Depression is a Choice because Low Inflation is the Wrong Goal Part I

Steve Waldman knocks it out of the park again with his new piece called “Depression is a Choice“. He’s like Babe Ruth without the strikeouts.

Here is something from my never finished piece on the Natural Rate of Interest, which directly relates to choosing depression. I think the Natural Rate of Interest is flawed for many reasons.

  • The NRoI does not exist due to non-ergodic behavior in our economy
  • The NRoI for an entire economy is unknowable; The natural rate cannot be an average of individual natural rates due to SMD
  • The NRoI isn’t strong enough to change our economy over a period of years
  • The NRoI concept suffers from ex-ante, ex-post problems
  • The NRoI doesn’t meet basic criteria for effective real time guidance.
  • The NRoI isn’t measurable or observable
  • The NRoI is mis-specified; it targets the wrong economic criteria for maximizing contract formation.

In short:

  1. The NRoI doesn’t exist
  2. If the NRoI does exist, it’s not stable
  3. Then, even if it does exist and is stable, it’s power is so weak it’s not useful to consider it in policy.
  4. Then, even if it does have a powerful impact on our economy, we have such a problem measuring it and observing it and knowing it in real time, we shouldn’t consider using it as any sort of guide for policy.
  5. Then, even if we can observe and measure it and consider using it as a policy guide, the NRoI is focusing on the wrong goal and should not be used as a policy guide.

Steve’s argument is related to the last of these, and we’re consciously choosing depression rather than effective policy. As usual, Steve pulls this off with both elegance and depth, enough so that I think I have to add another critique of the NRoI…

One of those reasons is that it is mis-specificed, in that it focuses on low inflation as a path to maximizing contract formation. The relationship between low inflation and (high growth and low unemployment) is not supported by the evidence.

Steve argues we’re choosing depression, and I think he’s correct. I have to think using the Natural Rate of Interest at all contributes to that choice of depression.

Well, on to the Natural Rate of Interest:

The Natural Rate of Interest places priority on low inflation rates over output and contract stability. I’ll argue zero inflation rates are – at best – the third priority of economic policy, after growth and low-variance inflation rates. This is in direct contradiction to the current consensus view well articulated by Michael Woodford in his monumental Interest and Prices.

“The present study argues instead for a different view of the proper goals of monetary policy. Its use to stabilize an appropriately defined price index is in fact an important end toward which efforts should be directed—at least to a first approximation, it should be the primary aim of monetary policy”

Restating this sentence in human-understandable terms: “The primary aim of monetary policy should be keeping inflation low.”

And why?

“…it is exactly because instability of the general level of prices causes substantial real distortions—leading to inefficient variation both in aggregate employment and output and in the sectoral composition of economic activity—that price stability is important.”

Or so he and the economics profession says. This relationship between Unemployment and Inflation is known as the Phillips Curve, and several Nobel prizes (yeah, it’s not really a Nobel, I know) have been won for work on the Phillips curve.

Here’s the problem with the Phillips curve – It does not seem to exist. Because when I look at the data, I don’t see a curve. Here’s a very simple regression of inflation vs. unemployment. If higher inflation lead to “ineffcient variation…in aggregate employment” then we’d expect to see a strong correlation between unemployment rates and inflation. As inflation gets higher, unemployment should go up too.

In fact, nobody could find a curve, so they started shifting the curve around to explain the problems. It worked pretty well, too. This shifting seemed to work for a while, and it worked enough to hand out another Nobel Prize to Phelps.

But I’m a trader, and I’d call what they did “Over-optimization”. Over-optimization happens when a trader backtests a trading idea and then starts to hone the parameters on the system until they end up with a profitable system.

It is easy to create an over optimized trading system. Here is an example of an over-optimized trading system. It starts with $250,000 and ends with over $619,000,000 in just about 3 years. That is over 950% return per year.  Awesome – at 900% per year, this $600,000,000 will be worth about $6bn by the end of 2012!

Question: Why don’t I trade this system?

Answer: This trading system has nothing to do with the real world. It will not make money in the future. It’s been perfectly designed to capture profits in the past. When the future is slightly different, it will lose money.

The 1990’s and 2000’s threw the problem of over-optimization of phillips curve data straight into the face of the world. Here is wikipedia on the problems:

However, in the 1990s in the U.S., it became increasingly clear that the NAIRU did not have a unique equilibrium and could change in unpredictable ways. In the late 1990s, the actualunemployment rate fell below 4 % of the labor force, much lower than almost all estimates of the NAIRU. But inflation stayed very moderate rather than accelerating. So, just as the Phillips curve had become a subject of debate, so did the NAIRU.

