I wish I understood this essay, but I don't. I recall Russ Roberts saying "How do you know when economists are overestimating their knowledge? ... They use decimal points." Not a criticism of you, but of the sacred cows in your field.
I'm eternally perplexed about why economists need to learn calculus; and just imagine the very specific pedigree you need to be a Fed official. And yet, the only function Fed officers appear to serve is tinkering with interest rates and printing money in the service of politicians. And when their tinkering leads to recession, the excuse is always that nobody could have predicted that the money printing would cause inflation, or that unexpected rate hikes might cause a few bank failures. When their chicanery fails to induce a recession, then they claim success. It has a very Wizard of Oz feel to it.
All the best economists, including yourself, are good story tellers. Is the math really necessary? Because it doesn't seem to be able to predict economic trends any better than Robert Shiller's animal spirits.
Economics is not engineering, which advances civilization with the discovery of physical laws and equations for fluid mechanics and electromagnetic interference and whatnot. It's more of a philosophical discipline, and those who became famous by foreseeing perverse consequences better than their peers were more behaviorists and historians than mathematicians.
The fact that Maynard Keynes is still considered a popular legend, rather than a charlatan who cynically showed politicians how to pull the wool over on their constituents, makes me suspect that the math isn't mathing.
Mathematics makes economics rigorous and transparent. Equations in these economic models are really just rational arguments with clear definitions. It’s really difficult to convey exactly what you mean without mathematics. That’s why to this day there are people discussing Marx and Keynes, as they did not write their stuff down in equations. However the ISLM model (which is based on Keynes, but not created by him) has a clear formulation and thus its predictions can be falsified and discussed scientifically. The economy is extremely complex, and without these mathematical models its much more difficult to describe exactly what you mean or what the premises of your arguments are. Once you start thinking deeply about economics, and have knowledge of mathematics, you would find that is an unavoidable tool. Of course its virtous to be a good storyteller, but that’s not real economics. Just like Neil de Grasse Tyson can make really god stories about physics, that is not physics. You say Keynes is a charlatan, but arguably he was one of the best storytellers among economists.
Also note, that for example understanding the mathematics behind these macro models John is describing here takes way more than understanding calculus. Furthermore, the reason economists learn mathematics is not just modelling, but to be able to do statistics, which is a centre piece of modern economics that is ever more empirical. Its good that economists are learning maths. The scientific method does not give preference to “easy” stuff. Knowledge gathering is not easy. There is a reason why Plato did not let enyone into his philosophy school who was ignorant of geometry.
Agree about understanding statistics, which is often counterintuitive. I call Keynes a cynic or charlatan because he described the way money printing pickpockets the electorate, but then advocated policies to facilitate that.
The problem with economics is actually not enough math. Beautiful prose alone can lead to serious internal inconsistencies. Read, for example, the Fed's musings on how monetary policy works. It cites all sorts of effects and "channels," none of which we have the ability to write down and work out. We need more and better little artificial economies in order to understand the real one. Alas, unlike physics or aerodynamics, our models will always remain quantitative parables, so they have to remain transparent as well. Nobody believes big black box computations, because we all know they are sensitive to small misspecification of little parts. More math and more transparency at the same time is a big challenge.
Some three decades ago, I was asked to review a paper at a finance association meeting for one of the financial economics journals. The paper intended to address Keynes' theory of normal backwardation in forward markets. The mathematics chosen found a general equilibrium wherein all the forward markets cleared and all transactions ultimately took place in the spot markets. In equilibrium, no one held forward positions. In my review, I asked a simple, direct question: How could one address a theory in which speculators held long term forward positions with a model in which no one held forward positions? The answer was gobblety gook along the lines expressed here. The incentives to publish and succeed in the academic environment are powerful. They are not necessarily aligned with increasing the understanding of real world economic problems. Leontieff addressed this very problem in his Presidential address to the American Economic Association in roughly 1970. Maybe things haven't changed much.
Bravo, Chuck! Your observations are spot on. Economics is profoundly philosophical, which is just as it must be, just like physics. Math is the language of science, precisely because math reveals illogic and reveals contradictions and nonsense, if we understand the math. But if we cannot translate the math into plain words, then we do not understand the math. John Cochrane understands the math and is a master of translating the math to comprehensible words, as he has just done in this eloquent, brilliant essay.
As I tell my students, ignore the math if it does not speak to you. Listen to my words. If they do not make sense to you, ask me to explain another way. If my words do not make sense to you, I'm probably not making sense.
John Cochrane, you are a voice in the wilderness. Know that there are many out here who are listening, hearing, and understanding what you are saying. Everything I was taught in graduate school about money and macroeconomics, which I finished in 1979, has turned out to be drivel. We were steeped in IS-LM and MV=PY. The sad part is that either my professors did not understand the math and its implications, or they were ignorant of what economists already knew by then; sad, either way.
I teach money and banking and finance on the backside of a 45-year career. You are making my job extremely challenging in my old age because I refuse to teach my students that which I am persuaded is not true. To teach students what I am persuaded is the closest approach to the truth, I am forced to abandon the textbooks, because they are filled with drivel. Fortunately, I can draw on your work and its clear explanations to show the way.
