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Stop reasoning from a price (or quantity) change

Summary:
Larry Summers always has interesting things to say, and his new twitter thread on the current state of monetary policy is no exception. He begins with an argument made by many other economists, that low rates imply central banks have less ammunition. He goes on to argue that this casts doubt on the proposition that central banks can create inflation. In my view, this gets things exactly backward, confusing cause and effect. The low rates are partly the result of contractionary monetary policies. Places with expansionary monetary policy have absolutely no difficulty keeping interest rates well above zero, and creating as much inflation as they wish.  Economists look at central banks that seem to have already done a lot, and have still fallen short, and then ask how much more

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Larry Summers always has interesting things to say, and his new twitter thread on the current state of monetary policy is no exception. He begins with an argument made by many other economists, that low rates imply central banks have less ammunition. He goes on to argue that this casts doubt on the proposition that central banks can create inflation.

In my view, this gets things exactly backward, confusing cause and effect. The low rates are partly the result of contractionary monetary policies. Places with expansionary monetary policy have absolutely no difficulty keeping interest rates well above zero, and creating as much inflation as they wish. 

Economists look at central banks that seem to have already done a lot, and have still fallen short, and then ask how much more they would have to do to get higher inflation. The actual answer is “much less”. Interest rates are not (primarily) a policy tool, they are an outcome. A more expansionary policy will lead to higher rates over time. A more expansionary policy will lead to a smaller central bank balance sheet as a share of GDP.

Because of this confusion, people are again calling for “helicopter drops” as if that will somehow “solve the problem”. But the Japanese tried that for many years, and the deflation ended only after they stopped doing a combined fiscal/monetary expansion. As David Beckworth points out, helicopter drops only work if the injections are expected to be permanent. But if helicopter drops were expected to be permanent, then monetary policy alone would work just fine.

The profession is finally beginning to reach the point that monetarists like Friedman reached decades ago—low rates don’t mean easy money.  But instead of ending the practice of reasoning from a price change, they either wildly swing over to NeoFisherian (another form of reasoning from a price change), or they start adding epicycles to the flawed Keynesian model:

Stop reasoning from a price (or quantity) change

Summers talks about “interest rate cuts” without explaining what causes the interest rates to fall. The liquidity effect? The income effect? The Fisher effect?

This is so frustrating. Instead of looking for ever more convoluted explanations for why low rates don’t “work” in Europe and Japan, how about we do what we teach out students to do in EC101, and stop reasoning from a price change.

And while we are at it, stop reasoning from a quantity change. Stop suggesting that low unemployment should cause high inflation.


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Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment".

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