What's my core message?
By Scott Sumner
I am currently working on the final chapter of a book manuscript, tentatively entitled “The Money Illusion: Market Monetarism and the Great Recession.” I am trying to identify my core message. What is the essence of my critique of mainstream macroeconomics? And why should anyone believe me? I’ll offer a few thoughts, but I’d be very interested in your outside perspective. BTW, one thing is very clear to me—-NGDP targeting is not at all a part of my core message, it’s totally compatible with mainstream macro.
It seems to me that market monetarism has two components, the market part and the monetarism part. In my view, monetarism is the school of thought that says shifts in the supply and demand for money drive the most important macro phenomena, including key nominal variables like inflation and NGDP growth, as well as business cycle movements in RGDP and unemployment.
More importantly, monetarism argues that other schools of thought reify various contingent epiphenomena, confusing side effects with core mechanisms. Thus non-monetarists are inclined to look at phenomena like inflation through the lens of changes in interest rates, bank credit, and/or the Phillips Curve.
To a monetarist, those epiphenomena are the side effects of changes in the supply and demand for money, in an economy with sticky wages and prices. But they are not the core mechanism. Increases in the money supply and/or decreases in money demand are inflationary even if they don’t move interest rates at all, and even if they don’t result in product or labor market tightness. In two recent posts, I explain this idea with a parable of an island economy lacking a financial system, where prices are flexible and the economy is always at full employment.
So that’s the core of the “monetarism” part of market monetarism. But what about the “market” part of the theory? I believe that the flaw in modern macro is that the efficient markets hypothesis is not deeply embedded into all of our models. Thus when there is a policy initiative such as QE, mainstream economists take a “wait and see” attitude. They say that after observing a year or two of macro data, we will have a better idea as to the policy’s effectiveness. A market monetarist says that within 5 minutes we’ll know everything that we will ever know about the effectiveness of the policy move. Inflation, RGDP and NGDP futures will immediately adjust to reflect the optimal forecast of the effect of the policy initiative. If those markets don’t exist, then other proxies such as TIPS spreads, exchange rates, commodity prices and stock prices will tell us all that we can know about the effectiveness of the policy. The future performance of the economy will be affected by that policy, but also a myriad of other factors. Waiting and observing the future course of events won’t tell us anything that we don’t already know.
Market monetarists see market driven regimes for “targeting the forecast” as a sort of “end of (macroeconomic) history”. They are the final stage in the long process of discovering an optimal policy rule. How can any policy ever be better than “the policy stance expected to reach the policy goal?” And how can any macro model’s forecast ever reliably beat the market forecast? Not occasionally, but reliably.
And of course we argue that market forecasts of the goal variable are the most useful measure of the stance of monetary policy. Other economists look at a wide variety of epiphenomena, especially interest rates. But the response of interest rates is dependent on any number of contingent factors, and can’t possible serve as a reliable indicator of easy and tight money. In the end, the only useful definition of easy and tight money is relative to the policy stance expected to achieve the policy goal—is money too easy or too tight? And again, it’s market expectations that will ultimately provide the optimal forecast.
Armed with this market monetarist perspective, we re-interpret macroeconomic history, trying to zero in on the core mechanism, and not be distracted by the various side effects of monetary shocks. What are some of those distracting side effects?
1. Changes in interest rates (due to sticky prices)
3. Shocks to the financial system (due to sticky nominal debt.)
4. Shocks to the labor market (due to sticky nominal hourly wages.)
These side effects are important, but the core message of MM is that these side effects are just that, side effects. They do not drive the process. That’s why one can find examples of inflation that cannot be explained by conventional models. A good example is 1933-34, when (wholesale) prices rose by 20% after a monetary shock that produced almost no change in either interest rates or the money supply. Instead, a sharp devaluation in the dollar dramatically reduced money demand (by increasing the future expected money supply), creating rapid inflation despite 25% unemployment, and despite much of the banking system being shutdown.
So why should anyone believe MMs like me? After all, from a perspective of 64,000 feet up I’m an almost complete nobody, who spent his career teaching at an average business school. What distinguishes me from 100 other monetary ranks, all making grand claims to have reinvented macro, attached to policy nostrums that can supposedly cure all our ills?
When I was a teenager I was impressed by bold, heterodox thinkers. “Yeah, how could those pyramids have been built without the assistance of aliens from outer space.” As an adult, I’ve come to appreciate the efficiency of intellectual markets. It’s very unlikely that any heterodox thinker that I read about will actually have offered an alternative theory that will survive the test of time. Objectively speaking, I’m far more likely to be just another monetary crank, not the savior of macroeconomics.
