Saturday, June 27, 2015

A long, late comment about that Omega point….

One of the problems with working all day and only writing here at odd moments in the evening, when I have energy and inspiration, is that I’m always late to every good party.  The Omega point discussion I want to write about is already very old news; it was on and over weeks ago, which is a few long epochs ago in interweb time.  But there were things about the whole conversation that enchanted me, and others that bothered me, so I might as well write those things down.

So here it is: a few interweb epochs ago there was an exchange of bewilderment between Martin Feldstein and Paul Krugman.  Feldstein was bewildered by the fact that the Fed’s flood of new money in the last few years has not yet created the corresponding flood of inflation or even the long run expectation of inflation that he (and many others) predicted, based on something like a quantity theory of money (“inflation is too much money chasing too few goods”).   And Krugman was bewildered by the fact that Feldstein was bewildered, since stable prices when interest rates are at the zero lower bound and the “natural, full-employment” interest rate would be much lower than zero is what HE predicted, based on something like the old Keynesian or Hicksian IS-LM liquidity-trap model.  

The contesting bewilderments between these two very smart economists does raise a question: why does it exist so strongly when both of them based their predictions and bewilderment on well known, widely taught economic theory?  Neither was dealing, I think, with any theory that the other did not completely understand and, in one way or another, even accept.

Then a few weeks ago Brad DeLong suggested an answer: what you predict depends on how far into the future you think the Omega point is, and how strong you think its influence is on the what is happening now.  

The Omega point??  I didn’t recognize that from my Econ 101 text.  I had to look it up.  If you feel up to an excursion into entropy and evolution and cosmology and the nature of time and God, follow the link to Pierre Teilhard de Chardin, But for now, let’s just say that the word that DeLong used may be non-standard in economics, but the idea is strong in the economic imagination: the point DeLong is talking about is an ideal, theoretical condition out there in the temporal distance that is pulling at us, tugging us toward it.   It is final result of all that is happening now, the time when all economic discord and turbulence will cease, when prices and wages all have adjusted, and the thing that people in the econ biz call the velocity of money will have stopped gyrating all over the place, and will have settled wherever it is supposed to be.  DeLong even says this directly; he says:

At that time the money multiplier will be a reasonable and a reasonably stable value. At that time the velocity of money will be a reasonable and a reasonably stable value. … And at that time the price level will be proportional to the monetary base.”

Assuming that nothing else happens to knock us off our course---no new crises, no earthquakes or tsunamis or plagues, no major wars, no long-simmering industries suddenly bursting  out and changing the world, no fundamental political changes that bend some cost curve up or down or sideways, no new bubbles or panics or manias, no out-of-the-blue, irrational desolation or exuberance---assuming that we are left alone to move where our current Omega point lures us, it is the point at which we will settle in the end.  It is, finally, the Fabled Economic Long Run.

And DeLong’s post starts by repeating the last phrase of the famous quote from John Maynard Keynes, in which he states that “in the long run we are all dead”.  Keynes was complaining, long ago, about economists who constantly refer to the long run and tell us all to be patient while we get there.  Keynes said: “Economists set themselves too easy, too useless a task, if in tempestuous seasons they can only tell us, that when the storm is long past, the ocean is flat again.” And in saying that, Keynes tells us that he thinks that when times are very hard or very turbulent, whenever, that is, people or politicians might turn to economic theorists hoping they might at last be of some real use, precisely at those times something very basic has pushed us far from long run equilibrium, and the Omega point might at exactly those times have raced far, far ahead of us into the distant future.  In fact (I think he might be saying) we are in a hard and turbulent time because the Omega point has raced ahead, and because there are barriers of some kind between it and us, and because it will be hard to get to it.  If it were easy to get to and there were no barriers to keep us from it we would be in it already, and the ocean would already be flat.  At times like that, he’s saying, the Omega-point-long-run is often so far off that it’s not a proper subject for economic thought.  The proper thought during a storm at sea is not a daydream about how peaceful it will be when the storm is over.  That may be tempting, but it’s not useful.  There’s a lot more practical value in thinking about how to survive the storm with as little damage as possible.

