UK academic economists should (and need to) work with markets not ignore them

A James Alexander post

Tony Yates has directed me to take a course in monetary economics. It seems like it would last a year at least. I would then be better able to understand the deep and meaningful research that tackles the Market Monetarist questions posed by me in a comment on his blog:

“Most of them are discussed at length in the applied monetary econ literature. Many not resolved conclusively. If someone paid me to do this, I would take you through it all, but it would take a couple of terms to take you through it. But don’t fire them thinking that somehow these are great mysteries central bank economists aren’t already thinking about, and that aren’t already dealt with in frameworks they are given and how they are applied. They are.”

For what it’s worth, I did take the shorter, but still challenging course on Scott Sumner’s blog, as well as slogging through a BSc Econ more than a few years ago.

I think Yates’ course might be interesting but would it really help me with my questions.. The blogsphere is alive with debate on them and sometimes academic papers are referred to, but most seem unsatisfactory in one way or another.

Anyway, would they help answer this question: Would you ever create a model that included occasional, but deeply random tightening and loosening of monetary policy by central banks?

To this one he answered: “Yes, if you thought central banks faced measurement error in real time, or changes in committee membership that meant changes in the preferences of the median committee voter. Have a look. Large literature on just that.”

However, this misses the point somewhat. It is not just a “measurement error in real time” that markets are dealing with. They want to know: What is the Fed or the BoE trying to measure? What are they targeting? These are deeper questions than mere “measurement error”.

And why have central banks picked 2% as the inflation target? Where is the rigorous model on that? Where is the academic model for that 2% becoming a ceiling?

The market understands all this confusion, or as Yates’ sweetly put it “many [questions are] not resolved conclusively”. The markets actively try to sum it all up in prices, in real time. Yates et al’s beloved “long and variable lags” are merely the arithmetical part of the markets’ realtime NPV calculations.

So why not use that market consensus, on the state of the economy (aka “real time measurement error”) and the state of mind of the central banks (aka “changes in committee membership that meant changes in the preferences of the median committee voter”),  to steer monetary policy. That is, use targeting of market forecasts for NGDP Level Growth?

Why the fear of markets?

It’s a real puzzle. I suspect many academic economists, UK ones especially, under-rate the market because they are so far removed from it. Most have final salary pension schemes, or presumably like Yates, also Bank of England/civil service like gold-plated, index-linked, unfunded ones. They think they have no direct stake in the markets and end up being dismissive of the whole thing.

I would recommend they go and sit and ponder the £5bn deficit in the academics’ own pension scheme and worry about how to fund those far-off liabilities, the ones linked to future inflation and future interest rates and many, many other assumptions about the future. And find investments that can deliver against those assumptions in a low-risk, low volatile way, via real financial and other assets. It’s tough.

Great and serious minds worry about this question. UK academic economists seem oblivious, yet their financial future rests on their fund making the right investments. On forecasting how markets will turn out. It’s not just an academic exercise but a real one. Markets are for real people like you, too, not just speculators.

Of course, maybe they expect the government to nationalise the university scheme like it did with the UK Post Office, take the assets, reduce the public sector debt and just add yet more unfunded liabilities onto the state sector balance sheet. Or rather off the balance sheet. Nationalisation would reduce some risks as it would provide a state guarantee. But what will the guarantee be worth it in 30 years time given the restrictions already starting to be imposed? Not trying to worry you guys or anything.