Tuesday, December 8, 2009

My biggest fear

One of the things that I've been trying to understand is to what extent the boyz down at the Fed get it.  No doubt, these are smart folks, they have great data, and they know 6000 times more about economics than I do.  But, is that knowledge counter-productive?  Some days it seems like they've grasped the fundamental problem that would require a major re-think of neo-classical economics -- namely that money is real, and that how you count stuff matters to the real economy -- and some days it seems like they are trapped in a "money is just a very efficient form of barter" mindset. 

Which is what makes reading stuff like this new paper from the Dallas Fed so scary.

If the nominal exchange rate regime matters for the determination of relative prices such as the real exchange rate or the terms of trade, it must matter because there is some kind of nominal price stickiness. For example, if the U.S. dollar/euro exchange rate is to affect any real prices, it must be because there are some nominal prices that are sticky in dollar terms and others that are sticky in euros. From the standpoint of modern macroeconomics, the question should be posed: What policy best deals with the distortions—from sticky prices and other sources? Is it a fully flexible exchange rate, or some sort of exchange rate targeting?

Now, this sounds like an interesting paper.  The basic question being why you need the nominal exchange rate to adjust when you could just have prices and wages adjust to produce the same effect in real terms.   In other words, if China keeps the Renminbi pegged too low, why isn't there more inflation in China or more deflation in the US?  Good question.  Maybe I'll read the paper. 

But note how the question is phrased (the bold emphasis is mine).  A behavioral fact as simple as the reluctance of people to take a pay cut is being called a "distortion".  Yeah, okay, it's a distortion of some economist's imaginary model of a perfectly frictionless economy, but that is not a very useful definition of "distortion".  Until these sorts of "distortions" are simply considered "facts", I'm not sure we're going to make any fundamental progress in managing or meta-managing the economy, and I will remain worried that the brave men in charge of the liquidity hose are all wet.

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