Let the circle be broken

Here’s Carola Binder:

In the New York Times, Binyamin Applebaum writes that Stein’s speech “underscored that the Fed increasingly regards bubbles, rather than inflation, as the most likely negative consequence of its efforts to reduce unemployment by stimulating growth.” In fact, the Fed’s concern about bubbles is not so new. After the Great Depression, it was widely believed that the stock market overheated in the 1920s, leading to the Great Crash in 1929 and the onset of the Depression. In those days, the word for bubbles or overheating was speculation, and it became a dirty word indeed. After the Great Depression, speculation remained a major concern of the Fed. The Fed very explicitly regarded bubbles as the most likely negative consequence of its efforts to reduce unemployment by stimulating growth.

For example, the United States economy was in a recession in 1953-54. In 1955, as the economy was recovering, the minutes from the Federal Open Market Committee refer multiple times to concerns about “speculative developments” or “speculative excesses.”

Yikes, it’s happening even sooner than I expected.

Governor Strong targeted prices and output in the 1920s, and opposed attempts to stop the stock market bubble.  After he died in 1928 the Fed ratcheted up rates until they drove the economy into depression. The Fed blamed the Depression on speculative excesses because . . . well . . . because otherwise it would be their fault. And that’s just not possible.

Ms. Binder then explains that the old fogies were still in charge of policy as late as the early 1950s, but by the 1960s the Depression generation took over:

In 1958, William Phillips published “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom.” This really kicked off the now-common idea that inflation is the most likely negative consequence of the Fed’s efforts to reduce unemployment. If the Fed is now starting to regard bubbles, rather than inflation, as the most likely negative consequence of its efforts to reduce unemployment, this is not a new trend. It is history of thought repeating itself.

This generation rightly ignored bubbles, and oddly (or not so oddly if you understand Market Monetarism and the EMH) they did not create any major bubbles despite a single-minded focus on easy money and jobs.  Unfortunately they also ignored inflation and NGDP growth, which was a big mistake.  Of course they blamed the Great Inflation on fiscal stimulus, unions, OPEC, wheat prices, and Peruvian anchovy production (I kid you not), even though none of those things had anything to do with 11% NGDP growth from 1972 to 1981, and indeed fiscal policy was not even expansionary. But what other choice did the Fed have? One could hardly expect them to blame themselves.

By 2006 the “Great Inflation” generation was in charge of monetary policy.  They quite rightly ignored bubbles, and they quite rightly saw the need for a nominal anchor.  At least they did so until they were distracted by the Great Financial Crash, when they let money get so tight that NGDP growth expectations plunged into negative territory.  There were probably several reasons for this policy failure, including an excessive reliance of backward-looking Taylor Rules, and too much focus on inflation rather than NGDP growth.  Of course they blamed the Great Recession on excessive speculation, and how could you blame them?  Otherwise they would have to acknowledge that money was way too tight in 2008-09, and that the Fed caused the Great Recession.

And so now we come full circle.  Do DSGE models incorporate Nietzsche’s Eternal Return?

PS.  Last week I attended a conference on the Great Depression at Princeton.  All the other participants were from elite schools, and they included historians, political scientists, and economists.  I noticed that many non-economists don’t share our view that the Depression was caused by tight money and that the Great Inflation was caused by central banks printing lots of money.  In fairness, I’m even more ignorant of fields like history than they are of monetary economics.

PPS.  Stephen Brien sent me this link, showing that starting in April the UK government will have real time data showing the entire nominal wage bill of the British economy.  Let’s hope they post it online, where it would provide invaluable real time information on the state of the British economy (a subject of great confusion today.)  Indeed in some ways this data is even more useful than NGDP, which is distorted by declining North Sea oil output, a trend that has little impact on employment.

HT:  Saturos


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71 Responses to “Let the circle be broken”

  1. Gravatar of Tyler Joyner Tyler Joyner
    20. February 2013 at 09:18

    This is where I get a little confused by Market Monetarism.

    You say that the Great Depression and the more recent financial crash were both caused by tight money. My question is, if the Fed had used an NGDP target, both the 1920s and the 2001-2006 time period would have experienced lower NGDP growth than they did, correct? So the system is as much about preventing the economy from “overheating” as it is about preventing overly tight money in a crisis?

  2. Gravatar of Suvy Suvy
    20. February 2013 at 09:32

    I think Irving Fisher explained what happened between 1920-1933 pretty well. People should go read The Debt Deflation Theory of Great Depressions. I posted this link on a different post in a comment response, but I’ll post it again. It’s very easy and simple to read; it’s also not very long.

    http://fraser.stlouisfed.org/docs/meltzer/fisdeb33.pdf
    The Debt Deflation Theory of Great Depressions by Irving Fisher

  3. Gravatar of Suvy Suvy
    20. February 2013 at 09:41

    “The very effort of individuals to lessen their burden of debts increases it, because of the mass effect of the stampede to liquidate in swelling each dollar owed…The more the debtors pay, the more they owe.”–Irving Fisher

  4. Gravatar of Daniel Daniel
    20. February 2013 at 10:14

    if the Fed had used an NGDP target, both the 1920s and the 2001-2006 time period would have experienced lower NGDP growth than they did, correct?

    WRONG. NGDP growth was right on track (more or less) until 2007.
    Nor was it growing at a particularly high pace in the 1920s

    Graphs to be found here

    http://thefaintofheart.wordpress.com/2013/02/19/president-coolidge-in-vogue/

  5. Gravatar of TravisV TravisV
    20. February 2013 at 10:38

    Prof. Sumner,

    With all due respect, I think you are losing to Yglesias and Mike Konczal on the EITC……

    http://slate.me/YgVKHU

    https://prospect.org/article/minimum-wage-101

  6. Gravatar of Andrew MacKay Andrew MacKay
    20. February 2013 at 10:49

    As a good economics student of this young generation, you can be damn sure i’ll be fervently on the lookout for the bubble bursting once people realize that there’s way too much arbitrary value assigned to some shiny yellow metal we find in the ground.

  7. Gravatar of Tyler Joyner Tyler Joyner
    20. February 2013 at 10:52

    Daniel,

    Okay, so the MM narrative can be (over)simplified as below?

    “NGDP growth was on track, then the housing bubble and subsequent financial crash reduced real GDP without overly affecting inflation, resulting in a sharp drop in NGDP, and the existing Fed policy of inflation targeting did little to help because inflation was mostly stable.”

    And the counterfactual is:

    “Had NGDPLT been the policy at the time, the drop in RGDP would be offset by a corresponding increase in inflation, keeping NGDP level, which while not eliminating the real shock, would at least have prevented tight money from actively making things worse”

    Do I have that about right?

