A conventional training isn't, but moving beyond the billiard-ball/thunder-and-lightning concept of causation has been one of the most important (though gradual) changes in metaphysics since about the 1940s. As early as 1954, Gilbert Ryle had realised it was inadequate (in "Dilemmas") and by 2012 there are plenty of attempts to get a more sophisticated philosophical understanding of causation by philosophers like Nancy Cartwright and James Woodward.

I've been starting to read the Lachmann/Shackle literature, but yes: it turns out I need to go back historically to Mises and Marshall first.

My intent here is more to focus on what is not explained by a static understanding of expectations and knowledge, rather than to get into the nitty gritty of discussing conventional economic thinking. I would start with Man, Economy, and State and Marshall's Principles to gain a better understanding of the latter.

Inflation targeting is only a remotely defensible policy if the output gap is readily forecastable. From about 1992-2005, you could make a good case that it was, because multiple countries were successfully flexible inflation targeting. In the UK, inflation began to considerably overshoot the target in 2006 and ever since inflation targeting has been comparable to money supply targets in the mid-to-late 1980s: people pay lip-service to them and targets are set, but their movements are highly unpredictable and the decisions of policy makers have had little to do either with forecasts or trends.

This is the reason why even flexible inflation targeting is a fair-weather policy: when the economy is being hit by multiple supply shocks, tax distortions and a significant slowdown in productivity growth, then medium-term predictions of the output gap are unreliable.

Coming from a philosophy background, I actually find the theory of causation parts easier to follow than some of the more basic equilibrium notions. In particular, what's the difference between the Misean/Rothbardian view and the Marshallian view? As you describe the various views, I find myself sympathetic towards the Misean/Rothbardian view, BUT I always thought that that was the Marshallian view. So I'm puzzled.

> who knew?) for mentioning my book to Samuel Brittan who was very gracious in his

> review in the Financial Times.

It was a very pleasant surprise to see your comment here, David. I not only mentioned your book but, as an impoverished student, sent a copy of it to him also. Anything to get him away from the idea of targeting nominal GDP growth (clearly better than inflation targeting, but subject to many of the same public choice problems that we have seen manifest with inflation targeting over the past few years).

> From the context in which you mention my book, one might assume that you would

> expect me to be part of the crowd that (to use Ralph Hawtrey’s classic metaphor)

> are now crying “fire, fire in Noah’s flood.”

Outstanding metaphor – thank you for reminding me. We have lost so very much through our abandonment of an understanding of the history of economic thought – what a disaster Samuelson has been for the health of the discipline!

I certainly did not want to imply that I thought you were part of the permanently pro-gold crowd (although I can see how a hasty reading of what I wrote might suggest that) and I do remember that you advocated stabilisation of the value of a basket, to include wages rather than a commodity standard. It was just that I wanted to establish my hard-money credentials before questioning the current extreme bullishness of this crowd – it is a simple truth of human nature that people tend to be very unsympathetic to opposing views at market extremes and often think that because you arrive at a different judgement of the situation that you do not appreciate the merits of their arguments rather than that you appreciate them but consider them incomplete.

I agree that falling real wages during times of recession is in the general case desirable. However, it is surely not the case that falling real wages _following_ a recession are always and everywhere desirable. In this particular case, I do think that overly easy Fed policy (in the context of certain pegged exchange rates and at a time of various negative supply shocks and inflationary psychology amongst commodity producers, consumers and merchants) has been associated with a decline in the value of the dollar towards the 2008 lows and a rally in commodity prices that has depressed real incomes.

It's not falling real wages themselves that are desirable, but that it makes it more attractive to firms to hire labour. Rising commodity prices at a time of lagging wages surely makes it more desirable for firms in agriculture, the extractive industries and their suppliers to hire workers – and, if you look at the data at a sectoral level, that is exactly what we have seen happening. But surely in aggregate and given the relative importance of different sectors in the economy the favourable effect is dominated by weakness in consumption and therefore in hiring in those industries.

We seldom have the opportunity for experiments in economics that are both useful, and controlled. But I do believe that if I am right then, as commodity prices stabilize and indeed fall quite substantially, we should see a pickup in US consumer confidence and a continued improvement in the labour market. Of course a macro observer who only looks at aggregates and isn't in this game to make money might be able to claim that the cause and effect is completely different and that real wages are in fact rising as the labour market recovers – so there will certainly be an identification problem.

