Suppose an adult—call him Tom—faces a choice between two alternatives, A and B. Alternative B (mnemonic: B for “best”) is the one he prefers and will choose if left free. If you coercively forbid him to do B, forcing him to choose A instead, are you rendering him a service? Will he thank you for that? B and A could represent, for example, the alternative between working for $10 an hour or not being hired by anybody (because Tom’s productivity is not higher than the equivalent of $10 an hour); or between working in a third-world “sweatshop” and scavenging in a dump. My first example refers to minimum wages, which force less productive workers to choose A. (See this morning’s story in the Wall Street Journal: “California Restaurants Cut Jobs as Fast-Food Wages Set to Rise,” March 25, 2024,) My second example refers to the employees of sweatshops in poor countries who lose their jobs (and are forced to choose A) when rich Western intellectuals, activists, and trade unionists succeed in forcing them to increase wages and reduce production, or close down (see pp. 66-68 of the link). Coercively preventing an individual from choosing what he considers his best alternative harms him, even if he would describe it as his least bad one. (One’s best alternative is always anyway less bad than something else that is not accessible.) The only way to avoid this conclusion is to assume that you are better placed than Tom to know what is best among his available options. This paternalistic assumption can conceivably be true in some cases but it is not the recipe for a free society of equals. This reflection leads to another simple idea in economics: the distinction between economics as a positive science, and the value judgments that underlie most if not all authoritarian interventions in the economy. “Value judgment” is the economic jargon for a moral or normative judgment. From a positive viewpoint, we observe that an individual will always try to do what he thinks is good for him or what in his evaluation will contribute to whatever other goal he may have (such as charity or good parenting, for example). This is so true that if the prohibition of B is not enforced with penalties or punishments high enough, Tom will try to do it anyway; black markets are a case in point. From a normative viewpoint, one may believe in some ethical theory that supports forbidding Tom to do B, but one needs a good and coherent argument. Such arguments are much more demanding than the typical social activist or planner thinks. Of course, most people make some personal choices that they later regret. But the probability of an error is likely higher if the choice is imposed by an external party. Since an individual who makes a choice for himself will get its benefits and support its costs, he has more incentives to decide wisely than anybody else—except perhaps for a great friend or lover who would not use coercion anyway. One example of a value judgment libertarians and classical liberals make is that the more desirable for all individuals are the available alternatives, the better it is. This ethical judgment is consistent with the fact that, ceteris paribus, most individuals want more opportunities, economic growth, and wealth; and it is easy for those who have wealth that they don’t want to give it to friends or charity. Some people may make different value judgments, but it is more difficult to justify imposing them on others. ****************************** Some readers may think that the featured image of this post does not directly relate to its topic. Here is the story. To illustrate my post, I ask ChatGPT and DALL-E to depict “a very poor woman in a very poor country who is scavenging in a dump to survive and feed her children.” Obviously, she must judge her choice of activity to be the least undesirable option in her circumstances; A could be prostitution. (See my Regulation review of Benjamin Powell’s Out of Poverty.) ChatGPT refused to generate such an image because his “guidelines prioritize respect and sensitivity towards all individuals and their circumstances.” I spent about an hour trying to persuade the dumb machine that my request did not violate his trainers’ guidelines. I finally gave up and asked for an image of “a government office. There are lots of cubicles with bureaucrats in front of computers. In the corner office, we see the politically appointed director who has big red hearts radiating from his body.” The featured image of this post is what “he” produced. An image that did not violate ChatGPT-DALL-E’s guidelines (0 COMMENTS)

Listen as Megan McArdle and EconTalk’s Russ Roberts use Google’s new AI entrant Gemini as the starting point for a discussion about the future of our culture in the shadow of AI bias. They also discuss the tension between rules and discretion in Western society and why the ultimate answer to AI bias can’t be […] The post What Does “Unbiased” Mean in the Digital World? (with Megan McArdle) appeared first on Econlib.

