So how does the decade of the 1980s end up being perceived as a defeat for Keynesians? To see it that way you have to systematically misrepresent both what happened to the economy and what people like Tobin were saying at the time. In reality, Tobinesque economics looks very good in the light of events.
So what exactly was "Tobinesque economics?" Krugman points us to Tobin's 1980 Brookings paper. Early in that paper, Tobin tells us about his view of the inflationary process - how we got where we did in the 1970s:
...when the authorities have chosen policies supportive of continued inflationary growth of MV, they have not done so from ignorance of arithmetic, indifference to inflation, or, in my opinion, political pressure. They have done so, rightly or wrongly, mainly because of the perceived consequences of nonaccommodation on the real performance of the economy. The inertia of inflation in the face of nonaccommodative policies is the big issue.Tobin's view was that there was substantial inertia in inflation, and that it was very costly to bring it down - a widely-held view at the time. But there were other ideas at the time as I discussed here. Tom Sargent, in particular, was emphasizing the policy relevance of modern macroeconomics for disinflation. According to Sargent, central bank commitment was important, and we could reduce the inertia in inflation if we had a credible commitment from the central bank to reduce it.
The picture that Krugman shows us from Tobin's paper is this one:
In Tobin's paper, after he shows us his simulation, he goes through some arguments about other factors that may not be in his model. Then, his punchline is this:
For these reasons,I think it would be recklessly imprudent to lock the economy into a monetary disinflation without auxiliary incomes policies. The purpose of these policies would be to engineer directly a deceleration of wages and prices consistent with the gradual slowdown of dollar spending. Macroeconomic policy and wage-price guideposts or controls would be concerted. Instead of issuing a monetary threat to everyone in general and to no one in particular, the government would seek the consent and cooperation of organized labor and business in a five-to-ten-year program to eliminate inflation at minimal cost in employment, production, and investment. The most promising incomes policy is to use tax-based incentives for complying with a sequence of gradually declining guideposts.
Tobin's telling us that it would be silly to disinflate through monetary policy alone. We need wage and price controls! So, how the 1980s was a victory for "Tobinesque economics," I have no idea. The Fed did what Tobin said they should not do, inflation did not have the inertia Tobin said it would have, and wage and price controls were thrown out with the policy trash. Further, the language of modern central banking is all about inflation targeting, commitment, and looking into the future. Tobinesque economics can only look good if you're not looking.
Despite his enormous success as an academic economist, I think Krugman could be even more successful as a used-car salesman given his willinbgness to misrepresent the facts to make a sale. I think the Nelson and Schwartz (2007) paper in response to Krugman is very illuminating on how wrong Tobin was, especially when his views are contrasted with Friedman's: https://research.stlouisfed.org/wp/2007/2007-048.pdfReplyDelete
In the 1980 Brookings paper, Tobin is still fighting with Friedman, basically. At the time monetarist ideas were getting traction at central banks. Volcker in particular was paying attention. Of course, Friedman's quantity theory ideas didn't always work out either. In the 1970s and 1980s, central banks were eager to adopt money growth targets, and they ultimately (for good reason) ran away from that.Delete
But I thought the Fed achieved deflation by lowering interest rates, not by raising them...right?ReplyDelete
I thought you would ask that. Driving the disinflationary process was a monetary contraction. The path the nominal interest rate follows in response to that monetary contraction is another story. At least, that is the way Volcker appeared to be thinking about the problem. He seemed to be bringing quantity theory ideas on board (i.e. he wasn't a fed-funds-rate-as-policy-instrument guy). Part of that experiment was reflected in the wide swings you see, prior to the 1981-82 recession, in the fed funds rate.Delete
Yes, I agree on the failure of monetary targets...after all I use your textbook. :) Didn't fed funds targeting start around 1990? That's when you start seeing a smoother path.Delete
In this case, I think it would be useful to read the FOMC transcripts for the Volcker era. Policy certainly was not implemented in the same way as it is now (or say, in 2007), with a directive from the FOMC to the New York Fed about a fed funds rate target. There's an idea that there's a period during which there was a target for non-borrowed reserves (which would be consistent with Friedman quantity theory ideas), but I've heard some people say that this was just window dressing, and that the fed funds rate target directive was going directly from Volcker to the New York Fed.Delete
I looked at an FOMC transcript for March 1980. Seems like a bunch of monetarists having a discussion. A lot of talk about money growth targets, reserve targets, money multipliers, and how maybe the committee had to tolerate interest rates going wherever.Delete
Are you referring to the October 6, 1979 announcement by the Fed that they would no longer target interest rates and instead would target reserves? For a good number of years, that decision and that date were highlighted in macro textbooks.Delete
This paper is overlong but does give all sorts of details about where the FOMC's heads were at, Volcker in particular:
Thanks for the reference. I knew the rough outline, but it's pretty startling to look at the transcripts, and compare the discussion with what goes on now.Delete
If you read Krugman's post you can see that he acknowledges that unemployment rose faster and came down faster than in Tobin's simulation. He also says that this is due to the fact that the FED did not follow the simple rule used by Tobin. Is this the case? The numbers obtained by Tobin look good, but the time of adjustment is pretty slower than in reality. A strictly rational expectations/flexible prices model would predict no effect on unemployment whatsoever. Looks like reality worked out a middle way between the Tobin model and the rational expectations model.ReplyDelete
No, I'm not letting Krugman off the hook.Delete
"A strictly rational expectations/flexible prices model would predict no effect on unemployment whatsoever. Looks like reality worked out a middle way between the Tobin model and the rational expectations model."