  8. Gravatar of marcus nunes marcus nunes
    20. February 2013 at 10:54

    @ Suvy
    By sheer coincidence I just did a post from your previous link to Fisher:
    http://thefaintofheart.wordpress.com/2013/02/20/theres-really-not-much-thats-new-under-the-sun/

  9. Gravatar of marcus nunes marcus nunes
    20. February 2013 at 10:57

    @ Daniel
    That´s right. As Benjamin Cole and argue in depth in our book,NGDP growth in 2003-06 was appropriate to bring NGDP back to trend (from which it had fallen in 2000-02. And we know that to climb back to trend, growth has to be temporarily higher!

  10. Gravatar of Tyler Joyner Tyler Joyner
    20. February 2013 at 11:29

    Marcus,

    How are you distinguishing the NGDP growth in 2003-06 from the housing bubble itself? (I’m using the word bubble because that’s what Scott called it in his “Defense of NGDP Targeting”)

    As far as I know, it’s commonly accepted that mortgage lending practices, CDOs, CMOs, Fannie/Freddie, the FHA depending who you ask, related insurance practices, etc. ad nauseam had caused the housing sector to grow beyond what was rational.

    So unless you’re disputing that, the “normal” NGDP growth was at least partially composed of abnormal growth in the housing sector.

    To be clear, I’m not even attempting to argue yet, I just honestly do not understand the internal consistency of the MM narrative.

  11. Gravatar of Matt D Matt D
    20. February 2013 at 11:46

    Scott, How do you respond to this paper by Alan Blinder arguing that the Great Inflation was mainly caused by supply shocks (and not monetary policy)?

    cheers,
    Matt D

    http://www.princeton.edu/ceps/workingpapers/176blinder.pdf

  12. Gravatar of Daniel Daniel
    20. February 2013 at 12:02

    Tyler,

    As a believer in the weak form of the EMH (“efficient market hypothesis”), I am bothered by the use of the term “bubble”. I believe it to be a useless concept, since it can only be identified in retrospect.

    Furthermore, housing began its decline in 2006, without any significant increase in unemployment.

    And frankly, when I read stuff like “grow beyond what was rational”, “abnormal growth”, I am puzzled (to put it mildly) – “abnormal” as opposed to what ? It’s the sort of stuff a central planner would say.

    Besides, you have the causation all wrong. Housing was already in decline, the financial crash was caused by the drop in NGDP (not the other way around). As for the Fed’s “inflation targeting” – they did that wrong too, allowing outright deflation to occur.

  13. Gravatar of TravisV TravisV
    20. February 2013 at 12:06

    Prof. Sumner,

    Is today’s FOMC release pushing down AD expectations substantially?

  14. Gravatar of Not surprising | Historinhas Not surprising | Historinhas
    20. February 2013 at 12:18

    [...] least not after the widely commented upon talk of Jeremy Stein a while back. Anyway, as Scott Sumner has [...]

  15. Gravatar of marcus nunes marcus nunes
    20. February 2013 at 12:31

    @Tyler Joyner
    You gave me an opening to ‘peddle’ my book with Benjamin Cole. In the book almost half of Chapter 6 (The Great Recession: Why did it happen?) discusses exactly the point you bring up! (Hope you buy and enjoy)
    The link is here:
    http://www.themoneyillusion.com/?p=18964

  16. Gravatar of ssumner ssumner
    20. February 2013 at 12:35

    Tyler, Yes, but the “overheating” of the 1920s had little or nothing to do with the Great Depression. NGDP growth was pretty slow during the 1920s.

    Then recent boom is more debateable, but I still think tight money was the much bigger policy mistake.

    TravisV, Can you be more specific? Which arguments of mine did they refute?

    Andrew. Touche!

    MattD. He’s wrong. If supply shocks were the problem you’d see normal NGDP growth, low RGDP growth, and high inflation. But instead we had normal RGDP growth (3%), absurdly high NGDP growth (11%/year in 1972-1981), and high inflation. It was obviously caused by money printing, which accelerated sharply in the mid-1960s. It’s not even a debateable point.

  17. Gravatar of Tyler Joyner Tyler Joyner
    20. February 2013 at 12:43

    Daniel,

    I explained why I used the word bubble in the post I addressed to Marcus specifically to avoid that argument. Call it whatever you want, pick a word and I’ll use it for the duration of this discussion.

    I don’t think your interpretation of events nor your policy opinions are any more “free market” than what I wrote.

    Fannie and Freddie, the Fair Housing Act, etc. are certainly government interferences in the market. Growth in the housing market due to those interferences can be characterized as “abnormal” – as in, it would be impossible to prove what growth would have occured in the absence of those interferences, but it seems highly probable that the government significantly affected the workings of the market.

    In the sense that it is government interference in the market, NGDPLT is certainly akin to central planning. The assertion by market monetarists that it makes no difference where money enters the market (as in the lengthy debates over Cantillon effect) does not change the fact that NDGPLT is premised upon the idea that the government “knows” what NGDP growth should be, and should take action accordingly. The seemingly chosen-at-random 4% growth trajectory Scott advocates is quite instructive. On the one hand, I have a certain amount of respect for the implied admission that needlessly complex models don’t necessarily come up with anything better than “I’ve looked at our historical NGDP growth figures, and 4% seems like a reasonable target”, but on the other hand you have to wonder: is that really how we’re going to set monetary policy for the world’s largest economy? The stakes aren’t exactly small here.

    Finally, I have a serious issue with the causation claims put forth by Scott and other market monetarists regarding the financial crash. I think, at the very least, the assertion that the sharp drop in NGDP caused the financial crash needs to be backed up. Nominal GDP is just that – nominal – and to claim that a change in it caused a reduction in real GDP is definitely something that cannot be accepted a priori, as has been done on this blog.

    I see that claim repeated frequently without any kind of explanation as to why NGDP drives RGDP and not the other way around. If anything I would think the two are endogenous.

    This is why I’m asking these questions. If I were a PhD macro economist maybe I’d already know the answers to these questions, but I’m not. More importantly, the people running our government and even the members of the Fed are not all experts in monetary policy. Even if you can provide a reason why NGDP caused the financial crisis, and I’d honestly love to hear it, I think that explanation needs to be much more front-and-center than it has been.

  18. Gravatar of ssumner ssumner
    20. February 2013 at 12:50

    TravisV, A drop in AD, but not “substantial.”

    Tyler, You said;

    “Nominal GDP is just that – nominal – and to claim that a change in it caused a reduction in real GDP is definitely something that cannot be accepted a priori, as has been done on this blog.”

