There’s central bank independence and then there’s central bank discretion. Contra some bloggers I do think central bank independence is a good thing. However, I think part of what the current recession has shown is that central bank *discretion* is bad. Sumner, Krugman ect. agree that a lot of pain could have been avoided if the central bank had tried harder to hit their historically implicit target (~2% inflation). The bank should be relatively free from interference from other parts of the government, but the actual policy it follows should be much more constrained.

I propose the following: congress passes a law that requires the central bank to meet a target, and if it fails to meet that target central bank officials would be summoned before congress to explain themselves. However, the actual target would be set by the central bank. The target would be set by vote say every 10 years by the reserve committee (and the vote would be mandatory, to reduce status quo bias, though perhaps allowing the vote to be postponed for less than say 2 years by vote) with the possibility of an emergency change if a super-majority of the committee desires it. The target itself could be anything, a monetary aggregate path, an inflation target, a price level path target, and NGDP path target etc., whatever rule the committee thinks does the best job of promoting a good economy, other than “doing whatever the committee members want”.

The other powers of the Fed could be left intact or not, but this would ensure that they are exercised in a way consistent with the Fed’s target.

The benefits of such a policy would be twofold. First, this policy is more consistent with the Rule Of Law than current policy; it reduces the uncertainty about what macroeconomic policy will be, allowing people and businesses to plan better. Second, it will force the central bank to take a much more theoretical approach to monetary policy than it has without requiring congress to be particularly informed on the subject. Hopefully this will avoid the apparent tendency to throw everything known about macroeconomics out the window during a serious crisis, when it is most valuable. It does both these things while still allowing for the possibility that if some problem with the current rule becomes widely appreciated, the central bank can take quick action to work around it.

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Silas poses the following question in the comments (link)

Let’s say a few scientists have announced that they’ve discovered an effectively unlimited/costless energy source (like the cold fusion situation). A few of their friends have gotten it to “work” too, in that it appears they’re really on to something — perhaps energy problems are about to be solved forever.

On the other hand, most claims like these turn out to be fraudulent or mistaken. And even if they’re doing everything properly, it could be that they’re not tabulating the energy flows correctly (i.e. not realizing that something critical is consumed in the process, meaning it requires more resources and energy input to keep it going indefinitely, which they hadn’t accounted for on deeming it costless). But still, there is much evidence for and against, and the truth or falsity of the claims really matters.

In this situation, it would be very wise not to commit resources to narrow uses, as the eventual unveiling of the truth about the energy claim will obviate many kinds of economic activities. If it turns out to be true, huge sectors of the economy become worthless: the drilling equipment for oil, energy prospecting equipment, coal mines, natural gas pipelines, equipment for maintaining these pipelines, transportation networks that exist because all of this, and, of course, all of the specialized workers and knowledge sets so related. Investing *more* in these will mean you’re “caught with your pants down” when the claims are verified to be true.

On the other hand, investment in the *opposite* direction will be painfully obviated if the claims turn out to be false. So all investments and most purchases carry an additional risk-cost, and so holding off on doing so is a rational response to the economic realities involving high uncertainty about the usefulness of particular goods. In this situation, if you got people to spend and invest for the sake of propping up spending and investing, you’re causing a huge waste of resources: since people don’t yet know which course of action is right, many more goods than otherwise are going to be committed to wasteful production structures.

First let me say that I haven’t come up with any satisfying answers to Silas’ question. I don’t know how to think about it properly, so I will be more humble.

There are a few reasons why the idea that a general reduction in spending due to increased money demand is a desirable signal:

  • A strong signal to avoid investment in affected sectors is already present, people who invest before the uncertainty is resolved will make worse investment decisions than people who don’t.
  • There are lots of reasons why money demand can increase and many of them do not have to do much with uncertainty like this. For example, some new financial technology might require lots of transactions and people need money in order to conduct the transactions.
  • A general spending reduction sends a very blunt signal. A shortage of money is likely to cause people to reduce their spending on many different margins, most of which will not be relevant to the sector. For example in the example you gave, the uncertainty is around one sector (energy) which may have little effect on some other sectors, so it likely makes sense to shift resources that cannot be transferred into the future into those sectors (say entertainment and housing)
  • The signal is fleeting, as prices adjust, the signal will go away even though the need for transfering resources into the future may continue. In a world with no sticky prices this signal would not exist; nominal spending would fall, but real spending would be stable.