If you read Sargent's views on the policy issue at the time, I think you'll see that he wasn't wedded to a particular model. At the time, these things were not well-developed - we didn't have a fully articulated "rational expecations" monetary model that was ready to answer policy questions. It's certainly not correct to say that "a strictly rational expectations/flexible prices model would predict no effect on unemployment whatsoever." But, we can certainly say for sure that Tobin's notion of high intertia in inflation and a protracted period of high unemployment was way off base, as was his contention that wage/price controls were necessary to bring inflation down in a sensible way.
So, I think this is pretty obvious. Nice try, though.
I read your previous post in which you show Sargent's ideas at the time and it is pretty obvious to me that Sargent got things much better than Tobin or other Keynesian economists at the time. At the same time, I totally agree that wage and Price controls were not necessary, and would have been a terrible idea. I was not questioning this, but simply discussing about the fit of different models. Of course, you are right that there are many different types of rational expectation/flexible Price models. The basic RBC model for instance would predict no effect whatsoever on employment following purely monetary policy shocks. Of course, adding a fiscal policy response would provide a different result. I was referring to an RBC model above. It does not look like the RBC model does a better job than Tobin's model at explaining the facts here, unless we assume movements in unemployment at the time had nothing to do with FED policy but where due to real/fiscal policy shocks. In this sense, I do not see a much better fit of the basic new classical model compared with the Keynesian model used by Tobin.Delete
Well, the RBC is a non-starter here, as that's not a model of monetary policy. We want something that captures a non-neutrality of money, so that we can see if this somehow matches the data. Of course, NK models have that. A well-defined exercise would be to see how much price stickiness you need to replicate the data for the Volcker period. Of course we know that it matters how you model the price stickiness. Calvo pricing says the costs of deflation are higher than if you have Golosov-Lucas state-dependent pricing, for example, or if you have indexation.Delete
"It is an established scientific fact that monetary policy has had virtually no effect on output and employment in the U.S. since the formation of the Fed."Delete
Well, Ed's entitled to his opinion of course, and he likes to be provocative. I wrote a post about that quote a while back, arguing that it wasn't completely crazy. After looking more at this episode, I think it's hard to dismiss the effect of monetary policy on the 81-82 contraction. I also buy the argument that the Fed screwed up in the Great Depression and probably made output and employment lower than they would have otherwise been.Delete
Surely it's an empirical matter how rational expectations really were around 1980 (or are in 2015). Suffice to say that if otherwise sensible men like James Tobin were skeptical that the Volcker Fed could bring inflation down that quickly, or were serious about doing so, that alone might have slowed the process down or made it more costly. RE, at least in its simpler forms, assumes that agents understand the economy's structure well enough that they don't (say) make consistent forecasting errors. If James Tobin didn't understand it very well, it's a fair bet he wasn't the only one at the time.ReplyDelete
To be sure, the cost of the disinflation was lower than Tobin foresaw. Krugman conceded that in his blog post. Krugman's real point---that inflation didn't simply stop dead, as it would in some of the simpler first-generation RE models of the Phillips curve, and disinflation was non-trivially costly on the real side (non-rational expectations, lack of credibility, name your poison) still stands.
