In a recent interview Paul Krugman expressed concern that under NGDP targeting an increase in the trend rate of RGDP growth would force the central bank to lower the rate of inflation. I replied something to the effect that this isn’t a bug, it’s a feature. BTW, Nick Rowe did a better job of explaining why this is so.
The reverse is also true; a period of low RGDP growth would lead to above average inflation. Why is “the worst of both worlds” deserving of praise? Because the alternative would be even worse. If higher inflation accompanies a growth slowdown, then the stagnation obviously is due to a real shock, not a fall in AD. If AD had declined, you’d have lower inflation during the period of stagnation. And when the economy is hit by a real shock, workers need to accept lower real incomes. You could do that by tearing up and renegotiating all wage contracts; or you could simply accept a bit more inflation.
Why does stagflation have such a bad rap? I think it’s because stagflation is often misdiagnosed. Under a NGDP growth target of 5%, stagflation is likely to be about 1% RGDP growth and 4% inflation—something like late 2007 and early 2008. Not good, but not the end of the world.
In one of yesterday’s posts I pointed out that we can’t trust any of the economic history that we learned in school–citing the 1929 stock market crash (which actually had no impact on the economy.) Another example is that “decade of stagflation;” the 1970s. The only problem with this commonly held view is that the 1970s were not a decade of stagflation; rather we saw an extraordinary surge in aggregate demand:
NGDP growth averaged: 10.4%
RGDP growth averaged: 3.2%
Growth was normal, and inflation was very high. Rapid growth in AD explains roughly 100% of the inflation during the 1970s. There was no stagflation, just inflation.
Now a purist can find a few individual years of stagflation, such as 1974. This occurred for two reasons. OPEC sharply cut oil output in late 1973, which was a severe real shock to the economy. And price controls were being phased out, meaning that part of the measured inflation of 1974 actually occurred in 1972-73, but was covered up to facilitate Richard Nixon’s re-election. (Actually that’s not quite fair—in those days many of the best and the brightest progressive economists supported wage-price controls.)
So the “stagflationary 1970s” is a big myth—almost as big a myth as the claim that the inflation of the 1960s was caused by LBJ’s refusal to pay for his guns and butter policies with higher taxes. Or the claim that the evil Republicans sharply cut the top MTR on the rich during the 1980s. Those are even bigger myths, something for future posts.