cochrane Claims the U.S. Is at Risk of Becoming "Argentina": Noah Smith Manfully Takes the Cochrane-Argentina Side of the Bet…

UPDATE (June 2014): We now have one year to run, which means that if there is going to be 5% inflation, it has to commence now. So how much should I charge Noah wants to back out of his position? On the one hand, I think if I buy it back from him I should do so at 99.99 cents on the dollar. At this point I think that core inflation above 5% with unemployment above 6% starting now for the next year really is a 10,000-1 shot, even with fat tails. On the other hand, I am reminded of Damon Runyon's: "Nothing between humans is more than 3-1."

More interesting, perhaps, is John Cochrane: It is now more than five-and-a-half years since John Cochrane began ranting about how the biggest danger facing the U.S. economy was not a persistent 8% shortfall of production relative to potential output, but rather that the doubling of the monetary base by the Federal Reserve from $700 billion to $1.4 trillion and the projected 50% expansion of the national debt from automatic stabilizers and an $800 billion expansionary discretionary fiscal policy would turn the U.S. into "Argentina".

So far no recognition on his part that perhaps he should perform a Bayesian update on his beliefs.

I have conducted a Bayesian update on my beliefs: back in 2007 I was 5% Austrian, 5% RBC, 30% Keynesian, 60% monetarist; now I am 1% Austrian, 1% RBC, 28% monetarist, 70% Keynesian. Why hasn't he conducted a Bayesian update on his?


A 5%/year inflation rate is not "Argentina", but we want to bend over backward to give the John Cochrane side a chance…

The bet, made in July 2012:

If, at any time between 7/28/2012 and 7/28/2015, core consumer prices, as recorded in the FRED database series CPILFESL, are up more than 5% in the preceding 12 months, and if over the same 1-year period monthly U3 unemployment (as recorded in FRED database series UNRATE) has not averaged below 6%, then Brad DeLong agrees to buy Noah Smith one dinner at Zachary's Pizza at 1853 Solano Ave. in Berkeley CA, and to pay Noah 49 times the cost--including tax but excluding tip--of Noah's meal at Zachary's in Federal Reserve notes, or in alternative means of payment accepted by Zachary's should Zachary's Pizza no longer be accepting Federal Reserve notes at the date of the dinner. This cost will be assessed as the total cost of the dinner to all, divided by the number of people present, regardless of how much pizza is consumed by or how much alcohol is drunk by specific individuals.

If however, the above condition is not satisfied, Noah agrees to buy Brad one dinner at Zachary's.

Miles Kimball will be the judge in charge of refereeing the bet. The decisions of the judge will be final and unappealable.

Furthermore, Noah's brave and gracious willingness to take the Cochrane-Argentina side of this bet at odds of only 50-1 will not be construed as a statement of his confidence in or of his support for any economist or position of economic analysis that judges expansionary fiscal policy at the zero lower nominal interest rate bound to be "insane" or that judges "1932" to currently be a less dire risk for the U.S. than "Argentina".

FRED Graph  St Louis Fed 3

The start was my noting that Sebastian Mallaby these days is sounding like a normal reality-based economist--and is far, far from the guy who back in March 2009 thought that what the audience at his CFR conference really needed to hear was the (unrebutted: the panel was stacked) opinions of John Cochrane:

What Do the 1930s Teach About Reforming Today's Financial Markets?: [T]he danger now is inflation.  And I would say it's a greater danger than most of the other people have said.  Our danger now is a run on Treasury debt.  It's not just can the Fed soak this stuff back up again, but can it soak this enormous amount of debt back up again when people don't want either money or Treasury bills or anything labeled "U.S. Government."  The danger is not 1932; the danger is Argentina, a massive run from Treasury debt.  And then monetary policy will not be able to do anything.  You can fool around with interest rates all you want.  When people don't want Treasury bills or money you're stuck….

The system is much more resilient than it was because of deregulation. Back in the Great Depression… if the Bailey Savings and Loan goes under, there is no way that JP Morgan, financed by an equity infusion from the sovereign wealth fund of Kuwait can come in and take over and start lending.  You're just stuck.  Well, we're not in that situation anymore….