I think one of the key issues is the time frame over which this plays out. I am not sure what kind of time frame Silas had in mind: ~2 months or ~2 years.

Over a time period of ~2 months, I am especially unsure how to think about the issue, but keep in mind that most proposals for nominal income targets focus on income expectations ~2 years out, and would only try to stabilize short term expectations to the extent that they affected longer term expectations (and only by trying to stabilize longer term expectations). I am unsure about the desirability of stabilizing income over  short time scales, but in any case, I don’t think it is possible.

Over a time period of ~2 years, I think I understand the issue a little bit better. Over the course of 2 years the appropriate response for the economy is to shift production away from investment in affected sectors and toward resources that can be stored until the uncertainty is resolved investment in unaffected sectors, consumption and leisure. It is important to note that there are many kinds of resources that you cannot transfer into the future easily, for example lots of kinds of labor. The proper response in these cases, is generally to do something else with them rather than do nothing with them. Prices are probably mostly flexible over this time period, so allowing nominal income to rise or fall will not affect resource allocation a lot, but will affect the dynamics of the transition.


I somehow failed to actually post this post earlier. Consider this to be a prequel to Silas against spending 2:

Notable internet guy Silas Barta thinks  calls for stabilizing spending (via the central bank) are ridiculous (link). I have looked for a good explanation of the fundamentals of monetary economics, but I haven’t found something I really like and can point people to. Sumner’s blog used to discuss such fundamental issues more often, but lately he focuses on the politics of monetary policy. I usually tell people skeptical of increased spending to read Sumner’s old blog posts, but that’s quite a bit of work, so it is not a very satisfying answer.

Anyway, in a recent comment, he makes a decent attempt at explaining the most important way that monetary disequilibrium affects economic activity (link)

When the Fed increases the money supply permanently, expected future NGDP will rise due to the “hot potato” concept. People don’t want to sit on a lot of cash forever. But then the fallacy of composition comes into play, what is true for the individual is not true for the group. As individuals we think we can get rid of excess cash holdings, and in a sense we can. But the group cannot, as the money is just passed from one person to another. So it the individual level the attempt to get rid of excess cash seems unimportant, we just swap if for some other good, service or asset. But as the group level if we are all trying to get rid of extra cash, it drives up AD and NGDP.

To summarize:

1. A permanent increase in money tends to raise future expected NGDP due to the “hot potato” process.

2. Higher future expected NGDP means more business confidence, higher current asset prices and more current investment.

The exact opposite occurs if there is an increase in money demand, not supply. Now people try to accumulate more money. This is what happened in late 2008. Even though the Fed did supply more, it was all demanded, and then some, partly because of fear, partly because of interest on reserves.

Both processes seem mysterious because they are based on expectations. The public and investors is looking at a complicated picture, and trying to forecast NGDP growth when we don’t even know exactly what the Fed’s future plans are.

An excess supply of money causes spending to rise and a deficient supply of money causes spending to fall. The hot potato concept is also called ‘monetary disequilibrium’, ‘excess cash balance mechanism’ and probably a bunch of other things.

So if you add more money to the economy when spending starts to fall then you will counteract monetary disequilibrium; this is why Sumner advocates stabilizing some measure of nominal spending. You can also think of stabilizing nominal spending as stabilizing the fraction of total (traded) output that a dollar will get you as opposed to stabilizing the quantity of output that a dollar will get you.

I agree that macroeconomists do a generally poor job of communicating their core theory of monetary economics. I haven’t seen such theory presented in my textbooks and I don’t see many macroeconomists emphasize it, but Sumner and Kling argue that up until about 3 years ago this was basically the macroeconomic consensus, and no one seems to dispute this. Until I started reading Sumner, I was, like Silas, very skeptical of macroeconomics, but Sumner changed my mind.

