God’s Monetary Policy
While starting from real world institutions and trying to find reforms to improve outcomes is often quite useful, it can also be good sometimes to do some “pie in the sky” idealistic theorizing. As Garett Jones says, “Every so often, economists should argue for first-best, politically unconstrained policy: After all, everyone needs a lodestar.”.

When people provide goods and services to others, they earn money. When they demand goods and services from others, they spend their money. How should the value of the money change in the meantime? When people take on debt, write contracts, and negotiate wages, they have certain expectations for how the nominal amount of money they agree on will translate into real goods and services. The future is uncertain, and so what happens when those contracts cannot be fulfilled on average for society? When there is a macroeconomic shock, do lenders and workers make up the difference, with inflation, or do debtors and unemployment make up the difference with deflation (some mix of the two?)?

An ideal monetary policy would bring money in to existance when there was slack and contract the money supply when the economy was pushing the limits of production. Ideally, monetary policy should be predictable. We live in a world where demands are always changing between goods; where technology and other shocks are always changing the costs of production. Monetary policy can only do so much in the face of such volitility, but it can make sure that income, on average, will be stable and it can react in a predictable way so that individuals can face the future with a minimum of uncertainty.

Which Price to Target
Central banks can only target one nominal variable. Once they add money to the economy, they don’t have any control over where it goes, nor do they control relative prices, which are determined by supply and demand. NGDP targets all prices, but Sumner himself says that if a practical way to target just wages could be found, that would be superior. If a flexible price changes, that has no impact on microeconomic efficiency. A higher price means less money for the buyer, but more for the seller, so the net effect is a wash. Only quantities matter for utility. When a price is sticky, changes in demand will disproportionately affect quantities rather than prices, which will cause welfare losses. Perhaps the greatest utility losses from sticky prices come from sticky wages, which result in unemployment. In the future, monetary theorists may focus on trying to build an index of the most sticky prices, or those with the greatest welfare losses, to target.

Minsky Problems
In any evolutionary system, stability can increase fragility over time. Firms/organisms adapt to the stable conditions and lose the traits that allow them to survive in harsh conditions. Shocks that once would have only slightly disrupted an economy or ecosystem become more damaging after a period of prolonged stability. Now, a market monetarist could say, “Fine, someone will break, but you can let them fail because they won’t take the whole system down with them.” Economists I have discussed this with vary widely in their level on concern for banking crises and other shocks, even assuming stable NGDP. Some are concerned that allowing banks to fail would be accompanied by high inflation and low real production, so even if NGDP were stable, it would be undesirable to allow the banking sector to fail. Others would say that the reason why the current crisis got so bad to begin with was falling NGDP and without the income shocks that most people faced, they would not have defaulted on their homes and it never would have gotten so far. I lean more towards the “let them fail” side of things. I have never met a cinder that was not fervent in its praise for the free market. But others do not share my faith, and dealing with the frictions and vulnerabilities of the banking sector is one possible area of future development in macroeconomic theory.

Cantillon Effects
In a world of sticky prices, who gets the money first can impact the economy. Were it not for these “Cantillon Effects“, the central bank would increase, not decrease interest rates by conducting Open Market Operations (OMOs). It is only because of the way they add money to the economy that causes the relative price of credit to change (and potentially screwing up the capital structure of the economy). The money then moves through the economy like ripples in a pool of water, going from sectors which receive the funds earlier to those which receive the funds later. In the long run, or under a period of relatively steady addition of money, there will be no effects, since prices will adjust over time. However, if NGDP is enacted, there will be times, such as the 2008 financial crisis, where a lot of money may need to be added to the economy very quickly, concentrated in a few sectors. In such a time, Cantillon effects could be quite powerful.

Modern Monetary Theory proponents often suggest using fiscal policy to inject money into the economy, sometimes in the form of direct transfers. In my opinion, if a lot of money needed to be added quickly, reducing tax rates would be the most effective method, since it would simultaneously reduce deadweight losses to the economy and increase the amount of money normal people would have in a fairly even manner. Direct lump sum transfers are another option. OMOs are kind of arcane and poorly understood by the average voter. Making monetary policy connected to either taxes or transfers would make the system more transparent and possibly increase transparency and political support for the Fed. In any event, refining the way money is injected could be an interesting field of research.

Other Potential Fields
Optimal currency areas is a somewhat interesting field. Keeping track of a currency for each town would be quite difficult, and a global currency would have too much regional variation for stabilization policies to have much effect. However, given that most currencies are at the sovereign nation-state level, there’s not much practical use for figuring out what the optimal currency area is.

Some people might worry about stabilizing interest rates. Interest rates are a price, and you should never reason from a price change. Unstable interest rates, even those stemming from market forces, may cause malinvestment due to maturity mismatch. So, people could invest in a firm, and then decide later to increase the interest they charge (perhaps due to increased riskiness) and thus the firm may have to give up on more roundabout methods of production. The evidence for such high elasticity is pretty slim though. If a firm wants to finance a long term project, they could borrow all the funds they need at once, avoiding this problem, or they could buy financial products designed to hedge interest rate risk. Additionally, firms only invest over a few years, and only if the returns are fairly predictable. There just aren’t that many companies financing 10 year projects which pay a 5% return by using unhedged short term bonds.

