The things we teach that aren’t true

One could write an entire book discussing all the assertions in economics textbooks that are not true.  I seem to recall that Coase complained that economics textbooks kept using lighthouses as an example of goods that can only be supplied by the government, even after it was shown that private organizations had supplied lighthouses. 

I don’t know whether textbooks claim that supply shocks help explain the high inflation of the 1970s, but at a minimum they leave that impression.  In fact, the high inflation of the 1970s was caused by monetary policy.  As the following data suggests, NGDP rose extremely rapidly during the 1970s and early 1980s.  Because RGDP rose at pretty much the same (3%) rate it rises in any other decade, fast rising NGDP is both a necessary and sufficient condition for the Great Inflation.  The only question is what caused such rapid growth in NGDP, or M*V.

1970 5.5
1971 8.5
1972 9.9
1973 11.7
1974 8.5
1975 9.2
1976 11.4
1977 11.3
1978 13.0
1979 11.7
1980 8.8
1981 12.1
1982 4.0

To the extent that oil shocks have any effect on NGDP, it is probably contractionary.  That’s why NGDP growth slowed in 1974 and 1980.  Thus the energy price shocks contributed almost nothing to the Great Inflation, although they help explain why inflation was higher in some years than others, as oil shocks tend to temporarily depress RGDP growth.

Marcus Nunes sent me a quotation from a 1997 paper by Bernanke, Gertler and Watson:

Macroeconomic shocks such as oil price increases induce a systematic (endogenous) response of monetary policy. We develop a VAR-based technique for decomposing the total economic effects of a given exogenous shock into the portion attributable directly to the shock and the part arising from the policy response to the shock. Although the standard errors are large, in our application, we find that a substantial part of the recessionary impact of an oil price shock results from the endogenous tightening of monetary policy rather than from the increase in oil prices per se.

Bernanke got to put this theory in action in late 2008, when the Fed tightened monetary policy in response to the high oil prices of mid-2008.  In this case monetary policy was much tighter than in 1974 or 1980.  In those earlier cases, NGDP growth slowed a bit, but RGDP slowed much more, producing “stagflation” in both years.  In contrast, in late 2008 monetary policy was so tight that we ended up with a disinflationary recession in 2009.

I was looking at the GDP deflator data and noticed an interesting pattern.  During my entire life (I was born in 1955) the GDP deflator rose by 1% or less only twice.  Any guesses?  Hint, they were the two years when many right wing economists predicted skyrocketing inflation as a result of the Fed’s supposedly ”easy money” policy of late 2008.  The period right after they doubled the monetary base in just a few weeks.  That’s right, only 2009 and 2010 saw a GDP inflation rate of 1% or less.

The implication of the Bernanke, et al, study is that the Fed shouldn’t overreact to supply shocks, or else they might trigger a recession.  Let’s see how they respond to the current surge in oil prices.  The early indications are that nothing has been learned:

One of the Federal Reserve‘s leading hawks warned Wednesday of the risks of maintaining easy monetary policy in the face of rising commodity prices

PS.  Some people think that Jimmy Carter had “bad luck” because of the 1979 revolution in Iran.  Look at NGDP growth in the years before the revolution—a period when oil prices were stable. 

Update, 2/26/11:  Marcus Nunes just sent me this link to his blog.  He had previously made the same point, with much more comprehensive data.

HT:  Marcus Nunes


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41 Responses to “The things we teach that aren’t true”

  1. Gravatar of Andy Andy
    25. February 2011 at 18:46

    I think the textbooks are even worse than you suggest. As I’m sure you know, the standard intro AS/AD model shows an oil price shock as a leftward shift in AS, and that’s basically the end of the story because you essentially treat the price level the same as the inflation rate.

  2. Gravatar of Scott Sumner Scott Sumner
    25. February 2011 at 19:06

    Andy, Good point. The higher NGDP growth basically comes from AD shifting right, and what’s more, shifting right at a faster and faster pace over time.

  3. Gravatar of Scott Sumner Scott Sumner
    25. February 2011 at 19:07

    I forget to mention that less AS raises prices, not inflation, as you suggested.