To respond to one specific question Silas asked: “But I don’t see how it’s responsive to my point that any method of increasing the money supply involves, in effect, bankrolling projects that couldn’t get private funding (or public support), and therefore will, on average, just compound the pain of any existing inefficiency.” I guess I don’t have a very satisfying answer to this except to say that just because a project cannot get funding does not mean that it doesn’t make real sense; for example if people don’t fund it because of how it will affect their money holdings.

I doubt that this will convince Silas that monetary disequilibrium is important, but I do hope this will convince him that it’s not ridiculous.


Silas responds

The best way I can think of to address your position is: the premise behind Sumner’s argument (and that of the macroeconomic consensus he references) is that total spending should be kept at some arbitrary level and growth rate.

But why? Why is more spending necessarily good? When people spend money, they are getting what they need via specialization and through a cash economy from (mostly) strangers.

Certainly, that has *usually* been a good metric of economic health: only a real undeveloped economy has people bartering or producing everything for themselves in their households. But this still runs into the Goodhard problem I complained about: you cannot take that general historical correlation and infer that, on the margin, decisions to spend less are “hurting the economy” — not unless you’re going to redefine the economy as “passing around pieces of paper”, which is about on the level of defining morality as “jumping off cliffs” and accusing people of being immoral because they’re cliff-jump-refrainers.

If I stop hiring my maid to clean my place, and do it myself, does that really indicate a loss of efficiency? There are any number of reasons I could be doing so. When you contort my incentives to the point that I reverse that decision, aren’t you just throwing the inefficiency right back in?

Spending is not, in and of itself, good. Rather, good spending is good. (Less, tautologically, the spending that people would do without manipulation, and because of an honest assessment of their situation, is good.)
Spending that exists only because incentives were jimmied until it looks like people’s best option … is not good.

Let me first say that I don’t have a strong opinion on whether a nominal income stabilization would respond correctly to a sudden change in the market vs. non-market economic activity. The case for  nominal income targeting rests in large part on the claim that changes in nominal income due to monetary disequilibrium are larger and more frequent than those due to other causes. Second, if is not good to force people into spending more than the ‘natural’ amount, it is also not good to force people into spending less than the ‘natural’ amount. The Sumner camp contends that the ‘natural’ amount is most likely when nominal income is stabilized; the price level camp contends that the ‘natural’ amount is most likely when the price level is stabilized. However, right now, even the price level is significantly below trend, so even if you favor a a price level target you should still desire higher spending (though not as high as those who want stabilized nominal spending).

Reading the Selgin paper and talking with Silas made me realize I understood the relationship between monetary policy and demand shocks much better than than I understood the relationship between monetary policy and supply shocks. This implies I should be less of an advocate.

By the way, Selgin’s argument for stabilizing nominal income with respect to supply shocks is that allowing prices to rise in response to negative productivity shocks and decline in response to positive productivity shocks will minimize the burden of price adjustments since the prices to adjust will be the ones that experienced a productivity shock.


I had heard of Selgin’s paper on the productivity norm (a policy of nominal income stabilization) before, but I had never read it. I’ve read it now, and it’s great! It explains a lot of the fundamentals of monetary economics, some of which I had understood before, and some of which I had not. It seems like a pretty good introductory piece on monetary economics; which is good since I was looking for one.

Nick Rowe’s posts (one, two) on macroeconomics and monopolistic competition discusses another important fundamental fact about monetary economics.


Scott Sumner argues that Nominal GDP expectations are critical to macroeconomic health, and I find his arguments pretty convincing. Low NGDP expectations (relative to trend) imply that the money supply is low relative to the demand for money. Unfortunately it is non-trivial to estimate NGDP expectations because there are no NGDP futures markets. The absence of a good measure of NGDP expectations makes assessing the performance of the central bank more difficult.

Fortunately, as I recently learned, InTrade will list basically any contract you like on their exchange for a fee of $100. Since this is pretty cheap, I will create a set of NGDP prediction markets for several future dates. Hopefully these markets will be active and produce meaningful estimates of NGDP expectations. If these markets are active, I think it should be easy to convince InTrade to continue to create new contracts as old ones expire.

