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Wednesday, October 31, 2012

The Science of New Monetarist Economics

It's been interesting to watch people like Steven Williamson turn on Narayana Kocherlakota because he no longer agrees with their views on monetary policy. The "economics should be a science" people like Williamson resort to the oh so scientific technique of name-calling, e.g. "goofy," "flimsy-excuse guy," e.g. see Williamson's latest (interesting that he chose to emphasize the name-calling rather than the economics in his title for the post). But to me the most notable thing about this is not Kocherlakota's change of heart. As Yglesias notes today, that's how science should proceed -- if the evidence is against you, change your views. No, the most interesting thing to me begins with statements such as this from Williamson two years ago:

the fact is that reserves are leaving banks in the form of currency as we can see in this chart. ... Note in particular that reserves have recently been leaving banks at a more rapid rate. It's possible that we would get more inflation even without QE2.

Or, around the same time:

I think it is quite possible that we will look back on QE2 as a severe error. In spite of the talk from some quarters about the intervention being too small, this is a very large-scale asset purchase for the Fed, on top of a previous very large purchase of mortgage-backed securities and agency securities. One possibility is that economic growth picks up, of its own accord, reserves become less attractive for the banks, and inflation builds up a head of steam. The Fed may find this difficult to control, or may be unwilling to do so. Even worse is the case where growth remains sluggish, but inflation well in excess of 2% starts to rear its ugly head anyway. Bernanke is telling us that he "has the tools to unwind these policies," but if the inflation rate is at 6% and the unemployment rate is still close to 10%, he will not have the stomach to fight the inflation.

My concern here is that, given the specifics of the QE2 policy that was announced, the FOMC will be reluctant to cut back or stop the asset purchases, even if things start looking bad on the inflation front. Once inflation gets going, we know it is painful to stop it, and we don't need another problem to deal with.

He was worried that economic growth would pick up soon (it didn't -- his model misled him, or he didn't use a model in which case I have to wonder about his "science") and inflation would become a problem. He supported this with charts, etc., and he also said inflation could be aproblem even if economic growth didn't pick up.

Well, it didn't happen. We didn't get the economic growth his model had him worried about, and we didn't get the inflation his model predicted. His argument may be that it just hasn't happened yet, but that was two years ago (Nov. 6, 2010), and whatever model was being used to worry about growth and inflation was wrong. Very wrong. If we listen to Williamson, we forego two years of more aggressive policy based upon a fear of inflation that doesn't materialize. Now, he says more aggressive policy has no real effects so it's useless anyway (so why risk the inflation), but theory and evidence disagree on this point. Most current work shows it did, indeed, have modest effects (another failed prediction of his model).

And this is just funny:

So the Kocherlakota of 2 1/2 years ago had some worries about the potential for inflation. Maybe he changed his mind for good reason? I don't think so. ...

Yes, all that inflation we've had should have validated his fears. Williamson's complaint appears to be that Kocherlakota predicted something two and a half years ago, it didn't happen, and he has the gall to use the fact that his prediction failed to change his mind? He changed his mind based upon evidence? He looked at evidence and did science??? How goofy is that? Doesn't he know -- as Williamson apparently knew years ago -- that inflation is just around the corner (according to his wonderfully scientific model)?

Williamson was wrong then, but right now because higher growth does look likely in the near future, is that the argument? Why should we believe his model of inflation and growth now now if it was wrong before? Or will inflation happen even without higher growth like he said could happen two years ago? What should we believe his model now if it was wrong before?

Look, I'm all for science, but that has to include changing your mind when your model is wrong. After two years of running around telling everyone the sky is about to fall, perhaps Williamson will understand why people are more likely to listen to the evidence based views of Narayana and others than to him.

    Posted by on Wednesday, October 31, 2012 at 11:08 AM in Economics, Monetary Policy | Permalink  Comments (14)


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