I don't see how Tobin's specific policy advice was still relevant. Krugman's not shy about handing out free policy advice. If he's in favour of bringing back incomes policies, that would be news to me.
No, a cat is not a horse, but both are members of the mammalian class. Models of mammals will apply to both.
(Disclaimer: economist at central bank in a developed Anglophone country, posting under a pseudonym as I'm not authorized to speak to the public. All views expressed above are my own.)
"Krugman's real point---that inflation didn't simply stop dead..."Delete
That's a straw man. No one was claiming at the time that you could stop it dead. And that's not Krugman's main point. His bottom line is that "Tobinesque economics looks very good." And we can read Tobin's article and see what Tobinesque economics is. Very high inflation intertia, we need wage-price controls.
If you look at the first paragraph on page 68, you see that Tobin assumed a certain kind of augmented Phillips curve, where in the neighborhood of 6% unemployment the annual effect of each percentage point unemployment on inflation was 2/3. (He actually had a nonlinear Phillips curve, with unemployment in the denominator, but I'm using the first-order approximation in the usual units for clarity.) This implies a "sacrifice ratio", in terms of unemployment, of 1.5.ReplyDelete
If we try to do a rough comparison of this number to what actually happened, we see that in the four years following peak inflation of the GDP deflator, 10.1% yoy in 1981Q1, inflation dropped to 3.5% yoy in 1985Q1. Meanwhile, if we take 6% unemployment as the relevant "NAIRU", from January 1981 to January 1985 there were about excess 10.4 percent-years of unemployment. The sacrifice ratio is therefore 10.4/(10.1-3.5) = 1.6... which looks awfully close to the 1.5 that Tobin was using!
Given this, you seem to be on pretty thin ice making fun of Tobin's supposedly high sacrifice ratio...
(Some calculations show a significantly lower sacrifice ratio for this period, due either to subtle differences in the interval chosen or, most often, to use of the CPI rather than the GDP deflator. But the CPI before January 1983 suffered from an immense flaw, which was that it measured owner-occupied housing costs in a way that reflected mortgage interest rates directly - and thus pumped up inflation in response to higher interest rates - rather than owner equivalent rent. This exaggerated the rise and fall in the CPI in the early Volcker years.)
What I said was that he was using adaptive expectations and a Phillips curve with a high sacrifice ratio. He gave a number which you could translate into a slope for the Phillips curve and I was trying to make sense out of that in terms of Okun's Phillip's curve estimates from here:Delete
But I gave up, as Okun was reporting numbers in terms of a GDP tradeoff. So you're right, that I just assumed that he assumed a high sacrifice ratio. But the question is: high relative to what? Suppose I buy Tobin's model (which I shouldn't). Then your calculation from the data isn't giving me the slope of the Phillips curve, as expectations of inflation are changing over that period. But, suppose we buy the model, and suppose that Tobin has the right sacrifice ratio. He's still messed up, as you can see from the chart. The recession it takes to bring the inflation rate down is just way too long. If we assume that he's got the sacrifice ratio right, then he's got way too much inertia in inflationary expectations. So, sorry, no thin ice. It's like Great Slave Lake on February 1.
I think you do Tobin a disservice. His paper deals with a great deal more than just wage/price controls. I think you have taken your desire to plug Krugman via his views on Tobin to an hyperbolic extreme. The macroeconomic environment of the 1970s was complex and probably unprecedented. The macroeconomists of the time had to deal with both supply and demand side shocks (cost structure effect of agricultural price rises early in the decade and two savage oil price rises and the associated offshore income transfer). REs might have had something to say about the way policy was conducted but it was no panacea for understanding the causes of the stagflation nor understanding the remedies for it, despite what Sargent might have argued. Fortunately, the oil price declined thru the 1980s and let the western world off the hook.
No way. I've given you the essentials of his argument.
"Fortunately, the oil price declined thru the 1980s and let the western world off the hook."
I'm not sure I get it. You think that a fall in the relative price of oil on world markets in the 1980s brought inflation down in the U.S. Caused the recession too?
Re hyperbolism: Tobin's paper is extensive and wide ranging - you focus on one element of it.Delete
I find it interesting that the RE policy prescription of breaking inflationary expectations by convincing all and sundry that policy makers were serious about monetary policy is acceptable to you, yet you ridicule Tobinesque economics (which you simplistically argue is about incomes policy). Sargent asserts that permanently changing expectations will work more quickly and so with a smaller sacrifice ratio than otherwise - an assertion which requires some demonstration empirically, not just with harebrained models.