I think it’s important to design these contracts well so their prices are both accurate and useful. The InTrade Real GDP markets (under Financial->US Eco Numbers) are a good anti-example; the various Real GDP markets are either not very informative or not very useful. The contracts tied to the Advance Real GDP figures are totally inactive; all of the markets I saw had 0 trades. The markets that rely on Final Figures are not terribly illiquid, but since they are binary markets that indicate only the probability that Real GDP will be positive/negative they are not terribly useful.

I think it is clear that a single market with a continuous payout is preferable to a set of binary markets as a single market will be much simpler for traders to trade in.

As I see it, the critical contract design questions are:

  1. How far apart should the contracts be spaced? 3 months, 6 months, 12 months?
  2. Should the contract payout be proportional the level of NGDP or the rate of change of NGDP in some period?
  3. How far out should the contracts start? What are the most important expectations? Expectations about NGDP 6 months out? 12? 24?
  4. What BEA data should the contracts be based on? Advance, Primary, Secondary or Final NGDP estimates?

Finally, there is the more difficult question of how to generate interest in the markets if regular InTrade traders are not inherently interested in the contracts. The most direct method that I know of is to subsidize trading by employing some type of automated market maker that is willing to lose some money. Peter McCluskey used this method to subsidize conditional prediction markets during the last election (see here). Unfortunately, he doesn’t seem to think his experiment was very successful. However since the last election there has been some research done on improved automated market makers.


Up until a few days ago, I had very little interest in macroeconomics, primarily because I had the impression that there were not very many well established, useful truths in macroeconomics. Then I read some of Scott Sumner’s writings which convinced me I was wrong.

Sumner’s thesis is that macroeconomists have a useful and well established framework for understanding the aggregate economy, and that the current downturn has been so bad only because most economists, including those at the Fed, have misunderstood or forgotten how to apply the framework properly. Reading his writings over the last few days has been fascinating. Sumner argues so forcefully and without apparent ideological motivation that I am compelled to investigate this framework.

So, thanks Sumner! For opening up a whole new branch of economics to me.

One of Sumner’s novel (to me) suggestions is to target Nominal GDP (NGDP) instead of the price level or inflation. Since I don’t know much about macro-economics I don’t have much to say about the proposal. I do have one way to frame the choice between price level targeting and NGDP targeting that I haven’t heard Sumner use (perhaps for good reason): targeting a price level path makes money stable with respect to the absolute quantities of goods it can be traded for; targeting NGDP makes money stable with respect to the fraction of total output it can be traded for. The latter might be desirable because it more nearly holds constant everyone’s ability to fulfill their agreements.


Decision Science News gives a tip on generating less biased estimates of your own future behavior:

When asked to make a forecast 1) generate an answer under ideal conditions, then 2) generate your forecast. Though you’d think the ‘ideal conditions’ would skew your forecast upwards due to anchoring, it does not. In fact, it causes you to generate more realistic forecasts of your own behavior.

Which is not too difficult. I believe that the logic behind this is that simply asking someone to “forecast X ” generates extremely similar results to asking someone to “forcast X under ideal conditions”. Asking someone (or yourself) to do both makes the fact that “non-ideal” conditions apply to forcast 2 very salient and thus more likely to take that fact into account. I suspect this technique is also useful for things like forcasting project completion  times.


This sounds like a quality idea:

So my new idea is this: Require that water monopolies (private and public) purchase insurance against outages, shortages, toxic spills, etc. Such a requirement would produce two good results:

1. Current practices would immediately improve with oversight — solving the free-rider/coordination problem (in principal-agent jargon) of monitoring utilities.
2. Insurance companies would pay for future problems, which reduces the problem with ex-post rate increases to fix them.

This approach would be difficult to apply when the types of events you want to prevents are unknown unknowns, so that it is hard to write regulation for it.


I am not normally a fan of anti-republican/anti-bush humor, but this Crooked Timber post is pretty darn funny

For example, an advocate of the Iraq war can be a virtue ethicist as regards their own heroic standard against Ba’athist dictatorship, a deontologist regarding obligations to punish the criminal behavior of their enemies, regardless of the unintended effects on the millions of people living in the general vicinity, and a consequentialist regarding the necessity to excuse the criminal behavior of their leaders for fear of subsequent bad effects on the polity.