  4. Gravatar of Benjamin Cole Benjamin Cole
    25. February 2011 at 19:08

    Excellent, excellent and timely post. And yes, the Nipponistas are already braying about commodities prices, and the need to tighten money.

    Hopefully, Bernanke will stay the course, and continue with QE, if anything ramping it up a bit.

    Remember, the goal of economic policy should be sustained prosperity, not price stability. If I had to chose one or the other, I go with prosperity.

  5. Gravatar of Andy Andy
    25. February 2011 at 19:14

    Just curious, do you think the best you can do with the AS/AD model to illustrate this is to show a repeated leftward shift in AS and rightward shift in AD, while remaining below potential output?

  6. Gravatar of marcus nunes marcus nunes
    25. February 2011 at 19:37

    Scott:
    Bernanke appears to be a “deep well of contradictions”. He has an academic hat under which he says all the right things. There are his Great Depression writings, his “what should Japan do” from 1999, even his prescient January 2005 op ed on the WSJ titled “What will happen when Greenspan is gone”? (He could have subtitled it “I will become the Chairman”!
    It got me thinking that academics do not make good “executives”. William McHesney Martin (1951-69), Volker (1979-87) and Greenspan (1987-05) were not academics and the economy under their MP guidance did rather well. Now look at things during the Arthur Burns and Ben Bernanke watch. A ” Great Inflation” and a “Great Recession”. Burns was a well known and respected academic and Business Cycle student (was Director of the NBER). Bernanke is well known by every economist and a hihly respected academic. Maybe theory and practice don´t mix!

  7. Gravatar of marcus nunes marcus nunes
    25. February 2011 at 19:46

    Sorry Bernake´s oped in the WSJ is from January 2000! (not 2005).
    Could also add, from the Great Depression years, John Williams who was a Harvard prof, member of the Fed Board and its chief economist. In that position he had a lot of say and influence and in November 1937, far into the 1937-38 second leg of the depression (partly at least induced by the increase in RR) he suggested a “cover up” arguing during the FOMC meeting that they shouldn´t reverse the RR policy lest the economy picked up and the Fed be accused of being responsible for the recession!

  8. Gravatar of StatsGuy StatsGuy
    25. February 2011 at 19:53

    @ssumner

    “The implication of the Bernanke, et al, study is that the Fed shouldn’t overreact to supply shocks, or else they might trigger a recession.”

    I don’t know that this is true – they could very well overreact and be fine IF they overreacted by the same magnitude in the other direction when the economy started keelhauling itself, which is to say they committed to level targeting. It’s not that I’m _for_ overreacting, but it’s virtually impossible to know for sure whether a short term supply shock (affecting headline inflation) is going to stick around long enough to become a long term supply shock, or will be self-stabilizing.

    Marcus may be right that practitioners are better than academics, but it’s not like the practitioners (the speculators in commodities markets, for instance) have hit the target every time.

    Less focus on not overreacting, more focus on level targeting.

  9. Gravatar of marcus nunes marcus nunes
    25. February 2011 at 19:58

    This is the Bernanke oped link:
    http://online.wsj.com/article/SB947027252754116777.html
    In this post from a few weeks ago there is a nice graphic combining NGDP, RGDP and inflation during Burn´s “Great Inflation” where it is clearly shown that that the leftward shift in AS from the oil shock is (more) than compensated by an increase in NGDP growth, perpetuating inflation! But Burns said MP was powerless, the inflation was a nonmonetary phenomenon and all he could do was compensate the negative employment effect of the shock, with (anti) inflation policy being the preserve of “incomes policy”!
    http://thefaintofheart.wordpress.com/2011/01/30/1-picture1000-words-3-pictures3000-words/

  10. Gravatar of marcus nunes marcus nunes
    25. February 2011 at 20:16

    A summary way of looking at the “problem”:
    Seven “lean years” under Burns (high & rising inflation & volatile real growth), followed by seven “fattening years” under Volker (inflation brought down and real growth volatility strongly reduced), followed by 18 “paradisiac” years of low and stable inflation and smooth growth, with all this work destroyed in two short years by the “man who knew it all”.

