The ongoing debate about Tyler Cowen’s stagnation thesis has gotten me thinking about what’s really at stake.  Here’s a few highly subjective thoughts:

Part 1  The Great Inflation:

I don’t mean price inflation, I mean inflation in the sense used by physicists explaining the early expansion of the universe.  In my admittedly subjective take on ordinary human life since 1500 BC, I see two periods (before and after), separated by one explosion of change; 1900-1960s.  In 1900 my grandmother (then 10 years old) lived in a little town in Wisconsin, without running water and indoor plumbing, without any sort of “health care” capable of doing more good than harm, without lights, phones, TVs, radio, cars, home appliances, central heating, etc.  Isn’t that pretty much how the Romans lived in 200 AD?  Yes, the outside world had trains and telegraphs and elevators by 1900, but I’m talking about daily life for the average person.  A Roman visiting her would have been surprised by some gadgets around the house, but not awestruck.  Go back another 1700 years to 1500 BC, and the Minoans had running water in their houses.  They would have been disgusted at how my grandmother’s generation had regressed in plumbing technology.

If at age 10 I could have been magically transported from the 1960s to 2011, I would have been very impressed by the internet.  But I might have also asked “Dude, where’s my flying car?”  I might have been surprised that people still flew in Boeing 7X7s that go about 575 miles an hour.  Where are those super-sonic jets?  I would have noticed changes, but nothing (except maybe the internet) would have blown me away.

In contrast a Roman or Minoan citizen would have been awestruck by the 1960s.  An average working man can blast down the highway at 80 mph?  You can watch TV shows?  Even electric lights (which modern people wrongly take for granted) would have astounded the ancients.  People have no idea what life was like when one’s entire world was quite dark and cold for 16 hours of the day.  Travelling alone at nighttime was frightening.  And here’s my claim, I think my grandmother would have been almost equally stupefied.  I wish I’d asked her, she died the month they landed on the moon.

Even in health care the big explosion was 1900 to the 1960s, when life expectancy rose from 47 (only modestly above Roman levels), to about 70 (only modestly below current levels.)  If you want to bring in the “big picture” and talk about how trains and the telegraph would have amazed the Romans, well then how about jumbo jets, rockets to the moon, nuclear power plants and nuclear bombs?  Ancient scientists might have been able to wrap their heads around Newtonian physics.  But general relativity and quantum mechanics?

Part 2:  I’ll take 1973

I’ve noticed that younger commenters like Morgan look back at the 1960s like I look back at the Dark Ages.  No high-speed internet connections!?!?!?  Here’s a challenge offered by Bryan Caplan, who’s also much younger than me:

Even stranger: I learned this thought experiment over a decade ago from none other than Tyler Cowen himself!  I think he called it the “deflationary century.”  His point: Most of us would rather have $1000 nominal dollars to spend on year 2000 goods than $1000 nominal dollars to spend on year 1900 goods. . . .

Of course, Tyler might say that his thought experiment works for 1900 versus 2000, but not 1973 versus 2010.  But none too convincingly.

None too convincingly?  I’m totally convinced.  I’d take 2011 over 1900 at the same nominal income, but I’d take 1973 over today in a heartbeat.  I’d cash out my high six figure Newton home and see what was available in the Hollywood hills for that price in 1973.  I’d take my low six figure income and live the life of a wealthy person in 1973.  Sure, I’d miss the internet.  But let’s face it, the internet is a sort of drug.  Unless you are Tyler Cowen, it crowds out more authentic pleasures like books, films, music, and jet travel to exotic spots (without T&A frisking at airports), all easily done in 1973 on the sort of nominal income that now makes me merely another faceless upper-middle class professional in today’s Boston metro area.

Yes, life expectancy was lower in 1973, but some of that was smoking, and I don’t smoke.  So where do I sign up for the time machine?