How can we be sure that what any Economist is doing today is not drivel. After all, no economist in 2021 forecast inflation, no economist forecast the financial crisis, and no economist even today can explain why the crisis happened in the first place.
I see that your 'stack post linked above is 2023. How is that a prediction? In any case, no economist and no person can predict the future. If they could, including you, they could become fabulously wealthy quite quickly. Physicists have the easy job of predicting cause and effect relationships, because atoms and molecules are well behaved at the macro level. Things don't get too weird until we go to the quantum level of reality.
I can be sure when economists are not talking drivel because I am one, and because I can think pretty well, though not as well as I'd like. Economics is not capable of predicting the future because humans have free will and because some humans evidently have bad will on top of it all. John is not the only economist not talking and writing drivel, but he is definitely one of the best.
Another couple are Tyler Cowan and Alex Tabarrok. I encourage you to listen to their podcast about the New Monetary Economics, recently posted on Marginal Revolution podcast, which you can find easily.
It appears that you may be an Austrian economist, like I am. I agree with you that piss poor regulation (which includes almost ALL regulation) and extra piss poor policy coming from government operatives did indeed cause the 2008 great recession, along with the housing finance debacle.
My impression about economics is that for all of the effort economists have made over, what, several centuries, about the only real predictability comes from people such as Thomas Sowell. The 800 Ph.D. Economists at the Fed have done little else but damage since the Fed was created. Why do we continue to put good money after bad in this field?
Surely, economics is THE subject crying out for insight that AGI might offer. While sciences (physics, chemistry, molecular biology) and engineering fields devote a large part of their resources to developing new measurement tools and methods to interrogate the complex, adaptive systems they study, to a person such as myself who is nothing more that a victim of what economists do, it seems to me that economists have few such tools after several hundred years. So what exactly does one do with 800 Ph.D's besides do damage?
The reason more academics haven’t fallen in line with the equilibrium selection interpretation of the Taylor rule is because it’s not correct. In JC’s expectations and neutrality paper he asks the question: when the nominal interest rate is increased do we get lower prices today (lower p(t)) or higher prices tomorrow (higher p(t+1)). The answer to that is itself an equilibrium outcome.
The logic of the NK equilibrium selection is in 2 steps. First the Taylor rule eliminates all equilibria except the unique bounded one and all the unbounded ones (which can come in several varieties). Step 2 is that fiscal policy eliminates the unbounded ones. Once in the resulting equilibrium, which is unique and determined jointly by both fiscal and monetary policy, the answer the question above becomes that it’s entirely lower p(t) that is the equilibrium response to a higher nominal interest rate today.
Further more, the fiscal policy required to rule out the unbounded equilibria isn’t as strict as JC sometimes implies. As Woodford showed in his book the hyper deflationary equlibria can be ruled out by any strictly positive lower bound on the growth rate of nominal government debt. Similarly, though not quite stated by Woodford, the hyper inflationary equlibria are ruled out by any finite upper bound on the growth rate of nominal government debt.
Once that’s done then the Fed acquires the ability to keep the price level at it’s chosen target with a Taylor rule and the Fed never has to threaten to blow anything up to enforce that.
This is a fascinating comment. Once you say that "fiscal policy eliminates the unbounded ones," it seems you've jumped completely to fiscal theory of the price level. But it seems you still acknowledge that in the model, inflation would be stable under a peg, and the Taylor rule means the Fed deliberately makes inflation unstable. That's really the core of the problem. The Fed doesn't do that.
Well, I agree that I am not contradicting the FTPL and for good reason, I consider it completely correct. However, that doesn’t mean I consider your interpretation of the mechanics of the canonical NK model to be correct.
Woodford’s explanation is very muddled but he stresses several times that he’s assuming fiscal policy is locally Ricardian but globally non-Ricardian. It’s not the fed making “threats” about what it would do in off equilibrium outcomes it’s the fiscal authority, and as such they aren’t “threats” but simply promises of the form “we won’t let nominal issuance grow too fast or too slow” which sounds reasonable and realistic. It’s those fiscal promises that are enforcing the desired equilibrium and in that equilibrium (though perhaps not in others) a Taylor rule doesn’t make inflation unstable, which is the substance of my comment.
A couple further points. You frequently note, quite obviously correctly, that the fiscal authority never really acts Ricardian even locally. Fine, globally non Ricardian works just as well in my preceding paragraph (and original comment) and yes that means the FTPL determines P. However, this isn’t inconsistent with NK mechanisms, the only role the locally Ricardian assumption plays is that for whatever reason Woodford wants to say that P* can be anything and that requires locally Ricardian fiscal policy. On this I am with you, no P* can’t be anything the fed chooses. (Instead of thought experiments about off equilibrium deflation consider one where the Fed randomly decides they’d like the price level 20% lower, can they do it?)
Lastly, yes inflation is “stable” under a pure interest rate peg but here you mean stable in the engineering dynamical system sense of having a long run limit (eigenvalues inside the unit circle type stuff). The price level under a gold standard is also “stable” in that sense but we don’t have a gold standard anymore because it allowed too much undesirable short term price level volatility. Presumably that’s the same issue with an interest rate peg, the price level is determinate but could be overly volatile (due to the same discount rate variation that makes equity prices look overly volatile relative to the path of dividends) and a Taylor rule type policy can smooth that out and as such stabilise real activity as well.