    Yes, but I can’t reinvent the wheel in every post. Virtually all macroeconomists agree that a big drop in NGDP will cause a drop in RGDP. I’ve cited lots of evidence over the years. Friedman and Schwartz (1963) is a good place to start, if you haven’t read it. Also Eichengreen’s Golden Fetters.

  19. Gravatar of Tyler Joyner Tyler Joyner
    20. February 2013 at 13:01

    Marcus and Scott snuck one in on me while I was writing that novella.

    Marcus: I’d love to read it – do you think the writing is accessible to someone with an interest in economics but little formal education?

    Scott: Hmm. Okay, so that raises a couple more questions for me. If the… let’s call it inefficiencies in the housing market (perhaps due to gov’t involvement or those evil big banks) were in part due to excessive lending, would tighter money not make sense?

    The part of your “Defense of NGDP Targeting” that I really liked was where you described why it was appropriate that lenders and borrowers both shared in the negative consequences of excessive lending – and I can see how that logic would apply to the financial crash. I can also understand how sticky wages and prices mean that, in the short term, inflation allows wages and prices to reach a better equilibrium following a negative change in RGDP.

    What I don’t understand is how a drop in NGDP caused the financial crash. It’s just a number composed of real GDP and inflation. How can it cause anything? What causes NGDP to drop before the crash? If there was no crash, would Fed policy remain or less the same? In which case you would think that NGDP would not have a sharp move.

    I really just don’t get that, and my intuition tells me that a lot of people who aren’t economists are going to have a hard time understanding it too. So my hope is that if you (or Daniel, or Marcus, or whoever) invest a little time explaining it to me, it will be easier to answer that objection in the future.

  20. Gravatar of Tyler Joyner Tyler Joyner
    20. February 2013 at 13:02

    Scott,

    Okay I’ll give those a go. Thank you.

  21. Gravatar of Steve Steve
    20. February 2013 at 13:10

    “the Fed increasingly regards bubbles, rather than inflation, as the most likely negative consequence of its efforts to reduce unemployment by stimulating growth”

    This is ABSOLUTELY TERRIFYING!

  22. Gravatar of Daniel Daniel
    20. February 2013 at 13:13

    Tyler,

    For starters, I would be really grateful if you’d stop contradicting things i never said.

    Yes, there is a lot of government interference in the housing market (and in the labour market, and in plenty of other markets) – I never said there wasn’t.

    Should the monetary authority (that is, the Fed) be concerned with that ? My answer would be “no”. I simply can’t imagine a scenario in which monetary policy is used to “pop bubbles” (whatever that means) without dragging the entire economy into a recession.

    If you’re interested in doing further reading, this would be a good place to start

    http://marketmonetarist.com/2012/01/20/guest-blog-the-two-fundamental-welfare-principles-of-monetary-economics-by-david-eagle/

  23. Gravatar of Daniel Daniel
    20. February 2013 at 13:17

    would tighter money not make sense ?

    Like I said above – “tighter money” would translate as “a drop in NGDP”. And since wages and debts are sticky, a drop in NGDP causes a drop in output – a recession, in other words.

    So you’re advocating a recession as a cure to the “inefficiencies in the housing market” …

  24. Gravatar of Matt D Matt D
    20. February 2013 at 13:21

    Scott, I think you are too dismissive of his argument. It’s really not fair to look at *average* NGDP growth/inflation over the decade 72-81. The average is skewed higher by the huge spikes surrounding the oil crises (and a few other commodity-price spikes, according to Blinder). Also, lo and behold, RGDP was negative in 1974 and 1980, the main years where the oil crises would have had a direct impact.

    How on earth did the Fed printing too much money over the previous decade or so happen to produce inflation spikes just around the times of the oil crises? Okay, maybe you argue the Fed should have tightened radically to keep NGDP growth steady. But that sounds perverse. If anything, one could argue that the Fed should have set looser policy than it did, to fight the recessionary impact of the oil price spikes.

  25. Gravatar of Michael Michael
    20. February 2013 at 13:28

    “What I don’t understand is how a drop in NGDP caused the financial crash. It’s just a number composed of real GDP and inflation. How can it cause anything? What causes NGDP to drop before the crash? If there was no crash, would Fed policy remain or less the same? In which case you would think that NGDP would not have a sharp move.”

    I’m also not an economist. I think part of the answer lies in the fact that we spend *nominal* dollars, not real ones. We all understand that inflation exists, but the vast majority of the contracts and transactions we enter into are defined in nominal terms. If your nominal salary is cut (or raised) by 10%, it is going to have a bigger effect on your behavior than a large fluctuation in the rate of inflation. In 2008-2009, the USA’s nominal income was slashed by 10% (relatvie to pre-crisis expecations).

  26. Gravatar of TravisV TravisV
    20. February 2013 at 13:30

    http://www.businessinsider.com/closing-bell-february-20-2013-2013-2

    if there was one sentence that freaked out the markets, it was this: “A number of participants stated that an ongoing evaluation of the efficacy, costs, and risks of asset purchases might well lead the Committee to taper or end its purchases before it judged that a substantial improvement in the outlook for the labor market had occurred.”

  27. Gravatar of Ron Ronson Ron Ronson
    20. February 2013 at 13:31

    What happens if the only way that NGDP can be kept on target is by using policies that will leads to unsustainable asset bubbles ?

    For example: The CB is targeting NGDPLT during a period when velocity is declining due to concerns about future economic prospects. The CB buys assets and drives up their price. The wealth effect will cause some people to sell assets and spend on final goods until the NGDPT is hit. But this will not address longer term economic concerns and so velocity may decline further leading to more CB asset buying to keep NGDP on trend. Eventually this will prove unsustainable and asset prices will crash and take down RGDP with them.

    In these circumstances would the CB not have been better advised to allow the NGDPLT to be missed so that the underlying economic concerns could have been addressed and not be masked by inflated asset-price being used to artificially boost NGDP?

  28. Gravatar of Mike Sandifer Mike Sandifer
    20. February 2013 at 13:40

    Scott,

    I’m often amused when I hear or read talk about the evils of speculation. Everything’s speculative. Everything we do in life is a gamble. The distinction some try to make between investing and gambling is wholly artificial and ridiculous.

    That being said, and while you can count me among the bubble skeptics, according to your worldview, the markets badly overestimated the Fed’s willingness to ease/competence in easing going into the ’08 crisis.

    I realize EMH doesn’t claim markets predict correctly at all times, but only that it does so better than any individual on average. However, it’s hard to escape the conclusion that market monetarists may consistently know better than the markets, hence what you claim as your successful, anti-EMH investment strategies. Some models are clearly superior to others, and yours is still obscure as far as most investors are concerned.