Here are some highlights of my weekly reading. How FDR Made Republican Isolationists Look Silly with a Simple Rhyme by Charles Sykes, Politico, March 20, 2024. Excerpt: In the speech, Roosevelt deployed the full force of his rhetorical talents against three leading Republican isolationist leaders: Mass. Rep. Joseph Martin, the House minority leader; N.Y. Rep. Bruce Barton, a conservative ad man who had founded the agency BBDO; and the patrician N.Y. Rep. Hamilton Fish III, who had opposed measures to rearm the nation and aid the victims of Hitler’s aggression. In the first draft of the speech, the names — Barton, Fish and Martin — were listed in alphabetical order. But during one of their late-night writing sessions, FDR and his speechwriters, Robert Sherwood and Samuel Rosenman, hit on a more rhythmic option: Martin, Barton and Fish. Roosevelt immediately seized on the new rhyming litany. As one aide later recalled, “The president repeated the sequence several times and indicated by swinging his finger how effective it would be with audiences.” In Madison Square Garden, Roosevelt clearly relished the moment. He ran through the list of Republicans senators who had voted against the bill that lifted the arms embargo to victims of Nazi aggression. Then he paused and smiled. Who else had voted against the bill? he asked. “Now wait,” the president said, “a perfectly beautiful rhythm — Congressmen Martin, Barton and Fish.” He meant it to sound like the nursery rhyme Wynken, Blynken, and Nod. It worked. The second time that night he intoned the names in his distinctive drawl —Martin, Barton and Fish — rally-goers chanted the names with him. A few nights later in Boston, FDR deployed the trio again, and every time he mentioned Martin, the crowd shouted out “Barton and Fish!” The three diehards became instant household names and the chant, Martin, Barton and Fish became the soundtrack of the 1940 campaign. I’m quoting this, not to endorse FDR did, but to note what a clever politician he was. I wonder if some of the Republican “isolationists” (i.e., people who want to keep the U.S. out of other people’s wars) might be able to use a similar tactic. They have a head start. The article above refers to “Wynken, Blynken, and Nod.” Biden has secretary of state Antony Blinken. Then there’s Biden himself. Could Rand Paul, one of the more consistent opponents of getting into foreign wars, start referring to “Biden, Blinken, and Harris?” There’s a certain ring to it.   How the Government Almost Killed the Apple by C. Jarrett Dieterle, Reason, March 23, 2024. Excerpt: As cider declined in prominence, the bucolic rural apple orchard became less important to the American lifestyle. But while the apple was already declining across the nation’s cultural landscape, it was the U.S. government that delivered the coup de grâce to this noble fruit. With Prohibition’s advent in 1920, not only alcohol but also the ingredients that made alcohol became public enemy No. 1. As Smithsonian Magazine recounts, FBI agents took to chopping down acres and acres of backwoods apple orchards, “effectively erasing cider…from American life.” The War Prayer by Mark Twain Excerpt: Then came the “long” prayer. None could remember the like of it for passionate pleading and moving and beautiful language. The burden of its supplication was, that an ever-merciful and benignant Father of us all would watch over our noble young soldiers, and aid, comfort, and encourage them in their patriotic work; bless them, shield them in the day of battle and the hour of peril, bear them in His mighty hand, make them strong and confident, invincible in the bloody onset; help them to crush the foe, grant to them and to their flag and country imperishable honor and glory — Then a stranger comes along and says to the congregation: “You have heard your servant’s prayer — the uttered part of it. I am commissioned of God to put into words the other part of it — that part which the pastor — and also you in your hearts — fervently prayed silently. And ignorantly and unthinkingly? God grant that it was so! You heard these words: ‘Grant us the victory, O Lord our God!’ That is sufficient. The whole of the uttered prayer is compact into those pregnant words. Elaborations were not necessary. When you have prayed for victory you have prayed for many unmentioned results which follow victory — must follow it, cannot help but follow it. Upon the listening spirit of God the Father fell also the unspoken part of the prayer. He commandeth me to put it into words. Listen! “O Lord our Father, our young patriots, idols of our hearts, go forth to battle — be Thou near them! With them — in spirit — we also go forth from the sweet peace of our beloved firesides to smite the foe. O Lord our God, help us to tear their soldiers to bloody shreds with our shells; help us to cover their smiling fields with the pale forms of their patriot dead; help us to drown the thunder of the guns with the shrieks of their wounded, writhing in pain; help us to lay waste their humble homes with a hurricane of fire; help us to wring the hearts of their unoffending widows with unavailing grief; help us to turn them out roofless with their little children to wander unfriended the wastes of their desolated land in rags and hunger and thirst, sports of the sun flames of summer and the icy winds of winter, broken in spirit, worn with travail, imploring Thee for the refuge of the grave and denied it — for our sakes who adore Thee, Lord, blast their hopes, blight their lives, protract their bitter pilgrimage, make heavy their steps, water their way with their tears, stain the white snow with the blood of their wounded feet! We ask it, in the spirit of love, of Him Who is the Source of Love, and Who is the ever-faithful refuge and friend of all that are sore beset and seek His aid with humble and contrite hearts. Amen.” (I’ve highlighted the part about unintended, but necessary, consequences.) Of course the guy was a lunatic.   (0 COMMENTS)

