Grasping Reality on TypePad, by Brad DeLong

This paragraph:

Nick Rowe (2013): Does house building cause house price inflation?: Our Sokal hoax http://worthwhile.typepad.com/worthwhile_canadian_initi/2013/12/does-house-building-cause-house-price-inflation-the-sokal-hoax.html: What we have just witnessed is the economics equivalent of the Sokal hoax...

...What matters is that the rest of us didn't all spot that mistake immediately. Even those of us who did see that something was wrong didn't immediately identify what exactly was wrong. We need to ask ourselves why...

The context is Steve Williamson's claim—which he still, four years later, joined by John Cochrane and others, claims to continue to hold—that if the Federal Reserve wants to raise inflation it should sell some of its bonds right now in order to push bond prices down and interest rates up. They call this "Neo-Fisherism"—although God knows why, because dollars will get you doughnuts Fisher would have rejected it strongly.

Nick Rowe provides Williamson's, Cochrane's, et al.'s argument, but as applied to the price of housing rather than to the overall price level, in order to show how silly it is:

Many economists have been puzzled by recent house price inflation. My theory shows that house price inflation was caused by too many houses being built.... Loadsa theory.... Let me give you the intuition with a simple thought-experiment. Suppose builders suddenly increase the stock of houses on the market. The rate of house price inflation must increase for people to be willing to hold those extra houses, because people demand more houses when they expect rising house prices...

Williamson and Cochrane, of course, do not talk about the price of houses but instead about the overall price level. If the Federal Reserve sells bonds for cash and thus shrinks the money supply, they argue, the rate of inflation has to increase in order to make people happy holding only the lesser amount of cash that is in the economy.

This is only an argument that a trained economist could make.

A non-economist would say that reducing the supply of something makes it not less valuable but more valuable—and so in the case of money would mean not inflation (when money becomes less valuable and so buys less) but deflation (when money becomes more valuable and so buys more).

But let us take seriously Nick Rowe's final observation in the first paragraph I quoted from him: "Those of us who did see that something was wrong didn't immediately identify what exactly was wrong. We need to ask ourselves why..."

Let us think about this.

Some days I believe that the tools and discipline of economics as a discipline is a very powerful intelligence force multiplier for those of us who have a certain breadth even if not a great depth of intelligence.[1]

Other days I believe that Economics is a dumbass multiplier for dumbasses, because its tools and discipline allow dumbasses to obscure their dumbassery, at least from themselves, at least for a while.

(Of course, both could perfectly well be true.)

The way I think about the breadth of intelligence required to be a good economist is this: A good economist must be able to:

1. Using algebra, move rapidly, seamlessly, and accurately from verbal descriptions to numerical equations.

2. Using analytic geometry, move rapidly, seamlessly, and accurately from numerical equations to geometric diagrams.

3. Using words, move back again rapidly, seamlessly, and accurately from geometric diagrams to comprehensible and intuitive verbal descriptions.

4. Cleanly an usefully take a complicated and confused situation and from it abstract the right salient features to include in a toy model.

5. Accurately and sensibly evaluate whether the conclusions of the toy model are in fact robust and generalizable to our real world.

Undergraduates generally fall down on (1) and (2)... on (3) as well... and, I might as well admit, on (4) and (5). Professional economists generally fall down on (3), (4), and (5)—as the Neo-Fisherians have managed and manage to do so, so stunningly.

Nick Rowe tries to explain what went wrong at greater length:

The quantity of houses demanded is a negative function of the price of houses and a positive function of the expected rate of increase of the price of houses. The quantity of money demanded is a positive function of the price level and a negative function of the expected rate of inflation. Ignore anything else... assume perfectly flexible prices and continuous market-clearing... assume actual and expected inflation are the same, just to keep it simple. Assuming a simple log-linear demand function for the stock of houses, the supply=demand equilibrium condition is:

H(t) = a - P(t) + b.Pdot(t)

The equivalent for money is (remembering the price of money is the reciprocal of the price level);

M(t) = a + P(t) - b.Pdot(t)....