Policy is chaotic. Who would invest in this climate?  It's not about toxic assets; it's about who wants to go in on a deal with Darth Vadar [sic], who can change his mind at any moment?  That's the uncertainty that's keeping things from getting going and that's what's slowing the rebuilding of financial markets.  We're facing growth-destroying marginal tax rates, an excuse for the government takeover of large and completely unrelated sectors, class warfare, vindictive ex post taxations….

My great hope is that the bounce-back will be quick before the quack medicine can be said to have worked.  (Chuckles.)  Just as we sort of -- as people think that this insane idea of fiscal stimulus -- which I'll go on with later if I get a chance -- came from Roosevelt's experience with no reason why it should work, there is a danger of thinking all of the crazy stuff they're doing now will have caused the bounce-back…

Cochrane than protested (sounding to my ear much like an old-line Fundamentalist Marxists--one of those who claims that Marx never said real wages will fall but only that there was a tendency for the real wage to fall) that he had not said that (i) unless the expansionary fiscal and monetary policies of 2009 were reversed the U.S. was about to experience an Argentina-like upward explosion of inflation, but only that (ii) there was a risk that, unless the expansionary fiscal and monetary policies of 2009 were reversed, the U.S. was about to experience an Argentina-like upward explosion of inflation.

And Noah Smith said that was a fair point.

I in turn counter-protested to Noah:

There was no reason to think that the expansion of the Fed balance sheet from $700B to $1.7T in mid-2009 would create too-much money chasing too-few goods--for as long as the economy was at the zero nominal interest rate lower bound expanding the Fed's balance sheet simply swapped one very low-yield nominal government liability for another with little effect on anybody's net liquidity or risk exposure. The marginal expansion of the projected national debt from the Recovery Act was absolutely trivial, and since the prospect of future health-care spending deficits had not provoked "Argentina" by 2008 there was no risk the additional marginal borrowing of the Recovery Act would provoke "Argentina" in the context of a depressed economy. Financial markets were not pricing in any chance of an upward explosion of inflation. Cochrane could neither (a) point at elements in the configuration of asset (and other) prices demonstrating that people besides him thought "Argentina" was a substantial risk, or (b) explain the market failure that kept people from hedging against the risk in such a way that we could see their hedges in market prices.

Thus Cochrane's point that he was just pointing out a "risk of Argentina" did not seem to me to be a fair point at all. If it really was a significant risk, then people who feared that risk ought to be hedging themselves on financial markets. If it really was a significant risk, than people ought--at the appropriate odds--to be willing to bet that that risk would actually come to pass. So I asked Noah if he was so willing...

Hence we decided on:

  • Zachary's pizza because we like pizza.
  • A three year term because we are hungry and would like to eat our pizza.
  • A twelve-month core CPI change of 5% as our definition of "Argentina"--yes, I realize that that is really absurd and is defining "Argentina" way, way down, but work with us on this…
  • An unemployment rate of 6% as marking exit from the depressed-economy régime--the transition from the "involuntary unemployment" to the "inflation" region on the Malinvaud diagram--and entry into a régime in which we would expect inflation to respond in the medium-term to expansionary policies
  • 50-1 as the appropriate odds to make the debt fair: a 2% chance of the deficits and monetary base expansions of the past four and the next three years triggering the transformation of the U.S. into "Argentina".

I must say that Noah appears to me to not be an expected utility maximizer, or to have a substantially different assessment of the odds than I do: I would have demanded 200-1 to take the Cochrane side of this bet…

Mark your calendars now for August 2015…


Noah Smith writes:

Noahpinion: Inflation predictions are hard, especially about inflation: John Cochrane responds here to a Brad DeLong jibe about inflation predictions. To make a long story short, back in 2009 Cochrane predicted inflation, it hasn't happened yet, and DeLong made fun of Cochrane for that fact. Cochrane essentially… [says:] The inflation prediction was (and is) a statement about risks, not a time-specific forecast….