Re oil: in part yes, the oil price fall released the inflationary pressure valve - it helped take the "flation" out of stagflation - and it helped ease the world economy out of a nasty slump. And of course, I am not saying it caused the recession.
There was a massive plummet in oil prices at the start of the 1980s (have a look at oil price movements 1978-1985). Oil prices of course skyrocketed with the 1979 Iranian Revolution.
But it did not last.
I would imagine that a supply side shock like that would have had recessionary and an inflationary impact. I would not imagine output to pick up immediately oil fell. So yes initially there would have been inflation and recession. With a shock like that, that would be expected. Imagine producers having to adjust to the loss of an important oil source. There would be waiting and seeing going on before they adjust their production levels. (Would the oil price fall last?) Also much Keynesian (JMK Keynesian) uncertainty - imagine the international political environment, concerns that the problems in Iran would have other consequences in the oil-producing Middle East. This was also the time USSR invaded neighbouring Afghanistan - a shock to the stability of the Cold War geopolitical structure. Questions about the ability of the US to exert authority and maintain the stability of the trading system and its essential supplies. Messy, complicated situation where monetary factors are only one part of the jigsaw.
Are you against prices and incomes policies in theory, or just in this particular episode? Some of the best performing countries during the 1970s (Germany, Japan, and many others) have such collective bargaining systems, many still do.
"...not just with harebrained models."Delete
Right. The hairbrained models that replaced the Tobin models that were used to give us such great advice.
On oil prices. Sure, those are big relative price movements. But prices peak in 1980 and then don't fall much until after the end of the 1981-82 recession, so oil prices don't appear to have much to do with reducing inflation during this episode.Delete
"Are you against prices and incomes policies in theory, or just in this particular episode?"
Well, the theory says these policies are wrongheaded. I also lived through an extensive period of wage-price controls in Canada in the 1970s. We had something called the Anti-Inflation Board. That experience was completely consistent with the theory - bad policy.
"Right. The hairbrained models that replaced the Tobin models that were used to give us such great advice."Delete
Actually, I think Tobin's inflation/unemployment forecast was pretty stunning. As for his incomes policy advice I don't have a view. If it were to cause reduced activity and unemployment would it be any worse than what RE would prescribe, viz. a buttoned down, high initial impact, market convincing, monetary policy which Sargent asserts would work faster than any other policy response, even though he has no empirical evidence for this?
An economy, particularly an open economy is a complex beast. Simple models draped in complex mathematics are a poor facsimile of reality. If you want to read about the real world factors which impinge on an economy may I suggest you read the first chapter of the BIS 2015 annual report. (You might find it boring seeing there is not one equation mentioned.)
"I think Tobin's inflation/unemployment forecast was pretty stunning."Delete
Exactly. I was stunned by how bad it was.
"Simple models draped in complex mathematics are a poor facsimile of reality."
Would that be all simple models, only models with complex mathematics, models that are simple with complex mathematics, or what? How can a simple model also be complex? A model is by definition not a facsimile of reality. You seem a little confused.
"I suggest you read the first chapter of the BIS 2015 annual report."
I flipped through it. Looks more or less generic. What do you think is so special that's going on in that chapter?
"Exactly. I was stunned by how bad it was."Delete
He got something right, the general trajectory - "stunning" might be an overplay - just trying to needle you. LOL!
"Would that be all simple models, only models with complex mathematics, models that are simple with complex mathematics, or what? How can a simple model also be complex? A model is by definition not a facsimile of reality. You seem a little confused."
Nice try Stephen. What I said is pretty clear.
I flipped through it. Looks more or less generic. What do you think is so special that's going on in that chapter?"
While the paper is overworked (it could be a third the size), it usefulness lies in describing the multifactorial nature of the world economy. For instance, the neo-Fisherite fascination with the interest rate and inflation rate is very narrow - there are a multitude of interconnected factors which explain the relationship.
"What I said is pretty clear."Delete
Yes, actually, I got the picture. Just trying to needle you. I see you're not on board with post-1970 macroeconomics. Too bad.
"...it usefulness lies in describing the multifactorial nature of the world economy."
Sure, I know there's a lot going on. You're certainly not motivating me to read this in detail, and what I saw was nothing new.