Let me try to phrase this slightly differently. Consider equation 8 in your expectations and neutrality paper, it has E[pi(t+1)] on the left side and a weighted difference of i(t) and pi(t) on the right side.
Let’s consider 2 types of equilibrium. Having lived in the UK until very recently I will call the first type of equilibrium the TRUSS equilibrium for Taylor Rule UnStable System equilibrium. The second type of equilibrium I will call the CBC equilibrium for Common Beliefs Correct equilibrium.
TRUSS equilibria are defined by the fact that a raise (fall) in i(t) is partially or fully reflected in a rise (fall) in E[pi(t=1)] in equation 8. The CBC equilibrium is defined by there being absolutely no reaction at all of E[pi(t+1)] to a change in i(t) in equation 8.
If the economy is in a TRUSS type equilibrium then yes a Taylor rule destabilizes inflation and only fiscal policy can determine the price level, it’s basically the situation you describe.
However, what about a CBC equilibrium and is there any such thing? Well, suppose that somehow some way changes in i(t) had no effect whatsoever on E[pi(t+1)], in that case the Taylor rule in the King formulation means the Fed can and does completely stabilise inflation at it’s target (note if the Fed follows the King formulation rule it never just “raises rates to lower inflation”, it only EVER raises rates if inflation when above target and only by the amount required to put it back on target). But then, if the Fed can and does keep inflation always at target then E[pi(t=1)] is always equal to the target and so does not react at all to changes in i(t) and we conclude that this is a valid equilibrium. The existence of a CBC equilibrium is nothing more than proposition 2.3 in Woodford. (Note that E[pi(t+1)] doesn’t need to be constant, it just needs to be constant as a function of i(t). It can vary as much as you like for any other reason, like changes to discount rates)
Now, suppose the fiscal authority adopts a rule to eliminate all TRUSS type equilibria, basically the fiscal Taylor rule you talk about it your book. What that actually does is put us in the CBC equilibrium and once in that equilibrium all of the Fiscal authorities promises about tightening fiscal in response to inflation and/or interest rates become off equilibrium promises, not observed in equilibrium but enforcing the desired equilibrium. Furthermore, by definition, in the CBC equilibrium Taylor rules are stabilising and operate entirely according to the conventional story.
One last addition, in the final paragraph of the rephrased comment it’s important to remember that the fiscal authority doesn’t need anything remotely as strong as the “fiscal Taylor rule” to fully eliminate the TRUSS type equilibria. Appropriate upper and lower bounds on nominal debt issuance are all that’s required.
Why write over simplistic equations about macro variables that ignore, for example,there is not one inflation but multiple sector inflations linked by complicated channels?
Why assume government policy can manage the arguments of these equations?
I am not a theorist, professor, but I suggested to you a while back that you write down two versions of a simple New Keynesian model -- literally side by side -- where one has the standard equations (some of which you don't like) and the other one embeds FTPL. It's one way to do this, but the gist of it is to write for people who do empirical work. If the front door is locked, take the side door.
My reasoning here is simple: that would drastically lower the cost for anyone interested in applying that stuff and bring some of your objections in focus. This would be especially useful in applied work.
Equilibrium equations at a minimum impose coherence in terms of long-run relations: if the right hand side of an equation is I(1), the left hand side cannot be I(0). If the equations change slightly, the restrictions changes and that can be exploited. Roger Farmer had a paper in which he bothered explicitly deriving the VECM implied by a linearized version of his model. Standard New Keynesian theory can be construed as a "disequilibrium theory" of business cycles with respect to a flexible price reference equilibrium and the reference point (that long-run RBC skeleton) contains the long-term information. If you add in a cross-sectional dimension (states in the US, provinces in Canada, countries in the EU), you can really leverage those small distinctions. The likelihood is much less flat once you add in that dimension, but this kind of exercise in showing how equations should be changed can be helpful in other ways: it can speak to nonfundamentalness issues in structural VARs.
I remember you mentionning that standard New Keynesian models, fiscal policy has to accomodate monetary policy for the old Keynesian intuition to pan out in New Keynesian models (e.g., fiscal policy needs to be contractionary when the central bank raises nominal rates for them to have the expected effects). Should we put data on fiscal surpluses in structural VARs when studying monetary policy? Going back to the previous comment about long-run restrictions, what in your kind of theory controls the long-run inflation rate and can permanently make it higher or lower? Martin Uribe (2022) famously argued that the price puzzle seen in many SVARs may be the result of confusing changes in short term nominal rates that are transitory versus changes that are permanent. /1
Maybe there's a way to exploit your work to recover a similar result, albeit with a different interpretation.
What I am suggesting you do, in other words, is to change your target audience. If the theorists will not listen to you and will not re-write their models along lines you believe to be more productive, then maybe you should write a little more for people doing applied work. What kind of variation does your theory says I can exploit to answer what question? Is there a way to leverage shifting parameter values or permanent versus transitory shocks? Is there a way to leverage cross-sectional information in a panel setting? Is there a way to look back at older SVARs from the 90s and the 00s and to re-interpret results in a productive way? Can I leverage timing in different data frequency to do something interesting? We have all sorts of really cool new tools out there that allows us to conduct analysis with really subtle variation in restrictions.