David Henderson points out that part of Tyler’s problem was that he titled his book “The Great Stagnation” which implies no progress.  In my previous post I agreed with Tyler’s view that progress slowed sharply after 1973.  But I see this as a return to normalcy.  Progress is still occurring, and compared to most periods of human history it is occurring at a rapid rate.  The real outlier was my grandma’s life.  That took us from an ordinary daily life not all that different from that of the ancient Romans, to a world (in the 1960s) not all that different from 2011.  Or at least that’s the highly subjective take of a grouchy, reactionary 55 year old.  But I suppose everyone thinks their youth was some sort of Golden Age.

Back in the 1960s people talked about “modern life” and “the modern world” as opposed to the old ways.  For me, the 1960s will always be the modern world.  And I don’t think I am the only one.  New York’s MOMA is full of art from the 1950s and the 1960s.

PS.  I don’t want any annoying historians lecturing me that America in 1900 was richer than Rome circa 200.  I know that.  Brad DeLong has a new post citing a study that says ancient Romans were at roughly the economic level of Vienna and Florence in 1875.  I don’t think they were even that high.  Sometimes I exaggerate for effect.

In a number of posts I’ve suggested that there is a basic confusion over stabilization policy.  Instead of viewing fiscal and monetary stimulus as two ways of influencing AD, most people talk as if fiscal policy affects real GDP, and monetary policy affects prices.  Today I’d like to argue that this logical error is deeply embedded in our profession, and indeed is a major cause of the crash of 2008.  Here’s The Economist:

The surprising weakness was caused in part by unusually cold weather but it is not fully explained by it. A frail economy ought at least to be free of price pressures but Britons have had no such luck. Inflation rose to 3.7% in December.  . . .

Such a run of bad news looks like an argument for a policy rethink. If the economy stays weak, it may not be robust enough to withstand further deficit-cutting measures, including a planned rise in national-insurance contributions this April. The persistence of high inflation (it has been well above the 2% target for most of the last three years) calls into question the idea that the Bank of England could counter the effects of fiscal tightening by easing monetary policy. Its benchmark interest rate is already as low as it can feasibly go, and a further round of “quantitative easing” would stretch too far the gap between the bank’s objective of low inflation and its actions. A concern that businesses and wage earners might think policymakers were going soft on inflation led two of the bank’s nine-strong monetary-policy committee to vote for an increase in interest rates this month (see article).

I don’t have a major problem with any individual sentence in this article.  And they end up arguing against a change in the policy mix, which I think is a defensible view.  But I do have a problem with the way the issues are discussed.  There’s very clear implication that it’s the duty of monetary policy to deal with (high) inflation, and the responsibility of fiscal policy to address growth.  If you don’t believe me, if you think in both cases The Economist was focused on AD, and randomly chose to mention the inflationary effect of AD when talking about monetary policy, and the growth impact of AD when discussing fiscal policy, then I have a challenge for you.  Please send me an article from the British press that suggests that Britain needs to address the 3.7% inflation with further fiscal austerity, and needs to address the slow recovery with more monetary stimulus.  That’s the policy I favor, but I doubt you will be able to produce a single article that favors that policy mix, and justifies both changes in the way I describe.

In talking to many ordinary people, in reading the financial press, and in talking to many economists, I have gradually become convinced that almost everyone compartmentalizes these issues in a way that isn’t justified by current macro theory.  I will argue that this has been very harmful.  Not just recently, but also back in the Great Depression.  Here’s what Keynes said in his famous letter to the NYT on December 31, 1933:

The other set of fallacies, of which I fear the influence, arises out of a crude economic doctrine commonly known as the quantity theory of money.  Rising output and rising incomes will suffer a setback sooner or later if the quantity of money is rigidly fixed.  Some people seem to infer from this that output and income can be raised by increasing the quantity of money.  But this is like trying to get fat by buying a larger belt.  In the United States today your belt is plenty big enough for your belly.