Conclusion
There will always be ways to improve social institutions. Perhaps, as per Keynes’ wish, monetary policy will become as boring as dentistry. Until then, it has a tremendous impact on the welfare of society and so much effort will be expended discussing and arguing over various policy points. There is a lot of room for improvement over our current institutional arrangement, and there will still be room for improvement (if/when) market monetarism is implemented.

2. The human brain has been shrinking over the last 1000 years.

3. Vat grown Fake Steak

4. Beware the reductio, for it shall become the truth.

5. Math Problem solving tips

2. Congress caught pirating videos, including porn. Is anyone surprised?

3. MITx, a new model for education. More here.

4. WordPress Photography contest.

5. Very interesting presentation, especially The Age of Reason. HT: Tabarrock.

Wealth by Age of head of household in 2004

A baby born in 1950 would be 62 today, just 4 years from Social Security retirement age. Given that life expectancy has continually improved over time, baby boomers are expected to spend more time in retirement than any previous generation.

Projected Demographics

Life Expectancy

Stock Market Returns
There are two key concepts for investments: returns and the value of the stock market. Returns are how much you get each year for a given investment. If a $100 stock pays $7 per year, the return is 7%, even if the value of the stock remains at $100 forever. The value of the stock market is the price of each stock times the number of shares of the stock. The value of the stock market cannot grow faster than the economy in the long run. The return on stocks can be higher than the growth of the economy, so long as dividends are not reinvested. In any event, it is unlikely that the stock market will return anything like it has historically in the long run. The capital stock can grow, but it faces diminishing returns, especially when combined with a shrinking workforce.

The Price to Earnings Ratio

The Price to Earnings Ratio is the price of a stock divided by the stream of dividends. It is highly variable, but does not have an upward or downward trend in the long run.

The Great Stagnation
In Tyler Cowen’s book, The Great Stagnation, he discusses how, since the mid 1970s, growth has dramatically slowed down. The economy has become dominated by a few highly regulated sectors which are slow to innovate, such as health care. Signaling, ineffective, futile, bureaucratized, end of life, health care. The areas with the most rapid growth are not things that old people spend money on, so the Stagnation will get worse, not better, even if technological improvement continues. Technology tends to make health care more expensive and more unequal. These is no sign that the government will become less involved in providing health care/insurance anytime soon, so there is little pressure on firms to cut costs.

Further Reading
Megan McArdle on Boomers
Boomers will reduce investment returns.
Fed paper on Boomers and investment
The Baby Bust

2. What would Deep Space 9 be like with modern technology?

3. #FedValentines. More here.

4. Autism Spectrum Quotient test. I got a 27. Average is around 15 for women, 17 for men, 23-25 for mathematicians/scientists.

5. Lectures are ineffective.

Political Power
In democracies, something becomes illegal when a certain percentage of a population is willing to vote for someone to make it illegal. In the U.S., typically, that requires a majority of people in a majority of districts to think something is bad enough to warrant criminal charges, which works out to about 20% of the population (p. 6) (25%, if all districts were the same size). In the abstract, it could vary between a tiny minority not liking something under a dictatorship to requiring a supermajority in a strict constitutional republic. Personally, I think a stong supermajority should be required for something to be made a crime, but getting there can be quite difficult. If 51% of the population is willing to fight over something, the 49% are SOL. Extolling people to respect a constitution can only get you so far.

Externalities
If the negative externality to an action is greater than the enforcement costs of prohibiting it, the action should be outlawed or taxed. Such logic has an internal logic to it, but ignores the dynamics of political power. Also, the size of externalities are often impossible to measure. If 51% of the population doesn’t like smokers, they can get smoking outlawed, regardless of how much smokers enjoy it. Additionally, it is impossible to figure out exactly how much people are subjectively hurt or helped by such a law. You can try to do some rough calculations, but there is no real exact method.

Natural Rights
Suppose Catholics hate Protestants and are willing to pay $1,000 to outlaw Protestantism, and Protestants only value their freedom at $950, does that justify outlawing Protestantism? Where are the default property rights? In the absence of transactions costs, people could Coasean bargain to the efficient solution, but the initial endowment still has a big wealth effect, and thus a big impact on outcomes. Should a crime require a violation of someone’s rights? Are some rights God-given and inviolable, or are “natural rights” merely a rhetorical technique to convincing people not to restrict your actions? I don’t really know the answer to all these questions. Personally, I like to live and let live, but that’s just not a popular option for most people.

Ideally, laws would conform to societal norms. If someone did something that the vast majority of people thought was wrong and worthy of punishment, they would be punished. If not, they would not. The American criminal code is really long and complicated. People might not even know about the laws they are accused of breaking, and everyone commits minor crimes. About 34% of the prison population is from victimless crime. Privatized prisons create a vicious cycle where they pay politicians to imprison more people, and use the money they are paid to lock up criminals to buy off more politicians.

