Back to the problem of 'dynamic inconsistency' ( see post from yesterday below) and the deficit. I have been trying in recent days ( here and here ) to provoke some discussion and controversy based on the argument that you shouldn't always take things at fact value. The pretext for this argument is a paper by Gauti Eggerston ( Committing to Being Irresponsible ). Since this is exactly what the Bush administration seems to be trying to convince everyone that it is doing, I thought the arguments in the paper might bear some examination. This argument has even more interest when you consider that Eggerston did his thesis at Princeton (where Ben Bernanke among others is based), and that non other than Paul Krugman was his supervisor (which is hardly surprising as he was among the first to propose the inflation solution for Japan). The weight of the argument revolves around what to do to avoid to avoid the problem of the lower zero bound (limit) to interest rates. How do you lower interest rates more when you reach zero? The argument is complicated and essentially as it is being presented revolves around 'expectations' of future rates and prices. It seems the best strategy to effectively lower real interest rates is to provoke expectations of inflation. There is a difficulty with this due to the 'dynamic inconsistency problem'. No-one would remain convinced that a discretionary independent central bank would maintain the policy for long enough to provoke the inflation, and so the players will not react to the expectation as intended. That is, we're all unlikely to behave like good girls and boys.
Another solution is to try and tie the banks arm behind its back, by imposing a (possibly legal) commitment to maintaining a given rate of inflation for a given period of time, but then again, it seems, we could all 'front run' that one, and again it wouldn't work. So enter Eggerston. His argument is that what is needed is a temporary abandonment of the independence of the central bank, and collusion between bank and government to provoke a big fiscal deficit via a significant tax cut and thus increasing government borrowing requirements. Since no-one (with the honorable exception of Glenn Hubbard, apparently, and maybe this was why he had to go??) has the least difficulty imagining that this will lead to significant and continuing inflation because the government will have an interest in maintaining it to reduce the capital value of its debt, then presumably we all reach for our guns, or rather, our wallets. But what about the politics? Maynard, for example, is not convinced and asks me :
does one believe that the Bush team has America's interests at heart (as opposed to interests of some small fraction of America) and does one believe that the Bush team is competent in figuring out how to translate America's interests into practice?
These kind of assumptions are not necessary. The politicians will always do what they do for whatever reasons occur to them at the time.The key player here is the central bank, and the members of the US Treasury who may be working in tandem with them. In fact the bluff might be that the central bank appears to lose its independence while actually running things. The President might even go so far as to appear before the senators to warn against the inadvisability of the deficit. I mean this is like one of those interactive movies where you can change the script to fit the characters as you like it best. In the end what the reality is is anybody's guess. And I suppose that's just the point, to keep us guessing. In that way we won't be able to front run it.
In conclusion, for Maynard, I have no idea whose interests Bush has at heart, to understand my 'reading' you don't need to know this, nor do you need to make any evaluations of how competent the administration is at doing anything other than giving a tax cut, running a deficit, and then needing inflation to get out of the mess. Finally if things go well, and there's more growth than anyone else can see in their wildest dreams they can claim the credit. On the other hand, if things don't work out that way, and they run up a big bill together with an inflation bonfire they will be remembered as the administration that died saving America from deflation. Either way they can say: see, we always knew what we were doing. Of course in my book neither of these scenarios will happen, we'll get the deficit and we'll get the deflation (ie the worst of both worlds), but then I'm looking at things in an entirely different way. All I am trying to do here is to give an account of what might otherwise appear to be highly perplexing behaviour, and to suggest that if you really want to have a go at them, you look at the situation from all its various angles - simultaneously.
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