Just write a letter to Santa Claus with your wishlist of empirical tests and investigations. Someone who has the time and tools required to do it will do just that. 2/2
Yes, absolutely. The "passive" fiscal policy is part of the predictions of the NK model. Raise rates, select equilibrium, lower inflation, Congress passes big taxes to pay interest costs on the debt and a windfall to bondholders. Check that last prediction!
Call me old fashioned, butI think we need fewer fancy models and more solid knowledge. As Friedrich Hayek said, “I confess that I prefer true but imperfect knowledge to a pretense of exact knowledge that is likely to be false.”
Also, I disagree with your comments on bank reserves and inflation (if I understood them correctly.) I think bank lending (that is, money creation) has been artificially suppressed due to onerous bank regulation. That's why the private credit business has become so huge. I think that if Trump really liberalizes bank regulation, we will very likely see a ramp up in bank lending, money supply, and, ultimately, inflation.
I think that one of the problems with economics is that we try to apply rational rules to an irrational population. My friend has a bold proposal to help resolve Social Security.
My friend Bob lives on $200k from dividends from all of the stock he bought over his career. He is very comfortable with this income. On top of that he receives $36,000 a year in social security. He muses about the silliness of this situation. So I asked Bob “How much would you be willing to take as a lump sum in lieu of a lifetime of payments?”
There is the obvious mathematical answer which is the net present value of the future payments.
But my friend Bob (who is irrational) says he would like enough for the “best damn vacation ever.” Bob thinks the system is on the verge of collapse and that SSI was intended to be a safety net.
BTW Bob also said, “This proposal should only be available for rich people who can prove that they don’t need the SSI income safety net.”
This article really made me question why we’re still using outdated models like active money and passive fiscal when better alternatives exist. Also the fiscal theory of the price level (FTPL) sounds like a step in the right direction but why do you think it hasn’t gained more traction in mainstream discussions?
It is slightly ironic that you have the answer to your own complaint. And you still seem to support the view in academia that ends up generating the situation that you complain about.
You never argue that Academia should be about what is true against what is not. Instead, you keep asking the same thing that everyone in control of academia ask the others: "Write something that *I* find "interesting"!".
I think that to make advances, you first need to recognize that academia is not about science. Academia, due to the publication process, is a "democratic" field (in the worst possible way): Decisions of what is the "truth" are made by majorities (with the votes of past winners carrying more weight). Science and actual truth have nothing to do with academia.
As the pragmatic junior academic told you: You write what you are told, not what is right.
Anyway, if you want to win your battle, there is a clear path: Start a political campaign, just like any other politician. You need rallies, and etc. Talk one on one, shake hands, show that you are "part of the people", try not to have too many (other) principles, be as ambiguous as possible.
Of course, nothing guarantees that you will improve society if you win, given that you are just advancing your own priors. But you should see the papers that contain the stories that you like published.
Now if you want to improve the world (and maybe even succeed in pushing your solutions if they are really correct), you can fight to change the publication process instead. But given that this is public good with very limited private benefit, I would not hold my breath waiting for anyone to do it.
Finally, I think that you are right in the discussion in this post. I am just realistic about academia in general...
There is another way of capturing policymaking within the New-Keynesian model. The simplest one without debt of any form (bonds, money, etc.). Instead of modelling monetary policy as a Taylor rule, model it as a ‘targeting rule’ in the sense of Svensson (2003, JEL). Here it will be (with specific parameters suppressed w.l.o.g.):
-x=pi
where x is the output gap (realistically, it should be specified in expectations). This depicts the way the CB will balance its goal variables output gap and inflation (here the simplicity makes it looks like they have equal weight - they need not be). If both goals cannot be attained, some negative output gap is allowed whenever inflation is high. This targeting rule will together with an inflation equation uniquely determine inflation and the output gap. There are no need for specifying explosive policy as under a Taylor rule specification.
But what will the actual interest rate be? For the equilibrium inflation and output gap, one can find the interest rate from the remainder of the model, say a dynamic IS curve. If one desires, one can express this unique interest rate in infinitely many ways. Some can be looking like Taylor rules, some will be exogenous functions of shocks with no ‘response’ to anything; there is free reign, and nobody will probably care. The CB announces its interest rate and explains how it has weighed output gap and inflation, given economic conditions, in its deliberations to reach a decision.
This is another simple way that resembles a lot what inflation targeting CBs, including the FED, do when they explaining policy and probably do policy. Who actually publishes Taylor rules as a reason for their decisions? (Pressed by its academic and public prevalence, some will as an aside, however, compute historical and expected future policies as a Taylor rule and spend a lot of time commenting on them.)
I agree completely that the research in the last decades have been ‘tainted’ by the modelling of monetary policy as a Taylor rule. But there are sometimes no need to go to fiscal policy to get unique equilibria that doesn’t require the CB to commit to ‘blow of the world if ... ’ .
I wish I understood this essay, but I don't. I recall Russ Roberts saying "How do you know when economists are overestimating their knowledge? ... They use decimal points." Not a criticism of you, but of the sacred cows in your field.