One possible response to that view is to deny that the long run can really move as far as that into the future, but DeLong (along with most economists these days, I hope) has seen enough of reality to know that it does not look like that.  Another response, the one DeLong describes in his post, is this: the Omega point may be far away but it is still very powerful.  It may not even exist anywhere but in the imagination of economists and economic actors (like bankers or businessmen or workers or consumers). But the imagined Omega point changes their---our--- current behavior.  A whimsical analogy: it may seem serene sitting on the level sand in the top of an hourglass, but you know how an hourglass works.  If you were sitting there on that sand you would know that deep beneath you is motion and drift, and that soon you would feel it, soon you would have to react, soon serenity would dissolve and you would be pulled through the vortex to the Omega point below.  And knowing that, you might react immediately to prepare, even though the sand you now sit on seems placid. 

Of course it’s common, and has been since somewhere around 1950 or so, to see the short run as Keynesian, and the long run as classical, and where you sit on the spectrum of ideology may depend on, or may determine, which of those two models you find most immediately useful, and on when you think the long run will arrive.   But DeLong, I think, was saying it depends also, or also determines, how you think the short run becomes long.   He paints a vivid picture of a “backward propagation” of behavior that is caused by our awareness of the distant Omega point, and how that might create a quick, even nearly immediate, economic response to large rises in the money supply, since current economic actors would feel in their bones that someday, as the Omega point nears, that increase in money would create inflationary pressure.  They would feel in their bones that because of how they believe the economy works there is already motion and drift beneath them, invisible, but there, and they would begin to prepare for the vortex they know is coming.   Because inflation, the Quantity Theory tells us, is always and everywhere a monetary phenomenon.  And because economic actors, even though they may not understand it on a theoretical level, on a mathematical level, are nevertheless saturated with a devout faith in the Quantity Theory.

As DeLong says this idea explains why economists with the same theories might differ in their beliefs even about what the near future holds:

“…beliefs in 2008 and 2009 that economies’ stays in liquidity traps would be very short…and beliefs since then that those who believe will not taste death before, but will live to see exit from the liquidity trap and an outburst of inflation as the Federal Reserve tries and fails at the impossible task of shrinking its balance sheet to normal without inflation–all of these beliefs hinged and hinge on a firm and faithful expectation that this long run is at hand, or is near, or will soon draw near…

“Back in late 2009 I thought that the liquidity-trap short run was likely to be a three-to-five-year phenomenon. It has now been six….The duration of the short run thus looks to me to be, this time, not three to five years but more like ten. Or more. The backward-propagation of the induction-unraveling of the short run under pressure of the healing rays of the long run Omega Point is not just not as strong as Marty Feldstein thought, is not just not as strong as I thought, it is nearly non-existent.”

But to me this does not seem like a surprise. 

I’m not surprised by it partly because I’m pretty ambivalent about the quantity theory of money even as a long run concept, but partly also because I’m still back there with Keynes: when the Omega point is really distant, and the transition to it looks like it’s difficult and uncertain, it is very probably so far away that we will never get there at all.   At least one thing, a tsunami or a new industry or a bout of irrational exuberance or depression, one thing at least will happen to us long before we reach that Omega point, and whatever it is will create a new storm on our ocean, and will shift the Omega point to some new position.  Something will turn the hourglass upside down or knock it on its side, or tumble it end over end down a hill, or break the glass that forms it, or something, and preparing to whirl through the vortex to an imagined Omega point beneath us will do us no good when we’re sitting under a torrent of sand dropping on our heads from above, trying to bury us. 

How likely is it that something will happen to interrupt our trip to the Fabled Economic Long Run?  How stable and certain is the Omega point?  My own view is that unless the Omega point really is “at hand, or near, or will soon draw near”, it’s not very certain at all.  And what’s worse, it’s not uncertain in a way that’s easy to handle: it’s not just subject to some random variation around a long run expected value.  It’s not stochastic.  It’s unknown.   We can prepare for it by gaining strengths that will be useful no matter what the future is.  But we can’t rationally forecast it with a formula.

One example of this that I’ve used often is the World-Wide Web: in 1989 we could not possibly have predicted the dot-com bubble of just a few years later, because there was no dot-com start-up in existence in 1989.  The Internet existed---the capability of sending data between computers.  But there was no HTML, no JAVA, no Visual Basic; there was no such thing as a web app.  There were none of the basic building blocks of modern e-commerce beyond the existence of the network itself.   The creation of the real World Wide Web changed the way business was done, and left any prior vision of a long run Omega point that we might have had in 1989 floundering in the dust.

But that’s a one-time event, right?  Surely that kind of thing doesn’t happen all the time; surely our longer run expectations are more secure in “ordinary” times than they were at that point, on the cusp of a transforming technology, before the first wave of a new and transforming industry.  Right?