  11. Gravatar of marcus nunes marcus nunes
    25. February 2011 at 20:20

    Sorry! But I think I was “captured” by the spirit of Morgan and Mark…

  12. Gravatar of Morgan Warstler Morgan Warstler
    25. February 2011 at 21:08

    More later, but perhaps it could be argued that the Fed is doing more to bring Democracy in the Middle East than anyone since Bush.

    If you grant that printing money causes food riots, but then you argue food riots lead to positive outcomes in dictatorships.

    Maybe the real strength of a global reserve currency, is the ability to transfer greater relative economic pain to the more backward parts of the world.

    Maybe the saying should be “The US catches a cold and the Middle East coughs up a lung.”

  13. Gravatar of 俺たちが教えていることが正しいとは限らない by Scott Sumner – 道草 俺たちが教えていることが正しいとは限らない by Scott Sumner – 道草
    26. February 2011 at 00:14

    [...] by Scott Sumner // スコット・サムナーのブログから”The things we teach that aren’t true“(February 25th, [...]

  14. Gravatar of Lorenzo from Oz Lorenzo from Oz
    26. February 2011 at 02:02

    On The Lighthouse in Economics, Wikipedia is your friend.

  15. Gravatar of Rien Huizer Rien Huizer
    26. February 2011 at 02:31

    Benjamin Cole,

    You said:

    “Remember, the goal of economic policy should be sustained prosperity, not price stability. If I had to chose one or the other, I go with prosperity.”

    That amounts to blasphemy! Anyway, the only way to get more prosperity is to stimulate the supply side. The main thing that monetary policy should do is to minimize turbulence and activist fiscal policy should not be tried at all.

    The reason that there is a market for other views is that politicians want a game that they can play and show off their differences. A world in which economic policy would have the same status of legitimacy and need for unity etc as , eg defence (with established rituals, clergy etc) would make politics much less attractive as an enterprise and boring. Not good for ratings at all. Keep the mystique!

  16. Gravatar of #14 – (s)Collegamenti « Idl3's Blog #14 – (s)Collegamenti « Idl3's Blog
    26. February 2011 at 03:48

    [...] The things we teach that aren’t true One could write an entire book discussing all the assertions in economics textbooks that are not true. I seem to recall that Coase complained that economics textbooks kept using lighthouses as an example of goods that can only be supplied by the government, even after it was shown that private organizations had supplied lighthouses. Continua a leggere… [...]

  17. Gravatar of Richard Allan Richard Allan
    26. February 2011 at 05:47

    “One could write an entire book discussing all the assertions in economics textbooks that are not true.”

    I mentioned Steve Keen’s “Debunking Economics” before, unfortunately he drops some howlers himself. Stuff like

    “The value of a capital good is the amount of labour expended in its production”

    and

    “The good thing about Post-Keynesians is that we have no political bias. The bad thing is that we have no theory of value.”

  18. Gravatar of Scott Sumner Scott Sumner
    26. February 2011 at 06:04

    Thanks Benjamin.

    Andy, It’s hard to show this on a AS/AD graph, because we are dealing with changes in the rate of change. Thus both AS and AD are shifting upward at an accelerating rate.

    Marcus, That’s an interesting observation about academics.

    Statsguy, You said;

    “It’s not that I’m _for_ overreacting, but it’s virtually impossible to know for sure whether a short term supply shock (affecting headline inflation) is going to stick around long enough to become a long term supply shock, or will be self-stabilizing.”

    This is a problem the Fed doesn’t need to worry about if they target NGDP.

    I agree on level targeting.

    marcus. Great post, I’ll add a link to my post.

    Morgan, Bernanke’s greatest achievement! :)

    Lorenzo. Thank, When I say “I seem to recall” I always forget that the internet can answer all questions. I’m one of those old guys who forgets how much progress there has been since the 1960s.

    Richard, Yes, the problem with most “debunkers” is that they themselves need to be debunked.

  19. Gravatar of DanC DanC
    26. February 2011 at 06:08

    Good points
    Plus

    Fed reaction to higher oil prices in 2008 had negative impact on housing(through higher rates) as a record number of adjustable rate mortgages were resetting. This exposed the real risk that existed for financial firms that had assumed that they had properly managed risk.