I'm eternally perplexed about why economists need to learn calculus; and just imagine the very specific pedigree you need to be a Fed official. And yet, the only function Fed officers appear to serve is tinkering with interest rates and printing money in the service of politicians. And when their tinkering leads to recession, the excuse is always that nobody could have predicted that the money printing would cause inflation, or that unexpected rate hikes might cause a few bank failures. When their chicanery fails to induce a recession, then they claim success. It has a very Wizard of Oz feel to it.
All the best economists, including yourself, are good story tellers. Is the math really necessary? Because it doesn't seem to be able to predict economic trends any better than Robert Shiller's animal spirits.
Economics is not engineering, which advances civilization with the discovery of physical laws and equations for fluid mechanics and electromagnetic interference and whatnot. It's more of a philosophical discipline, and those who became famous by foreseeing perverse consequences better than their peers were more behaviorists and historians than mathematicians.
The fact that Maynard Keynes is still considered a popular legend, rather than a charlatan who cynically showed politicians how to pull the wool over on their constituents, makes me suspect that the math isn't mathing.
Mathematics makes economics rigorous and transparent. Equations in these economic models are really just rational arguments with clear definitions. It’s really difficult to convey exactly what you mean without mathematics. That’s why to this day there are people discussing Marx and Keynes, as they did not write their stuff down in equations. However the ISLM model (which is based on Keynes, but not created by him) has a clear formulation and thus its predictions can be falsified and discussed scientifically. The economy is extremely complex, and without these mathematical models its much more difficult to describe exactly what you mean or what the premises of your arguments are. Once you start thinking deeply about economics, and have knowledge of mathematics, you would find that is an unavoidable tool. Of course its virtous to be a good storyteller, but that’s not real economics. Just like Neil de Grasse Tyson can make really god stories about physics, that is not physics. You say Keynes is a charlatan, but arguably he was one of the best storytellers among economists.
Also note, that for example understanding the mathematics behind these macro models John is describing here takes way more than understanding calculus. Furthermore, the reason economists learn mathematics is not just modelling, but to be able to do statistics, which is a centre piece of modern economics that is ever more empirical. Its good that economists are learning maths. The scientific method does not give preference to “easy” stuff. Knowledge gathering is not easy. There is a reason why Plato did not let enyone into his philosophy school who was ignorant of geometry.
Agree about understanding statistics, which is often counterintuitive. I call Keynes a cynic or charlatan because he described the way money printing pickpockets the electorate, but then advocated policies to facilitate that.
The problem with economics is actually not enough math. Beautiful prose alone can lead to serious internal inconsistencies. Read, for example, the Fed's musings on how monetary policy works. It cites all sorts of effects and "channels," none of which we have the ability to write down and work out. We need more and better little artificial economies in order to understand the real one. Alas, unlike physics or aerodynamics, our models will always remain quantitative parables, so they have to remain transparent as well. Nobody believes big black box computations, because we all know they are sensitive to small misspecification of little parts. More math and more transparency at the same time is a big challenge.
Some three decades ago, I was asked to review a paper at a finance association meeting for one of the financial economics journals. The paper intended to address Keynes' theory of normal backwardation in forward markets. The mathematics chosen found a general equilibrium wherein all the forward markets cleared and all transactions ultimately took place in the spot markets. In equilibrium, no one held forward positions. In my review, I asked a simple, direct question: How could one address a theory in which speculators held long term forward positions with a model in which no one held forward positions? The answer was gobblety gook along the lines expressed here. The incentives to publish and succeed in the academic environment are powerful. They are not necessarily aligned with increasing the understanding of real world economic problems. Leontieff addressed this very problem in his Presidential address to the American Economic Association in roughly 1970. Maybe things haven't changed much.
Bravo, Chuck! Your observations are spot on. Economics is profoundly philosophical, which is just as it must be, just like physics. Math is the language of science, precisely because math reveals illogic and reveals contradictions and nonsense, if we understand the math. But if we cannot translate the math into plain words, then we do not understand the math. John Cochrane understands the math and is a master of translating the math to comprehensible words, as he has just done in this eloquent, brilliant essay.
As I tell my students, ignore the math if it does not speak to you. Listen to my words. If they do not make sense to you, ask me to explain another way. If my words do not make sense to you, I'm probably not making sense.
.
John Cochrane, you are a voice in the wilderness. Know that there are many out here who are listening, hearing, and understanding what you are saying. Everything I was taught in graduate school about money and macroeconomics, which I finished in 1979, has turned out to be drivel. We were steeped in IS-LM and MV=PY. The sad part is that either my professors did not understand the math and its implications, or they were ignorant of what economists already knew by then; sad, either way.
I teach money and banking and finance on the backside of a 45-year career. You are making my job extremely challenging in my old age because I refuse to teach my students that which I am persuaded is not true. To teach students what I am persuaded is the closest approach to the truth, I am forced to abandon the textbooks, because they are filled with drivel. Fortunately, I can draw on your work and its clear explanations to show the way.
How can we be sure that what any Economist is doing today is not drivel. After all, no economist in 2021 forecast inflation, no economist forecast the financial crisis, and no economist even today can explain why the crisis happened in the first place.