Let’s go back through a few decades to see what might have changed the Omega point in each of them.  I’ll mention just what comes quickly to my mind, which means I’ll leave out a vast number of important things that don’t, and I don’t doubt that you’ll experience some frustration with my lists because I’ll leave out the very things that you think were most important.  So just regard my lists as a start, as scratch lists, and feel free to add to them.

Imagine yourself not in 1989 but in 1999 trying to look at the long run, the Omega point over the next decade.  What would you have forecast?

In the following decade, the 2000s, we had two new wars sucking away our national wealth, and the horrific events that preceded those wars.  We had a Presidential election contested up to---and some say decided by---the Supreme Court.  We had the Bush tax cuts early on, an immense housing bubble through much of the middle of the decade, and then the largest financial crisis since the great depression.  We had the Tea Party, sequesters and fiscal cliffs.  On the up side, the iPhone and iPad and all of their competitors hit the market, creating an industry that is still expanding, and after that we not only could order things from abstract stores without walls, we could do it from our hand held computers (our phones) while we sat on a park bench.   Industry insiders may have expected each of those things, but most of us did not.  YouTube, Facebook and Twitter all were founded and blossomed; and even industry insiders did not expect those, because there were no industry insiders in the new industry of social media.  SpaceX was founded in 2002. In 2000 the Federal budget ran a significant surplus…remember that?  Which the CBO projected would continue through the decade and wipe out the Federal debt.   Alan Greenspan, the Ayn Rand acolyte and fiscally conservative Chairman of the Fed, went before Congress to warn them that the budget surplus was far too big, that we were paying off the national debt so fast that it was dangerous to our economic well being, and he then begged Congress to be more fiscally profligate.  Mid-decade we had Hurricane Katrina that trashed New Orleans; in 2010 we had an earthquake that devastated Haiti.  In 2004 there was a tsunami that pushed the Indian Ocean well inland across much of Southeast Asia.  Oh…and of course, a Republican President requested, and Congress enacted, a $700 billion bank bailout, an amount that at the time seemed almost inconceivably huge, and in quick succession after that we elected the first black President in US history, and the new President asked for and received from Congress a $787 billion economic stimulus bill on top of the bank bailout.  He also proposed, and Congress passed, a national health care bill that drove the Republican party to such frothy-lipped distraction that it would repeatedly bring the whole country to the brink of fiscal default by refusing to raise the ceiling on the debt that the CBO, at the start of the decade, had thought would shrink until it vanished. 

How much of that did you predict in 1999?

For the 1990s we’ve already mentioned the emergence of the World Wide Web and the dot-com bubble.  Amazon was founded in 1994.   Web TV, Java, Google, and the first Gulf war.  Clinton was impeached by the House, and then acquitted by the Senate.   The Los Angeles riots in 1992. Did you predict all of that in 1989?  Do you want to argue that those things had no impact on the long run Omega point?

For the 1980s we can point to the emergence of personal computers as a major industry; it had really started in the 1970s, but IBM took it to the big time with the first IBM PC in 1981.  Those of you who are very young can’t begin to understand what a radical transformation that was.  MS Dos emerged; the Apple Macintosh was marketed with the famous Super Bowl ad.  At the end of the seventies there was a widespread fear that rapid inflation was built in to the system in a wage-price spiral, but a deep Fed-induced recession in the very early years of the 1980s killed inflation expectations by driving interest rates through the roof.  Then we had “morning again in America” in the middle years, as soon as the Fed allowed it, and recession again at the end.  In 1982 Israel invaded Lebanon.  Reagan fired 13,000 air traffic controllers, which reputedly so damaged the labor unions in the United States that they have not really recovered since.  Again, those of you who are too young to remember how things were before that event won’t really understand how transforming that act was, and how much it changed the economy we live in.  Congress, with Reagan strong encouragement, reduced the top tax rate from 70% in 1979 to, for a time, 28% in 1986.  Iran-Contra.  Nicaragua.  Oliver North sneaking secret documents out of the OEOB in his secretary’s undergarments, and his potted plant defending him at Congressional hearings.

Back another decade: what would you have predicted looking forward from 1969?  The 1970s ended the Vietnam War in somewhat chaotic fashion; President Richard Nixon was impeached and resigned; in 1973 OPEC imposed an oil embargo that sacked the US economy in many ways.  A Republican President imposed Wage and Price Controls, an almost Marxist intrusion of federal fingers into the operations of private markets.  Crude oil prices rose from under $2 per barrel in 1970 to over $36 per barrel in 1980. $36 per barrel may sound cheap by modern standards, but think what an18-fold increase in the price of oil from its current level would do to our economy now---from the current roughly $60 per barrel to over $1000 per barrel.  Think about that. Do you think that would have no impact on our long run expectations?  Other seventies events: Apple computers, Atari computers, Visicalc,  Ethernet and TCP/IP.  Floppy disks, microprocessors, videocassette recorders, LCD screens.  Word processors.  Pong and the beginning of computer gaming.