>I agree with you that gold and commodity prices could very well be headed for a big

>fall, especially if concerns about the euro cause a shift from euros into dollars

>reinforcing deflationary pressures on the US economy just as QE2 is winding down.

Yes – I do think that weakness in peripheral Europe (that cannnot but help spill over into the core) will be an important part of the factors at work. But I think we are in for a broad dollar rally so that the Euro is not likely even to be the weakest currency. In studying the history of large market moves over time, I am struck by how there usually tends to be a combination of factors all working together. I am struggling a little bit with tying the loose ends on my dollar bullish writeup, but I think relative interest rate spreads, falling commodity prices and an improving current account are all important parts of the picture. One major reason why people hate the dollar relates to chronic current account deficits. But actually ex-energy the situation has been improving since 2005. Energy imports in quantity terms have been stable (until the past couple of years when they started shrinking) but the price of crude has risen a great deal since 2001. So I think that people underestimate the impact of shale oil on future US imports – domestic production of shale oil could increase by 3mm barrels a day when US energy imports are only c. 9mm barrels a day. And as well as the quantity of imports falling, the price is also likely to fall (can discuss why at greater length elsewhere). So one can expect a very substantial improvement in the US current account. Looked at in a different way, I think the US consumer has had a sufficient scare that he will be somewhat more cautious for years to come. Corporate savings rates are unlikely to deteriorate significantly. There is a decent chance the government does cut spending significantly. And since the current account reflects net savings across all these sectors, the overall numbers ought to start to improve.

> The first outbreak of the debt crisis in early 2010 caused a significant appreciation in

> the dollar relative to the euro which nearly tipped the US economy into a second

> downturn in the summer of 2010 before Bernanke and the Fed prevented deflation

>from setting in by embarking on QE2.

It's hard to know what the counterfactual would have been. I am inclined to think however that Mr Bernanke has deflation on the brain. The guy markets himself as an expert on the Great Depression – even back in the early 90s my friends and I thought the guy was clueless and awful; subsequent events have done very little to change that assessment. So he has written a book about it – I am not sure if that makes him qualify as an expert – and as a result is inclined to see every episode of a financial panic as something that might be the trigger for a depression. But that simply isn't how markets and economies work. Over a couple of thousand years there have been many financial panics – but it's only a few of them that kick off lasting depressions. We simply do not understand why, and it is wrong to fool ourselves into thinking that we do. (I have an idea about what is at work, but it's very tentative and needs fleshing out).

The difference between a panic and a depression is that in the former case after the panic passes, no matter how great the damage might seem, animal spirits quickly return and the process of rebuilding resumes. Russia after her 1998 default might be one relatively recent example. With a depression, the period of subdued animal spirits lasts for rather longer. What drives animal spirits? Well, it seems to me that ought to be a topic for much greater study than it currently is. Economists have made the misplaced assessment that since non-rational behaviour is not rational, it can not be studied by rational means. Which is clearly nonsense when expressed in those terms.

It is my belief that 2008 was simply a panic of the old-fashioned sort made rather more spectacular by the use of insane structures of leverage and by the atmosphere of moral hazard created by growing state sponsorship of the financial markets ever since the failure of Conti Illinois. I think the Fed did exactly the wrong thing by treating it as a depression-in-the-making, and I am not at all concerned about the prospect of falling home prices, falling stock prices, falling consumer prices, or even falling money or real wages in the US over the next few years. I think, by the way, that the use of deflation to mean very different things at the same time without the speaker being clear even in his own mind what it is that he means is a symptom of the great state of decay that has overtaken this field of thought.

If one should wish to be more specific, let him turn to the CPI. Clearly headline inflation shows no sign of deflation as we see the effects of commodity price rises since the 2009 low. But turning to core, one ought to note that there is a heavy weighting of housing-related items in this index – both owner's equivalent rent (OER) and tenant's rent. Following the overbuilding of the past years the vacancy rate for apartments spiked to 12%; it is now below 10% and will next year be c. 5%. We know from King's Law of Prices that when demand is relatively inelastic small changes in supply of perishable commodities can have substantial impacts on their price. So I think that we will be quite surprised at the evolution of rent over the next couple of years, and at the impact on the CPI. Core should be running at 1.8% by the end of the year, just based on what has happened to the apartment vacancy rate till now, and on a lagged final pricing response to producer price inflation.