But I do: https://charles72f.substack.com/p/basel-faulty-the-financial-crisis
I see that your 'stack post linked above is 2023. How is that a prediction? In any case, no economist and no person can predict the future. If they could, including you, they could become fabulously wealthy quite quickly. Physicists have the easy job of predicting cause and effect relationships, because atoms and molecules are well behaved at the macro level. Things don't get too weird until we go to the quantum level of reality.
I can be sure when economists are not talking drivel because I am one, and because I can think pretty well, though not as well as I'd like. Economics is not capable of predicting the future because humans have free will and because some humans evidently have bad will on top of it all. John is not the only economist not talking and writing drivel, but he is definitely one of the best.
Another couple are Tyler Cowan and Alex Tabarrok. I encourage you to listen to their podcast about the New Monetary Economics, recently posted on Marginal Revolution podcast, which you can find easily.
It appears that you may be an Austrian economist, like I am. I agree with you that piss poor regulation (which includes almost ALL regulation) and extra piss poor policy coming from government operatives did indeed cause the 2008 great recession, along with the housing finance debacle.
Doesn't our profession become a joke when it turns from a search for truth into a game of publishing?
Doesn't our profession become a joke when it turns from a search for truth into a game of publishing?
My impression about economics is that for all of the effort economists have made over, what, several centuries, about the only real predictability comes from people such as Thomas Sowell. The 800 Ph.D. Economists at the Fed have done little else but damage since the Fed was created. Why do we continue to put good money after bad in this field?
Surely, economics is THE subject crying out for insight that AGI might offer. While sciences (physics, chemistry, molecular biology) and engineering fields devote a large part of their resources to developing new measurement tools and methods to interrogate the complex, adaptive systems they study, to a person such as myself who is nothing more that a victim of what economists do, it seems to me that economists have few such tools after several hundred years. So what exactly does one do with 800 Ph.D's besides do damage?
The reason more academics haven’t fallen in line with the equilibrium selection interpretation of the Taylor rule is because it’s not correct. In JC’s expectations and neutrality paper he asks the question: when the nominal interest rate is increased do we get lower prices today (lower p(t)) or higher prices tomorrow (higher p(t+1)). The answer to that is itself an equilibrium outcome.
The logic of the NK equilibrium selection is in 2 steps. First the Taylor rule eliminates all equilibria except the unique bounded one and all the unbounded ones (which can come in several varieties). Step 2 is that fiscal policy eliminates the unbounded ones. Once in the resulting equilibrium, which is unique and determined jointly by both fiscal and monetary policy, the answer the question above becomes that it’s entirely lower p(t) that is the equilibrium response to a higher nominal interest rate today.
Further more, the fiscal policy required to rule out the unbounded equilibria isn’t as strict as JC sometimes implies. As Woodford showed in his book the hyper deflationary equlibria can be ruled out by any strictly positive lower bound on the growth rate of nominal government debt. Similarly, though not quite stated by Woodford, the hyper inflationary equlibria are ruled out by any finite upper bound on the growth rate of nominal government debt.
Once that’s done then the Fed acquires the ability to keep the price level at it’s chosen target with a Taylor rule and the Fed never has to threaten to blow anything up to enforce that.
This is a fascinating comment. Once you say that "fiscal policy eliminates the unbounded ones," it seems you've jumped completely to fiscal theory of the price level. But it seems you still acknowledge that in the model, inflation would be stable under a peg, and the Taylor rule means the Fed deliberately makes inflation unstable. That's really the core of the problem. The Fed doesn't do that.
Well, I agree that I am not contradicting the FTPL and for good reason, I consider it completely correct. However, that doesn’t mean I consider your interpretation of the mechanics of the canonical NK model to be correct.
Woodford’s explanation is very muddled but he stresses several times that he’s assuming fiscal policy is locally Ricardian but globally non-Ricardian. It’s not the fed making “threats” about what it would do in off equilibrium outcomes it’s the fiscal authority, and as such they aren’t “threats” but simply promises of the form “we won’t let nominal issuance grow too fast or too slow” which sounds reasonable and realistic. It’s those fiscal promises that are enforcing the desired equilibrium and in that equilibrium (though perhaps not in others) a Taylor rule doesn’t make inflation unstable, which is the substance of my comment.
A couple further points. You frequently note, quite obviously correctly, that the fiscal authority never really acts Ricardian even locally. Fine, globally non Ricardian works just as well in my preceding paragraph (and original comment) and yes that means the FTPL determines P. However, this isn’t inconsistent with NK mechanisms, the only role the locally Ricardian assumption plays is that for whatever reason Woodford wants to say that P* can be anything and that requires locally Ricardian fiscal policy. On this I am with you, no P* can’t be anything the fed chooses. (Instead of thought experiments about off equilibrium deflation consider one where the Fed randomly decides they’d like the price level 20% lower, can they do it?)
Lastly, yes inflation is “stable” under a pure interest rate peg but here you mean stable in the engineering dynamical system sense of having a long run limit (eigenvalues inside the unit circle type stuff). The price level under a gold standard is also “stable” in that sense but we don’t have a gold standard anymore because it allowed too much undesirable short term price level volatility. Presumably that’s the same issue with an interest rate peg, the price level is determinate but could be overly volatile (due to the same discount rate variation that makes equity prices look overly volatile relative to the path of dividends) and a Taylor rule type policy can smooth that out and as such stabilise real activity as well.