    I’d like to see you do a post sometime displaying some rigorous thinking on why you ignore EMH when investing. My suspicion is that very strong EMH models are wrong, and that it’s merely the case that, as with so many other skills, only a minority of people at any one time are good investors.

  29. Gravatar of Suvy Suvy
    20. February 2013 at 13:43

    By the way, it seems that I’m not the only one who’s really scared by the Fed announcement today. We’ve got a major debt problem; inflation helps. It’s critical that we reduce debt/income ratios; that means you’ve got to keep the pressure on. You’ve got to restructure more debt, liquidate the junk debt, and keep sustaining income levels so the debts can be systematically wiped out. There are no other options. I’m not a fan of folly in the equity markets, but we can’t control folly that happens in the private markets.

    We do need to worry about debt induced bubbles, but there should be no reason why we should be worried about a potential stock bubble when we have a highly indebted society where there is no private sector credit demand. We need to systematically wipe out the debts; that means that the Fed has to keep the pressure on.

  30. Gravatar of Mike Sandifer Mike Sandifer
    20. February 2013 at 13:47

    Scott,

    That is to say, I’d like your implicit thinking to become explicit and for you to examine your thinking as an investor and how it may or may not be reconciled with your comments about EMH.

    Yes, I know your gut may make it hard to accept EMH, even when your head disagrees, but shouldn’t you take to trying to resolve this conflict at some point?

  31. Gravatar of Mike Sandifer Mike Sandifer
    20. February 2013 at 13:55

    Suvy,

    How are you defining “major debt problem”? All evidence seems to indicate we have no major debt problem, and why would 100 or 200% debt/GDP ratio ever be a problem for a sovereign currency issuer? I’m not saying we should just run the debt up without concern, but only that we’re nowhere near a “major” problem.

    If an average family can have mortgage debt at 3 times income or more, plus car loans, student loans, credit cards, etc., why would a government that can tax and print money have a problem? And which is less likely to vary much over time? The growth of any individual family’s income, or that of a major economy?

    Don’t mention that mortgage loans are collateralized. The US has hundreds of trillions of dollars in assets that can be taxed, if need be.

  32. Gravatar of Tyler Joyner Tyler Joyner
    20. February 2013 at 14:00

    Daniel,

    You said my characterization of the housing “bubble” sounded like a central planner – I disagree, on several fronts.

    If I’m discussing the effect I think government interference had on the housing market, that might be speculation, but it’s not central planning. Discussing the negative effects of central planning not necessitate engaging in central planning.

    I made no claims about unemployment.

    Should the monetary authority be concerned with why NGDP is rising or falling? I think the composition of NGDP is inherently important to any plan to keep it at a target level. If NGDP growth is high because the government is running $20 trillion deficits, half of which goes to building statues of Scott and the other half pays for building theme parks in every town, then increasing the monetary base to maintain that trajectory doesn’t make much sense, does it?

    Scott’s estimate of when we should start measuring NGDP growth from and how far we have to overshoot it in order to get back on trajectory is, on some level, a subjective judgment of what is “normal”. My question is quite simply: if the government is interfering in markets and creating incentives that a more free market might not create, how can we know what “normal” is? Maybe 2% NGDP growth is sustainable in a highly developed service economy. Maybe 6% is.

    I never said monetary policy should be used to pop bubbles, but if you concede that government interference in the housing market may have created temporary growth, or that government interference in various markets is distorting growth in complex ways, then it seems difficult to make judgments on what NGDP growth should be.

    Prescribing NGDPLT without even considering fiscal policy and the real economy seems like a psychologist writing presciptions for anti-depressants without bothering to cross-check them against the six other prescriptions the patient got from their primary care provider.

    Scott alludes to this in his “Defense of NGDP Targeting”. He said a drop in NGDP was the proximate cause of the crash, even if the housing crisis was the ultimate cause. Does it not seem questionable to prescribe a policy to fix the symptom without considering the ultimate cause? Even if market monetarists are 100% correct, and NGDPLT can seriously reduce the effects of events similar to the housing crisis, does that not also effect the propensity of agents such as the government or the banking sector to get into those situations in the first place?

    Anyhow, I’ll read through the links you and Scott provided here. Maybe those questions will answer themselves.

  33. Gravatar of They never ‘give in’ | Historinhas They never ‘give in’ | Historinhas
    20. February 2013 at 14:12

    [...] has given a short and precise answer to MattD´s [...]

  34. Gravatar of marcus nunes marcus nunes
    20. February 2013 at 14:23

    @Tyler Joyner
    Our intention was the general reader. The more that understand the concept the better. Read and then tell me if we were successful!

    @ MattD
    I´ve elaborated a bit on Scott´s summary dismisal of Blinder:
    http://thefaintofheart.wordpress.com/2013/02/20/they-never-give-in/

  35. Gravatar of kebko kebko
    20. February 2013 at 14:32

    This is from an article from today’s Wall Street Journal, on the FOMC minutes:

    “After battling between gains and losses immediately following the release of the minutes, prices drifted higher as bond investors took comfort in the Fed’s presence…Still, bond traders expect gains to be harder to come by going forward as the Fed’s exit strategy draws increasing attention.”

    How can there be such a seemingly universal disconnect between public commentary on the bond market and the market itself?

  36. Gravatar of Don Geddis Don Geddis
    20. February 2013 at 14:38

    @Ron Ronson: “…more CB asset buying to keep NGDP on trend. Eventually this will prove unsustainable…

    For a nation with fiat currency, and debts denominated in its own currency, why would your scenario ever become unsustainable?

  37. Gravatar of Ron Ronson Ron Ronson
    20. February 2013 at 14:49

    @Don,

    In theory it could go on for ever but in reality as asset prices increase returns on those assets would fall and people would only hold them in expectations of further price increases – in this situation even a minor negative shock could cause an asset price collapse.

  38. Gravatar of Don Geddis Don Geddis
    20. February 2013 at 15:00

    @Ron: Not if the CB is always available to purchase the asset at a given price. No real world negative shock is stronger than the ability of the central bank to support a nominal price level.

  39. Gravatar of Suvy Suvy
    20. February 2013 at 15:01

    Mike Sandifer,

    What I mean by major debt problem is the debt in the private sector. There is a reason why the economy isn’t growing like it otherwise should–there’s no private sector credit demand. In order to get private sector credit demand, the private sector balance sheets need to be cleared. Inflation is a very good way to wipe out the private sector debts. The US public sector debt is not to the level that we should panic(like Japan), but we certainly shouldn’t want it to rise further.

