Interest rates, inflation, and cargo-cult macroeconomics

Brad Delong:

If Stephen Williamson were to have spent any time reading, say, Milton Friedman, he might not make elementary mistakes such as this one here:

Stephen Williamson: New Monetarist Economics: How to Get Worked Up Over Nothing: Suppose a cash-in-advance model with a representative consumer, period utility u(c), discount factor b, constant aggregate endowment y. c is consumption. The consumer needs cash to buy c each period. Suppose y is a fixed quantity of output received by a firm, which is sold for cash within the period, and then the cash is paid as a dividend to the consumer at the end of the period. Have the money stock grow at a constant rate m. The real interest rate is constant at 1/b - 1. The nominal interest rate is (1+m)/b - 1, and the inflation rate is m. Constant m implies a constant nominal interest rate and a constant inflation rate. If m < 0, there is deflation, and the nominal interest rate is sufficiently low to support the deflation. I can think of the instrument the central bank sets as either the money growth rate or the nominal interest rate - that part is irrelevant.... What's the problem?

Williamson's intellectual error is truly elementary. As Milton Friedman liked to say, high nominal interest rates are a sign that money growth has been high in the past and is expected to be high in the future. But that does not meant that you can lower expected future money growth by reducing interest rates today.

The problem is that Williamson is confusing the direction of causation--and thus committing himself to cargo-cult macroeconomics with his claim that the way to reduce inflation is to permanently reduce nominal interest rates. The cargo cults of the South Pacific noted a strong correlation during World War II between (a) the existence of airstrips, and (b) cargo airplanes landing and disgorging huge amounts of consumer goods. They thought it was worth trying to see whether this relationship was causal: would building airstrips cause cargo planes to appear and land?

They experimented... and found that causation ran the other way: it was the expectation on the part of the Seabees of the United Nations forces fighting the Japanese Empire that cargo planes would want to land on some island that prompted them to construct the airstrips.

If the central bank sets the money growth rate as its target, the economy converges to its stable equilibrium. If the central bank sets the short-term nominal interest rate as its target, the economy diverges from its unstable equilibrium. This is the reason that Milton Friedman called for the central bank to set money stock growth at its equilibrium level rather than to set the short-term nominal interest rate at its equilibrium level.

As Jed Harris pointed out, if Stephen Williamson had been in Paul Volcker's place in 1979-1983 he would have lowered rather than raised interest rates in order to reduce inflation. Williamson would then have been much surprised when inflation further accelerated. He would have been significantly more surprised than the cargo-cult airstrip diggers were when no planes arrived. They, after all, were simply testing a hypothesis about the direction of causation in an empirical regularity. They were not claiming a gold-plated theoretical warrant that the direction ran in his particular way.