There are many ways to try to alleviate this problem, such as political activity and whatnot, but there is something simpler that everyone can do which would solve the problem without any political reform: jury nullification. Jury nullification occurs when a jury finds a defendant not guilty, even when there is conclusive evidence, because the law itself is unjust. The point of using a lay jury is to bring an outsider’s moral perspective into the legal system.

If the trial were simply a fact finding excercise, there would be no need for either juries or even lawyers. Judges could do everything themselves. Juries act as a check on the abuse of power, both by corrupt judges and by corrupt legislatures. Juries do not have to disclose why they came to the verdict they did. If you are in a trial, do not flaunt that you intend to nullify, because you might be removed by the prosecution’s lawyer. However, do not worry that you will be punished if you do nullify an unjust law.

Update:
I decided I should elaborate on my societal norms comment at the beginning, after some comments on Google +. When I say “societal norms”, I mean a situation where over 95% of the population agree with a crime. 99.99% of Americans agree that murder, rape, theft, assault, and fraud are wrong. If you take a random sample of 12 Americans, you will very likely get all 12 in agreement on the wrongness of murder. Knowledge of jury nullification will have roughly no impact on conviction rates for murder. Only about half of Americans support criminalizing marijuana possession for adults, and even fewer support criminializing medical marijuana. Even if only 25% of Americans know about jury nullification, and 50% of those nullify charges for marijuana, the chances of conviction drops to around 20.14%. If half of the population know about jury nullification, and half disagree with the crime), the conviction rate will be only 3.17%. I doubt prosecutors will be willing to go through the trouble of 5+ trials just to convict someone of such a crime.

Further Reading
General article about prison reform
Cost of prisons
Everyone breaks internet laws

2. Trial by Battle. Pete Leeson has got to be one of the coolest economists out there. Here are his other papers.

3. Andrei Schleifer on the transition from communism.

4. Great new video by Ok Go. Some commentary on intellectual property and the music industry.

5. Timothy Taylor talks taxes. A bit of background here.

The citizens of Ponyville live a idyllic life, free to pursue their favorite pastimes. Nopony ever goes hungry. While there are rich ponies, nopony is poor. Other than a few curios, there is no mechanization, no firms, and no other elements of a modern economy. With the Pegasus ponies controlling the weather, there is no danger of famine. Ponies typically have small families, so they are never hit by a Malthusian trap, which is where there aren’t enough natural resources to support all the ponies. War is almost unknown, except in ancient history. Government is minimalist, with a monarch (and her sister), who rarely do anything without consensus, but who maintain power by their god-like magical abilities. While Equestria is often attacked by various supernatural creatures, all repairs are always complete before the next episode, with only minimal grumbling.

*SPOILER ALERT*

Sweet Apple Acres has a monopoly on apple production, and restricts the quantity of cider to extract rents, much to Rainbow Dash‘s chagrin. Sure, the Apple family makes a show of working hard, but the truth is, which becomes apparent later in the episode, they could hire additional workers to meet the demand if they really wanted to. It is unclear why they didn’t increase prices to help reduce the shortage, but it probably has something to do with fairness norms. The underpricing led to misallocation – because the Apple family didn’t charge enough, Pinky Pie drank 10 mugs of cider and Rainbow Dash got none. Note that if Pinky Pie had known that Rainbow Dash wanted cider, she would have shared, but she didn’t because of imperfect information. Higher prices would have resulted in a more efficient allocation, even without Pinky Pie having knowledge of other ponies’ demand curves.

Flim and Flam, two Unicorn ponies, show up with their invention, the Super Speedy Cider Squeezy 6000, which promises to expand output to eliminate the shortage. Flim and Flam offer to vertically integrate, but demand a 75% cut of the profits, which is unacceptable to the Apple family. The Apple family could simply monopoly-price the apples and still restrict the quantity of cider, but doing so would expose their charade of “not being able to make enough”.

Having reached a gridlock, Flim and Flam offer to have a contest to determine who will get the cider monopoly. They think that with their superior technology, they will be able to outproduce the Apples. With their whole stream of future profits on the line, the Apple family recruits the protagonists to help with production. With the additional workers, they are able to produce cider faster than Flim and Flam, even using their outdated capital. Flim and Flam decide to sacrifice quality for quantity and manage to win the contest. However, nopony wants to drink their low-quality cider, so quantity demanded falls to zero, and Flim and Flam decide to exit the market entirely.

To a normal viewer, the episode had a happy ending, with everypony learning that you shouldn’t sacrifice your standards, etc, etc. To an economist however, the ending was less than optimal. Even in a monopoly, cost reductions translate to increased quantity and lower prices. If Flim and Flam had made a better initial offer, the Apple family would have been able to get more profit, make more cider and lower prices. If Flim and Flam had opened a competing firm, they would have reduced the Apply family’s profit, but the increased quantity and reduced prices would have raised total market surplus. In the end, Ponyville returned to an inefficient monopoly with outdated capital and no new gains from trade.

emlan

2. How to pronounce things. (funny)

3. A riff on the most important lesson of economics. Love needs wisdom.

4. Japanese manhole covers

5. Schneier on Prisons. Private prisons are a really bad idea. Somethings you want to be inefficient, expensive, and totally uninterested in profit.