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Dear Ed,
On June 29, 2009 you posted a fairly long reply to a comment
about deflation. Among others, you wrote:
I feel that the feedback dynamics
modeling approach might be useful in this regard [modeling
inflation, unemployment etc] - although the process of building
useful models might require considerable patience and diligence.
Such replies, as well as the overall direction of the EcoNowMics
section, make me think you haven't read "Exploring
General Equilibrium" by
Fischer Black.
In case that's true, I wonder how your outlook on Economics might
change should you become familiar with the ideas from this
masterpiece. I'm pasting a few quotes below just to try to stimulate
your interest.
Kind regards,
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[random excerpts from "Exploring General Equilibrium" by Fischer
Black]
My version of the general equilibrium model suggests that the
overall rate of inflation is unaffected by
open market operations
and other instruments of monetary policy. When a government prints
money to finance most of its spending, it causes hyperinflation.
Running the printing presses to finance spending implies a large
budget deficit.
I think it's the deficit that causes hyperinflation, rather than
the money growth itself. An economy with hyperinflation has so
many distortions that I think of it as out of equilibrium.
If monetary policy doesn't normally affect inflation, what does?
The inflation rate is indeterminate. It can be whatever people think
it will be. (The
money supply will passively accommodate whatever the
inflation rate turns out to be.) Here, in fact, is a pure case of
self-fulfilling expectations. If people expect a certain
inflation rate, that's what they get, because they set prices and
wage rates to match their expectations.
Monetary policy might even play an indirect role in fixing
the inflation rate. If people think
monetary policy works, and they see signs of a tight monetary
policy, they may reduce their inflation expectations. This, in turn,
may reduce actual inflation.
Both temporary and permanent shocks to many economic variables
reflect revisions in expectations about future tastes and
technology. I think we can summarize many of these revisions as
variations in the expected "match" between wants and resources,
where we specify both wants and resources in great detail along many
dimensions. We make investments in human and
physical capital
in the light of our best estimates of future tastes and technology.
When these estimates turn out to be more right than wrong, we have a
good match between wants and resources, and times are good. When we
are wrong, we have a bad match and times are bad. The more
specialized the economy, the more detail we need in order to
understand the match.
Why are
asset prices so volatile? I have never found this question as
interesting as Shiller
(1989) has. He looks at current news and finds that prices seem to
change even when there's no news. I think about expectations, which
are constantly changing as people process old news. He looks at the
smooth path of dividends and finds that prices seem to change more
than the present value of dividends. I think of dividends as
depending on current and past prices, rather than of prices as
depending on expected future dividends, so smooth dividends seem
natural to me.
Given the volatility of expectations, I'm surprised that asset
prices aren't more volatile than they are. We see asset volatility
for the same reasons that we see variation in growth rates across
countries and through time, and for the same reasons that we see
business cycles. The questions are different, but the answers are
the same. Asset prices vary because we make highly specific
investments while looking far into the future; as time goes by,
we change our beliefs about the future along many dimensions, which
makes our investments seem more relevant - or less relevant - and
thus changes the values of claims on those investments. Sometimes
asset prices change because we become more patient - or less
patient - and sometimes they change because we become more
tolerant of risk - or less tolerant of risk - but we don't need
those sources of volatility to understand why prices often change
for no apparent reason.
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Thank you for your email. We can
apply EcoNowMics thinking to the various propositions above.
Perhaps this exercise can help you understand my hesitation to base
my thinking on Black's work, such as you cite above.
1. I
think it's the deficit that causes hyperinflation, rather than the
money growth itself. -- FB
Deficit is a flow, specifically the
excess of an outflow over an inflow; it accumulates into a stock,
namely into Debt. Money growth is a flow, specifically the
printing of money; it flows into a stock, namely the money supply.
Neither of these flows flow into a level
with the name hyperinflation. Inflation is, technically,
another name for money growth rate. It also means, loosely,
price increase. Hyperinflation is a large rate of either money
growth of price increase.
Black's assertion does not connect
deficit to inflation in way that defines the moment-of-now linkages;
he also resorts to "causal" thinking.
2. The
inflation rate is indeterminate. It can be whatever people think it
will be. -- FB
Indeterminate comes from Latin, in
+ determinare (to determine); it means without definition or
determinability.
Here Black says we can't determine
inflation rate and then goes on to suggest that people's
expectations determine it.