    I define aggregate demand a little bit differently: AD=I+dD/dt=NGDP+NAT. It’s healthy to have a certain amount of credit expansion in an economy; however, the credit must be used to increase the capital base of a country. If the credit is used to speculate on asset price where rising leverage creates rising asset prices, you have an unsustainable boom. We’re suffering from the consequences of such a boom. The sooner the private sector balance sheets are repaired, the sooner the economy will start to grow again. Increasing debt is a important part of a well-functioning capitalist economy; the key factor is debt/income ratios. You have to make sure that even if debts are rising, debt/income ratios are not rising unsustainably.

  40. Gravatar of Don Geddis Don Geddis
    20. February 2013 at 15:07

    @Tyler Joyner: “The seemingly chosen-at-random 4% growth trajectory Scott advocates

    I think it was 5%, not 4%. And it’s not random. He’s explained many times: it matches the 5% growth during the Great Moderation (~1980-~2005), and is typically composed of 2% productivity growth, 1% population growth, and 2% inflation.

    I don’t understand is how a drop in NGDP caused the financial crash.

    Debts and contracts are typically denominated in nominal values, not indexed for inflation. Debtors make a promise of future payments, based on their expected future income. If that income doesn’t materialize as expected, then all of a sudden you see society-wide defaults and bankruptcies. The “drop in NGDP” means that people no longer have the income to make their debt payments.

    Maybe 2% NGDP growth is sustainable in a highly developed service economy. Maybe 6% is.

    You’re confusing RGDP with NGDP. Perhaps 2-3% RGDP growth is sustainable for an advanced economy over the long run; perhaps not.

    But any value of NGDP growth is “sustainable”. If not taken up by productivity growth or population growth, it will show up as inflation. But a central bank can sustainably achieve any NGDP growth rate it chooses, indefinitely.

  41. Gravatar of Ron Ronson Ron Ronson
    20. February 2013 at 15:20

    @Don: My assumption was that the CB only cares about NGDP being on target not about asset prices.

    Assume that the economy (for whatever reason) needs to make some structural adjustments that would involve a temporary fall in RGDP which would be reflected (without CB action) in a corresponding fall in NGDP. By increasing asset prices the CB can for a while maintain NGDP and RGDP but eventually when holders of assets no longer want to hold them at unsustainable prices there may be a financial panic that will have a real effect on RGDP.

    At this stage the CB (by buying huge quantities of assets) may still be able to hit the NGDPT target but this will likely cause inflation rather than prevent the fall in RGDP it is meant to.

  42. Gravatar of Matt D Matt D
    20. February 2013 at 15:27

    @Marcus Nunes

    So you take the causation further back: the Fed’s overly-loose policy caused OAPEC to raise the price of oil, with the Yom Kippur war serving merely as an excuse to do so. I question the word “caused” in that sentence. Maybe overly-loose policy was a big, underlying reason for the embargo, but it was a bad reason, even from the oil producers’ perspective, since it pushed advanced economies to become much less energy intensive. A moderate price hike would have been called for, and in no sense were oil producers forced to hike prices.

    But what about in 1979? Did Fed policy cause the Iran-Iraq war and the collapse of Iranian oil production? Was it even a contributing reason? Of course not.

    Oil prices are set by supply and demand for oil, sometimes with monetary policy decisions by some government, somewhere, serving as a contributing factor, but often times not. Suppose somebody discovered tomorrow that Venezuela’s remaining oil reserves actually contained nothing but Jello. The price of oil would triple, inflation in the U.S. would spike. Would any of this be the Fed’s fault? No, unless you maintain that the Fed should drive the U.S. into a deep recession to keep NGDP growing at some arbitrary rate. And that would be perverse.

    I’m not sure if the numbers in Blinder’s argument add up, but the oil crises were *mainly* exogenous events. To believe otherwise, is to support a quasi-mystical view of the Federal Reserve’s powers over world events.

  43. Gravatar of 123 123
    20. February 2013 at 15:28

    The best proof that Godwin’s law is false. NSFW but ontopic. http://www.youtube.com/watch?v=hwxcXnFW07s

  44. Gravatar of Matt Waters Matt Waters
    20. February 2013 at 15:39

    Tyler,

    To simplify things some:

    1. Given no structural reasons for unemployment, cyclical unemployment will rise and fall according to NGDP, not inflation. This is common sense for employees at an individual company, where the company’s revenue determines what it can pay employees, and declining revenue almost always means lay offs or fewer hours than lower wages.

    2. Employment does not care about the make-up of NGDP. It does not care if its a speculative bubble, wasteful government spending, private consumption or good, positive NPV private investment. Demand is demand, whether for building statues of Scott or whatever.

    3. Living standards, on the other hand, does care very much about the makeup of NGDP. Let’s say somehow you have the want raise NGDP by $100 billion because of high unemployment. Here are your two choices:

    a. Build statues of Scott with the money, directly raising employment.
    b. Exchanging the money for bonds so that the bond-owners will either spend money on private investment or spend down wealth they already have on consumption.

    (b) is essentially how monetary policy loosens, while selling bonds the Fed bought before is how monetary policy tightens. (a) is wasteful Keyensian stimulus spending.

    4. Outside of the zero-lower-bound, most of the money the Fed printed went to some sort of new spending. The issue in 2008 was that the demand for risk-free bonds went up so much that any money the Fed printed quickly pushed short-term risk-free bond rates as low as they could go. Money is now a substitute asset for T-bills because they both yield at least 0.25%, but when new excess reserves are issued they don’t do anything in the real economy. Therefore, initiatives at the zero-lower bound typically deal with ways to increase velocity, such as lowering long-term rates or setting looser expectations of future policy.

    5. The makeup of NGDP is also not determined only by the level of government spending, wasteful or otherwise. The capital misallocation had a lot of causes, both from what government did (GSE’s) and government didn’t do (too little/wrong regulation is some areas of banking).

    Basically, NGDP targeting is about keeping the employment level stable regardless of other underlying factors while also generally keeping a low inflation rate. So NGDP targeting would not tighten policy in summer of 2008, when the Fed raised interest rates despite increasing unemployment, but would significantly tighten policy in the 70′s when high unemployment was structural (“stagflation”). The governmental policies that determine the composition of that NGDP is what the rest of economics is about.

  45. Gravatar of marcus nunes marcus nunes
    20. February 2013 at 15:43

    @MattD
    If you harbor any doubt about your last sentence go and check David Beckworths “The US is a monetary superpower”!
    In the price of oil episodes, there are certainly other (many times emotional) factors involved, but I have no doubt that inflationary monetary policy in the US (which also was behind the break-up of Bretton Woods) was the most important objective factor behind the oil rise. Remember that in the years after 1974 inflation continued unabated. But monetary policy is ‘exempted from blame’! Also, in the ‘jello’ example, a spike in inflation is the expected outcome given sticky prices elsewhere. But it does not imply inflation, a continuing rise in ALL prices. (note the rise in BOTH headline and core prices in the 70s. That´s inflation. In the GM we observe mostly changes in relative prices.

