Two reactions to this piece by Paul Krugman:
1. If Krugman believes that disinflation is "incredibly expensive," then he should be more wary of exploiting the Phillips curve tradeoff that he imagines exists.
2. Krugman should do some research on the debate about disinflation that occurred circa 1980. At the time, various "gradualists" thought that the sacrifice that would have to be made in reducing inflation would be very much larger than it actually turned out to be. People like Tom Sargent (see "The Ends of Four Big Inflations" and this paper) had a better grip on what was going on than the adaptive expectationistas.
Here's what MIT professor, and former chief economist of the IMF, Oliver Blanchard wrote in his 2006 macroeconomics text (4th ed.) on the US disinflation of 1979-1985:ReplyDelete
By 1982 the sacrifice ratio looked quite attractive. The cumulative decrease in inflation since 1979 was nearly 9.5%, at a cost of 6.3 point-years of unemployment – a sacrifice ratio of 0.66, relative to the sacrifice ratio of one predicted by the traditional approach. But by 1985 the sacrifice ratio had reached 1.32. A 10% disinflation had been achieved with 13.2 point-years of excess unemployment, an outcome actually worse than the outcome predicted by the traditional approach.
In short, the U.S. disinflation of the early 1980s was associated with a substantial increase in unemployment. The Phillips curve relation between the change in inflation and the deviation of the unemployment rate from the natural rate proved more robust than many economists had anticipated.
– Page 199
And this is for a disinflation from about 15% to 5%, where you're not dealing with nominal wage cuts. When resistance to nominal wage cuts becomes an issue (where there's a mountain of empirical evidence showing a lot of resistance), it would be a lot worse.
So, because Blanchard put this in his book, it's the ultimate truth?ReplyDelete
Not necessary, but he gives interesting figures for after the initial good news showing, in the end, "credibility" didn't seem to make that much of a positive difference. And it shows a highly respected expert in this area taking an opposing view.Delete
Your memory and mine about the disinflation of the early 80s are quite different (probably reflects at least one of us getting old). But mine fits with the summary in Blanchard's book.ReplyDelete
I remember being at a conference where Martin Bailey using an old-fashioned Phillips curve model predicted that a very sharp increase in unemployment would accompany an attempt by the Fed to disinflate over, say, a five year horizon. A bunch of us scowled something like "It will depend upon whether the Fed announces a credible policy--if it succeeds in convincing the public of its intention, then we can get the disinflation without any increase in unemployment; in fact, employment may improve since the economy will function better at lower rates of inflation". The lesson I learned was that it's to be harder to be credible than I had thought--Volcker bought his credibility by beating up the real economy--and Bailey's estimates about the costs of disinflation turned out to be remarkably prescient.
"Volcker bought his credibility by beating up the real economy"Delete
That's accurate. I guess it's a matter of how the beating looked relative to what you were expecting. But Volcker brought the inflation rate (year-over-year CPI inflation) down from about 15% to 2.5% in the space of 3 years. What's the cost of 15% inflation forever relative to 2% forever, and what's the cost of lost GDP in the 1981-82 recession?
I find it amusing that the proposition that disinflations are costly is supporting by a single case study, the Volcker recession. Also, I think there is critical work out there that deserves reconsideration. There is empirical literature that suggests the effects of monetary policy aren't as large on output as Krugman suggests - Uhlig's 2005 paper being a famous example. The question of the size of monetary policies effects on output is no where near closed. In fact, Mertens and Ravn have a paper suggesting the "Volcker recession" might be largely due to the timing of tax policy:ReplyDelete
Again, the case isn't closed and Krugman should stop pretending it is. And yes, Steve, you already pointed out the irony of this. Krugman has been calling for 4-5% inflation for a while now. If disinflations are costly, how do you justify this policy? Or are we just going to have 4-5% inflation forever ...
"...a single case study..."Delete
For example, Sargent's four big inflations paper was about how you could go from hyperfinflation to moderate inflation over a short period of time with the right change in the fiscal policy regime.
Here's the basic question. Suppose the rate of inflation is x, and we have convinced ourselves that a long-run rate of inflation of y might be preferable, where y < x. But we think that there might be some non-neutrality of money that might come into play on the transition path from x to y. What do we need to have in place to answer the question? Obviously we need a model that can capture the non-neutrality (whatever it is), and allow us to evaluate quantitatively the welfare effects of alternative paths we could follow in getting from x today to y at some date in the future (where the "alternative paths" can involve difference choices of that future date). You could probably take Christiano/Eichenbuam/Evans and get an answer to the question, but would you believe it?