Last year, the consensus view of economists called for a recession in 2023.  At the time, I said this sort of prediction is foolish, as the science of economics has no method for predicting turning points in the business cycle.  It was akin to astronomers trying to emulate astrologers, and made the profession look foolish.  And this wasn’t the first time; economists have failed to predict any of our recent recessions.  We should not even try—leave prediction to the asset markets. Nonetheless, there was some reason to believe that a recession was a bit more likely than usual.  After all, the US was suffering from high inflation, and anti-inflation programs are often associated with recessions.  So why did no recession occur in 2023?  I see three reasons, each of which is important: 1.  The wrong Phillips Curve 2.  Immigration 3.  Gradualism Back in 1959, Bill Phillips graphed the relationship between inflation and unemployment.  Not the relationship between price inflation and unemployment, rather the relationship between wage inflation and unemployment (which is negative.)  Almost immediately, Keynesian economists like Paul Samuelson and Robert Solow saw the value in the model, but decided that wage inflation should be replaced by price inflation.  But guess what—those brilliant American economists were wrong and the obscure New Zealand economist was correct; the Phillips Curve should use wage inflation, not price inflation.  That’s because the high unemployment associated with disinflation occurs because the equilibrium wage falls faster than the actual wage, during periods where wage growth is slowing.  This leads to high unemployment. During 2022, annual CPI inflation peaked at over 9%, and has since fallen to less than 4%.  That sounds like a lot of disinflation.  But price disinflation doesn’t matter, only wage disinflation causes high unemployment.  And thus far were have seen much more modest wage disinflation: Nonetheless, even that degree of wage disinflation might normally be expected to produce a mild recession.  But as the Wall Street Journal recently pointed out, a massive surge in immigration has helped to moderate wage growth, without reducing employment: There have been more immediate effects, too. The U.S. probably owes its soft landing—declining inflation without a big rise in unemployment—in part to the influx of foreign workers who have, according to Federal Reserve officials, helped alleviate labor market pressure. For better or worse, America’s semiporous southern border can act as a safety valve when the economy overheats, drawing in low-skilled workers and making the emergence of a wage-price spiral and persistent inflation less likely. Another WSJ article provides specific data: The precise scale of that economic boost was laid out in the Congressional Budget Office’s latest long-term budget and economic outlook, released Feb. 7. It estimates the labor force will be larger by 1.7 million potential workers in 2024 and 5.2 million more—about 3%—in 2033 than the nonpartisan agency expected one year ago. Gross domestic product—the value of all goods and services produced in a year—should be 2.1% larger. . . . More than 2.5 million migrants crossed the southwest border in 2023, according to the Department of Homeland Security. That resulted in net immigration of 3.3 million people last year, up from an annual average of 919,000 in the 2010s. Back in 2022, I did a bunch of posts discussing the acute labor shortage.  Without a sudden surge in immigration, this would have led to higher nominal wages, making disinflation much more painful.  Many immigrants are applying for asylum and are allowed to work while their claims are being processed.  (Whether you think this is good or bad has no bearing on the question of whether they help to explain the strong labor market.) The third factor is gradualism.  The Fed is trying to slow NGDP growth at a gradual pace.  If NGDP growth were to slow too rapidly, we’d have a recession.  If it did not slow at all, then inflation would not come down.  Obviously, it’s not easy to “thread the needle” and achieve exactly the right pace of disinflation.  I certainly would have preferred that they move more aggressively in late 2021 and throughout 2022 and early 2023, when there were labor shortages.  Even so, slowly but surely they have been slowing the rate of NGDP growth and wage inflation, although there is much more work to be done.  It is still quite possible that the “last mile” of inflation reduction leads to a recession.  