    Higher oil prices were also causing troubles for Detroit, airlines and travel. Indeed it was the blow that knocked GM to the floor and caused Nevada to shiver.

    However I think you are to quick to discount political and fiscal changes. Candidate Obama had moved to the front in all polls. He promised higher taxes, increased regulation, pro-union policies, trade “reform”, and a health care overhaul. Forward looking planners either had to plan for these possible changes or sit out for a period until you see what actually happens.

    QE may have helped improve the economy but the pretty dramatic midterm elections showed that the leftward shift in the political structure and moved back toward the center.

    I don’t want to go to far down this road, but at a time when resources needed to be reallocated, you had an anti-business administration and Congress creating negative incentives for domestic growth (even as investment overseas increased).

    And while you are currently centered in the East don’t forget that California, a very large economy on it’s own, is being held down by a failed political system.

  20. Gravatar of DanC DanC
    26. February 2011 at 06:11

    sorry for the multiple times I wrote to instead of too,

  21. Gravatar of links for 2011-02-26 « Idl3's Blog links for 2011-02-26 « Idl3's Blog
    26. February 2011 at 07:02

    [...] TheMoneyIllusion » The things we teach that aren’t true (tags: Economia) [...]

  22. Gravatar of David Pearson David Pearson
    26. February 2011 at 07:44

    Scott,

    The reaction of TIPS yields to the oil price hike is telling. Duration-adjusted 5yr yields (the 4/15/15 bond) are strongly negative, and the inflation spread is over 2.6% as of Friday. Since QE2 was signaled, 5yr real yields have now fallen, while inflation expectations are materially higher.

    Assume market efficiency in the TIPS market. What is the bond market telling us? One interpretation: expect QE3 as the Fed fights the deflationary effect of the oil price shock — this would depress real yields while raising inflation spreads. In other words, the TIPS market is telling us that the Fed will not make the mistake of tightening, but, instead, will accommodate the price shock through more bond purchases. As market views of inflation are rising, these expected purchases have the necessary effect of depressing the real component of Treasury yields.

    In any case, the level of real 5yr yields tells us something about market expectations of the impact of QE on growth. Certainly, if markets expected a decent recovery and rising credit demand, they would price in higher real yields as a result. You have argued before that real Treasury yields are not a proxy for RGDP expectations. If that is the case, then what is the explanation for negative TIPS yields? And, if it is market inefficiency, what prevents arbitrage? Also, why should these yields experience a steep drop in reaction to the oil price spike?

  23. Gravatar of EconStudent EconStudent
    26. February 2011 at 08:16

    Dr. Sumner,
    I’m a young economics student and enjoy your blog. I understand your premise with this posting. However, in practice, I seem to be confused as to why it is that a central bank would tighten $policy in response to an oil shock. As Bernanke’s paper suggests: “impact of an oil price shock results from the endogenous tightening of monetary policy” and you say: “the Fed tightened monetary policy in response to the high oil prices of mid-2008″. I would think that looser $policy would be the plan of action favored. What am I missing here?

  24. Gravatar of OGT OGT
    26. February 2011 at 10:11

    Sumner- Could you unpack what Bernanke et al mean by ‘endogenous tightening.’ Is that just failure to fully counteract the supply shock in maintaining NGDP?

    Also, in an era of unmoored inflation expectations isn’t that a bit of a dangerous game?

  25. Gravatar of Doc Merlin Doc Merlin
    26. February 2011 at 16:24

    Yes, basically everything taught in intro macro is bunk, I include AS-AD in that.

  26. Gravatar of Scott Sumner Scott Sumner
    26. February 2011 at 18:33

    DanC, Those are good points, but I still think it was mostly monetary policy. Given the fall in NGDP (which is controlled by the Fed) the fall in RGDP was almost inevitable. Europe had a very similar downturn.

    David, I don’t entirely agree with your interpretation of the TIPS spreads, as the TIPS respond with a lag to inflation shocks (due to the indexing formula, which is lagged a couple months.) In addition, TIPS reflect headline inflation, so they overreact to sharp commodity price movements. We really need a TIPS linked to core inflation, but alas we don’t have that. I still think the lower yield on 5 year nominal bonds suggests tighter money. Longer term nominal yields tend to move in the same direction as expected NGDP growth.