Regarding Point 1, this is a very fair retort. Predictions are not necessarily forecasts. Saying "we are probably in a bubble that will burst sooner or later" is a different thing from saying "the bubble will burst at 10:36 A.M. next Thursday". I think people instinctively demand too many forecasts and not enough other kinds of predictions from macroeconomic models…

I disagree. I do not think that is a fair retort.

Two points:

First, and less important, a reader of Cochrane (and Smith) would believe that I had said something like "Cochrane confidently predicted in March 2009 that an explosion of inflation was imminent". I don't think I did. What I said was:

Back in the spring of 2009… Sebastian Mallaby['s]… idea of the kind of people whom he really needed to push up onto the stage were people like… John Cochrane, claiming that the "danger is not 1932; the danger is Argentina, a massive run from Treasury debt" and "this insane idea of fiscal stimulus".:

John Cochrane, March 30, 2009: The New Financial Deal: What Do the 1930s Teach About Reforming Today's Financial Markets?: [T]he danger now is inflation. And I would say it's a greater danger than most of the other people [who have mentioned it] have said. Our danger now is a run on Treasury debt. It's not just can the Fed soak this stuff back up again, but can it soak this enormous amount of debt back up again when people don't want either money or Treasury bills or anything labeled "U.S. Government." The danger is not 1932; the danger is Argentina, a massive run from Treasury debt. And then monetary policy will not be able to do anything. You can fool around with interest rates all you want. When people don't want Treasury bills or money you're stuck…

If someone says "you were wrong to fear risk X" it is not a retort to say "I never said X would happen, I only said it was a risk!" In general, I think, you do get further when you engage what your critics say rather than what they did not say…

Second, and more important, any economist's claim "I did not say it would happen, I only said that it was a substantial risk that might happen" does not thereby create an Invincible Fortress of Rightness from within which the economist can laugh all critics to scorn.

FRED Graph  St Louis Fed

If you say that something is a substantial risk and it does not come to pass, then--if you are an economist--you are committed to either (a) pointing at elements in the configuration of asset (and other) prices that demonstrated that people besides you thought it was a substantial risk at the time and took significant steps to insure themselves against it, or (b) explaining what was the market failure that kept people from hedging against the risk in such a way that we can see their hedges in market prices.

The inflation that Cochrane feared would follow the Federal Reserve's expansion of the high-powered money stock from $800B in 2008 to $1.7T in early 2009 has not come to pass. It has not come to pass even though the Federal Reserve has since not returned the high-powered money stock to normal but instead boosted it further to $2.7T and current market expectations are that it is more likely than not to be $3.3T by the end of the year. Yet there is no sign at all that anybody trading in asset markets is fearful enough of future inflation to price any probability of an acceleration of inflation into asset values.

FRED Graph  St Louis Fed 1

That is what the 10-year and 30-year break-even inflation rates from the Treasury nominal-TIPS spread tell us. If there is anybody ought there who believes in the risk of future inflation and is willing to put their money on it, the break-even inflation spread should be high. It isn't. It wasn't.

And the explanation of what the market failure here is, of why we should not take what asset prices are telling us seriously--why there were (and are) big risks of inflation even though market prices say there are not? Missing. Completely missing.

If you are an economist, you are supposed to put forward a coherent argument--expectations, risks, prices and quantities, market failures--that adds up to a consistent whole. If you are an economist, you are supposed to follow the rules--and there are rules, aren't there?

Thus, Noah, I really do not think it is "a fair retort" to say:

  • Risks of high inflation in 2009 were really really big!
  • TIPS in 2009 were really really undervalued!
  • Investors who were then holding TIPS had huge expected excess returns--and a return distribution with a large negative beta!
  • No, I have no explanation for why asset market prices then did not match fundamentals.

Of course, if you are not an economist but an ideologue, or are simply playing for a Team Republican which wants to pressure the Fed to keep nominal demand growth depressed, then the rules are different. Then you can simply blather in an evidence-free fashion without restraint, and nobody can complain…

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