Let me try to phrase this slightly differently. Consider equation 8 in your expectations and neutrality paper, it has E[pi(t+1)] on the left side and a weighted difference of i(t) and pi(t) on the right side.
Let’s consider 2 types of equilibrium. Having lived in the UK until very recently I will call the first type of equilibrium the TRUSS equilibrium for Taylor Rule UnStable System equilibrium. The second type of equilibrium I will call the CBC equilibrium for Common Beliefs Correct equilibrium.
TRUSS equilibria are defined by the fact that a raise (fall) in i(t) is partially or fully reflected in a rise (fall) in E[pi(t=1)] in equation 8. The CBC equilibrium is defined by there being absolutely no reaction at all of E[pi(t+1)] to a change in i(t) in equation 8.
If the economy is in a TRUSS type equilibrium then yes a Taylor rule destabilizes inflation and only fiscal policy can determine the price level, it’s basically the situation you describe.
However, what about a CBC equilibrium and is there any such thing? Well, suppose that somehow some way changes in i(t) had no effect whatsoever on E[pi(t+1)], in that case the Taylor rule in the King formulation means the Fed can and does completely stabilise inflation at it’s target (note if the Fed follows the King formulation rule it never just “raises rates to lower inflation”, it only EVER raises rates if inflation when above target and only by the amount required to put it back on target). But then, if the Fed can and does keep inflation always at target then E[pi(t=1)] is always equal to the target and so does not react at all to changes in i(t) and we conclude that this is a valid equilibrium. The existence of a CBC equilibrium is nothing more than proposition 2.3 in Woodford. (Note that E[pi(t+1)] doesn’t need to be constant, it just needs to be constant as a function of i(t). It can vary as much as you like for any other reason, like changes to discount rates)
Now, suppose the fiscal authority adopts a rule to eliminate all TRUSS type equilibria, basically the fiscal Taylor rule you talk about it your book. What that actually does is put us in the CBC equilibrium and once in that equilibrium all of the Fiscal authorities promises about tightening fiscal in response to inflation and/or interest rates become off equilibrium promises, not observed in equilibrium but enforcing the desired equilibrium. Furthermore, by definition, in the CBC equilibrium Taylor rules are stabilising and operate entirely according to the conventional story.
One last addition, in the final paragraph of the rephrased comment it’s important to remember that the fiscal authority doesn’t need anything remotely as strong as the “fiscal Taylor rule” to fully eliminate the TRUSS type equilibria. Appropriate upper and lower bounds on nominal debt issuance are all that’s required.
Good grief, John this kind of “grumpy economist” newsletter is enough to make me GRUMPY. Do some “average Joe” kind of writing, I know you can.
Why write over simplistic equations about macro variables that ignore, for example,there is not one inflation but multiple sector inflations linked by complicated channels?
Why assume government policy can manage the arguments of these equations?
Figure out the simple equations before you try more complicated equations. Always good advice.
I am not a theorist, professor, but I suggested to you a while back that you write down two versions of a simple New Keynesian model -- literally side by side -- where one has the standard equations (some of which you don't like) and the other one embeds FTPL. It's one way to do this, but the gist of it is to write for people who do empirical work. If the front door is locked, take the side door.
My reasoning here is simple: that would drastically lower the cost for anyone interested in applying that stuff and bring some of your objections in focus. This would be especially useful in applied work.
Equilibrium equations at a minimum impose coherence in terms of long-run relations: if the right hand side of an equation is I(1), the left hand side cannot be I(0). If the equations change slightly, the restrictions changes and that can be exploited. Roger Farmer had a paper in which he bothered explicitly deriving the VECM implied by a linearized version of his model. Standard New Keynesian theory can be construed as a "disequilibrium theory" of business cycles with respect to a flexible price reference equilibrium and the reference point (that long-run RBC skeleton) contains the long-term information. If you add in a cross-sectional dimension (states in the US, provinces in Canada, countries in the EU), you can really leverage those small distinctions. The likelihood is much less flat once you add in that dimension, but this kind of exercise in showing how equations should be changed can be helpful in other ways: it can speak to nonfundamentalness issues in structural VARs.
I remember you mentionning that standard New Keynesian models, fiscal policy has to accomodate monetary policy for the old Keynesian intuition to pan out in New Keynesian models (e.g., fiscal policy needs to be contractionary when the central bank raises nominal rates for them to have the expected effects). Should we put data on fiscal surpluses in structural VARs when studying monetary policy? Going back to the previous comment about long-run restrictions, what in your kind of theory controls the long-run inflation rate and can permanently make it higher or lower? Martin Uribe (2022) famously argued that the price puzzle seen in many SVARs may be the result of confusing changes in short term nominal rates that are transitory versus changes that are permanent. /1
Maybe there's a way to exploit your work to recover a similar result, albeit with a different interpretation.
What I am suggesting you do, in other words, is to change your target audience. If the theorists will not listen to you and will not re-write their models along lines you believe to be more productive, then maybe you should write a little more for people doing applied work. What kind of variation does your theory says I can exploit to answer what question? Is there a way to leverage shifting parameter values or permanent versus transitory shocks? Is there a way to leverage cross-sectional information in a panel setting? Is there a way to look back at older SVARs from the 90s and the 00s and to re-interpret results in a productive way? Can I leverage timing in different data frequency to do something interesting? We have all sorts of really cool new tools out there that allows us to conduct analysis with really subtle variation in restrictions.
