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Saturday, July 16, 2011

The Usual

Mike Konczal quotes Matt Yglesias and I lose it as always.

I think very very highly of both of them.

First, you note that we won't be in a liquidity trap forever (the qualifier "in a moving economy" is key and "moving" does not mean "with growing GDP" but "with a non trivially positive federal funds rate").

I will discuss Yglesias as quoted here (I haven't clicked that link) and other things of his I read a while ago. I note that he does not deal with the issue of a liquidity trap *at all*. In particular he assumes that a higher inflation target implies higher inflation. This is not necessarily true. I can certainly imagine a world in which the Fed can't convince people that it will drive unemployment below the NAIRU when we reach it (probably after current FOMC members' terms are over) and in which it is both true and believed by investors that the FED can't do anything except manipulate short term safe interest rates. In that world, a higher declared inflation target would have no effect. An analogy might make things clear and, anyway, is fun. My inflation target is 5%. This target has not saved the economy. No one cares hat I want inflation to be, because I can't get the inflation I want. Do people really believe that the FOMC can ? If you answer yes, explain why ?

Money sitting around depends critically on what one means by money. It does not refer to retained earnings of firms which are not invested in fixed capital. That wealth is lying around, but it isn't in the form of money. They hold bonds, so what matters is the real interest rate not the inflation rate. Notably, medium term real interest rates haven't moved since Bernanke mentioned QE2 at Jackson Hole and increased for months starting when actual purchases of 7 year notes began.

The cost of holding money as opposed to other assets is the nominal interest rate. Yglesias proposes a higher federal funds rate (same real rate given higher inflation). This is a very odd form of expansionary monetary policy (I mean backwards). Wouldn't it be better to stay at the 0 bound, achieve inflation somehow, and have a lower real interest rate ? I mean Yglesias's plan for expansionary monetary policy is called contractionary monetary policy by everyone else. To stop money from lying around one needs a positive nominal interest rate. I don't think higher interest rates are what the economy needs.

The argument about mortgages is valid. It is not simple.
Many mortgages are ARMs (and especially many underwater mortgages) but many are fixed rate mortgages. I think the key question is why don't people with fixed rate mortgages refinance ? My guess is that a lot of it is unsophisticated sluggishness. But if people aren't sophisticated, they won't understand that they should base their consumption decisions on the spread between interest rates on TIPS and nominal Treasury securities will they ? I sure don't.

The people who's spending will be increased by inflation are people who are forward looking but can't refinance, because their mortgage is underwater or loaning to them was silly to begin with or their incomes have tanked. So you need people who are much much more sophisticated than average (so they look at real interest rates) *and* made huge mistakes. There are lots of such people, but not lots compared to US population.

With actual inflation slowly slowly mortgages will resurface (cease to be underwater). House prices rise with the general price level other things equal. That will help. Significantly in 2020 or so.

I think that Yglesias noted that monetary policy is very important, affects the distribution of wealth, was set for over a decade by a very hard core Randian and is ignored by progressives (basically by progressives who remember the 70s). So he studied it. But it is, as you note, tricky right now. It is hard to leave boring knowledge just sitting around waiting for the end of the liquidity trap. But it is also reality based.

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