    Having said all that, it’s possible you are right and I am wrong, indeed I hope you are right. It’s also possible that the price of oil will fall if the Libyan situation is resolved.

    Econstudent, You are right, I think they made a huge mistake in tightening in late 2008. I think the Fed finds it hard to ignore the high headline inflation rates, a problem the Bank of England is struggling with now. Almost everyone in Britain thinks they need more stimulus, but they are about to tighten. It’s all coming from political pressure associated with high headline inflation rates. The same could happen in the US.

    OGT, I am actually not sure. I suppose I assumed he meant keeping nominal rates fixed, even as the Wicksellian equilibrium rate fell due to a weak economy. That’s just a guess, maybe someone else knows.

  27. Gravatar of Mark A. Sadowski Mark A. Sadowski
    26. February 2011 at 19:27

    Supply side shocks have the opposite effect on AD than most people expect.That’s why we have to be on guard for their interpretation. They’re wrong!

  28. Gravatar of DanC DanC
    27. February 2011 at 05:12

    I guess I view the downfall in Europe due, at least in part, to the false assumptions about risk management. Greece, Ireland, Spain etc all seem to think that they had hedged financial risk and took on unsustainable debt levels (private and public).

    Higher oil prices would have caused a mild recession. That recession alone would have strained and perhaps exposed the underlying false assumptions of the financial system.

    However higher interest rates imposed to fight potential inflation (probably unrealistic) quickly exposed that the risks that the financial system had been taking (especially in housing).

    A person goes out in frigid air and suddenly develops severe chest pains. Why? The cold causes a contraction of the blood vessels that reduces blood flow to the heart. If your blood vessels are healthy no big problem. However if you have atherosclerosis (perhaps previously unknown) the cold air can trigger a fatal heart attack. The cold air exposed (and contributed slightly to) a higher level of heart disease.

    In this case I think the Fed is the cold air that exposed the underlying risks that the financial systems around the world were taking.

    I also think that the fiscal policies of Obama and the Democratic Congress placed additional burdens on the weakened economy. (Like forcing a heart attack victim to walk to the third floor to get treatment and then you offer them a glass of water rather then oxygen.)

    Milton Friedman spent a great deal of time talking about failed fiscal programs because, despite the best efforts of the Fed, economies have a hard time functioning if incentives are distorted.

  29. Gravatar of daily links 02.27.11 « increasingmu daily links 02.27.11 « increasingmu
    27. February 2011 at 11:17

    [...] Sumner basically proves that 1970s inflation was caused by monetary policy, not oil shocks. [...]

  30. Gravatar of David Stinson David Stinson
    27. February 2011 at 14:28

    Hi Scott. Good post.

    You state:

    “To the extent that oil shocks have any effect on NGDP, it is probably contractionary.”

    You make a similar(ish) point here:

    “NGDP growth slowed a bit, but RGDP slowed much more, producing “stagflation” in both years.”

    I am wondering whether perhaps a better way to state it might be that oil shocks tend to reduce the path of potential real output (as opposed to reducing RGDP below its potential level)?

  31. Gravatar of Konker Konker
    27. February 2011 at 20:16

    Hi

    Please send your link to the Bank of England policy committee who are considering raising rates to reduce commodity price inflation. It wont push down the price of internationally commodities, but it might make the country use less of them and so produce less goods.

    The one complicating factor however is exchange rates, which would rise if interest rates go up. Since oil is priced in dollars, the import cost of oil would come down a bit. I guess the overall effect will be the trade off between the positive effect of lower oil versus growth dampening effect of higher interest rates.

  32. Gravatar of Mikko Mikko
    28. February 2011 at 03:03

    I have a question for you: If you think about external shocks to an economy, say oil prices go up a lot. How does this affect an economy implementing inflation targeting or NGDP targeting?