There is the "fundamental" solution, where the equilibrium time-path depends only on the time path of M(t). And then there are an infinite number of "bubble" solutions.... Economists normally adopt the "fundamental" solution.... If there is an [unforeseen] upward jump in M(t)... expect[ed]... to be permanent, the fundamental solution says... P(t) must jump too.... [But] if the theorist forgets that P(t) can jump up, the only way to restore equilibrium is to assume that Pdot(t) jumps down... onto one of the bubble equilibrium paths... [unless] when M(t) jumps up, Mdot(t) jumps down at the same time.... [Neo-Fisherians implicitly claim] Q[uantitative ]E[asing] causes inflation to fall because QE causes people to expect a bigger negative QE in future.... That seems implausible....

So, what went wrong? How come even those of us who did get that something was wrong didn't immediately figure out what exactly was wrong? I blame maths.... (Perhaps I should have written a slightly different post, a real hoax, arguing that rising house prices are indeed caused by building too many houses, just to see how many people would fall for it? But a hoax post on money would be much easier to pull off.)

About the only thing I can disagree with Nick about here is the last part of his:

We all make mistakes. What matters is that the rest of us didn't all spot that mistake immediately.... We need to ask ourselves why. We can't blame the person who made the mistake if we didn't immediately see it either...

I agree that we do need to ask why the mistake was made—and, if we did not spot it immediately, why not. But we can blame the person who made the mistake.

Being a dumbass is blameworthy.

And continuing in persistent dumbassery is hyperblameworthy.

Noah Smith has a theory: Those economists attracted to "Neo-Fisherism" are, he believes—and I believe—overwhelmingly economists who used to believe that the Federal Reserve's Quantitative Easing policies were dangerously inflationary. Perhaps they find it psychologically impossible to admit they were wrong without attempting to count coup somehow by still claiming that their intellectual adversaries were wrong as well. So how an they be made to look wrong? By saying that via clever economic theory they can demonstrate that Quantitative Easing is not a weak way of raising inflation, but instead a way of lowering inflation!: We were wrong, but you were wrong too.

I think that is too clever: I think that this is just people who are very weak on (4)—"cleanly an usefully take a complicated and confused situation and from it abstract the right salient features to include in a toy model"—and weaker still on (5)—"accurately and sensibly evaluate whether the conclusions of the toy model are in fact robust and generalizable to our real world"—and perhaps weakest of all on (3)—"using words, move back again rapidly, seamlessly, and accurately from geometric diagrams to comprehensible and intuitive verbal descriptions"—but whose facility on (1) and (2) has gotten them some sort of reputation.

Nick Rowe says that to some degree this is somehow OK: "we all make mistakes..." I disagree: systems of thought that make it, somehow, very easy for highly trained people to make very bad mistakes are not OK. Nick Rowe puts the blame on features of economics that make it difficult to correct the mistakes. I think it is deeper. The fact that an argument look sane and interesting in economics when every normal person without the tools of economics would be able to instantly recognize it as dumbass—that is a serious problem for Economics. The lesson? It is hard to be a good economist. It is easy to be a bad one. And knowing the formal tools of economic theory does not, in general, help one—it can hurt.

Nick Rowe (2013): Does house building cause house price inflation? Our Sokal hoax http://worthwhile.typepad.com/worthwhile_canadian_initi/2013/12/does-house-building-cause-house-price-inflation-the-sokal-hoax.html: "What we have just witnessed is the economics equivalent of the Sokal hoax...

...Take any asset. It could be houses, or it could be money. The only difference (in this case) is that the price of money is the reciprocal of the price of other goods, so the rate of increase of the price of money is the rate of decrease in the price of other goods (i.e. the deflation rate).

The quantity of houses demanded is a negative function of the price of houses and a positive function of the expected rate of increase of the price of houses.

The quantity of money demanded is a positive function of the price level and a negative function of the expected rate of inflation.

Ignore anything else that might affect the demand for houses, or money, just to keep it simple. And assume perfectly flexible prices and continuous market-clearing, just to keep it simple. And assume actual and expected inflation are the same, just to keep it simple.