3. If
people expect a certain inflation rate, that's what they get,
because they set prices and wage rates to match their expectations.
-- FB
Here Black claims the "people" somehow
explain inflation. He does not present the linkages between
expectations and prices and wages and he does not explain the
process of formation of these expectations.
Expectations generally lag behind actual
data, as people come to expect, after some averaging delay, some
continuation of the current situation. Prices and wages
generally change in response to consumption/inventory ratios through
a process of negotiation.
4. If
people expect a certain inflation rate, that's what they get,
because they set prices and wage rates to match their expectations.
-- FB
Again, we have little evidence of
expectations leading prices. It's generally the other way
around. These days, many people are expecting a high rate of price
increase, consistent with the inflation of currency and the
attending increases in reserves within the banking system.
Prices of homes and wages are not currently rising with these
inflationary expectations. In this case, many banks have money
to loan and unwilling to make the loans. This might have more
to do with their current loan policies and politically correct
regulations than with their expectations of inflation.
5.
Asset prices vary because we make highly specific investments while
looking far into the future. -- FB
We cannot see into the future; the future
does not exist, except as a concept of the now. People respond
to pressures and motivations they feel in the moment of now.
6.
Asset prices change because we become more patient ... and ...
because we become more tolerant.
Here we have the rate of change of price
depending on the rate of change of "patience" and on the rate of
change of "toleration."
I know of no studies verifying this; I
know of no set of linkages that connect these elements.
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Thursday, October 29, 2009 8:26
AM
Dear Ed,
I'm addressing some of your comments, quoted with >.
> my hesitation to base my thinking on Black's work,
> such as you cite above
The book has 300 pages. I only typed a couple of paragraphs.
> Black's assertion does not connect deficit to inflation...
Two keywords (for me) in that paragraph are 'suggests' and 'many
distortions'. I take what he says as merely a proposal, something
that could happen at times. 'Many distortions' suggests many other
possible factors and connections.
> Here Black says we can't determine inflation rate and then goes
> on to suggest that people's expectations determine it.
> Here Black claims the "people" somehow explain inflation.
Indeterminate also means vague, uncertain, undecided, not
established. Other words from the same paragraph include: can be,
might, if people think, may, may. Again, I take this as a very
interesting idea of what may happen sometimes. I don't see it as a
claim that something fully explains something else.
> Again, we have little evidence of expectations leading prices.
> It's generally the other way around.
I'm not familiar with the lack of evidence, or the abundance of it
for the other way around.
> We cannot see into the future.... People respond to pressures
> and motivations they feel in the moment of now.
It appears to me this is what Black had in mind. I interpret
'looking far into the future' as the plans and ideas that exist in
the moment of now.
> Here we have the rate of change of price depending on the
> rate of change of "patience" and on the rate of change of
> "toleration." I know of no studies verifying this; I know
> of no set of linkages that connect these elements.
I'm not familiar with studies denying this. Black wrote 'sometimes'
and again I take all this as a suggestion, not as a claim. In the
subsequent paragraph (which I didn't type), Black wrote:
The details matter. We can't understand the powerful role of varying
expectations without looking at outputs that range from peanuts to
spaceships, and at inputs that range from truck driving skills to
experience in doing coronary bypass operations. We just can't
understand volatility using a model that has two inputs and one
output, or even one that has 200 inputs and outputs.
Overall, I like Black's book a lot because of the gems (ideas and
suggestions) that I found in it. Your mileage may vary. I feel that
I've done enough typing just trying to recommend it. :-)
Kind regards
PS One final example of an idea that I like a lot is Black's
insistence that the economy has billions of sectors:
[Fischer Black] In the real world, the match between wants and
resources is defined over a vast number of sectors along many
dimensions. To make our investments in human and physical capital,
we must form expectations about tastes and technology in each of
those sectors for an array of future times. [...] I think of the
world as having billions of relevant sectors. [...] When we define a
sector as a plant, or as a single job within a plant, or as an
individual product or service, some sectors are expanding and some
are contracting all the time. |
| Wednesday, October 28, 2009
Hi Ed
I read your response to the Fisher Black FAQ. I feel you covered the
points with a logical rebuttal. One big difference is that it seems
FB feels things are OUT of equilibrium as hyperinflation and your
models show everything is IN equilibrium based on the flows of the
systems.
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