Krugman Monetary Policy and Models

Paul Krugman recently wrote two blog posts on monetary policy in a liquidity trap. In “Timid Analysis” Krugman presents a model in which Nash favors the bold

But a necessary (not sufficient) condition for this to work is that the promised inflation be high enough that it will indeed produce an economic boom if people believe the promise will be kept. If it isn’t, then the actual rate of inflation will fall short of the promise even if people believe in the promise – which means that they will stop believing after a while, and the whole effort will fail.

Note the language of mathematics “necessary (not sufficient)” used without appeal to stated axioms or assumptions such as “if we assume that the assumption that the world is in Nash equilibrium is a useful approximation to reality.” I’m nit-picking a blog post, but, technically, Krugman slipped into asserting that it is necessarily true that if a belief is contradicted by the evidence then people “will stop believing after a while”.

The day before yesterday, when discussing Congressional testimony on the effects of the Bernanke Fed’s monetary policy in a liquidity trap

What gets me here is the complete unwillingness to accept the reality test. Here you have monetary economists who made a totally wrong prediction, at a time when other people were not only getting it right, but explaining carefully both the theoretical and the empirical basis for their prediction. Yet the reaction of those who wrongly predicted runaway inflation is to assert that (a) nobody could have predicted (even though some us did) and (b) it’s just special circumstances. The possibility of conceding that their model was wrong never seems to cross their minds.

Is it necessarily true that any belief that QE would cause high inflation would end after “a while” because of the Bernanke FOMC’s timidity and the effort to decide by consensus ? At least the testifying monetary economists admit that QE hasn’t already caused high inflation. Many ordinary economic agents are convinced that the true inflation rate is high.

I am forced to think of his objections to the free coinages of Silver. Krugman often uses the standard assumption of mainstream economic theory that outcomes must be Nash equilibria (and, of course, uses it very well). He argues (convincingly) that people who try to dispense with theory become accidental theorists: theory what ever you think about it, you can’t do without it (take a tip from one who’s tried).

But that doesn’t mean that the best approach is always to try to improve on existing theory. Sometimes it works better to abandon the old theory and attempt to tickle the mysterious hypothesis generating sub-organ by looking around at the world. Modern medicine was not developed by improving on the theory of the four humors, nor was modern Chemistry developed by improving on alchemy.

Krugman’s stubborn insistence on using the word “necessary” when asserting that, after a while, people abandon beliefs that don’t fit the evidence in a blog largely devoted to noting examples of people who refuse to abandon beliefs which don’t fit the evidence is paradoxical.

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