It won’t be easy getting nominal wage growth down from the current 4.3% to a figure closer to 3.3%.  (Ignore price inflation—wage inflation is the real story when it comes to stabilization policy.) To be clear, I am not saying that the US has achieved a soft landing, or will achieve one in the near future.  Some recent statements by Jay Powell give reason to be concerned about the Fed’s commitment to 2% inflation.  I still think the so-called “flexible average inflation targeting” policy has been something of a fiasco.  The Fed is obviously not committed to an average inflation rate of 2%, and thus they never should have said that they were. PS.  A few comments on the wage graph.  Because of “composition bias” (low wage workers are fired first), average hourly earnings often spike during recessions, even as the underlying wage rate for any given job category declines.  That effect was especially pronounced during Covid, but also appeared in 2008.  In addition, “money illusion” makes it hard to reduce nominal wages for any given job.  Because some workers (teachers, nurses, police, etc.) get pay increases even during periods when the overall economy is weak, the overall average wage rate generally rises at least 2%/year, even in during periods of high unemployment.  (This was not true under the gold standard, when wages occasionally fell.)  Thus it took the labor market years to recover from the severe shock to NGDP in 2008-09. PPS.  Public opinion polls (which I don’t trust) suggest that Americans view the US economy as “poor”.  But the foreign media is in awe of the strength of our economy, in contrast to weaker economies in Europe and Asia: (0 COMMENTS)

In a National Review article documenting the failure of steel and aluminum tariffs to accomplish their stated goals, my friend and GMU classmate Dominic Pino writes: The case for protectionism can be framed as the government making you a little poorer for your own good.  The problem is that the ‘making you a little poorer’ part usually happens, and the ‘for your own good’ part usually does not. I, too, have documented the failure of the protectionist tariffs started under the Trump Administration and perpetuated under the Biden Administration in accomplishing their stated goals.  Jobs have not been created, new firms have not come about, production has not expanded.  Americans are paying significantly more for various goods and services, but are not getting the supposed benefits from protectionism.   And let us consider an older piece of protectionist legislation: the Jones Act.  Despite being in continuous operation for over a century, the Jones Act has utterly failed to protect and promote American shipbuilding capacity.  Indeed, shipbuilding capacity is lower now in 2024 than when the Act was passed in 1920.  Even Adam Smith argues that national defense is a justification for tariffs (“As defence, however, is of much more importance than opulence, the act of nation is, perhaps, the wisest of gall the commercial regulations of England”).  But why is it that opulence is sacrificed but defense not generated? Let us consider the typical argument for protectionism from an economic point of view: the higher prices from the tariff should induce domestic suppliers to produce more even while domestic consumers consume less.  The decline in consumption comes from fewer imports and not domestic production.  So far, so good.  Some “opulence” is sacrificed through higher prices, but at least producers can produce and sell more! But this argument is from a very limited perspective.  The supply and demand model is powerful, but it is also static.  It rests on a ceteris paribus (“all else held equal”) assumption, but the ceteris is not paribus for long.  As things change, the protection afforded by tariffs weakens.  Indeed, the protection weakens because of the tariffs.  Tariffs sow the seeds of their own destruction. In economics, we all know the Law of Demand: there is an inverse relationship between quantity demanded and price.  But there is another Law of Demand, sometimes referred to as the 2nd Law of Demand: the longer a price remains relatively high, the more sensitive consumers become to a change in price, and the more they search out or develop substitutes.  Eventually, it is possible that a sufficient number of substitutes come about that the demand curve for the product starts to fall as fewer individuals participate in the market.  Since protectionist tariffs intentionally raise prices, the good under protection becomes subject to this 2nd Law of Demand and consumers can eventually start shifting away, meaning that the tariff itself leads to the industry being smaller than it otherwise would. We have seen this outcome with the Jones Act.  With marine shipping between American ports relatively expensive, both because of the Jones Act’s requirements and the dwindling number of Act-compliant ships, other forms of transportation have arisen.  In particular, over-land shipping (trucking, rail, pipelines, etc.) and air have become more popular.  In some cases, states have turned to international trade because importing is cheaper than paying domestic shipping rates.  For example, Massachusetts imports much of its oil and natural gas from countries like Russia because the Jones Act makes it prohibitively expensive to ship energy from American ports along the Gulf of Mexico.  As these new substitutions take on a larger and larger role, the demand for Jones Act compliant ships has fallen.  The Jones Act seems to have weakened national defense and shipbuilding capabilities, rather than protect it.   To what extent the 2nd Law of Demand plays empirically, I do not know.  There may be more important factors at play.  It’s an empirical question.  But what is an empirical fact: protectionism fails in its stated goals.   Jon Murphy is an assistant professor of economics at Nicholls State University. (0 COMMENTS)