People often claim that Keynes didn’t believe in liquidity traps.  If a liquidity trap is a situation where increases in the quantity of money have no impact on AD, then Keynes certainly did believe in liquidity traps.  In the preceding paragraph he is clearly making the “pushing on a string” argument.  But notice that he makes it for output, not prices.  In the very next paragraph Keynes switches gears:

It is an even more foolish application of the same ideas to believe that there is a mathematical relation between the price of gold and the price of other things.  It is true that the value of the dollar in terms of foreign currencies will affect the prices of those goods which enter into international trade.  In so far as an overvaluation of the dollar was impeding the freedom of domestic price-raising policies or disturbing the balance of payments with foreign countries, it was advisable to depreciate it.  But exchange depreciation should follow the success of your domestic price raising policy as its natural consequence, and should not be allowed to disturb the whole world by preceding its justification at an entirely arbitrary pace.

First a little context.  The first sentence of this paragraph is a jab at George Warren, an FDR advisor who claimed a mathematical relationship between the price of gold and the price of goods.  Irving Fisher had similar views, although was perhaps a bit less dogmatic than Warren.  Note that Keynes calls this a “foolish application of the same idea.”  In other words, saying 20% more money means 20% higher incomes and the idea that 20% higher gold prices means 20% higher goods prices are basically two sides of the same fallacy.  Except that they aren’t at all.  Indeed Keynes knows this, he knows that Warren’s dollar depreciation program did raise the US price level, and raised it dramatically.  The WPI rose strongly throughout 1933, and the weekly increases were highly correlated with changes in the dollar price of gold.

More importantly, everyone knew this.   If Keynes had attempted to apply the liquidity trap concept to prices, his reputation would have been torn to shreds.  He almost always applied the monetary policy ineffectiveness concept to real output, almost never to prices.  Especially if the monetary shock was large, and would obviously be inflationary.  Keynes was no fool.  He was careful to suggest there was no “mathematical relation” with prices, a very different argument for no effect at all.  But there is a problem here.  The Keynesian model says inflation and real growth go hand in hand.  When the economy is at less than full employment (as it certainly was in 1933); one cannot have rising prices without rising output.

Here’s an important difference between Keynes and Paul Krugman.  Krugman does understand the implication of Keynesian theory.  He does understand that if monetary policy is ineffective in raising output, then ipso facto it is ineffective in raising prices.  In 2010 the Fed was accused of putting the cart ahead of the horse—artificially pushing prices higher with monetary policy (QE2, which depreciated the dollar) rather than letting prices rise “naturally” as a consequence of economic recovery driven by more domestic spending.  Keynes would have opposed QE2; he would have called it “unnatural” and “arbitrary.”  Krugman, who understands Keynesian theory far better than Keynes ever did, supported the policy.  (BTW, Keynes got his way;  FDR gave up on monetary stimulus two weeks later and never tried it again.)

Allan Meltzer once wrote that it was odd that Keynes never suggested that central banks target inflation at something like 4%, so that they could avoid the zero rate bound, and thus the need for fiscal stabilization policy.  I think Keynes would have been horrified by that idea.  For Keynes, the “natural” price level is a stable one, unless you need a bit of reflation to make up for a previous plunge in prices.  The “natural” way to boost AD is with more government spending, or more investment.  Money should not be a “belt” that prevents economic recovery, but it also shouldn’t be used to “artificially” push the economy higher, by boosting prices.

You’re probably thinking that we have advanced far beyond the primitive analysis of the 1933 Keynes (the low point of his career, BTW.)  Unfortunately not.  Consider the 100 most prominent macroeconomists.  When AD started plunging sharply in the second half of 2008, how many vigorously and loudly insisted on the need for a much more aggressive monetary policy stance?  Here’s the list:

1. . . .

Well that didn’t take long.  But if I had to list the number who forcefully advocated fiscal stimulus, it certainly would be a quite long list.  The general view was; “Well, rates are already pretty low, and the base has been rising.  So monetary policy can’t be holding back the recovery.  The belt is not too tight.  Time to engage in fiscal stimulus—which is more certain to boost spending.  After all, G is part of C+I+G, but I don’t see “M” in that formula.”