Furthermore, the concept of rational expectations had become subject to much doubt when it became clear that the main assumption of models based on it was that there exists a single (unique) equilibrium in the economy that is set ahead of time, determined independently of demand conditions. The experience of the 1990s suggests that this assumption cannot be sustained.

Why is this important? Because Michael Woodford – arguably the most influential economist for Central Banking practices in the world today – uses thinking based on a world where the Phillips curve is a strong relationship. Here are his words again about the importance of price stability.

“…it is exactly because instability of the general level of prices causes substantial real distortions—leading to inefficient variation both in aggregate employment and output and in the sectoral composition of economic activity—that price stability is important.”

But we know the Phillips Curve – and 20 years of variations and thinking and new equations on the relationship between unemployment and inflation – have given us approximately zero reason to believe there is a relationship between inflation and aggregate employment.

Instead, we see a very, very weak relationship between Inflation and Unemployment. The level of Inflation explains about 1% of the level of Unemployment on a direct regression.

(Hey economists – why don’t you plot data like everyone else? You know, where the independent variable is on the x axis and the dependent variable is on the y axis? Are you stupid or just don’t want to be bound by silly conventions the rest of the modern world uses? And why aren’t you using R or Matlab or Mathematica, like every other science uses?)

As Steve W points out:

“But the preferences of developed, aging polities — first Japan, now the United States and Europe — are obvious to a dispassionate observer. Their overwhelming priority is to protect the purchasing power of incumbent creditors. That’s it. That’s everything. All other considerations are secondary. These preferences are reflected in what the polities do, how they behave. They swoop in with incredible speed and force to bail out the financial sectors in which creditors are invested, trampling over prior norms and laws as necessary. The same preferences are reflected in what the polities omit to do. They do not pursue monetary policy with sufficient force to ensure expenditure growth even at risk of inflation. They do not purse fiscal policy with sufficient force to ensure employment even at risk of inflation. They remain forever vigilant that neither monetary ease nor fiscal profligacy engender inflation. The tepid policy experiments that are occasionally embarked upon they sabotage at the very first hint of inflation. The purchasing power of holders of nominal debt must not be put at risk. That is the overriding preference, in context of which observed behavior is rational.


“But if we want to change the behavior of the polity, it’s not enough to argue over clever policies that, if implemented, might do the trick. We’ve got to change its preferences, which means either buying off the median influencer, or changing her identity via political struggle. Alternatively, we can wait until what are now problems of aggregate demand morph into supply problems (after people become unemployable and capital decays), or into threats of political and social unrest. The median influencer may change her views if tight supply makes goods costly despite fiscomonetary conservatism. Or if her neighborhood is on fire. But I’d prefer we avoid all that, and take a more proactive route.

In the meantime, we have to recognize that what we are experiencing is not a technical failure. It is not “magneto trouble”. We, collectively, are making a choice. The task before us is to change our mind.” (Bold mine)

One way to help change our minds is to recognize the Natural Rate of Interest is so irredeemably flawed it cannot and should not be part of our thinking about the economy at all.

And, of course, More to come…




Expert in business development, product development, and direct marketing. Developed strategic sales plans, product innovations, and business plans for multiple companies. Conceived the patent pending Spot Equivalent Futures (SEF) mechanism, which allows true replication of spot and swap like products in the futures space.

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5 years 4 days ago

Keynsians and MMT/MMR people think you can not get inflation when there is unemployment. This graph shows that is not true at all.

5 years 4 days ago

That’s a false generalization. In fact, MMTers arranged the job guarantee specifically because of this. They believe you will get inflation without full employment and govt pump priming….

5 years 3 days ago

MMT/MMR says you don’t get inflation till you are at productive capacity. But clearly if 8% of your people are out of work you are not at productive capacity. So you say it differently but it is the same wrong idea.

Detroit Dan
5 years 6 days ago

Rogue’s on a roll…

5 years 6 days ago

When you said that the NROI for an entire economy is unknowable, I almost fell off my chair while charting the maps of Atlantis and Shangrila. Saying NROI is unknowable is like saying you won’t fall off the earth when you sail too far to its edge! That’s just ogrepuss. With belief like this, what’s next? That lightning is not caused by Jupiter’s anger?

Anyway, I don’t have time for this. I have to get back to burning Aristotle’s books of blasphemy.

5 years 6 days ago


Detroit Dan
5 years 6 days ago

Excellent post, Michael. Thank you…

5 years 6 days ago

Although I admit I don’t fully understand the concept, I have always felt that the NROI was a tool for selling the proposition that interest rates are both the measure of but also the only legitimate lever by which to bring about economic wellbeing. A somewhat one-sided and circular argument that’s good if your aim is to obscure what’s really going on.

Detroit Dan
5 years 6 days ago


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