Pursuit of Truthiness

my gut tells me I know economics

Archive for the ‘monetary policy’ Category

The Fed Can Commit

leave a comment »

Anna seems to trust Ben's commitment

I have heard otherwise-intelligent people insist that the Federal Reserve is incapable of making believable commitments to take certain actions in the future.  For instance, Angus keeps saying things like

“Please repeat after me:

THE FED HAS NO MECHANISM TO BIND ITSELF TO LIVE UP TO ANY ARBITRARY PROMISES IT MAY MAKE TODAY ABOUT THE FUTURE!!!

Promises to act against one’s preferences in the future that are made without any commitment mechanism are simply cheap talk and are extremely unlikely to shape agent’s expectations or actions.”

It is obviously wrong to say that the Fed has no commitment mechanism.  The Fed makes believable commitments every day.  It does not need to resort to Schelling-style special tricks like having its employees make contracts with 3rd-parties to lose lots of money if the inflation target is missed (though of course these tricks are available and potentially useful).  The real commitment mechanism is that your reputation is itself a valuable thing, and the Fed’s leaders know this and have less-than-infinite discount rates.  Ben Bernanke has carefully developed a reputation for keeping his word; he is not going to throw this durable good away in 2012, because he will still find it useful in 2013, and he values his 2013-utility a significant positive amount.  Because Bernanke knows the importance of the expectations channel, he knows his reputation is more important than just about any one-time action.  Ben will not sell his birthright for a mess of pottage.

We don’t even need to delve into the complexities of monetary policy to establish the obvious truth that the Fed can make commitments.  Just consider the fact that thousands of Fed employees feel almost certain that the Fed will give them their next paycheck as promised.  Surely the Fed would benefit in the short term by not paying them; it could get them to keep working for a few weeks at least by insisting there was some technical problem with the payroll system.  Why doesn’t the Fed try this?  Because the leaders of the Fed know that their reputation for doing what they say [eg paying people, even if they promised too high a salary] is far more valuable than any short-term savings.  Their employees know this too, making it much easier for the Fed to manage their own labor market; for instance, no one is demanding payment up front, because they trust they will be paid later.  Similarly, the FOMC announces their meeting dates months ahead of time.  Somehow they always manage to meet when they said they would, even if everyone attending realizes at the last minute it is not a great time; they value their reputation more than a one-time inconvenience.  That’s some magical stuff right there people!

Odysseus binds himself to the mast

Written by James Bailey

October 17, 2011 at 3:47 pm

The Strong Dollar

leave a comment »

I have heard many people say that the Keynesian counter-recession policies of easy money from the Fed and deficits from Washington have been rendering the dollar worthless.  I know inflation has actually been below-trend (so the dollar’s purchasing power remains strong domestically), but today I finally got around to looking up the international strength of the dollar:That’s right, the dollar has barely declined since the beginning of the recession, despite the big increases in deficits and the monetary base.  It is much stronger than we would predict from the pre-recession trend.  People “know” that the dollar must be weaker because of what the Fed and Obama are doing; it seems so obvious that they don’t feel the need to look up the numbers, which show otherwise.

Of course, a strong dollar is not necessarily good; I believe the main reason people think it is a good thing is because it has the word “strong” attached.  Sometimes a strong dollar is about as desirable as a case of strong influenza.  Given our apparent aggregate demand shortfall, this seems to be one of those times.  Since I am not doing much importing, exporting, or international travel, I don’t have much of a personal dog in the fight; but it seems the country could do with an even weaker dollar.

Written by James Bailey

August 19, 2011 at 9:54 am

Monetary Policy: The Most Important Policy

with 3 comments

Scott Sumner has said that monetary policy was the Achilles heel of conservative/libertarian/free market economics all through the world in the 20th century.  I am realizing how big a problem it still is.  I always thought that it we be great if some twist of fate brought us President Ron Paul, because I think most of his proposed policies would make Americans much better off; my only big disagreement is with his monetary policy.  However, I can’t say I disagreed when I read Adam Ozimek’s description of what hypothetical presidents would bring:

You know who else ran for President in 2008? Ron Paul. President Paul would have yanked out Bernanke and put in a gold bug, which would have outdone anything any other president could do, short of unnecessary nuclear war, in terms of a welfare loss. President Paul would have heralded in the Great Depression 2, not the Great Recession.

I don’t think it is unreasonable to expect a second Great Depression to do as much damage to free-markets and libertarian politics as the first.  You might think that a libertarian president could get lucky and get elected during good economic times, when tight money would not push us all the way to a Depression.  However, any President that does drastically shrink the government is going to cause a recession; almost every post-war demobilization is accompanied by a recession.  This doesn’t mean we shouldn’t end wars or shrink government of course, but such times do call for an accommodative monetary policy- and given the current state of libertarian beliefs and politics, we are likely to get just the opposite.  Unless we get a new Milton Friedman(who I guess is now a money-debasing statist), a libertarian president will be bent on bringing “sound money” and will be a disaster for the country and for free markets.

Written by James Bailey

April 6, 2011 at 2:53 pm