This was a tragic error.  The easy fiscal policy and tight money of 2009 have put us where we are today.  By 2010 the Keynesians realized the fiscal stimulus wouldn’t do the job (and to their credit, a few Keynesians like Krugman argued this from the beginning.)  So by 2010 you had famous Keynesians like Alan Blinder desperately seeking monetary policy options.  Since they can’t easily break away from the “interest rates are all that matters” view of monetary policy, Blinder ended up gravitating to the idea of negative rates on bank reserves, a wacky scheme first mentioned in a couple publications by yours truly in early 2009.  Others said printing money was worth a shot, after all, what do we have to lose?

I still think our language is holding us back.  We should never discuss AD issues by talking about prices and output; we should always refer to NGDP.  If we did so, we’d be much less likely to discuss policy in the confused way The Economist does in the excerpt above.  It would sound bizarre to say “The UK government should refrain from fiscal austerity, lest NGDP falls, and they should refrain from monetary stimulus, or else NGDP might rise.

That doesn’t mean the P/Y split is completely inconsequential.  In terms of human welfare we’d prefer to have more real growth and less inflation.  But that’s a supply-side issue, which can’t be addressed through demand-side stimulus.  Some commenters have made clever attempts to argue that fiscal stimulus would be better for aggregate supply, but I guess I’m just too libertarian to buy that argument.  I’d rather have monetary policy target NGDP along a stable 5% growth trajectory, and have all fiscal decisions subject to rigorous cost/benefit considerations.  Because a “targeting the forecast” approach means expected future NGDP would always be on target (even though current NGDP may be below target) there would be no “depression economics.”  Fiscal policy makers should operate in a classical world with real opportunity costs.

How will we know if the quasi-monetarists have won?  When everyone else starts using their language.  The more I see bloggers like Matt Yglesias and Brad DeLong talk about NGDP, the happier I am.  It doesn’t matter if they stay Keynesian—NGDP talk will slowly and insidiously lead to quasi-monetarist thinking.  That’s why Krugman slapped down David Beckworth last year; Krugman argued that talk about NGDP would lead to dangerous monetarist ideas.  At the time I argued that he was being illogical.  Now I see that the field of macro can’t be understood in strictly logical terms.

Normally you’d be better off looking at how someone like James Hamilton evaluates economic data, but I’ll take a stab at this one.  In early 2008 when we were in danger of slipping into recession, I got interested in the unemployment rate as a leading indicator (it is usually viewed as a lagging indicator.)  I asked myself how much of an increase in unemployment (during economic expansions) would be needed to indicate something more than just a blip in the recovery and that a new recession was underway.

I noticed that during expansions the unemployment rate never seemed to rise more than 0.6%, before falling again.  That is, unless we were actually going into a recession.  In that case unemployment rose much more, indeed at least 1.9% (in the mild 1980 recession.)  In between was a sort of donut hole, with almost no increases in unemployment of more than 0.6% that did not mean a recession was underway.  (Thus the US doesn’t have mini-recessions, even though all our economic theories predict we should see them more often than regular recessions.)  I say almost, because there was one exception; unemployment rose 0.8% during the 1959 nationwide steel strike, without any recession.  But the US economy is now far more diversified, and such an event is now very unlikely.  The share of employment in unionized industries like autos and steel has fallen sharply.  Here’s what I infer:

1.  Increases in unemployment of more than 0.6% are almost always indicators of recession.

2.  Increases in unemployment of more than 0.6% are ALWAYS economically significant.

The second statement is slightly more definitive, because I consider the 1959 steel strike to be an economically meaningful event.

If I’m right, then any change in the unemployment rate of more than 0.6% over a relatively short period of time, probably indicates that the actual unemployment rate changed—that it wasn’t all statistical noise.

Between November 2010 and January2011 the unemployment rate fell from 9.8% to 9.0%.  Let me emphasize that I strongly believe some of this was noise in the data, perhaps as much as 0.6% of the fall.  Thus the actual rate may have fallen from say 9.5% to 9.3%.  But I don’t think it was all noise, otherwise we would have seen previous episodes where the unemployment rate ticked up by more than 0.6% without triggering a recession.  And over the past 63 years (more than 750 months) we just don’t see meaningless blips that large.

