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Reverse Causation

Warning – this is nerdy. It could make your head hurt. I am not responsible for any head trauma that results from you reading this.  

Paul Krugman has a new post defending the Hicksian IS-LM model that he claims steered him to some pretty good predictions about the impact of a rising monetary base during the crisis. I made all of the same predictions (low rates, low inflation, sluggish growth, etc) without this model. In fact, I’d argue that my track record is a bit better because I didn’t predict negative impacts from the 2013 “austerity”. And I’ve argued that his model is, at best, flawed, and at worst, very flawed.

Of course, this isn’t a personal competition. Dr. Krugman is WAY smarter than I am. I know that. I just happen to have few unique insights on banking and monetary policy because I am a market practitioner and not a trained economist. And that’s what this debate is really about – defunct economic models. And the reason I care so much about this debate is because I think it’s important to discard old and useless economic models that don’t reflect reality like the one where market practitioners exist. The reason why is because, in order to create better policy for the future, we need to have better models and understandings of the world. And models that are based on IS-LM have too many theoretical assumptions in them to be as useful as one might think. More importantly, if we conclude that these models generate correct predictions then this fosters a status quo environment in economic thinking. In essence, we should all continue to rely on the old models instead of adapting the models.  Basically, if Krugman is right then mainstream macro had this all figured out long before the crisis!

Of course, we know, for a fact, that this isn’t true. For instance, take a look at how most mainstream economists treat the concept of reserve injections. They still think that reserves lead to some risk of high lending and high inflation in the future. But we know for a fact that this is totally wrong. It’s been confirmed by the Federal Reserve, S&P, The Bank of England and people like myself have been describing this for almost a decade now. But the models that most mainstream economists use keep telling them that all these reserves could spark sky high inflation at some point. They have the causation precisely backwards! Reserves don’t lead to lending. Lending leads to reserve accumulation.

That’s not the worst of it though. In his response to Brad Delong Dr. Krugman says:

But what I found was that the liquidity trap was still very real in a stripped-down New Keynesian model. And the reason was that the proposition that an expansion in the monetary base always raises the equilibrium price level in proportion only actually applies to a permanent rise; if the monetary expansion is perceived as temporary, it will have no effect at the zero lower bound. Hence my call for the Bank of Japan to “credibly promise to be irresponsible” — to make the expansion of the base permanent, by committing to a relatively high inflation target. That was the main point of my 1998 paper!

This is pure theory. 100%. Not only is it based on the concept of the Natural Rate of Interest, which is a totally theoretical concept. But it’s based on this idea of the “long-term”. While we can’t disprove the NROI, we can disprove the idea of permanency. And anyone who works in the financial markets will understand this point as I’ve explained it before.

Basically, asset managers are risk managers. That is, in the aggregate, we are always looking out into the future trying to be prepared for shifts in the financial markets. So, the smart asset managers hedge against the knowns as well as the unknowns. One of the great knowns is that, when inflation rises, your allocation has to shift because the Central Bank and the markets will respond to a shift in future inflation. So, there are always asset managers who are hedging against this risk. The idea that a Central Bank can set permanent high inflation expectations is based on the idea that asset managers won’t hedge away the risk of future rate hikes or Central Bank policy contraction. This assumption does not at all reflect how people in my line of work think!  The reason why is because, if the Central Bank could actually create high inflation with its policies then the financial markets will hedge for policy contraction in the future. There is no “permanency” in any of this. There is only a series of short-terms that asset managers prepare for.

So, what we have here is a theory that is a “stripped down” model that misrepresents banking, uses a theoretical concept that may or may not exist and applies a totally unrealistic theory about permanency on top of all of that. Frankly, I find it hard to believe that any rational person could use such a model. And the sooner these kinds of models go away the sooner we will get to more realistic models and better policy outcomes.


1 – The Basics of Banking

2 – Central Banks can’t Set Permanent Long-term Expectations 

3 – Nobody Needs to Understand the Liquidity Trap