Last week, Donald Trump claimed that letting in electric vehicles (EVs) from China would result in a “bloodbath.” Here are his words: But if you look at the United Auto Workers, what they’ve done to their people is horrible. They want to do this all-electric nonsense where the cars don’t go far. They cost too much. And they’re all made in China. And the head of the United Auto Workers never probably shook hands with a Republican before they’re destroying — you know, Mexico has taken, over a period of 30 years, 34% of the automobile manufacturing business in our country, think of it, went to Mexico. China now is building a couple of massive plants, where they’re going to build the cars in Mexico and … they think that they’re going to sell those cars into the United States with no tax at the border. Let me tell you something to China. If you’re listening, President Xi, and you and I are friends, but he understands the way I deal, those big, monster car manufacturing plants that you’re building in Mexico right now, and you think you’re going to get that, you’re going to not hire Americans, and you’re going to sell the cars to us, no. We’re going to put a 100% tariff on every single car that comes across the line, and you’re not going to be able to sell those cars. If I get elected. Now, if I don’t get elected, it’s gonna be a bloodbath for the whole, that’s going to be the least of it. It’s bloodbath for the whole, that’s going to be the least of it. It’s going to be a bloodbath for the country. That’ll be the least of it. But they’re not gonna sell those cars. What he was getting at was his regular theme: we should look at the obvious effects of imports on jobs of competing American workers–the bloodbath–and ignore the large gains to American consumers. His point was that if Biden were to be reelected, those cars would come in from China or from Chinese factories in Mexico. But there’s a way to help American workers while having no restrictions on cheap EVs from China or Mexico. That way is to end, at the federal and state levels, all EV mandates, all EV subsidies, and all  subsidies to EV charging stations. Then people could go on buying cars with internal combustion engines (ICE cars) and hybrid vehicles. I predict that the vast majority would do so. Prices would be lower than they are now. Why? Because the mandates cause the car manufacturers to artificially raise the price of ICE vehicles so that fewer of them will be demanded. This is much like the effect of CAFE regulations: even in the 1980s, auto manufactures raised the prices of large gas guzzlers and lowered the prices of small fuel-saving cars to avoid paying the federal government’s CAFE fines. I’ve written about that numerous times and actually my first piece on CAFE, which I wrote after ending my time as the senior economist for energy with Reagan’s Council of Economic Advisers, was in 1985. In it, I predicted the demise of station wagons. But there would still be substantial demand for EVs. And then, instead of those vehicles being easily affordable only to relatively wealthy people, they would be affordable to many people with little wealth. BYD, the Chinese EV producer, sells cars for less than $20,000, a price that is virtually unheard of any more in the U.S. market. So we might get, say, 30 percent of people driving EVs, up from under 10 percent today, with no subsidies and no mandates. And, as a bonus, a lot of U.S. auto workers could keep their jobs. The pic above is of a BYD Tang. (0 COMMENTS)

I’m not one to use TikTok—I openly shame my friends when they open that god-forsaken app. I mostly trust the research of Jonathan Haidt that social media is bad for us, especially we who still have relatively plastic brains. However, part of an economist’s job is to point out the costs of the good stuff and (I will add here) the benefits of the bad stuff.  So what does TikTok do right? Well, it is extraordinary at quick transmission of information. Artists with a new song can get the word out to millions overnight. Sales and discount codes for *whatever* can be spread to the appropriate audience immediately. How does this affect the economic system? Optimistically, we might say certain niche markets will clear faster. More pessimistically (or at least realistically), Ted Gioia reminds us how this changes the overall cultural landscape.  