Dinner at Zachary's

Moving out of Ann Arbor, first to Japan for a couple weeks and then on to New York, so blogging will be sparse in August.

Inflation hawks have predicted 10 out of the last zero inflations. Japan printed Space Battleship Yamato-loads of money and inflation went from negative to just over zero. More recently, the Fed's massive asset purchases and ardent promises to keep interest rates at zero until the heat death of the Universe have not pushed core inflation higher than the 2% target. Furthermore, slack demand from Europe and China do not bode well for a robust global recovery in the next few years. Additionally, markets expect very low inflation for a long time to come (and second-guessing the market is always a gamble). Also, the Fed seems to have a good number of influential members who think 5% inflation would be a calamity far worse than 8% unemployment. And finally, liquidity-trap New Keynesian models of the macroeconomy, which recognize the importance of the Zero Lower Bound of nominal interest rates, seem to me far more credible to me than the flexible-price models that predict higher inflation.

To sum up: Inflation looks incredibly unlikely to me at this point. So why on Earth did I just bet Brad DeLong dinner that the U.S. economy will experience substantial inflation at some point during the next three years?

Short answer: Dinner with Brad DeLong at Zachary's will be fun even if I lose.

Longer answer: I got 50-to-1 odds on the bet (if I win, Brad buys me dinner and pays me 49x the cost of dinner). That means that I am essentially betting that there is a 2% chance that something really funky happens to the global economy over the next three years. What kind of funky thing would cause inflation to go over 5% even as unemployment stayed over 6% (as per the terms of the bet)? Perhaps the Chinese state will collapse, disrupting supply chains and sending import costs soaring; or perhaps the Saudi state will collapse, sending oil prices soaring. And perhaps the Fed will be spooked so much by these events that it would allow 5% inflation as a hedge against global economic collapse.

Or, alternatively, perhaps the models (or mental model-sketches) used by John Cochrane, Steve Williamson, Jim Bullard, Charles Plosser, Narayana Kocherlakota, and other inflation hawks are much more right than I realize! I always talk about the basic ignorance of macroeconomists about how the economy works, so in a sense I'm putting my money where my mouth is.

Am I giving Brad a great deal by not demanding 100-to-1 or 200-to-1 odds? Probably, yes. In fact I was going to demand 100-to-1 but I felt it would be rude. But small probabilities are notoriously hard to estimate, or even guesstimate. So instead of expected utility maximization, I'm using a different decision theory rule, limiting my potential losses. The worst that can happen to me is that I will have to buy Brad dinner, during which he will probably laugh at me.

Also, note that if by some odd twist of fate Brad loses the bet, not only will it be good news for the economy (5% inflation would really help us out), but it will mean that the 49 Zachary dinner cost equivalents that he will be forced to pay me will not buy me 49 Zachary's dinners unless I eat way too much pizza...so he'll have the last laugh...

Update: As of 5/6/2013, I have hedged my bet with Brad by taking the opposite side of the exact same bet with Patrick Chovanec at 25-to-1 odds. Note that in theory this means that I could have executed an arbitrage, as long as the price of a pizza was guaranteed to be the same, and if a fractional pizza could be specified. In any case, I now get to have pizza with both Brad and Patrick, at a guaranteed total cost of (nearly) zero, with the possibility of earning 25 times the cost of a Zachary's pizza in the unlikely event that inflation comes in at >5% sometime in the next 2 years...