Even an actual drop of 0.1% per month would be significant, that is faster than we had in 2010, and even faster than the pace of recovery that most forecasters expect over the next 5 years.  And remember that my argument suggests that 0.2% is the minimum plausible estimate for how much unemployment has actually improved; it may be a bit more.

I think this is why bond prices fell and yields rose.  The bond market knows that the payroll numbers are usually more reliable.  But they also know that both numbers are subject to error, especially with snowstorms disrupting data processing at some firms.  I actually know someone who expects to soon get a job, but the actual hiring has been held up by the recent storms in Boston, which have created a work backlog.  I think the bond market understands that while the payroll number is usually better, a change in unemployment that large is almost always economically significant.

BTW, my recession indicator worked pretty well in the 2008 recession.  By December 2007 unemployment was up 0.6% from the low, and in March 2008 it was up 0.7%.  Yes, the recession had already begun by March, but as late as mid-2008 some prominent forecasters still didn’t expect an outright recession.

PS.  I’ve been very busy and am way behind on comments.  I hope to get to the backlog this evening.

PPS.  Paul Krugman has a new post on the ECB in 2008 that is similar to arguments made by me and other quasi-monetarists about the Fed in 2008—they wrongly focused on high commodity prices.  Of course we tend to look at NGDP.

PPPS.  I just realized there is another (less appealing) possible interpretation.  It may be that the bond market thinks the lower unemployment numbers makes a premature Fed tightening more likely.  Let’s hope not.

Update (2/5/11):  Just as I predicted, James Hamilton’s analysis is better than mine.  He relies heavily on this excellent Rebecca Wilder post.

As you know, I’ve been critical of “recalculation” models of the US recession.  I think it’s mostly demand-side, and some unknown part of the supply-side is government labor market interference.  Only a modest portion is recalculation.  But Arnold Kling’s model almost perfectly explains the current Icelandic recession:

Economy Minister Arnason wants more for Iceland than fishing and geothermal energy. He acknowledges that the nation got into banking without the right infrastructure or the know- how to do it well. Still, he doesn’t think Icelanders have to go back to fishing now that they’ve proven themselves inept at finance.

His government needs to find work for the 2,000 highly educated finance-sector employees who lost their jobs, he says. Otherwise, they’ll migrate, and a shrinking population is the biggest scourge for this small, isolated island nation.

“The choice isn’t between fishing and banking,” Arnason says. “The choice is building a healthy, diversified economy.”

Some Keynesians might object that it’s also a demand problem; after all, Iceland went through a severe financial collapse, one of the worse in world history.  All the major banks failed, with liabilities totaling 1200% of GDP.  The housing industry collapsed.  Surely that points to a decline in AD?

Actually no.  Those Vikings wouldn’t have been able to survive in that harsh climate without having some smarts.  Unlike the foolish Irish, the Icelanders decided to let the big banks fail and have the creditors pick up the tab, not the taxpayers.  To prevent a fall in AD, they sharply depreciated the kroner.  I had trouble finding NGDP data, but if you look at the graph halfway down this link, you’ll see Icelandic NGDP rose continually through the worst of the 2008 crisis, and has continued to move gradually higher.  In contrast, Irish NGDP has plunged.  Ireland lacks the nominal income to repay its euro debts, and even to pay euro wages without steep wage cuts.  Ireland faces both recalculation and a severe demand shock.

The rise in NGDP did not prevent a fall in Icelandic RGDP; their financial collapse was a very severe real shock.  Those bankers can’t be immediately retrained as fisherman.  The reason Iceland fits Kling’s model so perfectly is:

1.  There was no demand shock

2.  It’s not even clear what the new patterns of specialization and trade should look like. Iceland is groping in the dark (literally, during these winter months) for new industries.