  46. Gravatar of Ron Ronson Ron Ronson
    20. February 2013 at 16:00

    Here are your two choices:
    @Matt

    on

    “Here are your two choices:

    a. Build statues of Scott with the money, directly raising employment.
    b. Exchanging the money for bonds so that the bond-owners will either spend money on private investment or spend down wealth they already have on consumption.”

    Seems like you have a third choice

    c) Spend the money on subsidies for private investment. This would make marginal investments profitable and make sure the money directly affects RGDP and is not spent “subsidizing” inflation (of final goods and assets) which may be the result of QE.

  47. Gravatar of Matt Waters Matt Waters
    20. February 2013 at 16:04

    @ Ron

    “In these circumstances would the CB not have been better advised to allow the NGDPLT to be missed so that the underlying economic concerns could have been addressed and not be masked by inflated asset-price being used to artificially boost NGDP?”

    Also see my post above. Asset “bubbles” do not happen out of thin air, but take real people investing real money in real debt. So if money is exchanged for a privately-held bond, a real person decides what to do with that money.

    Homo economicus would only invest that money for discounted cash flows that meet their desire for present money vs. future money and their risk-tolerance. If the increase in NGDP from 2001 to 2006 was only done by perfectly rational agents, we would have hit the zero-lower-bound after 2001 due to high demand for savings and low supply of credit-worthy assets. Then the Fed’s possible other policies would have pushed up investing by either lower long-term real rates or nominal rates below zero through charges on excess reserves. As interest rates go lower, there is a higher supply of loans and more money is spent on consumption.

    In the real world without homo economicus, the NGDP spending can in fact go to loans that will not pay back. But this requires irrationality on the part of the ultimate lender. There are plenty of explanations for why the mortgage borrowers, originators and bank employees all acted rationally, but there’s no explanation for misallocation on the part of the ultimate lender other than irrationality. Irrationality happens for various reasons, but some government policies can increase the efficiency of markets and markets generally tend not to be so irrational.

    Instead, money-owners generally act like homo economicus would. Since they hold onto money more, the prevailing risk-free real rates may need to be lower to induce the spending increase. In the worst case scenario, higher NGDP does not mean bubbles but inflation exactly equal to the NGDP increase, or inflation a little bit higher due to the real costs of inflation. If NGDP changes always led to simple inflation or deflation, then I wouldn’t care particularly about an NGDP target. However, the real world shows horrendous costs and idle human talent for no reason than central banks did not effectively increase NGDP.

  48. Gravatar of Matt Waters Matt Waters
    20. February 2013 at 16:27

    Ron,

    That last comment was directed at your earlier post.

    Subsidies to private investment are essentially Keynesian spending. Instead of enacting lower interest rates through monetary policy, you are issuing government debt to create lower interest rates. I guess this would turn out the same if you trusted the government to subsidize every loan equally like a general decrease in interest rates would.

    Also, unlike monetary policy, the government will be liable for some of the future interest rate payments. With swapping newly printed money for bonds, the government sees future interest rate payments decrease since it will be paying interest to itself.

    The ultimate distributional effects between the two proposals is hard to keep together in my head. My first reaction is that current money-holders do better with your proposal at the expense of future income-earners, while my proposal is the other way around. One group is not any more entitled than the other group.

    But perhaps the hardest thing for me to accept is that real interest rates need to go down for the currently wealthy in order to meet spending targets. Decreasing real interest rates outside the ZLB has been fine in the past. However, a 5% NGDP target with perhaps 2% inflation may require a real rate lower than -2%, i.e. a nominal rate below 0%. The answer may just be that somebody’s ox has to be bloodied vs. some other alternative, and it’s a question of overall utility which policy has a better outcome just like all other questions on government policy.

  49. Gravatar of Ron Ronson Ron Ronson
    20. February 2013 at 16:45

    @Ken: I too recoil instinctively at the thought of “Keynesian” spending. However given that using monetary policy at ZLB is unknown territory and even its supporters agree that it could lead to higher short-term inflation – both of end prices and of assets (and in fact see this as feature) I think that market-orientated fiscal policy (tied to a NGDP target and using newly created money when required) could be a safer option.

    Market Fiscalism if you like.

  50. Gravatar of Eric Eric
    20. February 2013 at 16:56

    Setting a target for the central bank will not work with Fed Transparency. The publishing of the minutes of the Fed has clearly shown the market responses to changes in the Fed ‘thinking about’ changes. When the Fed minutes contain normal discussion, setting a target is useless. Unless the target is in the Constitution, it will be ‘up for discussion’. Once any discussion about changes in any Fed policy occur, many of the benefits of a set target are usurped.

    As brought up in some comments, sometimes supply shocks provide a real argument for different targets. For example, demographics are changing and that will impact the ‘correct’ target. If you population is falling (like Japan), should you keep the same NGDP target? Or you get a supply shock (oil)? Or a war? The point is setting one target will lead to really bad results in the real world. Once this becomes apparent, Fed Transparency will lead the market to change and the target to become useless.
    Conclusion: Because Fed members are not robots and Fed policy is ‘up for discussion’, NGDP targeting will not work in practice. You can say the Fed will target x, but if any serious discussion occurs about ‘exceptions’, the advantages of targeting evaporate.

  51. Gravatar of Bill Woolsey Bill Woolsey
    20. February 2013 at 17:09

    With nominal GDP targeting, too much demand for housing implies too little demand for other goods and services.

    To the degree the reason for the excessive demand for housing was excessive lending to those wanting to buy houses, then it is likely that there was too little lending to those wishing to purchase other goods and services. Of course, it is also possible that there could instead have been little little equity finance or even that people should have consumed more of their own incomes or else firms funded more investment out of current profit or even accumulated retained earnings.

    For example, if Basil capital regulations wrongly treats housing as low risk and so banks find it more profitable to lend more to those buying new homes and less to business, then we could see less spending on various sorts of capital goods that various businesses find useful and more spending on new houses.

    If investors believe that Fannie and Freddie will be bailed out, then investors will hold more Fannie and Freddie bonds and fewer corporate bonds. More new houses will be built and fewer of all sorts of different capital goods will be built.

    The implicit assumption of bad macroeconomic thinking is that if there is less lending or spending on something or other, then total spending will be lower because those who would have spend will just accumulate more money balances. That last action is just implicit in the “analysis” and ignored.