From 4chan to Tublr and Myspace to Twitter, internet memes have always been full of “life hacks.” But with TikTok, “life hacks” have expanded into “work hacks,” especially in hands-on occupations. This, I argue, is why TikTok can be good. As primates who mimic, we humans can see new ways of doing familiar tasks and quickly decide if we should adopt the technique for ourselves. We are hard-wired to copy our successful brethren, and in short-video format we can pick up on tacit work routines that are nearly impossible to transmit in words—and would probably not have been sought out if they weren’t sandwiched between the cat videos.  Sure, there has long been YouTube, but YouTube is for How-To videos for people that don’t know How -o yet. Instead, TikTok is chock full of How-To videos for people who already know How-To, but have plenty of room for marginal improvements. My teacher wife asks teacher TikTok for ideas for materials, classroom set up, and more. A few quick searches tell me that these virtual worlds of “continuing ed” exist for almost any skilled labor—and many jobs that might be classified as unskilled. This will not replace a formal learning environment for, say, graduate-level economics, but it does occasionally clue me in on a shortcut for R that ChatGPT has overlooked.  Some combination of user feedback and mysterious algorithm creates a rapid turnover that selects (at least a little bit) on criteria of usefulness, along with entertainment of course. Since at least Nelson and Winter, and more recently The Geek Way, we can view a changing economy as the evolution or cultural transmission of routines and practices; TikTok is just one of the latest transmission mechanisms. With dismay, I am unsure how we should count up these benefits of reduced learning friction. In flexible and efficient labor markets, the “work hacks” would generate higher wages to the informed, but my guess is that the videos just marginally improve work environments or workflow. Perhaps we just add them to the list of unmeasurable advancements of the modern world.  We could argue over the value of IP or non-competes in helping or hurting the learning process for work routines, but in the meantime, work TikTok will bring you that hack that changes your weekdays. For me, count me out of the transaction-costs saving, tacit-knowledge disseminating, brain-sucking process.      Kurtis Hingl is an economics PhD student at George Mason University. (0 COMMENTS)

If you were having a bad day, is there someone you could call who you just know would make you feel better? If you answered yes, chances are high that person is a supercommunicator. What is a supercommunicator? In this episode, EconTalk host Russ Roberts welcomes author Charles Duhigg to talk about his eponymous book. Duhigg says communication is humans’ superpower; humans have built neural pathways specifically suited for communication. But what can we do to become better at it? Duhigg says there are simple skills that anyone can learn. Roberts found a lot of practical tips he can use from Duhigg’s book; we hope maybe you’ll get some you can use, too! And don’t miss the question-based conversation toward the end, where Roberts and Duhigg each share their answers to such questions as, would you rather be rich or famous? What’s your perfect day? And more… We of course also hope you’ll take a few moments to share your reactions to the questions below in the comments. And if you happen to use them in a class or dinner table conversation, we’d love to hear about that, too. You can always share with us at econlib@libertyfund.org. Here’s to a great conversation!     1- Duhigg identifies three different types of conversations/responses, and stresses that being able to identify which type you’re engaged in is crucial to becoming a supercommunicator. What are these types of communication, and what are the complementary ways in which you can exert control over the conversation? How does such control enable you to cooperate with the person you’re conversing with?   2- How does Duhigg describe the difference between debate and conversation? Why does Duhigg suggest that religion sees much more conversation, and very little debate? What do you think should be the goal of conversation?   3- Duhigg introduces Roberts to the practice of “looping,” which Duhigg argues helps you prove to your conversation partner that you are actively listening. What are the three steps of looping, and how does each work? How does Duhigg suggest that looping can serve as a “self-hack,” and to what extent are you convinced?   4- Roberts suggests that strategies such as looping may eliminate spontaneity from conversation. How does Duhigg respond? How might Duhigg’s notion of “deep questions” mitigate this challenge? (And what does their “Fast Friend” conversation at the end of the episode suggest?)   5- I want to repeat a question asked in the episode and get your reaction: Why don’t we teach communication any more? Where should it be taught? (0 COMMENTS)