As rents start rising, and as disposable incomes benefit from continued labour market improvement and from falling commodity prices, it would be very surprising not to see a stabilization in the housing market. It is my judgement that this will support credit growth more broadly, and that the financial sector (which has underperformed the broad equity market for quite some time now) will stabilize over the next few weeks and start to perform very well.

If I am right, then there is very substantial upside to US rates over the next couple of years – particularly in the 2-5 year sector, where implied expectations of future short term rates are currently very depressed.

For me, a very important breakthrough in understanding how to better grasp future economic developments was realizing the importance of misattribution of mood. As Prechter and others have pointed out, humans tend to herd and one of the dimensions of this herd behaviour is a shared group emotional state. When the mood is positive, people tend to mistake their positive feeling for the situation objectively being better than it really is; when the mood is negative they mistake their negative feeling for things being worse than they really are. Unfortunately, economics training has not yet found a way to remove this social mood herding behaviour from practitioners. And becoming aware of its influence on one's own assessment of economic data I have found to be most helpful. I do think that sentiment (another word for social mood) with regards to the US outlook is overly negative and is likely to mean revert over the coming few years. Consumer confidence remains basically at recession levels despite a tremendous rally in stocks and an ongoing improvement in economic activity and the labour market. I think we will look back and marvel at how pessimistic we all were.

The older economists knew very well the phenomenon of which I speak – as Pigou wrote, "[t]he error of optimism dies in the crisis, but in dying it gives birth to an error of pessimism. This new error is born not an infant, but a giant; for (the) boom has necessarily been a period of strong emotional excitement, and an excited man passes from one form of excitement to another more rapidly than he passes to quiescence". Well the giant is still with us for now, and no doubt will be for some years.

Thank you for the link to your paper on the relationship between inflatonary expectations and equity prices – I look forward to reading it.

For what it is worth, my reading of the situation today suggests that we should see this link break down from here for a while. I think that as commodity prices come down, this should be positive both for real incomes and for animal spirits and that we should see the US equity market therefore tend to do better. It is remarkable how in financial markets by the time great attention has been drawn to an effect, the internal dynamics of the situation have quietly changed in a manner that means this effect is about to change. One of the reasons this game is so fascinating.

You might be interested in having a look at a paper I .wrote earlier this year (“The Fisher Effect under Deflationary Expectations”) in which I discussed and provided empirical support for the destabilizing role of the interaction between deflationary expectations and low real interest rates since 2008. Here’s a link: http://papers.ssrn.com/sol3/papers.cfm?abstract_i…
Reply

If you recall, the monetary standard for which I argued in my book was not a gold standard but a labor standard in which the goal would be to stabilize the average wage level. Almost no one is now claiming that wages are rising. Indeed, many hypocritically like to cite the fact that money wages have been stable since the 2008 to accuse the Fed of driving down real wages by causing driving up the prices of commodities, as if falling real wages were not a predictable (and desirable) market response to high unemployment. Under a labor standard in which the money wage level was stabilized, we would generally see falling output prices in periods of real economic growth, and rising output prices in periods of recession. That would tend to stabilize economic fluctuations and reduce unemployment over time.

I agree with you that gold and commodity prices could very well be headed for a big fall, especially if concerns about the euro cause a shift from euros into dollars reinforcing deflationary pressures on the US economy just as QE2 is winding down. The first outbreak of the debt crisis in early 2010 caused a significant appreciation in the dollar relative to the euro which nearly tipped the US economy into a second downturn in the summer of 2010 before Bernanke and the Fed prevented deflation from setting in by embarking on QE2. With James Bullard whose support for QE2 was very important on the FOMC in 2010 showing signs of becoming an inflation hawk now, I am very nervous that the slowdown in US growth in the first quarter may continue and perhaps worsen in the remainder of this quarter and the next quarter. And who knows what will happen then?

You might be interested in having a look at a paper I wrote earlier this year ("The Fisher Effect under Deflationary Expectations") in which I discussed and provided empirical support for the destabilizing role of the interaction between deflationary expectations and low real interest rates since 2008. Here's a link: http://papers.ssrn.com/sol3/papers.cfm?abstract_i…

I do agree that metaphors are only useful in communicating the essence of complex ideas – they are certainly not a substitute for thought and for understanding the historical context of business cycles, credit crises and panics as well as the present-day institutional and valuation context. But we do not live in a reflective age, and we do not place the best people in charge of private institutions or public policy. And so I suppose that in the end we get what we deserve.