Paul Krugman also has a couple posts on Iceland.  In this one he points out that Icelandic RGDP fell about the same amount as in countries with much smaller financial crises, and that employment did considerably better.  I see those two arguments as being related.  Suppose Iceland had a real shock big enough to reduce RGDP by 15%, whereas Ireland and the Baltics merely had real shocks big enough to reduce RGDP by 8%.  But now assume that Ireland and the Baltics also had negative demand shocks, caused by their attachment to a euro that was way too strong for their economies (and indeed a bit too strong even for Germany.)

In that case Ireland and the Baltics might see RGDP declines as big or bigger than Iceland, even though their real shocks were smaller.   And this is what happened.   This also explains why employment did better in Iceland.  Recall that their real shock was much bigger, so for equal drops in employment you’d expect a bigger drop in Iceland RGDP than in the other crisis countries.  But we know that the decline in RGDP in Iceland was actually a bit less than most of the others.  This is because the good AD policies allowed some fraction of unemployment bankers and real estate people to find jobs in other industries.  Those new jobs were at lower levels of (measured) productivity per worker, which explains why RGDP fell more than employment.)

In other words, monetary policy did not slow the process of recalculation in Iceland.  In the other crisis countries monetary policy took a bad situation and made it even worse.   Unemployed workers in overbuilt sectors were not able to find jobs in other sectors, as total demand was falling.

PS:  How about some suggestions for Iceland:

1.  More tourism; most people don’t realize how awe-inspiring their volcanos are.

2.  Create more quirky pop groups.

3.  Give banking another shot.  Don’t assume Icelanders are “inept” at banking; assume they’ve become “experienced.”

4.  Grow pineapples in greenhouses heated by geothermal power.

5.  Resume raping and pillaging northern Europe, as in the Viking days.  (Oops, that’s already been done to northern European creditors.)

6.  Become the 51st state, or rejoin Denmark.

What else do you guys suggest?  Where’s their comparative advantage?

I almost always agree with Paul Krugman’s views on inflation.  We’ve both been skeptical of claims that US monetary and fiscal policy will produce high inflation.  Krugman points to the economic slack in the economy, I focus on TIPS spreads.    In a recent post, Krugman made the following observation:

. . . if we think of wages as the ultimate core price, I don’t see any mechanism in today’s America whereby rising commodity prices translate into higher wage contracts.

But what does the historical record say? It depends on which era you’re looking at.  . . .

The two big commodity price shocks of the 70s did, in fact, feed quickly into core inflation. Since then, however, nada.

Why the difference? The obvious point is that back in the 70s many labor contracts included cost of living adjustments (COLAs). This in turn partly reflected stronger worker bargaining positions and also real doubts about whether monetary policy would contain inflation. Today, none of that: COLAs are rare, and commodity-price fluctuations don’t feed into wages at all.

My only observation here is that we don’t even need to bring COLAs into the picture.  Wages respond to trend NGDP growth, and those growth rates were extremely high during the 1970s, even during recession years.  For instance, NGDP grew at an 11% rate between 1971:4 and 1979:4, and then grew another 9.6% in 1980, despite a mild recession.  Since monetary policy determines the trend rate of NGDP growth, this analysis is consistent with Krugman’s observation that in the 1970s there were “real doubts about whether monetary policy would contain inflation.”  But the phrase “contain inflation” is a tad misleading—suggesting that inflation was like a wild animal on the loose and needed to be reined in by the Fed.  The Fed caused the Great Inflation.

As you know, I often say “never reason from a price change.”  I think we’d be better off talking about the impact of NGDP on wages, which is fairly stable, rather than the impact of prices on wages, which is highly dependent on whether prices are rising because of more demand, or because of supply-shocks.  As we saw in mid-2008, high headline inflation doesn’t translate into big pay increases if not associated with fast NGDP growth.  The Economist made a similar observation for Britain:

But a jump in inflation caused by higher commodity prices and a rise in VAT””in an economy with spare capacity””is quite different from one caused by excess demand and a pay-price spiral. It intensifies the squeeze on households from other tax rises and curbs consumer spending.  Although the central bank is facing calls to tighten monetary policy soon, that would be warranted only if there were signs of inflation getting embedded into expectations and feeding through to higher wages.