George Selgin’s new Cato working paper demolishes the now fashionable view that banks are not intermediaries between savers and borrowers. (It’s a sad comment on our profession that the paper needs to be written.) Toward the end of the essay Selgin makes the following observation (on page 41): Yet there’s a fundamental sense in which banks are strictly intermediaries. It is the sense one gains by thinking in terms of real, long run or general equilibrium magnitudes. That is, by thinking of banking in the same way economists think of other industries. That changes in the nominal quantity money are at least roughly “neutral” in the long run is perhaps the most fundamental tenet of neoclassical monetary economics. It doesn’t mean that monetary expansion never has important real short-runconsequences: most obviously, it can lower unemployment when the cause of that unemployment is a lack of aggregate demand. But it doesn’t generally alter the relative size of particular industries, or of firms within them. Instead of depending on thenominal quantity of money, firms and industry’s success or failure depends on the real demand for their products. My critics often tell me that I don’t understand banking, and that’s why I believe in a supposedly fictitious “money multiplier”.  In fact, I don’t need to understand anything about banking to determine the money multiplier.  That’s because the long run money multiplier in banking is exactly the same as the long run money multiplier in any other industry. This claim may sound a bit over the top, so let me clarify that money multipliers defined in the conventional way do differ from one industry to another.  The usual definition is the change in the broad money supply divided by the change in the monetary base.  But that’s not a very convenient definition.  It makes more sense to define the multiplier as the percentage change in a broad money aggregate divided by the percentage change in the monetary base.  By that definition, the long run money multiplier is precisely one.  And that follows from the long run neutrality of money: The long run effect of an exogenous increase in the monetary base is a proportionate increase in all nominal aggregates. Suppose I’m told that there’s a planet circling Alpha Centauri.  And this planet contains a civilization.  And the civilization contains an industry entitled @#$%&.  We have no information as to what product @#$%& produces.  We don’t even know whether it produces a good or a service.  My claim is that I can predict the money multiplier for industry @#$%&.  In the long run, an exogenous 47% increase in the (fiat) monetary base on this faraway planet will produce a 47% increase in the nominal size of industry @#$%&. So the problem is not that I don’t understand banking, it’s that my critics don’t understand the long run neutrality of money.  An exogenous increase in the monetary base has no long run impact on the real demand for base money.  My critics confuse nominal and real variables, assuming that a purely nominal effect is somehow “real”.  Nominal shocks can have real effects in the short run, but those effects are due to sticky wages and prices.  These short run effects reveal nothing at all about the fundamental role of banking in the economy.  Banks are intermediaries between savers (lenders) and borrowers. PS.  Does it matter if this faraway planet has the floor system, where it pays interest on bank reserves (IOR)?  It matters for some questions, but it doesn’t matter for the long run money multiplier in response to an exogenous increase in the monetary base.  Peter Ireland showed that the best way to think about IOR is as a one-time shift in the demand for reserves.  Even with IOR, long run money neutrality continues to hold true. PPS.  By “long run”, I mean in the period after all sticky wages and prices have fully adjusted to the monetary shock. PPPS.  Here’s the M2 multiplier, showing the effect of IOR (in late 2008) and other factors such as changes in nominal interest rates and forward guidance: (0 COMMENTS)

As the US has come down from high inflation over the past year, a gulf has opened between economists, triumphant over low inflation and no recession, and consumers, who still feel financially precarious. Economists, looking at the data, wonder why consumers can’t appreciate how good things are. Consumers, for their part, accuse economists of using out-of-touch metrics, or – worse – trying to paint a rosy picture for the presidential reelection. Enter Bolhuis, et al., with a new working paper to explain the disconnect. True, the Consumer Price Index (CPI) shows inflation back down to approximately normal. But, they argue, a big part of consumer sentiment boils down to the costs of debt service and borrowing, which remain very high by the standards of the past few decades.  Oddly, borrowing and debt service costs aren’t included in the CPI at all. Some have even suggested this is a deliberate omission to make inflation look lower than it “really” is (and as evidence for this, point to the fact that the BLS changed the definition in 1983 to exclude them). So does it make sense to include borrowing costs in the CPI, as Bolhuis et al. propose?   