    Assuming that prices are sticky, for inflation targeting it would seem that higher oil prices (for exogenous reasons) mean that inflation rises, which would cause the central bank to put on tighten and to cause a downturn, even though there is really no endogenous reason for the price change. Is this correct reasoning or am I missing something?

    Exogenous reason for oil price change could either be reduction in supply or fast growth of demand elsewhere. Now the question becomes: should a central bank really tighten monetary policy because elsewhere people are paying more for their oil.

    How would things go under NGDP targeting regime?

  33. Gravatar of Scott Sumner Scott Sumner
    28. February 2011 at 06:08

    Mark, I agree.

    DanC, I agree.

    David Stinson, You may be right. Or there may be some of both.

    Konker, I would just add the the UK probably needs a weaker pound right now.

    Mikko, NGDP targeting is much better during a supply shock. With inflation targeting the central bank is forced to deflate the non-oil part of the economy, causing a recession.

  34. Gravatar of Mikko Mikko
    28. February 2011 at 07:36

    So can we then make the claim that the recession 2008-2009 was at least partly due to the central banks deflating economy to prevent foreign boom caused oil and other resource led inflation?

  35. Gravatar of John Papola John Papola
    1. March 2011 at 05:31

    Question:

    If it is totally okay to shift from 10% NGDP growth down to 5% NGDP growth, and the whole “sticky wages and prices” situation isn’t a dealbreaker in that case… why, then, is it so horrible to advocate shifting from 5% NGDP growth to 0% (no growth or decline whatsoever)?

    If the Hayek/Selgin/William White story is true, and 5% NGDP creates a situation of accumulating, compounding easy money which drives a boom/bust cycle… why not give 0% a try? Productivity Norm!

    I don’t buy the zero bound as an argument, considering that we’re already talking about institutional changes to the Fed. If they can make this shift, surely they can deal with the magical unicorn of Keynesianism called the Liquidity Trap.

  36. Gravatar of ssumner ssumner
    1. March 2011 at 06:28

    Mikko, Yes, I think so.

    John, You said;

    “If it is totally okay to shift from 10% NGDP growth down to 5% NGDP growth, and the whole “sticky wages and prices” situation isn’t a dealbreaker in that case… why, then, is it so horrible to advocate shifting from 5% NGDP growth to 0% (no growth or decline whatsoever)?”

    It depends what you mean by “OK.” In 1982 we had 10.8% unemployment, highest since the 1930s. It may have been woth the cost, as high inflation is damaging to an economy (puts a high tax on capital.)

    I think the argument is much weaker for moving from 5% to 0%. The damage from inflation is lower, and there are increased costs because wages are especially sticky at 0% change. Also, central banks don’t know how to operate in a zero rate environment. But if we go to NGDP futures targeting, I’d support gradually loowering NGDP growth to about 3%.

  37. Gravatar of Doc Merlin Doc Merlin
    1. March 2011 at 18:01

    @Scott Sumner:
    I don’t like that, it allows the state to absorb (and destroy with deadweight losses) some of the productivity gains made in an economy. In the very long term, a per capita productivity norm would be better in that respect, imo (although I think free banking would be even better).

    I would go so far as to say that most of the modern financial industry is a direct result of people trying to find assets that help them avoid the downside of excess NGDP growth in their own currency.

  38. Gravatar of Scott Sumner Scott Sumner
    3. March 2011 at 07:16

    Doc Merlin, The extra money from seignorage is pretty tiny at low inflation rates.

  39. Gravatar of Tim Fowler Tim Fowler
    10. March 2011 at 16:06

    Scott – What is your response to this?

    http://theamericanscene.com/2011/03/01/questions-for-scott-sumner

  40. Gravatar of Scott Sumner Scott Sumner
    18. March 2011 at 04:56

    Tim, At the bottom I relied in the comment section

  41. Gravatar of Government Spending Won't Save Us | Coalition to Reduce SpendingCoalition to Reduce Spending Government Spending Won't Save Us | Coalition to Reduce SpendingCoalition to Reduce Spending
    23. July 2013 at 09:31

    [...] policies attempting to combat structural unemployment. Rapid nominal GDP growth during the 1970s suggests that the inflation was monetary, rather than being exclusively about expensive oil. No such [...]

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