    Or worse, there is a notion that everyone is already spending all their income, and then spending rises because they now borrow more than they are earning and spend it. But, they obviously can’t keep on building up debt, right?

    This ignores the fact that spending always generates a matching income. Any level of spending can be funded out of any level of current income.

    The only “problem” or limit is that people typically want to hold more money when they earn and spend more, and if the amount of money is limited, they will end up short of money and spend less than their income. Of course, this isn’t really a “problem” in general but rather how a monetary regime provides a nominal anchor.

  52. Gravatar of Steve Steve
    20. February 2013 at 17:48

    Current, former Fed officials warn of bubbles:

    http://www.youtube.com/watch?v=sen8Tn8CBA4

  53. Gravatar of Michael Michael
    20. February 2013 at 18:39

    “Scott alludes to this in his “Defense of NGDP Targeting”. He said a drop in NGDP was the proximate cause of the crash, even if the housing crisis was the ultimate cause. Does it not seem questionable to prescribe a policy to fix the symptom without considering the ultimate cause? ”

    Hey, Tyler.

    One key point here – sometimes symptoms can kill. If you bring a baby to the ER with a 107 degree fever, the doctor is not going to futz around trying to figure out what is causing the fever. Could be a virus, could be some kind of wierd tumor, could be bacterial infection, could be a variety of things. But at that that moment, it doesn’t matter. The doctor’s immediate job is not to allow the high fever to be the proximate cause of death. Yes, the fever is “just a symptom”, but that doesn’t mean it should be ignored.

    What about the ultimate cause? Well, that matters, too. The doctor cannot content himself with getting the fever down, he needs to address the underlying cause. But if he fails to addresss the proximate cause, he needn’t bother with the underlying cause, either.

  54. Gravatar of Geoff Geoff
    20. February 2013 at 18:54

    Bill Woolsey:

    “With nominal GDP targeting, too much demand for housing implies too little demand for other goods and services.”

    Only if you define the NGDP target to be the “correct” aggregate demand.

    If it’s incorrect, then too much demand for housing does not imply too little demand for other goods and services.

    You’re really just saying “The NGDP target is correct” in a different way.

  55. Gravatar of Becky Hargrove Becky Hargrove
    20. February 2013 at 19:11

    Geoff,
    NGDPLT is not representative of a “correct” aggregate demand; rather it is like a mirror of consumption potential writ large, IOW it shows to a broader public what a banker already knows in terms of consumption possibilities for income variations along a continuum.

  56. Gravatar of Mike Sandifer Mike Sandifer
    20. February 2013 at 19:43

    Bill Woolsey,

    That seems a great summary of the absurdity of the boom/bust bubble perspective.

  57. Gravatar of Steve Steve
    20. February 2013 at 20:47

    “By 2006 the “Great Inflation” generation was in charge of monetary policy… Of course they blamed the Great Recession on excessive speculation, and how could you blame them? Otherwise they would have to acknowledge that money was way too tight in 2008-09, and that the Fed caused the Great Recession.”

    One of the consequences of improved health care and much longer life expectancy, is that this generation will be in power MUCH longer than previous generations, therefore the down cycle will last MUCH longer. From a policy perspective, we will be living much further in the past than at any other time in human history.

  58. Gravatar of TravisV TravisV
    20. February 2013 at 21:51

    “Killing words”

    by Marcus Nunes

    http://thefaintofheart.wordpress.com/2013/02/20/killing-words

  59. Gravatar of Benjamin Cole Benjamin Cole
    21. February 2013 at 00:01

    Excellent blogging.

    I detest the gloomy school of monetary thought that we have to stay in a perma-recession as otherwise we will have speculative bubbles and inflation, and then we will have to tighten money and go into a recession…..

  60. Gravatar of phil_20686 phil_20686
    21. February 2013 at 03:10

    Tyler, I think I can help you understand the MM approach. You seem to think of NGDP as “a number made up of RGDP and inflation”. This is exactly the viewpoint that MM’s reject. Firstly, only nominal variables are directly measurable. You can directly measure NGDP. You cannot directly measure RGDP, all you can do is measure NGDP and strip out inflation. That is in itself a tricky proposition. In the UK the BoE tracks 8 different measures of the price level. The current difference between the largest and the smallest is some 6%. What measure of inflation am I suppose to use to generate RGDP?

    Instead note that NGDP = demand. Rewrite your passage with NGDP replaced by demand and it will make perfect sense. “Scott claims that a fall in demand caused the 2009 financial crises”. Exactly right! Changes in NGDP are changes in demand. If you have more demand than production capacity you get inflation. Too little demand and you get an output gap.

    Of course the Fed should stabilise demand irrespective of what caused the fall. Your conception of NGDP as RGDP+inflation handicaps you when you present your counterfactual. You wrote

    “Had NGDPLT been the policy at the time, the drop in RGDP would be offset by a corresponding increase in inflation, keeping NGDP level, which while not eliminating the real shock, would at least have prevented tight money from actively making things worse”

    No, this is wrong. Had NGDPLT been the policy, the nominal shock experienced by the finanical markets would not have transitioned into real economy, as falling lending would not have affected demand, which would have been supported by the central banks. Knowing this, there would have been little to no reason to stop lending, and the finacial crises would have been a historical footnote, similar to the dot-com crash.

  61. Gravatar of Daniel Daniel
    21. February 2013 at 03:17

    Eric,

    Setting a target for the central bank will not work with Fed Transparency.

    Then the Fed IS NOT TRANSPARENT !!!

    I simply cannot wrap my mind around this. If the central bank has a target, but the target is always up for discussion, then the intentions of the central bank ARE NOT TRANSPARENT !

    If you population is falling (like Japan), should you keep the same NGDP target?

    Yes, why not ?

    Or you get a supply shock (oil)?

    Gee, and all this time I thought the major advantage of targeting NGDP is that it handles supply shocks especially well (compared with inflation or price level targeting) …

    The point is setting one target will lead to really bad results in the real world.

    Please explain how.

  62. Gravatar of Daniel Daniel
    21. February 2013 at 03:19

    Correction – in the case of Japan, I meant to say NGDP per capita.

  63. Gravatar of Daniel Daniel
    21. February 2013 at 03:34

    Tyler

    even if the housing crisis was the ultimate cause.

    You really have to stop attributing your own statements to other people. Really now.

    I don’t remember anybody around here arguing that housing was the “ultimate cause” of anything. Mainly because HOUSING HAD BEGUN ITS DECLINE IN 2006 !!!

    Read that – and then read it again. And read it some more, if you have trouble grasping it.

