Animal Spirits and the Two Natural Rates

In my last post I pointed out that it is not enough for monetary policy to guide the economy back to the natural rate of interest. Central banks and national treasuries must use financial policy to guide us back to the natural rate of unemployment.

Imagine two economies in parallel universes. I will call them economy A and economy B. Both economies are populated by identical copies of the same people. They have the same endowments of land labor and capital. And each economy has access to identical technologies for producing goods. In economic jargon: they have the same fundamentals.

But although these economies have identical fundamentals, the people in economy A are naturally optimistic. They believe that shares in their stock market are worth PA. And PA is a large number. The people in economy B are pessimists. They believe that their stock market is worth PB. And PB is a small number. Importantly, PB < PA.

A Tale of Two Natural Rates

Narayana Kocherlakota makes the case for more public debt. Paul Krugman and Steve Williamson agree. (I have to keep rereading that sentence before I believe it). What is this argument all about and how does it relate to the soul of Keynesian economics?

Let's start with a key premise in the Kocherlakota speech. There is a theoretical concept called the ‘neutral real interest rate’ and one of the jobs of a central bank is to get us back to that rate of interest as quickly as possible. The ‘neutral rate’ is what Wicksell called the ‘natural rate of interest’ and I'm going to stick with Wicksell’s terminology here.

Somebody at the PBC blinked

In a recent post I made this comment about China’s decision to intervene in its own stock market.

China is holding more than $1.2 trillion dollars of U.S. government debt. If the Bank were to tap those funds to stabilize the Chinese stock market it could not simultaneously maintain an exchange rate peg. If China goes that route, look out for upheaval in the foreign exchange markets.

Chinese policy makers are now learning that lesson. The Peoples Bank of China (PBC) has allowed the Renminbi to tumble by more than 3% in the last few days. The ride may not yet be over.

What’s happening and why? It's my guess that there are investors on the margin who are pulling money out of the Chinese market and moving it into the world capital markets. Those investors are betting against the valuation that the PBC is putting on domestic assets. The outflow of funds  puts downward pressure on the RMB and if the PBC were to maintain its previous parity they would be obliged to sell their holdings of dollar denominated assets to support the currency.

The PBC blinked! But that's a good thing. They’ve chosen a domestic target over an exchange rate target and to make that work, the world needs to keep buying Chinese goods.

I have advocated a policy of Treasury and Central Bank intervention to stabilize domestic asset markets. What we are seeing in the Chinese case is that this policy is inconsistent with a fixed exchange rate.

Playing Chess with the Devil

I love this quote (with my amendments for economists)  from the NY Times article about Terrence Tao. 

The true work of the mathematician economist is not experienced until the later parts of graduate school, when the student is challenged to create knowledge in the form of a novel proof piece of research. It is common to fill page after page with an attempt, the seasons turning, only to arrive precisely where you began, empty-handed — or to realize that a subtle flaw of logic doomed the whole enterprise from its outset. The steady state of mathematical economic research is to be completely stuck.

It is a process that Charles Fefferman of Princeton, himself a onetime math prodigy turned Fields medalist, likens to ‘‘playing chess with the devil.’’ The rules of the devil’s game are special, though: The devil is vastly superior at chess, but, Fefferman explained, you may take back as many moves as you like, and the devil may not. You play a first game, and, of course, ‘‘he crushes you.’’ So you take back moves and try something different, and he crushes you again, ‘‘in much the same way.’’ If you are sufficiently wily, you will eventually discover a move that forces the devil to shift strategy; you still lose, but — aha! — you have your first clue.

That's pretty much how I feel about research. Another analogy is that research is like solving a Rubik's Cube: You're about to put the last piece in place and you find you have to go back 25 moves and start over.

Why the Belief Function Matters

A debate on the monetary transmission mechanism was recently reignited on the blogs with a post by Noah Smith, posts from Nick Rowe and Brad De-Long and a response to Noah from John Cochrane. This was all triggered by a set of slides prepared by Michael Woodford and Maria Garcia Schmidt for a Riksbank Conference in June 2015. A good starting point is the summary here back in 2014 by John Cochrane. 

The question: If the Fed raises the interest rate will it cause more or less inflation? The answer is complex and the topics that must be dealt with in formulating that answer are at the heart of monetary economics. 

In my own work, I emphasize two central points.

1. Monetary rational expectations models always have multiple equilibria.

2. The right way to deal with this is by explicitly modeling how people form beliefs using a concept that I call the belief function.

Fasten your seat belts; the ride is about to get choppy.

Chinese policy makers are concerned with the dramatic recent falls in the value of the Chinese Stock Market. They are right to be concerned. Although we can, and should, allow financial markets to allocate capital across sectors, the market as a whole is a creature of sentiment. And U.S. experience suggests that market crashes often precede deep recessions.

Today, the Peoples Bank of China was given the authority to purchase shares in the Chinese Stock Market. This is a bold experiment; but it is not unprecedented. In 1998, in the midst of the Asian Financial Crisis, the Hong Kong Monetary Authority engaged in a similar exercise. That intervention was large and successful and was the beginning of the end of the Asian crisis.

Behavioural Economics is Rational After All

There are some deep and interesting issues involved in the debate over behavioural economics. Greg Hill posted a comment on my previous blog where he says:

Now, you really have to ask yourself whether the kind of rationality involved in [Thaler's idea of a nudge], where a minimal change in cost results in a significant change of behavior, is same kind of rationality Lucas and Sargent have in mind.

That led me to explain my views a little further.

The most interesting issue [with behavioural economics] is whether we should continue to accept the neoclassical assumption that preferences are fixed. Let's go with that assumption for a moment.

If preferences are fixed, then we face a second question. What form do they take? For a long time, macroeconomists assumed that people maximize the discounted present value of a time and state separable von Neumann Morgenstern expected utility function. The narrow version of behavioural economics asserts that this assumption is wrong; but people are still utility maximizers.