Thursday, September 17, 2009

Hoisted from the archives – my old post on Freshwater and Saltwater macroeconomic theory

Long before Paul Krugman elevated the central schism in macroeconomics to the front page I wrote about it on this blog.

My old post is reprinted below (with a few trivial modifications to make it more readable than the original):

Freshwater and Saltwater:  macroeconomic theory and losing money

Background for the non economists. In 1976 Robert Hall christened the central schism in macroeconomic thought as being between the freshwater and saltwater schools. The division was picked by their location (on the Great Lakes and Rivers versus the coastal schools). The division exists today – and indeed is being played out in Krugman’s (saltwater) blog and by the Chicago economists who think he is a bozo idiot.

Having got through the background here is the post…

Does everyone agree that Greenspan kept monetary policy too loose for too long?

I thought so!

When I did economics at University (admittedly at that Freshwater school on the Molonglo River called the Australian National University) that was meant to end in inflation – not deflation.

I like my theory to accord at least loosely with reality. Especially if I am going to bet real money on the outcome – rather than pontificate in papers from the ivory tower of academia.

More to the point – I thought (in true Freshwater style) that sustained low interest rates were a sign that monetary policy had been tight and that sustained high interest rates were a sign that monetary policy had been loose.

Given that basic understanding of macroeconomics I thought that regional banks that made more than half their profits out of carrying the yield curve would be carted out when loose monetary policy did eventually lead to higher interest rates. I was short a lot of banks – and whilst that was good – I spent a long time being short interest rate plays (whereas I should have been short the credit sensitive banks). I have detailed that mistake here. Bill Gross made a similar mistake declaring (early) the 25 year bull market in long dated treasuries over – so despite Bill Gross’s saltwater location at Newport Beach I was wrong in good company.

Now the subject of freshwater, saltwater and other macroeconomic elixirs is the subject de-jour amongst economic bloggers – but I have conducted the experiment – with real money – and I can confidently say (brutally backed by less-than-ideal-financial outcomes) that the saltwater guys were right.

John Hempton

PS.  I know that the inflation junkies are still predicting hyper-inflation – but they were also predicting it in January when I wrote the original post.  The Freshwater guys are still wrong. Will the backers of the Freshwater school please put out a testable timetable?

PPS.  A reasonable summary of the issues I lived can be found in Justin Fox’s book.  Whether Krugman should have referenced Fox in his magazine article is an open question – but I think Fox’s summary is right… Krugman lived the issues in the book and did not need Justin Fox to explain them to him…


Charles Butler said...

Testable timetable? How impertinent. Next you'll be demanding best-before dates on predictions of the apocalypse.

John Hempton said...

Charles - maybe I am being tough - but having lost money on the bet (or at least not made money for the right reasons) I am overly sensitive.

If you refuse to admit you were wrong in the money management game (and worse refuse to acknowledge that you might be wrong) you lose BADLY. You blow up.

So - yes - I was wrong. And the theory is STILL WRONG.


Charles Butler said...

That's the whole issue. If you've got money on the line, there comes a point where you have to admit that there was an outcome - positive, negative or neutral. If what's in play is ideology, you can dick around with the time frame to your heart's content, Or just wait long enough for an opportune moment to declare victory and go home. After all, all things do come to pass in the fullness of...

Matt Canavan said...

I am not sure the freshwater economists thought that low interest rates leads to inflation. Here is Milton:

"After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die."

hat-tip, Scott Sumner

babar ganesh said...

if someone truly believes that hyperinflation (or even mildly high inflation) is on the near or medium term horizon and they are willing to stand behind this via their investment portfolio, the obvious choice is a highly levered real estate portfolio.

i don't see a lot of takers.

But What do I Know? said...

You know, an alien coming down from space would probably say that raising interest rates is the best thing for the economy--because the great boom in the eighties and nineties occurred when rates were much higher than the 2000's. If you view the S&P 500 and Fed Funds rate curves since 2000 from six feet away they look pretty similar. There are all sorts of reasons to explain this away--policy lags, for one--but the fact remains that short-term interest rates and stock market performance have been positively correlated throughout this decade--in complete defiance of conventional thinking. Maybe economic events cause interest rates, rather than the reverse.

As Yogi Berra said, "In theory, there's no difference between theory and practice, but in practice there is."

Marxelo said...

Yes! Give us a time table! The trick that in the long run classical economics is always right is... a trick!

Jim Glass said...

It's the law of supply and demand.

Falling interest rates mean either increasing supply (loose money) or declining demand (due to tight money).

One must look at things other than the interest rate to tell the difference.

Here's Sumner on this subject in regard to the current recession in some detail.

Mr. Canavan is right that Sumner has cited Friedman and a bunch of textbook writers on this point -- as evidence of how little economists believe in the textbooks they use to teach, when put to the real-world test.

As an aside, in the US and Europe demand for rental cars is down 15% from a year ago, yet the cost of renting a car is up 30%.

So don't anyone think the big drop in demand for rentals is creating bargains that are readily available -- if you just show up at the airport you may not be able to get a car at all. Reserve early!

Anonymous said...

Having seen the freshwater economists up close, I have to say they have spent too much time blowing air up each other's a**ses.

They were in love with their own models and ideologically drunk on the victory of the Washington consensus post-Thatcher and Reagan.

Like any intellectual movement, they started going to seed when they decided among themselves that they had won the ideological battle.

With financial markets imploding around them - and the concept of 'free markets' being the best arbiter of outcomes going up in smoke - they have resolutely stuck their heads in the sand.

Here in Australia, the zealots in the Coalition are clearly still listening to them (the Sinclair Davidsons of the world), but one senses the general population's bulls**t detectors have now kicked in and we're heading back toward an era of economic pragmatism.

John Haskell said...

I've read the original post twice and now all the comments, and I still don't understand.

Low interest rates supposedly lead to inflation. We now know this to be a "fallacy."

Does this site believe that the only definition of "inflation" is "upward change in consumer price index"?

Can an increase in the nominal price of capital assets, such as condominiums in Las Vegas, count? Or are we blinkering ourselves with constructs such as "owner equivalent rent" which indicate that there was no inflation 2002-2006?

The Austrians (not much water of either type there, not sure where they fit) argued that low interest rates led to malinvestment. That hypothesis certainly did not suffer from exposure to reality in the 2002-2006 time frame.

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