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Central Banks Can’t Set Permanent Long-term Expectations

Here’s another strange post from another Conservative economist. This time it’s Nick Rowe trying to explain why Paul Krugman’s view of the ineffectiveness of monetary policy inside a liquidity trap, is wrong. I don’t much care for the politics of all this back and forth and yes, this is largely a political debate between Conservative economists (Cochrane, Sumner, Rowe, etc) and Liberal economists (Krugman, Wren-Lewis, etc). I’ve been critical of Krugman’s IS-LM model and his rationale for his conclusions and I also don’t agree with much of the ideas espoused by Market Monetarists like Nick Rowe.  But I think Nick is making a seriously unrealistic assertion in this latest post.

In that post he’s discussing why monetary policy might not be effective at times. And his point mostly boils down to expectations:

“Of course there is something the central bank can do in period 1. It can stop doing the thing that got the economy into the liquidity trap in the first place. It can stop announcing that it will cut the money supply by 10% in period 2, and announce instead that it will not do that.”

What Nick is basically saying is that monetary policy becomes ineffective when the Central Bank doesn’t set long-term expectations appropriately. For instance, if you have a two period economic environment and the Central Bank says that they might alter policy in period 2 then the policy implemented in period 1 won’t be very effective because the expectations about period 2 will offset it.

This gets into all sorts of messy intertemporal debates, but it really makes no sense to begin with because a Central Bank can’t set permanent long-term expectations. Call this the “expectations transmission mechanism paradox”. That is, the economy is too dynamic and policy adapts to the dynamism of the economic system. Future policy can NEVER be etched in stone. There will always be a level of discretionary intervention in the economy because policy makers will always be forced to update their models and policy tools as the economy evolves. They will always have to make discretionary decisions about the future because the economy is always adapting faster than policy can adapt. There is simply no such thing as setting long-term expectations because the economy is too dynamic to set realistic long-term expectations about a future that is largely unknown.  Private sector actors know this and they manage their risks to account for that reality. But for some reason economists, in their unrealistic models, seem to think that this is a realistic possibility. As if the economy exists in some linear steady state textbook model. It doesn’t.

So yes, the Central Bank can try to set expectations, but the idea that they can set permanent expectations about the future is totally unrealistic and defies the logic of understanding the economic system for what it is. And so all this discussion about setting long-term expectations ends up being a big waste of time because it involves a model of the economy that doesn’t reflect our reality.