Mechanical vs. Intentional Economics
Humans act with purpose. Each time someone takes an action, any action, they have a goal in mind. If the goal is valuable to them, and they have sufficient resources, they will keep acting until they achieve that goal. If someone is hungry, they will eat until they are full. If someone wants to buy a house, they will work and save until they can afford it. The stopping point is defined by the goal and the resources needed to achieve it. Because economics is the study of human action, I believe that it must take into account the fact that humans have goals, and that they will try to achieve those goals.
The split between the “Intentionists” and the “Mechanists” is most clear in macroeconomics. On the intention side of things you have Market Monetarists, the Public Choice school, and most Austrians. On the mechanical side are most mainstream and empirical economists, who base their estimates on mathematical models or correlations. On the intentions side, Scott Sumner compares the central bank to a captain of a ship – if the course is off, change the steering wheel until you are back on course. In his paradigm, the central bankers have the goal of stabilizing the economy. Given that they have infinite resources, they should act until that goal is achieved. On the other side are people like John Cochrane, who say things like, if the central bank does X, the outcome will not be that big, so why bother? There is no room in such a mechanistic model for a central banker with a goal, who acts to achieve that goal. He wants precise concrete steps that the central banker could do to solve the problem (or believes that no such steps exist).
The problem with this line of thinking is that economic behavior is human behavior, and human behavior is emotional and depends on signals. Both inflation and deflation are self-reinforcing. If people expect deflation, they will horde money, causing more deflation. If they expect inflation, they will rush out to spend their money as quickly as they can to preserve its purchasing power and thus will cause the very inflation they fear. It is up to the central bank, not only to provide actual monetary stability, but to provide expectations of monetary stability as well. What are the things someone can do to affect expectations? Some would argue very little. Mike Munger often points out that since current policymakers can’t place binding constrains on future policymakers, any attempt at tying oneself to the mast is bound to fail. One solution is to move one step up the chain of command. If Congress rewrites the Fed’s mandate, the Fed’s actions will be effectively bound in all time periods. But I think that’s not a persuasive perspective. I don’t think the Fed has an incentive to deflate in the future, once they have verbally committed themselves to a particular target. I think if the Fed triggered higher NGDP growth now, future Feds would still stick to the past target.
Interest Rate Confusion
One common paradigm problem is the interest rate trap. The Fed normally uses interest rates to communicate how much money they will print. Lower interest rates imply that they will print more, and higher less. But interest rates can’t go below 0, so the Fed can’t effectively signal to people how much it intends to print when they are at the zero lower bound. Mathematical models which specify that setting the interest rate is what the Fed does have no way to deal with this situation.
Now, some economists may object that setting interest rates really is what the Fed *really does*, and that once the Fed hits the zero lower bound, it is powerless to increase NGDP/inflation/whatever. That’s just silly, and if it were true, it would be a fantastically good thing. Imagine such a world for a moment. The government would never have to tax anyone ever again. They could just issue bonds and demand that the Fed buy them all at 0% interest and hold them to maturity. No inflation – we’re at the lower bound! The government debt could be totally eliminated as well; same logic. More money will eventually cause more inflation, even if the Fed can’t change interest rates.
The Example of Switzerland
On September 6, 2011, the Swiss central bank pegged the Franc at 1.2 Euros per Franc, which had been approaching parity the month prior. In plain language, the Franc was worth more than the Swiss central bank wanted it to be. Since they can print as many Francs as they want, there is no theoretical lower limit to the value of the Franc. Now, because of the chaos in the European markets these days, there is tremendous upward pressure on the value of the Franc, so “mechanical paradigm” observers predicted that the Swiss would have to print a tremendous number of Francs to defend the peg. However, currency traders will only buy Francs if they believe the Francs will become more valuable. If the value is held constant, there is no reason to buy them, and thus the total number of newly minted Francs can be much lower, so long as traders believe the Swiss central bank. Traders who bet that the central bank will fail will make money if the central bank backs down, and lose if they do not. Credibility is a substitute for action.
The immediate effect was that the Swiss central bank had to buy a huge amount of Euro denominated assets. But since the third quarter of 2011, the Swiss central bank’s balance sheet has actually shrunk from Fr 305 billion to Fr 245.5 billion. Once their actions were tested and found resolute, traders backed off. No one wants to continually lose money betting against a determined central bank.
NPR update on the peg
Sumner on the peg
Evan Soltas on the peg, update. I suppose it’s not surprising that they had to buy more assets, given the instability in the Eurozone.
The Chuck Norris Theory of Central Banking