Pessimists and the Output Gap

Arnold Kling has a good post up responding to John Taylor's view of the Taylor rule. Arnold Kling highlights a key issue: The main disagreement between hawks (people who want the central bank to focus on fighting inflation) and doves (people who want the bank to focus on stimulating the economy)  is actually about the true nature of the output gap. Mainstream economists are more likely to use traditional measures, which are unstable but generally indicate that the Fed  is either about right or needs to engage in unconventional practices. However, those outside the mainstream are more likely to be economic pessimists about the potential of the overall economy (such as the recalculation theorists or others sympathetic to the Austrian school's idea of malinvestment), view the output gap as much smaller than traditional measures, and worry more about inflation than trying to stimulate the economy in its current form.

If economic pessimists believe there is a small output gap, that should mean that economic pessimists should be more worried about inflation than deflation.  What does that make economic pessimists who believe that deflation is the main problem? They either aren't pessimistic on the economic system in general and believe that policy stimulus will help but it won't be forthcoming (like Krugman), or if they are pessimistic on the system as a whole their approach will probably be to reject the framework of the relationship between the output gap and inflation entirely since it doesn't fit into their view of the world. 

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I studied Bioengineering at the University of California at San Diego. While there I served as a trustee on the investment committee of the UCSD Student Foundation, a group that manages an endowment to fund scholarships. While in college I applied my interest in finance and economics by working as a summer associate at Clarium Capital Management, working part time my senior year, and joining full time when I graduated in 2006, staying there through August 2010. I am currently working as a portfolio manager at another global macro hedge-fund in the Presidio (And blogging about more directly market related ideas at their restricted blog). I’ve been focusing on quantitative finance, currencies, commodities, the interplay between finance and politics, demography and other long term trends.

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