Unsurprisingly, households are now expecting inflation to be higher over the coming year. But other official figures published this week showed no sign of a pay-price spiral. Average earnings are rising by just 2.1%, a very muted rate by historical standards. It is difficult to envisage wages taking off when the public sector is shedding jobs and facing a two-year pay freeze and there are 2.5m people unemployed, close to 8% of the labour force. Indeed the youth-unemployment rate has reached 20.3%, the highest since comparable records began in 1992.

The economy clearly retains quite a bit of spare capacity””the main reason why the Bank of England has insisted that the flare-up in inflation will be temporary. The bank has lost credibility as the inflation overshoot has persisted and its forecasts have proved incorrect.

[there was a rogue paragraph in the original version, which I deleted]

Keynesians often focus on economic slack as a determinant of wage gains.   That’s a bit too simple (as we saw in the 1970s); the more sophisticated Keynesian models now account for expected inflation.  And in fairness, the “slack” model of wages does seem to outperform the NGDP growth rate model during recoveries, when wage gains are often quite moderate, despite fast NGDP growth.

But there’s a good reason why wage gains often trail NGDP growth during a recovery—wage cuts trail declines in NGDP during most contractions.  Thus wages are still adjusting to the previous drop in AD during the early stages of a recovery.  The Keynesian model is good at explaining cyclical variations in wages, but not so good at explaining long run changes in trend wage growth, and trend NGDP growth.  For that you need the quantity of money.

Britain is facing an interesting dilemma.  The BOE clearly understands that NGDP, not prices, are the best indicator of demand.  They understand that it would be a mistake to react to the 3.7% headline inflation in December (yoy), by tightening monetary policy.  But they are constrained by the fact that almost everyone (wrongly) thinks it’s the central bank’s job to control inflation.

In contrast, fiscal policy is almost always evaluated in terms of real GDP growth.  This dichotomy makes no sense.  There is no macro model of any school of thought that says monetary policy controls inflation by shifting demand, and fiscal policy controls RGDP by shifting demand.  Yet when RGDP growth in Britain came in at a disappointing minus 0.5% in Q4, almost all the reports pointed not to the BOE, but to the fiscal austerity of the new British government. Even Brad DeLong, who devoted much of his talk at the recent AEA meetings to emphasizing the importance of NGDP, quotes an article giving a RGDP number for Britain.  RGDP numbers tell us nothing about whether demand stimulus is succeeding.  In fairness, I believe the UK NGDP numbers come out with a lag, but the problem is much deeper than that.  The media overwhelmingly sees fiscal policy as a RGDP issue and monetary policy as an inflation issue.  Until both are seen as NGDP issues we will not be able to come up with coherent policy regimes, which assign fiscal and monetary policy their appropriate roles.

There are two ways British policy might fail.  First, the BOE might fail to hit its implicit NGDP target.  Why would that occur?  Not because Britain is in a liquidity trap.  They are actually expected to tighten policy this summer.  And Britain can always depreciate its currency if it wants to.  It could even cut rates another quarter point.  No, with 3.7% inflation it’s madness to even talk about liquidity traps.  If they fail it will be because fear of politically embarrassing headline inflation numbers caused BOE officials to take their eye off the ball (NGDP.)  However if BOE policy does fail to boost NGDP, I predict fiscal austerity will be blamed.

Alternatively, policy might fail because the Gordon Brown government did significant damage to the supply-side of the UK economy, by increasing the size of the state.  A supply-side failure would show up as stagflation, i.e. appropriate NGDP growth but high inflation and slow RGDP growth.  Although we saw a bit of stagflation in the 4th quarter, it’s too soon to draw any conclusions.  Inflation will probably slow over the next few years.

I predict that if policy does fail for supply-side reasons, the failure will be widely attributed to demand-side factors, especially fiscal austerity.  That’s because everyone focuses on RGDP, and almost no one pays any attention to NGDP.