"...there are a multitude of interconnected factors which explain the relationship."
Such as what? Enlighten me.
"Such as what? Enlighten me."Delete
I thought you said you read the paper?
"Just trying to needle you."Delete
Yes, I know.
"I see you're not on board with post-1970 macroeconomics. Too bad."
RE was a refreshing new approach. The problem was that it's proponents pushed it one unreal equation too far.
Fortunately Henry is around to correct all of us as to what is useful economics. Gee Henry, you should publish your brilliant ideas and get a Nobel Prize, since you've got it all figured out.Delete
Or, perhaps, not.
"so oil prices don't appear to have much to do with reducing inflation during this episode."ReplyDelete
Yes, that's the $64 assertion. The oil price peaked at $40 in 1979 and then steadily declined to $30 after 3 or 4 years, plunging to $12 mid decade and then averaging around $20 for the next 15 years or so. These are significant falls. The recession would have caused oil demand and hence prices to fall. Falling oil prices would have softened economy wide cost structures. Falling oil prices would have contributed to expectations of falling inflation - could have been an important factor. Who knows?
"The recession would have caused oil demand and hence prices to fall."Delete
So, what caused the recession then?
"So, what caused the recession then?"Delete
I leave it to experts like yourself to deal with that.
It's your story. You're supposed to flesh it out for me.Delete
"The recession would have caused oil demand and hence prices to fall."ReplyDelete
The other factor that was probably beginning to kick in was the substitution effect.
"It's your story."ReplyDelete
We started out with Mr. Tobin. Here we talking about oil prices. My "story" is that things aren't as mono-dimensional as some people make out.
"You're supposed to flesh it out for me."
That's your story. You're the one that get paid for this.
My pay for this is zero. This is pure recreation.Delete
Sargent appears the most off base to me based on the quote from your previous post. He ties inflation to persistent government deficits. Reagan had massive persistent deficits, yet inflation went down.ReplyDelete
I'm assuming you're talking about "The Ends of Four Big Inflations." I'd say that Sargent's point was, with regard to those episodes, that hyperinflation in the those episodes was driven by out-of-control fiscal policy. But to turn that out-of-control fiscal policy into hyperinflation requires the cooperation of the central bank, or control of the central bank by the fiscal authority. Sargent notes that these big inflations stopped quickly when fiscal policy was brought under control. But, in the case of the United States during the Volcker era, we had a central bank that was very much independent, pursuing a disinflationary policy. I wouldn't make the case that Reagan fiscal policy was out of control. "Massive" isn't the right word for the deficits, I think. At worst, at the recession trough, the deficit gets above 5% of GDP, and it's down to 2% or less by the end of Reagan's term. But, you're bringing up a useful point, which is that Volcker's policies were very much driven by the quantity theory of money - Friedman monetarism. Sargent wrote extensively about ideas that question the quantity theory - Unpleasant Monetarist Arithmetic, for example. I think that, looking at this episode, quantity theory ideas worked - Volcker's policy brought inflation down quickly. But the Fed found money growth targeting subsequently unworkable, and abandoned it. So I don't think Sargent was off base at all.Delete
My understanding is that Reagan tripled the national debt under his term. I don't see how that can be under control relative to his predecessors.Delete
Well, you don't need to rely on your "understanding," you can look it up. On FRED, there is a time series called:Delete
Federal Debt: Total Public Debt as Percent of Gross Domestic Product
That shows that, over Reagan's term, Federal Debt as a percentage of GDP increased from about 30% to about 50%. And that number is now over 100%. I'm not offering an opinion on Reagan or his fiscal policy, but I wouldn't call it out of control, any more than current fiscal policy in the U.S. is out of control.
"But the Fed found money growth targeting subsequently unworkable, and abandoned it."ReplyDelete
When you say "unworkable" can you explain exactly what you mean?
Do you mean it was difficult to control?
If it did the job why give it the flick?
If the relationship between money growth and inflation is unstable, that doesn't matter too much if your goal is getting inflation down from something very high to something low. But if your subsequent goal is to maintain a low and stable inflation rate, then that's not going to work so well if you're trying to do that by following Friedman's dictum: money growth targeting. That's why some countries adopted explicit inflation targeting, as the U.S. did (in a modified form) under Bernanke.Delete
Would you say that quantitative controls don't work efficiently because central banks don't entirely have control of it? Every time a commercial bank issues a new loan, new money is created.Delete