What Is the CPI Anyway? The Consumer Price Index is one of the most popular price indices, usually thought of as tracking the “cost of living”. It’s used for things like adjusting tax brackets and Social Security payments over time, as well as tracking the impact of inflation on consumers. But “cost of living” can mean any number of things, so let’s be more precise. The CPI is supposed to track, not prices in general, but the cost of consumption – as opposed to investment. “Cost of consumption” is a very different understanding of “cost of living” than “typical household expenses”. In the first place, if our metric is consumer welfare, we’re interested in forward-looking costs of prospective consumption decisions, not backward-looking expenses. More practically, there are two basic problems that separate these understandings: (1) Not all household expenses are consumption, and (2) not all household consumption is an expense, even though it does have a cost.   So What’s Consumption? In economics, “consumption” means the satisfaction of present needs – again, as opposed to investment, which is spending today to satisfy future needs. So the basic question the CPI asks is: how costly is it, in money terms, to meet your current needs? In large part, you can track this by tracking the prices of consumption goods. Food, entertainment, services like haircuts, and so on. But this runs into problems with big-ticket items like cars and houses, what economists call consumer durables. When you buy a house, you don’t consume it all at once; you hopefully enjoy its services over a very long period of time. And the price you pay for it today reflects, not just your current need for shelter, but also your expected need for shelter all the way into the indefinite future. In other words, a house is an investment, with all the uncertainty that entails.  So it clearly doesn’t make sense to include house prices in the CPI. It’s just a different sort of thing. But now we’re faced with a double problem: (1) Since the future does eventually turn into the present, we do want to include the cost of shelter in the CPI. But (2) what’s the cost of consuming the services of something you already own? With a little bit of opportunity cost logic, we can solve this problem by using rental prices instead of house prices. After all, even if you own your own home, the opportunity cost of living in it yourself, is the income you could have made renting it. So an increase in rent prices really does increase the cost of consumption, even for homeowners who don’t register the expense. In general, consumer durables are factored into the CPI, not with their sale price, but with their user cost – that is, with an explicit or implicit rental price. (Curiously the BLS does not do this for cars, even though logically it ought to use lease prices rather than sale prices. Nevertheless, Bolhuis et al. show that this matters much less than for shelter, which comprises over 1/4 of the CPI’s weight)   Borrowing Costs and Investment Returns So it’s worth thinking about how the CPI would account for changes in the price of consumer durables like houses. If house prices rise, and rental prices rise proportionally – a “neutral” inflation – then increases in house prices and the cost of housing services have increased proportionately, fully reflected in the CPI. If house prices rise faster than rent prices, however, that’s a capital gain – an increase in the wealth of homeowners (and a decrease in the wealth of potential homebuyers). Importantly, a capital gain is an unpredictable ex post change in wealth, and not a change in the cost of forward-looking consumption. In terms of how it affects consumer decisions going forward, it’s a very different beast. This distinction doesn’t change if money was borrowed to finance that investment. If the interest rate on a loan rises, that’s an ex post capital loss on an investment, and not a change in the cost of forward-looking consumption. The interest rate, fundamentally, is the price of investment, not of consumption, and any indirect effects on the price of consumption are taken into account in the CPI.   What’s the Takeaway? Now, this isn’t to say debt service and borrowing costs don’t matter. Capital gains and losses do affect consumers’ wealth – and that matters: wiping out wealth can still seriously impact standards of living, even if the cost of consumption stays the same. So what should be the lesson of Bolhuis et al.? For the typical economist, the main question on how inflation affects consumers is whether incomes rise faster or slower than prices. Often they’re slower, meaning consumers become worse off in real terms, at least temporarily. But in addition to that, Bolhuis et al. point us to the fact that policy actions to contain inflation – even successful ones! – can have serious effects on the types of investment that consumers are likely to do, which can be an important factor in the political dynamics of inflation. This is an important point, and should not be underrated. Nevertheless, it’s also important to have a measure that corresponds roughly to the cost of consumption in a forward-looking sense, because that’s the major factor in consumer decisions going forward, and in estimating the value of money over time in terms of the needs it can satisfy. (And indeed, the 1983 redefinition of the CPI was not a PR move at all, but the result of rigorously grappling with these sorts of conceptual issues as financial innovation made the old CPI less and less workable.)   Cameron Harwick is a monetary economist and Associate Professor of Economics at SUNY Brockport. Follow him on Twitter at @C_Harwick. (0 COMMENTS)