A James Alexander post
I am not a wonk, and barely an expert. This is a bit wonkish, but still worth reading for the non-expert. Mark Sadowski inspired it!
Yates and the “long and variable lags” brigades who flourish inside our central banks and elite universities remind me of quack doctors in the world before the discovery of the circulation of blood. They prescribe remedies for which they have no agreed scientific basis, but don’t really get tested because if the the patient recovers they win, if the patient dies it was because the disease was proven uncurable. We only find out the effects of their hit and miss cures at the end of the treatment.
For anyone wanting a quick read on just what a mess modern, consensus, macroeconomics is in the Wikipedia entry on the standard paradigm. “New Keynesian” reads like a discussion between two competing schools of seventeenth century apothecaries. No-one has a clue, but they definitely know the other side is wrong.
Modern doctors prescribe cures to which they generally know the results. Start this course of drugs now and in a certain period of time you will be cured. Setting the course is everything. If doctors didn’t know ibuprofen stopped most headaches they wouldn’t prescribe it. The long and variable lag from the taking the pill to the headache going is completely irrelevant.
Curiously, the first paper Yates cited (Christiano, Eichenbaum and Evans) is actually in agreement with the supposedly “utopian” Market Monetarists. It’s hard to know why Yates brings it up, but thanks anyway. The paper contains a crucial quote:
“To actually implement a particular monetary policy rule, the growth rate of money must (if only implicitly) respond to current and past exogenous shocks in an appropriate way. This is true even when the systematic component of policy is thought of as a relationship between endogenous variables, like the interest rate, output and inflation.”
Put simply, monetary policy changes have to act quickly on money, on the money side of the economy itself (the MV bit of MV=PY). If it isn’t acting, or expected to act, it isn’t working.
Market Monetarists say you can tell if it is working instantaneously by looking to see if the size of the money economy is expected to grow. Scott Sumner’s great contribution is to suggest a “money economy” growth futures market, or NGDP futures market. It would be the equivalent of all the best medical brains putting their money where their mouth was, or reputations on the line. Doctors in medicine do this today, everyday, by earning money through proven, successful treatments. Setting courses, more or less knowing the results – not much waiting around to watch the long and variable lags. They act with confidence in the outcomes of the courses they set.
In the absence of futures markets we are forced have to use somewhat unsatisfactory substitutes like market forecasts of inflation (in the US TIPS spreads), or other forward-looking instruments like stock market indices and bond yields, or FX rates that incorporate the expectations of one currency’s inflation prospects vs another (amongst other things).
The market’s reaction is the policy. When the market reacts to unexpected data points or new news in FOMC speeches, decisions, leaks, minutes, etc, then that tells us how the policy is changing. Immediately. Instantaneously. With no lag. Unexpected silences from the Fed in the face of big market moves can also be telling, as now. It is harder to interpret than unexpected news, but it is still there.
Yates directed me to his own co-authored paper but it seems as weird as most modern macro in that it has no role for money. The equivalent of those quack doctors working without knowledge of the circulation of the blood. When writing about monetary policy with such authority as Yates and so many macroeconomists like him, the plain man would expect money to figure in their highly technical models of the economy, but it doesn’t. No wonder Yates and so many central banks like the Fed, the BoE, the ECB who use the same moneyless-model have proven so hopelessly wrong during the crisis. Their model is literally and metaphorically bankrupt due to the absence of the key measure of monetary policy, money or the money economy itself.