Looking forward from 1959?  In the sixties: lord---do we really have to do the sixties???  The riots, the civil rights movement, the anti-war movement---the Vietnam War itself?  The whole suite of New Frontier and Great Society programs, including Medicare and Medicaid?   Leaving the planet Earth, for the first time in history: we had barely left the atmosphere at the beginning of the decade, and by the end we had landed men on the moon.   The event itself has not yet impacted any Omega point, but the process of getting there surely did.  The Civil Rights Act, the Voting Rights Act.  The assassinations of John Kennedy, Robert Kennedy, Martin Luther King, Malcolm X, the Birmingham church bombing, Medger Evers, Chaney, Goodman and Schwerner.  Woodstock and Altemont. 

And the fifties: the Interstate Highway System, the Korean war, the invention of the credit card, radial tires and the transistor radio, Cobol, Fortran and, of course, the births of Barbie and Mr. Potato Head.  Sputnik and the start of the space race.  The House Un-American Activities Committee, and McCarthy in the Senate. 

Forties:  Nazism, Pearl Harbor and all of WWII, the Marshall Plan, the entire south walking out of the Democratic National Convention and forming their own separate States Rights Democratic party.  The beginning of the Cold War.

Thirties: New Deal, WPA, Great Depression, Social Security, the dust bowl, Hoover Dam, the Rural Electrification Administration and the Tennessee Valley Authority, and the publication of Keynes’ General Theory, which created modern macroeconomics, and also created a schism in the economic world that we have not yet resolved.

The point of all this is that if the Omega point is not too far away---if we’re fairly close to long run equilibrium---then its fire will warm us, and we will all react to it, and do our best to prepare for it.  If it’s close it’s powerful on its own as our “long run” destination, but also powerfully affects our short-run behavior, because we really believe in it, we can feel it.  But the farther it is in the future the less likely it is that we will ever get to whatever Omega point is pulling at us. It’s still a valid abstraction.   It is still the direction that the economic fundamentals are now moving us, in some sense.  But if the Omega point is a decade away, if too much has to happen to get us from here to there, then the odds are that a great deal of turbulence will intervene between now and that long run, and by the time it really could be at hand, or near, or soon draw near, by that time the Omega point that pulls at us will not be the one we see now.  By that time the Omega point will have moved to a very different place.  And I think most people can see that, and react as though they can see it.  The distant Omega point does not warm us.  It’s like a fire in another room, or even in another house. 

One quick word about the Quantity Theory and the money supply, and I’ll stop.  There seems to be a great deal of panic in some circles that the Fed has quadrupled the quantity of base money in the years since 2007.  That is the source of Dr. Feldstein’s original bewilderment and DeLong’s comment about the price level being proportional to the monetary base when we at last reach the Omega point.  But lost in this panic is the fact that the monetary base is never stationary: it doubles about every 10 years to accommodate a rising nominal GDP, and has been doing that for many decades.  Yes, the base money supply has quadrupled from its level at the close of 2007, but it’s already been 8 years since then.  The Fed will have to be alert, yes, and be ready to draw that supply down if it becomes necessary.  But as time goes on the amount that will have to be drawn down dwindles.  At that time, the Omega point time that DeLong sees in the future, the Fed’s scramble to “shrink its balance sheet to normal” may not seem impossible at all.  If the Omega point is 12 more years away, the Fed has already accomplished the task: all it has to do is stop expanding, which, in fact, it is doing.  The base money supply has held more or less steady for the last year.

Here’s the truth: the ocean is never ever flat.  There are calmer times and more turbulent times, but it’s never flat.  Even if the general economic models, the Keynesian short run and the classical long run, all capture real trends in our economic lives, and point to some economic destination that results from our policy choices, we can’t believe that ordinary economic actors will rationally treat that long run single-point destination as inevitable.  In fact, to turn that phrase backwards, we can’t think that it would be rational for them to think of it as inevitable, particularly when the process of getting there will take time, and has to leap a few hurdles.  Because, to abuse a phrase, the Omega point is just one damned thing, while real-world economies are one damned thing after another.