I’m not sure I have a good answer to this dilemma. I suppose I could point out that there was a period when quite a bit of praise was lavished on my blogging (here, here, here and here), by reporters and other bloggers. They seemed to think that the way things were playing out somehow validated the arguments I had been making. But that success occurred at a pretty modest level; I certainly didn’t convince the overall profession. In the end, all I can do is view myself as one tiny component of the “wisdom of crowds”. Yes, markets are efficient, but only because each trader is willing to take a fresh independent look at the situation, and do their best to make accurate forecasts. And yes, the market for ideas does tend toward efficiency in the long run, but only because intellectuals are willing to continually probe weaknesses in existing theory, and seek better ones.
Robin Hanson and Scott Alexander recently reviewed a new book by Eliezer Yudkowsky, which wrestles with exactly this question. I haven’t read the book yet, but was intrigued by Scott’s summary of one of Eliezer’s examples:
Eliezer spent a few years criticizing the Bank of Japan’s macroeconomic policies, which he thought were stupid and costing Japan trillions of dollars in lost economic growth. Everyone told Eliezer he couldn’t be right, because he was an amateur disagreeing with professionals. But after a few years, the Bank of Japan switched to Eliezer’s preferred policies, the Japanese economy instantly improved, and now the consensus position is that the original policies were deeply flawed in exactly the way Eliezer thought they were. Doesn’t that mean Japan left a trillion-dollar bill on the ground by refusing to implement policies that even an amateur could see were correct?
Of course other people that I view as monetary cranks, such as the MMTers, also see events confirming their worldviews. But I believe the following Alexander observation offers a bit of evidence beyond “he said, she said”:
Why was Eliezer able to out-predict the Bank of Japan? Because the Bank’s policies were set by a couple of Japanese central bankers who had no particular incentive to get things right, and no particular incentive to listen to smarter people correcting them. Eliezer wasn’t alone in his prediction – he says that Japanese stocks were priced in ways that suggested most investors realized the Bank’s policies were bad. Most of the smart people with skin in the game had come to the same realization Eliezer had.
If I have the serene confidence of a monetary crank, or a religious nut, it is founded on one bedrock principle—it’s really hard to get rich. And it’s hard to get rich because markets are pretty efficient. If markets reacted the wrong way to economic news, then it would be easy to profit on that market flaw. But it isn’t.
At its core, market monetarism is about the view that the best estimate of the way that the world works is roughly the way that the markets believe it works. The specifics will always be a work in progress. Market participants will continually discover new perspectives on the economy, and incorporate those perspectives into their mental model of the economy. I hope that future market monetarists disprove some of my claims, and come up with better versions of the theory. Maybe they’ll discover that markets believe that fiscal stimulus is effective.
However the basic MM framework for thinking about the economy is likely to survive:
1. Shocks to the supply and demand for money drive the nominal aggregates.
2. Unexpected movements in the nominal aggregates drive fluctuations in real output and employment. They also contribute to financial instability.
3. The market forecast of key macro variables provides the optimal way of understanding what’s going on with the economy, predicting its future course, evaluating the stance of monetary policy, and indeed setting the policy instruments.
To be persuasive, a monetary crank needs to explain not just why they are right, but why the mainstream is wrong. I have tried to do this in dozens of posts, all under the theme of “cognitive illusions”. The mainstream has incorrect views of the operation of the macroeconomy, because MM is counterintuitive and the mainstream view is intuitive. It seems like Fed changes in interest rates are the “real thing” and not just an epiphenomenon. It seems like the theory of “supply and demand” predicts that an overheating economy would cause inflation, even though it does nothing of the sort. (Excess demand occurs when prices are held too low; it is not a theory of why prices change.)
There’s no objective reason to rely on the pronouncement of an intellectual mediocrity like me. I was just lucky, with a set of research interests the dovetailed almost perfectly with what was needed to make sense out of the 2008 crisis. But Eliezer Yudkowsky is another story. He is a formidable intellect who took a fresh look at all the arguments, and ended up in the market monetarist camp. If he and I ever diverge on some core epistemological point, by all means believe him, not me.
PS. If you follow the 4 links above, you’ll find that all my good press occurred on September 13 and 14, 2012. That was right after the Fed announced monetary stimulus measures to offset the impact of the fiscal austerity expected in 2013. More than 350 Keynesians predicted the fiscal austerity would significantly slow growth. We said it would not. And bloggers like Paul Krugman and Mike Konczal said this policy experiment would be a test of market monetarism.
We won. Surely that counts for something?
Has it really been 5 years? As Springsteen would say, all I’m left with is boring stories of glory days. And the feeling that I got far too much credit, especially relative to other MMs.