When You Wish Upon A Star...

Source: Decline of the Empire

One of the things you’ve got to love about Paul Krugman is that he says outloud what every economist is thinking, but doesn’t have the guts to say, especially when times are tough. Here’s Paul on Generating Inflation Expectations—

A number of readers have asked how the Fed can change inflation expectations when it has little or no current traction — that is, what can the Fed actually do?

Good question, which goes back to my original writing on the subject.

The key point is that we won’t be in a liquidity trap forever. Eventually something will come along — a technology-driven investment boom, a recovery of consumer spending as debt gets paid down, whatever. At that point the economy will recover to the point where inflation starts to rise — and at that point the Fed would normally begin raising rates to choke off that inflation.

But if the Fed can promise not to raise rates at that point, to wait until inflation has risen substantially, it can affect long-term inflation expectations — which is what matters for investment. And higher long-term inflation expectations can boost the economy now.

Eventually something will come along. There it is, the Walt Disney version of our economic future. I’ve written about the deeper roots of this dream of Neverending Progress in Economists—The High Priests Of Progress and before that in The Law Of Civilization And Decay. If you’re a new reader, I recommend you read both.

In psychoanalytic theory, Paul’s fantasy is called wish fulfillment—

the satisfaction of a desire, need, or impulse through a dream, fantasy, or other exercise of the imagination.

When you wish upon a star…

makes no difference who you are
Anything your heart desires will come to you

If your heart is in your dreams, no request is too extreme
When you wish upon a star as dreamers do

Fate is kind, she brings to those who love
The sweet fulfillment of their secret longing

Like a bolt out of the blue, fate steps in and sees you thru
When you wish upon a star, your dreams come true

I model deflation, at zero nominal interest rate, in a microfounded general equilibrium
model. I show that deflation can be analyzed as a credibility problem if the
government has only one policy instrument, money supply by open market operations
in short-term bonds, and cannot commit to future policies. I propose several policies
to solve the credibility problem. They involve printing money or nominal debt and
either 1) cutting taxes, 2) buying real assets such as stocks, or 3) purchasing foreign
exchange. The government credibly “commits to being irresponsible” by using
these policy instruments. It commits to higher money supply in the future so that
the private sector expects inflation instead of deflation. This is optimal since it curbs
deflation and increases output by lowering the real rate of return.

Read more at Decline of the Empire