  64. Gravatar of ssumner ssumner
    21. February 2013 at 05:27

    Tyler, You asked:

    Okay, so that raises a couple more questions for me. If the… let’s call it inefficiencies in the housing market (perhaps due to gov’t involvement or those evil big banks) were in part due to excessive lending, would tighter money not make sense?”

    No. You’d want a policy of tighter credit.

    More to come . . .

  65. Gravatar of Geoff Geoff
    21. February 2013 at 06:19

    Dr. Sumner:

    “No. You’d want a policy of tighter credit.”

    Can’t the Fed can only reduce credit indirectly by reducing the rate at which it increases bank reserves?

    A “policy” of tighter credit would seem to be a policy of tighter money, at least from the Fed’s perspective. They don’t tell the banks how much to lend and not lend, do they?

  66. Gravatar of ssumner ssumner
    21. February 2013 at 06:34

    MattD, You asked:

    “How on earth did the Fed printing too much money over the previous decade or so happen to produce inflation spikes just around the times of the oil crises?”

    It didn’t. I agree that the oil shocks created the inflation spikes, but not the Great Inflation, the high average inflation. With 5% NGDP targeting inflation would have spiked to perhaps 5% in 1974 and 1980, sort of like mid-2007 to mid-2008. But inflation was far above 5% even before the 1980 oil shock! My point was that the Great Inflation, the very high average rate of inflation from the late 1960s to the early 1980s could not possibly have been caused by supply shocks, otherwise RGDP growth would have slowed and NGDP growth would have been the normal 5% or so.

    Fed money printing did cause the double digit NGDP growth, and that’s what caused the high inflation. I did a post on this subject a few months back.

    Ron, You asked:

    “What happens if the only way that NGDP can be kept on target is by using policies that will leads to unsustainable asset bubbles ?”

    Then bring on the unsustainable asset bubble! As we saw in 1929, 1987, 2006, and 2008, unsustainable assets bubbles are only harmful when NGDP is unstable. That’s why there was no recession in 2006-07, and 1987-88, but deep recessions in 1929-30 and 2008-09.

    Mike Sandifer, I didn’t expect the Fed to screw up either, so I can hardly blame the markets.

    I take gambles to have a bit of fun, but I don’t ignore the EMH. I buy index funds whenever possible. My gambles have to do with regional bets—which relates more to my views on neoliberalism than market monetarism.

    kebko, That’s priceless.

    Eric, Your comment is a complete non sequitor, as it would imply no policy works. BTW, I’ve advocated NGDP per capita, so that addresses your population issue. Other real shocks don’t matter.

    Michael, You said;

    “Scott alludes to this in his “Defense of NGDP Targeting”. He said a drop in NGDP was the proximate cause of the crash, even if the housing crisis was the ultimate cause. Does it not seem questionable to prescribe a policy to fix the symptom without considering the ultimate cause? ”

    No, because under NGDPLT a housing crash would not cause NGDP instability.

  67. Gravatar of phil_20686 phil_20686
    21. February 2013 at 08:30

    Scott, I am actually skeptical that it would have been wise for the Fed to target 5% NGDP throughout the sixties and seventies. For example, in the sixties the labour force in the US grew by 30% in a decade. That is 2.5% NGDP growth right there. Add two percent inflation and the above average productivity growth in that era and you would need an NGDP target higher than 5% under those circumstances.

    I think that you should write a paper/post enumerating the cases where NGDP targeting does badly, or at least when 5% NGDPLT would need adjustment.

    We are pretty much right now in the sweet spot when NGDP targeting outperforms all other types of monetary policy by a large margin. A lot of the time most reasonably sensible prescriptions would do ok. But I would think that the 60′s and to a lesser extent the seventies would have been a time when 5% NGDP growth would have been excessively tight, possibly even to the point of deflation.

    Similarly, right now we are in the nightmare scenario for inflation targeting in the UK where the bank is meant to target inflation but inflation is high for reasons that are totally independent of monetary policy, even though demand is weak. Largely because of the poor measure of inflation and changes in regulated sectors like utilities and education, which have unbalanced the CPI.

    If people had thought about this situation before the fact, it would be obvious what to do, and people could point to the prior literature. Similarly, if NGDP targeting gets taken up, it will one day run into its nightmare scenario of super strong growth in the labour force and or productivity, or of a major supply shock, or of what to do in the event of a WW2 like scenario in the UK.

  68. Gravatar of Matt D Matt D
    21. February 2013 at 14:38

    Scott,

    The inflation spikes skew the average. Look at the inter-crisis years: Inflation in 1976, 1977, and 1978 was 5.8%, 6.5%, and 7.6%. This is high inflation by contemporary standards — and I’ll grant that overly-loose policy could have been the cause. But you can’t, or you shouldn’t, ignore the spikes. If you allow for some lag effects, so that the oil price spike created several years of very high inflation in 1974, 1975, 1979, 1980 and 1981, then the “Great Inflation” looks much less “great.”

    There are good reasons to allow for lag effects from the spikes, particularly in the 1970s, when the U.S. economy was much more energy intensive than it is today. That combined with the sheer magnitude of the oil price increases – oil was ten times more expensive at the end of the decade than it was in 1972 — produces a pretty compelling story about how the oil price spikes played a much bigger role in the Great Inflation than both market monetarists and many mainstream economists allow for.

  69. Gravatar of ssumner ssumner
    22. February 2013 at 09:16

    Phil, I’ve always favored NGDP targeting per capita, I just leave that out most of the time because it gets repetitive. NGDP per working age adult is also fine.

    Matt, I’m afraid you exaggaerate the role of oil shocks. Ask yourselve why the increase in oil prices from $20 to $147 didn’t cause a measureable rise in core inflation during the 2000s. Then look at the core inflation numbers for the Great Inflation. NGDP growth averaged 19% in 1980:4 and 1981:1. Oil played zero role in that NGDP surge. What sort of inflation rate would you expect if NGDP is growing at 19%? Then look at the growth rate of the monetary base (in a high interest bank environment with near zero ERs) from 1948 to 1981. Look how it accelerates sharply in the mid-1960s. What sort of inflation surge would that have produced if there had been no oil shocks? When oil prices plunged in the 1980s, why did the CPI keep rising, rather than fall back to 1972 levels?

    The oil shock theory of the Great Inflation fails on all sorts of levels, theoretical and empirical. It confuses growth rates with levels. It confuses relative and absolute prices. It ignores NGDP. It ignores the currency surge. If it were true, NGDP would not have risen rapidly—but it did. RGDP should have slowed sharply, but it didn’t.

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    22. February 2013 at 20:51

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