Just write a letter to Santa Claus with your wishlist of empirical tests and investigations. Someone who has the time and tools required to do it will do just that. 2/2
Yes, absolutely. The "passive" fiscal policy is part of the predictions of the NK model. Raise rates, select equilibrium, lower inflation, Congress passes big taxes to pay interest costs on the debt and a windfall to bondholders. Check that last prediction!
Passive fiscal policy is NOT a prediction of NK model, it’s an assumption.
Call me old fashioned, butI think we need fewer fancy models and more solid knowledge. As Friedrich Hayek said, “I confess that I prefer true but imperfect knowledge to a pretense of exact knowledge that is likely to be false.”
Also, I disagree with your comments on bank reserves and inflation (if I understood them correctly.) I think bank lending (that is, money creation) has been artificially suppressed due to onerous bank regulation. That's why the private credit business has become so huge. I think that if Trump really liberalizes bank regulation, we will very likely see a ramp up in bank lending, money supply, and, ultimately, inflation.
I think that one of the problems with economics is that we try to apply rational rules to an irrational population. My friend has a bold proposal to help resolve Social Security.
My friend Bob lives on $200k from dividends from all of the stock he bought over his career. He is very comfortable with this income. On top of that he receives $36,000 a year in social security. He muses about the silliness of this situation. So I asked Bob “How much would you be willing to take as a lump sum in lieu of a lifetime of payments?”
There is the obvious mathematical answer which is the net present value of the future payments.
But my friend Bob (who is irrational) says he would like enough for the “best damn vacation ever.” Bob thinks the system is on the verge of collapse and that SSI was intended to be a safety net.
BTW Bob also said, “This proposal should only be available for rich people who can prove that they don’t need the SSI income safety net.”
This article really made me question why we’re still using outdated models like active money and passive fiscal when better alternatives exist. Also the fiscal theory of the price level (FTPL) sounds like a step in the right direction but why do you think it hasn’t gained more traction in mainstream discussions?
It is slightly ironic that you have the answer to your own complaint. And you still seem to support the view in academia that ends up generating the situation that you complain about.
You never argue that Academia should be about what is true against what is not. Instead, you keep asking the same thing that everyone in control of academia ask the others: "Write something that *I* find "interesting"!".
I think that to make advances, you first need to recognize that academia is not about science. Academia, due to the publication process, is a "democratic" field (in the worst possible way): Decisions of what is the "truth" are made by majorities (with the votes of past winners carrying more weight). Science and actual truth have nothing to do with academia.
As the pragmatic junior academic told you: You write what you are told, not what is right.
Anyway, if you want to win your battle, there is a clear path: Start a political campaign, just like any other politician. You need rallies, and etc. Talk one on one, shake hands, show that you are "part of the people", try not to have too many (other) principles, be as ambiguous as possible.
Of course, nothing guarantees that you will improve society if you win, given that you are just advancing your own priors. But you should see the papers that contain the stories that you like published.
Now if you want to improve the world (and maybe even succeed in pushing your solutions if they are really correct), you can fight to change the publication process instead. But given that this is public good with very limited private benefit, I would not hold my breath waiting for anyone to do it.
Finally, I think that you are right in the discussion in this post. I am just realistic about academia in general...
There is another way of capturing policymaking within the New-Keynesian model. The simplest one without debt of any form (bonds, money, etc.). Instead of modelling monetary policy as a Taylor rule, model it as a ‘targeting rule’ in the sense of Svensson (2003, JEL). Here it will be (with specific parameters suppressed w.l.o.g.):
-x=pi
where x is the output gap (realistically, it should be specified in expectations). This depicts the way the CB will balance its goal variables output gap and inflation (here the simplicity makes it looks like they have equal weight - they need not be). If both goals cannot be attained, some negative output gap is allowed whenever inflation is high. This targeting rule will together with an inflation equation uniquely determine inflation and the output gap. There are no need for specifying explosive policy as under a Taylor rule specification.
But what will the actual interest rate be? For the equilibrium inflation and output gap, one can find the interest rate from the remainder of the model, say a dynamic IS curve. If one desires, one can express this unique interest rate in infinitely many ways. Some can be looking like Taylor rules, some will be exogenous functions of shocks with no ‘response’ to anything; there is free reign, and nobody will probably care. The CB announces its interest rate and explains how it has weighed output gap and inflation, given economic conditions, in its deliberations to reach a decision.
This is another simple way that resembles a lot what inflation targeting CBs, including the FED, do when they explaining policy and probably do policy. Who actually publishes Taylor rules as a reason for their decisions? (Pressed by its academic and public prevalence, some will as an aside, however, compute historical and expected future policies as a Taylor rule and spend a lot of time commenting on them.)
I agree completely that the research in the last decades have been ‘tainted’ by the modelling of monetary policy as a Taylor rule. But there are sometimes no need to go to fiscal policy to get unique equilibria that doesn’t require the CB to commit to ‘blow of the world if ... ’ .