Treasuries today were 1.69% +/-
Inflation is our problem
Not right now obviously. Once we thought that financial crises were a thing of the past, though. I've heard that it helps to think about potential problems before they arise.Delete
Here's another interesting problem. Suppose that a few months from now we think we have too little inflation (and some people think that is the case now). How do we get it?Delete
A lot of people talk about how you wrongly constantly predict high inflation, but the problem is, it's hard to know; you never say how high, or when, even within some ranges, like 4-6% in the next year, or two years.
When you predict inflation is coming, can you give us some kind of specificity? It doesn't have to be that precise, but at least something like 4-8% in the next year, or two.
You're not paying attention. I don't forecast inflation, or make any other specific forecasts. That's not my business. I can't have "wrongly" predicted high inflation if I didn't issue a specific forecast, right? All I do is discuss what the risks are. Why don't you tell me your inflation forecast?Delete
I obviously don't have the training to forecast this.Delete
But even saying there's a risk is not that meaningful or useful without at least some, even very wide, specificity (unless this is well implied to people in the know in parsing these statements).
Can you at least give us some kind of idea, like, more likely than not, over 4% within the next 2 years if we don't change Fed policy.
No idea. At the moment, all bets are off. We were in uncharted territory anyway, and events in Europe are just adding to the uncertainty. Yields - real and nominal - are falling on US government debt. Why? Our debt is viewed as safe. Why? That's self-fulfilling. Under current conditions, an increase in the demand for nominal US government debt not only increases the price of that debt but lowers the price level (that's what happens when there is a large stock of excess reserves in the financial system and reserves are a perfect substitute for government debt). So temporarily, we are going to get less inflation. But you might expect that low real interest rates might lead to an investment boom. We're not getting that because of the high level of uncertainty. People are trying to reassure us that the financial system is prepared for a Greek default, but is it? And is it prepared for cascading problems in Italy, Spain, and France? People were also very reassuring in early 2008. Yikes.
Argues, "I've heard that it helps to think about potential problems before they arise."
What problems to you see arising from all the unemployment in Europe and here?
The key question is whether this is a problem for monetary policy. The world looks quite unpleasant relative to four years ago. And it's relative more unpleasant for some than for others. But is there an alternative monetary policy that could make us better off?ReplyDelete
The key question is whether this is a problem for monetary policy. The world looks quite unpleasant relative to four years ago. And it's relative more unpleasant for some than for others. But is there an alternative monetary policy that could make us better off?
It seems to me that what the Fed says, or does not say, is a part of its monetary policy, perhaps now as much or not more so than what steps its takes such as buying more treasury bonds or changing reserve requirements or whatever.
In that regard, there are no less than three policies that the Fed could adopt right now.
First, it could announce that, in the long run, the Federal deficit will not be a problem for the United States because it is going to permit prices to rise so as to reduce the deficit to notational GDP ratio. IOW, creditors are going to pay off the deficit through the tax of inflation, sharing in the pain of the crisis.
Second, it could rebut the false analogies of CA, IL, and other large states with Greece. These large states are not runaway free spenders. They are just screwed by our political system which imposes federal taxes on rich states and then sends the money by federal transfer states to poor states like KY, Miss, SC, etc., rather than returning the money to CA or IL.The FED ought to set the record straight---that the states we have that are like Greece, Spain, Italy, are our unproductive ones like TN, Miss, Ky, SC, etc.
Third, it ought to explain to everyone that Greece, Spain, Italy, etc., are in trouble because of the stupidity of a currency union, without a political union. The Fed should affirm that it would assure the solvency of everyone when the big Euro is broken, by buying new bonds issued in local currency (lira, etc.). In fact, we should be working to set up Portugal, Spain, Ireland, Italy, and Greece, Poland and all of Eastern Europe, as trading partners, removing all import barriers , if these countries would move out of the Euro. This would force Germany to send money south, or face loss of these markets.
This is a time for us to think like Churchill and align ourselves with the lesser powers in Europe.
Personally, I would like to see us in partnership with the South.