Assuming a simple log-linear demand function for the stock of houses, the supply=demand equilibrium condition is:

H(t) = a - P(t) + b.Pdot(t)

The equivalent for money is (remembering the price of money is the reciprocal of the price level);

M(t) = a + P(t) - b.Pdot(t)

It is well-understood, at least since Brock (1975) "A simple perfect foresight monetary model", that this equilibrium condition permits an infinite number of solutions. There is the "fundamental" solution, where the equilibrium time-path depends only on the time path of M(t). And then there are an infinite number of "bubble" solutions. Even if M(t) is constant for all time, P(t) can rise without limit at an ever-increasing rate, or fall without limit at an ever-increasing rate, along any one of these bubble paths.

Economists normally adopt the "fundamental" solution, but some economists think we might sometimes observe "bubble" solutions.

If there is an upward jump in M(t), that was not foreseen, and if people expect that increase to be permanent, the fundamental solution says that P(t) must jump too to restore equilibrium. A permanent increase in the money supply causes a permanent increase in the price level. If the theorist forgets that P(t) can jump up, the only way to restore equilibrium is to assume that Pdot(t) jumps down. A permanent increase in the money supply causes a fall in the inflation rate. But that means the theorist is assuming the economy has moved from the fundamental equilibrium path onto one of the bubble equilibrium paths.

There is an alternative way to get an increase in the money supply to cause deflation, while sticking to the fundamental equilibrium. You need to ensure that when M(t) jumps up, Mdot(t) jumps down at the same time. The money supply increases, but is expected to start declining from now on. The jump up in M(t) causes the P(t) to rise. The jump down in Mdot(t) causes Pdot(t) to fall, which in turn causes P(t) to fall. If you rig it just right, so the two changes have just the right relative magnitudes, the net effect is no change in P(t), and a fall in Pdot(t).

[Update: Here's the above paragraph in math. Assume A=0, and initially M=1 and Mdot=0. So people expect P to stay constant at 1. Suddenly M jumps to 2, but the central bank also announces that M will decline at rate 1/b from now on. There is no jump in P, but Pdot is now -(1/b).]

But note one thing very well. This fundamental solution, where an increase in the money supply causes no rise in the price level but a fall in the inflation rate, requires people expect that the money supply will eventually be lower than if it had never increased in the first place. QE causes inflation to fall because QE causes people to expect a bigger negative QE in future than the original positive QE. That seems implausible to me.

The proper way to discuss questions like this is to talk about the extent to which QE is expected to be permanent or temporary. Scott Sumner, to give just one example, has been saying that QE has little effect because it is expected to be mostly temporary, given the failure of the Fed to announce a sensible target. You talk about the central bank's monetary policy target, and how that influences people's expectations of future prices (or NGDP, if prices are sticky). And you discuss the effects of QE within the context of that monetary policy framework.

Notes:

[1] Here I like to cite John Maynard Keynes's obituary for Alfred Marshall:

The study of economics does not seem to require any specialised gifts of an unusually high order. Is it not, intellectually regarded, a very easy subject compared with the higher branches of philosophy and pure science? Yet good, or even competent, economists are the rarest of birds.

An easy subject, at which very few excel!

The paradox finds its explanation, perhaps, in that the master-economist must possess a rare combination of gifts. He must reach a high standard in several different directions and must combine talents not often found together. He must be mathematician, historian, statesman, philosopher—in some degree. He must understand symbols and speak in words. He must contemplate the particular in terms of the general, and touch abstract and concrete in the same flight of thought. He must study the present in the light of the past for the purposes of the future. No part of man's nature or his institutions must lie entirely outside his regard. He must be purposeful and disinterested in a simultaneous mood; as aloof and incorruptible as an artist, yet sometimes as near the earth as a politician.

Much, but not all, of this ideal many-sidedness Marshall possessed. But chiefly his mixed training and divided nature furnished him with the most essential and fundamental of the economist's necessary gifts-he was conspicuously historian and mathematician, a dealer in the particular and the general, the temporal and the eternal, at the same time... back