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The Fed is not a passive observer

Summary:
I recently read an interesting book about octopus consciousness, written by Peter Godfrey-Smith.  This caught my eye: Some philosophers have always disliked this obsession with sensory input, with receptivity, seen in theories of the mind. . . . In everyday experience there are two causal arcs.  There is a sensory-motor arc, linking our senses to our actions, and a motor-to-sensory arc as well.  Why turn the page?  Because doing so will influence what you see next. . . .Philosophers often use the metaphor of a stream of experience.  Experience, they say, is something like a river in which we are immersed.  This image is quite misleading, though, as the flow in a river is almost entirely outside our control. Exactly!  And this is my problem with mainstream macro.

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I recently read an interesting book about octopus consciousness, written by Peter Godfrey-Smith.  This caught my eye:

Some philosophers have always disliked this obsession with sensory input, with receptivity, seen in theories of the mind. . . . In everyday experience there are two causal arcs.  There is a sensory-motor arc, linking our senses to our actions, and a motor-to-sensory arc as well.  Why turn the page?  Because doing so will influence what you see next. . . .Philosophers often use the metaphor of a stream of experience.  Experience, they say, is something like a river in which we are immersed.  This image is quite misleading, though, as the flow in a river is almost entirely outside our control.

Exactly!  And this is my problem with mainstream macro.

The standard view is that the Fed observes the nominal economy, and then reacts to “fix” problems that develop on occasion.  Economists ask themselves, “What can the Fed do to end a demand-side recession?”  Or how can it stop an inflationary spiral?  I see the Fed as causing changes in the nominal economy, and ask myself, “What can it do to stop causing demand-side recessions?”  What can it do to stop causing inflation?

The mainstream view is that a “shock” hit the US in late 2007, tipping the economy into recession.  In my view, the Fed’s tight money policy pushed us into recession.  Then the Fed eased aggressively in January 2008, and the economy expanded in the second quarter of 2008.  But the Fed began to worry about inflation in the spring and summer of 2008, and sharply tightened policy again in the second half of the year.

Godfrey-Smith suggests that philosophers focus too much on how we see the environment, as if we are passive observers, and not enough on how our actions shape the environment that we perceive.  In my view, the Fed is too quick to discount the possibility that the “shocks” it perceives are actually the effects of its previous actions, or inaction. (A distinction that is essentially meaningless. What does it mean to not do monetary policy?  Barter?)

Godfrey-Smith points out that the (relatively intelligent) octopus has its brain distributed throughout its body, and that each arm can make its own decisions:

The octopus’s loss of almost all hard parts compounded both the challenge and the opportunities.  A vast range of movements became possible, but they had to be organized, had to be made coherent.  Octopuses have not dealt with this challenge by imposing centralized government on the body; rather, they have fashioned a mixture of local and central control. One might say the octopus has turned each arm into an intermediate-scale actor, But it also imposes order, top-down, on the huge and complex system that is the octopus body.

The Fed should control the price of NGDP futures contracts, while allowing the banking system to determine the money supply and the bond market to determine interest rates.

PS.  Of course I’m not the first to compare the Fed to an octopus:

The Fed is not a passive observer

Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment". In May 2012, Chicago Fed President Charles L. Evans became the first sitting member of the Federal Open Market Committee (FOMC) to endorse the idea.

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