Tuesday, March 22, 2011

Man-Q: Rational Terrorism

I want to recommend an article to read. It isn't new, but it provides a history of the new economic thought that arose in the 1970s and '80s. The article is Economics in Disarray, by N. Gregory Mankiw, dated 22 June 1991, available at AllBusiness, a D&B Company.
Disarray is one of my favorite themes.
It's about a dozen half-pages long, and every time you go to the next page, the screen jumps around before settling down. But the article is definitely worth the hour it takes to read. Prob'ly less than an hour, for you.

From page 5 of Mankiw's article:

The argument against discretion is illustrated most simply in an example involving not economics but politics - specifically, public policy about negotiating with terrorists over the release of hostages. The announced policy of the United States and many other nations is that we will not negotiate over hostages. Such an announcement is intended to deter terrorists: if there is nothing to be gained from kidnapping, rational terrorists won't take hostages. But, in fact, terrorists are rational enough to know that once hostages are taken, the announced policy may have little force, and that the temptation to make some concession to obtain the hostages' release may become overwhelming. The only way to deter truly rational terrorists is somehow to take away the discretion of policymakers and commit them to a rule of never negotiating. If policymakers were truly unable to make concessions, the incentive for terrorists to take hostages would be reduced substantially.

The same problem arises less dramatically in the conduct of monetary policy. Consider the dilemma facing the Federal Reserve. The Fed wants everyone to expect low inflation, so that it will face a favorable trade-off between inflation and unemployment. But an announcement of a policy of low inflation is not credible. Once expectations are formed, the Fed has an incentive to renege on its announcement in order to reduce unemployment. Private economic actors understand the incentive to renege and therefore do not believe the announcement in the first place. Just as president facing a hostage crisis is solely tempted to negotiate their release, a Fed with discretion is sorely tempted to inflate to reduce unemployment. And, just as terrorists discount announced policies of never negotiating, private economic actors discount announced policies of low inflation.

Mankiw's presentation rests on a few assumptions. First, it rests on the assumption that the Phillips Curve is a useful tool: that an increase in inflation can be used to reduce unemployment. But economists claim to have given up on the Phillips Curve.

Second, it rests on the assumption that inflation is generated by expectations. But if that is true at all, expectations are a weak force. As G. Thomas Woodward observed, it takes more money to support higher prices, and if more money is not forthcoming, inflation cannot long continue. No matter the state of expectations.

Third, Mankiw's analysis rests on the assumption that everyone -- the Fed and "economic actors" alike -- everyone understands the cause and cure of inflation.
"The Cause and Cure of Inflation" is a chapter title from Money Mischief
It is indeed a popular view, that everyone knows the cause of inflation and how to stop it. Nonetheless, we have never actually stopped inflation. This failure in the face of apparent certainty leads people to say the government doesn't want to stop inflation...
I am talking here of the 40 years BEFORE the crisis of 2008.
...leads people to say the government doesn't want to stop inflation, doesn't want to balance the budget, doesn't want to promote the general welfare, doesn't want to do the things that we want government to do.

I see things differently, of course. To me the failure to stop inflation is evidence that our certain knowledge is wrong. It is evidence that we do not in fact know the cause of inflation, and do not know how to stop it.

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