Friday, March 14, 2008

Questioning the Assumptions of Modern Monetary Economics

Amid the carnage in the financial markets and the related response by the Fed, Edmund Phelps steps back to question modern monetary economics:

In recent times, most economists have pretended that the economy is essentially predictable and understandable...Today we are seeing consequences of this conceit in... central banking. "[R]ule-based" monetary policy, by considering uncertain knowledge to be certain knowledge, [is] taking us in a hazardous direction.


In the 1970s... a new school of neo-neoclassical economists proposed that the market economy, though noisy, was basically predictable. All the risks in the economy, it was claimed, are driven by purely random shocks -- like coin throws -- subject to known probabilities, and not by innovations whose uncertain effects cannot be predicted.

This model took hold in American economics and soon practitioners sought to apply it... Policy rules based on this model were adopted at the Federal Reserve and other central banks.

The neo-neoclassicals claimed big benefits from these changes... They asserted a decline in "volatility" in the U.S. economy and credited it to the monetary policy rules at the Fed.

Current experience is putting these claims to the test.


The claim for rule-based monetary policy is weak on its face. In deciding on the short-term interest rate it controls (the Fed funds rate) the Federal Reserve thinks about the "natural" interest rate -- the rate needed if inflation is neither to rise nor fall. Then the Fed asks whether the expected inflation rate is above or below the target. The Fed also asks whether the unemployment rate is above or below the medium-run "natural" unemployment level -- the level to which sooner or later the actual rate will return.

But the medium-run natural unemployment rate and the natural interest rate are anything but certain...

The Fed's view seems to be that the medium-term natural unemployment rate is stable. Thus the rise of actual unemployment in the past year is wholly or largely temporary... Yet there are good reasons why the medium-term natural unemployment rate may be a lot higher now than before...The Fed's view [also] seems to be that the natural interest rate has decreased with the business downturn. But this too is uncertain...

Phelp's discussion boils down to a RBC vs. New Keynesian interpretation of current events. He is arguing that maybe the economy is not temporarily deviating from its long-run trend growth path, but rather there has been a permanent shift. If so, then assumptions about the natural rate of interest and full employment can be way off the mark leading to distortionary monetary policies by the Fed.

Phelp's concern about a falling natural rate of interest seems particularly compelling at this time. Robert Gordon (via Michael Mandel) believes the productivity boom of the 1995-2004 is over. Since productivity is a key determinant of the natural interest rate, it stands to reason that the natural interest rate has fallen. This development would imply recent Fed actions may have a distortionary effect down the road. Below is a graph of trend productivity from Robert Gordon:


  1. >> "Phelp's discussion boils down to a RBC vs. New Keynesian interpretation of current events."

    I disagree. His criticism applies to both type of models.

    He has a problem with reducing uncertainty to rational expectations over well-defined probability distributions. -- All that talk about risk vs. uncertainty and so on.

    Contemporary stochastic models deal with subjective expectations and uncertainty in a rather heavy-handed manner. I think that point should be conceded.

    His interpretation boils down, I think, to an the Economy of Keynes vs. Keynesian Economics type of thing... Keynes was not an (American, sticky-prices) Keynesian.

    I read the theme as being Keynes & Hayek on uncertainty.

  2. I see your point Gabriel.

    I was thinking more along econometric lines: are we in a trend-stationary world (Keynesian) or a difference-stationary world (RBC)? Although the difference between the two have blurred over time and I may be oversimplifying matters, the distinction is that the Keynesian view is about bringing the economy back to its relatively-steady full employment level thru AD management, while the RBC view is that there are too many permanent shocks to trend to know what the full employment level is at any time. Thus AD management is futile possibly even distortionary.

  3. In my humble opinion, the Fed is too focused on full employment and not focused enough on inflation. I am not an advocate of price level stabilization policies, but I am in favor of stability itself through minor, but meaningful changes in the price level. However, I fear that the Fed will not accomplish either of its goals through AD management.

    The deflationary pressure of the productivity growth in the 1990s and early 2000s kept inflation low despite the low interest rates prevalent under Greenspan. It appears that Bernanke isn't likely to be so lucky. Thus, I think that Phelps is correct in asserting that a policy of AD fine-tuning is likely to be distortionary.