How an honest persons learns everyone is wrong

[cthulu2016]

I enjoyed this snippet from a (Very Wonkish) Krugman piece about how he came to his (ground-breaking at the time) understanding of an environment where a central bank cannot cut rates because they are already at zero.

By trying to prove the conventional view that everybody (including Krugman) assumed to be true at the time, and failing.

That is quite different from working backward from what you wish, for personal or political reasons, to be true.

(Baseball Sabermetrician Bill James used to distinguish sports writing and stats analysis by saying that a sabermetrician looked at baseball stats for the story within them while a sports writer looks at stats for evidence for the story he already decided to write.)

...What caught me in the Waldmann piece, however, was the brief discussion of the Pigou effect, which supposedly refuted the notion of a liquidity trap. The what effect? Well, Pigou claimed that even if interest rates are up against the zero lower bound, falling prices will be expansionary, because the rising real value of the monetary base will make people wealthier. This is also often taken to mean that expansionary monetary policy also works, because it increases money holdings and thereby increases wealth and hence consumption.

And that’s where I came in (pdf). Looking at Japan in 1998, my gut reaction was similar to those of today’s market monetarists: I was sure that the Bank of Japan could reflate the economy if it were only willing to try. IS-LM said no, but I thought this had to be missing something, basically the Pigou effect: surely if the BoJ just printed enough money, it would burn a hole in peoples’ pockets, and reflation would follow.

But what I did was a little different from what the MMs have done this time around: I set out to prove my instincts right with a little model, a minimal thing that included actual intertemporal decisions instead of using the quasi-static IS-LM framework. [If you have no idea what I'm talking about, you have only yourself to blame -- I warned you in the headline]. And to my considerable surprise, the model told me the opposite of my preconception: there was no Pigou effect. Consumption was tied down in the current period by the Euler equation, so if you couldn’t move the real interest rate, nothing happened...

http://krugman.blogs.nytimes.com/2013/08/10/the-pigou-effect-double-super-special-wonkish/

[Squinch]

1. That is, as Krugman promised, delightfully wonkish.

Another nice observation in there is this:

Of course, you can invoke various kinds of imperfection to soften this result, but in that case it depends very much who gets the windfall and who pays the taxes, and we’re basically talking about fiscal rather than monetary policy. And it remains true that monetary expansion carried out through open-market operations does nothing at all

...supporting the idea that the fiscal policy determined tax structure that decides the actual spending of the expanded monetary base, is the key. Which supports the idea that the "Mitt Romney pays 9% taxes/guy who is poor enough to pay just payroll taxes pays 18% taxes" structure we have now is exactly the wrong way to go.