Steve Waldman has responded to my recent post claiming that the inflation of the 1970s was a monetary phenomenon. He still insists it’s more useful to think of it as a demographic phenomenon. Let me try to explain my two objections in a different way.
Consider an unrelated issue. Some have argued that hyperinflation is not a monetary phenomenon because the ultimate cause is deficit spending. The inflation occurs because the government prints money to pay its bills. There’s obviously some truth in that, but I think it makes more sense to view monetary expansion as the cause, and deficit spending a a reason for the monetary expansion. Here’s why. Suppose you learned in school that deficit spending was the cause of hyperinflation. Then Reagan is elected in 1980 and starts running huge deficits. What would you predict to happen to inflation? And what actually happened? Deficit spending is only a problem (for inflation) when governments finance the deficits by printing money, not when they finance the deficits by selling bonds. That’s why it’s more useful to think of monetary policy as the cause of hyperinflation, and fiscal expansion as a reason for inflationary monetary policies. [Of course even looking at the supply of money is not enough, the demand is also important, as we've seen since 2008.]
In the comment section to my post Mark Sadowski dug up a lot of data on demographics in other developed countries during the Great Inflation, and afterwards, and found that Waldman’s model doesn’t fit them very well at all. Not even close. I believe this shows that other paths were possible. The Fed did not have to create high inflation to hold down unemployment; indeed they probably exceeded the peak of the “inflation Laffer Curve” and were actually increasing unemployment. One of Lucas’s most famous papers showed essentially no relationship (across countries) between inflation and unemployment, and further research suggested the relationship might even be positive.
In this passage Steve seems to misunderstand my argument:
But reading his post, I don’t see any substantive inconsistency between his views and mine at all. He argues that the Fed overstimulated, because if it was trying to prevent unemployment, it would simply have stabilized nominal wage growth. Instead it tolerated — or caused, depending how you tell the story — wage inflation in excess of its long-term growth rate. My view is that stable nominal wages and full employment (under the Fed’s more robust 1970s definition of full employment) were simply inconsistent, so stabilizing nominal wages would not have been an effective strategy. Decent employment of a labor force growing faster than productive employment was only possible via a combination of falling real wages and a cross-subsidy from creditors, that is by high inflation.
I don’t understand why cross subsidy from creditors would affect unemployment, but the more important problem is the way he slides from my argument for stable nominal wage growth to his argument that falling real wages were needed. That’s exactly the point of stable nominal wages! It forces the Fed to do a monetary policy that delivers the appropriate decline in real wages, via higher inflation. So yes, slightly higher inflation was appropriate, as I acknowledged. My point was that the Fed went far beyond the extra inflation needed to stabilize nominal wages (and depress real wages), and indeed it sharply raised nominal wage growth. That’s totally pointless inflation that doesn’t lower unemployment at all. The countries that did not engage in that sort of reckless inflation did no worse than those that did.
We had 13% inflation in 1980. Suppose instead that inflation had risen from 1.5% in 1964 to 6% in 1980. Does anyone seriously think the unemployment problem in 1980 would have been even worse with 6% than 13%? Surely nominal wages would have adjusted to that lower NGDP/person track by 1980. I think the mistake people make is thinking too short term. Yes, given the 12% inflation in 1979, a 6% rate in 1980 would have led to high unemployment, about 10% to be precise. But not if the Great Inflation had never occurred.
I’m a pragmatist, and hence prefer definitions of causality that are useful for policymakers. When Obama’s aides were sitting around a table deciding on fiscal stimulus it did no good for some aide to assert “Fiscal stimulus doesn’t work. In the case usually cited (1940s) it was WWII that caused the rapid RGDP growth, not fiscal stimulus.” The other aides would (rightly) say; “Well how did WWII cause RGDP to rise? Wasn’t it via fiscal stimulus?” And if at an FOMC meeting someone says “Inflation is not a monetary phenomenon because the money supply changes for a reason, the policymakers are going to (rightly) wonder how that concept of “causality” helps them in their deliberations about the appropriate monetary policy. The blogosphere is all about debating policy options. We need proximate causes to do so coherently.
PS. I also disagree with this claim:
To say that policymakers [in the 1970s] erred or even misestimated, you’d have to claim they did not understand that their employment-focused policies might bring inflation. I think it’s pretty clear that they did understand that.
Policymakers of that era had highly flawed models of the economy, just as they did in the 1930s, and just as they do today. These bad models produced bad policies, everything from stop/go inflation cycles to price controls. During the 1965-69 upsurge in inflation the rate of unemployment actually plummeted to 3.5%, far below the natural rate. They tried to stop the inflation with income tax increases! (I kid you not.) Then price controls.
The Keynesians went from claiming that Friedman was a crackpot, to saying; “well of course we always knew expansionary monetary policies cause inflation, the real issue is money supply targeting vs. fine tuning.” As they absorbed one monetarist idea after another they began to redefine “Keynesianism” to make it look like they were right all along.
No, the central bankers of the 1970s were often clueless. Go back and read the minutes if you don’t believe me. Or save time by reading studies by people like Ed Nelson.