In a recent post I pointed out that during the 1970s we had normal (3.2%) growth and that 100% of the high inflation was due to NGDP growth being much higher than 5%, indeed about 10.4% on average between 1970 and 1980.  So even during the 1970s, inflation would have been only around 1.8% under NGDP targeting. I think Karl Smith accepts that argument.  But he also claims:

The 1970s were definitely an era of stagflation

He later defends this statement by pointing to the relatively high levels of unemployment during that decade.  I had thought the word ‘stagflation’ meant high inflation plus slow output growth (due to slow growth in AS.)  Karl seems to think it means high inflation plus other bad things, like high unemployment.

Rather than arguing over semantics, I’d rather focus on the important issue; what does the 1970s tell us about NGDP targeting?  I think Karl and I would both agree that (whether or not there was stagflation during the 1970s) under 5% NGDP targeting there definitely would not have been any stagflation.  The 1970s are not a counterexample to my claim that 5% NGDP targeting would produce good results for those variables that central banks can affect.

It’s true that we could have done better on the supply-side with improved public policies during the 1970s, which would have led to more rapid growth.  But that’s also true of the 1950s and 1960s, when more lenient immigration laws would have produced faster growth.  It’s always true that RGDP is well below the level that would have occurred with better public policies.  But I think if the term ‘stagflation’ is going to mean anything useful, it has to refer to a periods where, for any given rise in AD, slower than normal AS growth leads to higher inflation.  The 1970s do not meet that definition.

I agree with Karl that changes in the unemployment rate are a better indicator of the business cycle than changes in RGDP.  But I hope that we can both agree that slow growth in AS did not cause the high inflation of the 1970s.  Yes, the natural rate of unemployment rose by about 2% during the 1970s, but any inflationary impact of that increase was offset by faster than normal growth of the labor force.  Hence inflation was completely demand-side.

I agree that oil shocks, considered in isolation, raised the price level during the 1970s.  But the impact of higher oil prices was more than offset by the impact of faster than normal labor force growth.  Hence the supply-side of the economy did not have any inflationary impact on the economy in the 1970s.  Our textbooks are wrong, just as they are wrong when they tell our students that the classical economists believed the AS curve was vertical.  Or that Fisher believed velocity was constant.  Or . . .  but it would take too long to list all the errors.

PS.  I do agree the term ‘stagflation’ applies to 1974.

PPS.  In the comment section of my earlier post Numeraire makes some points that are similar to those of Karl Smith.

Update:   Tim Duy sent me a very good post he did last year that makes some similar points, and includes some graphs comparing the 1970s to the past decade.

When I was younger this is how the Senate worked:

On September 27, 1986, the US Senate voted by a lopsided margin to overhaul the tax code to the benefit of the extremely rich. The act, the second of the two major Reagan tax cuts, was written by Democratic Senator Bill Bradley of New Jersey and Democratic Representative Richard Gephardt of Missouri, and was signed into law by President Ronald Reagan on October 22, 1986. It was the first major alteration in US tax law in 40 years.

The law cut the income tax rate on the wealthiest Americans from 50 to 28 percent, while simultaneously increasing the tax rate on the poorest citizens from 11 percent to 15 percent. Tax brackets were reduced from 15 to four, and the top corporate tax rate was slashed from 46 percent to 34 percent. The law included a bevy of other measures punishing the poor and low-income workers, including abolishing interest deductions for debt on consumer loans such as credit cards and tightly restricting deductions for Individual Retirement Accounts (IRA).

The 74-23 Senate vote saw 33 Democrats vote in favor of the bill, many of them leading liberals, including senators Kerry and Kennedy of Massachusetts, Gore of Tennessee, Leahy of Vermont, Biden of Delaware, Proxmire of Wisconsin, Glenn of Ohio, Moynihan of New York, Lautenberg of New Jersey, and Harkin of Iowa. Only 12 Democrats, together with 11 Republicans voted against the bill, which was championed by the Reagan administration.

How could we recapture the idealism of the 1980s?  This is how:

…we propose an X tax, consisting of a flat-rate firm-level tax on business cash flow and a graduated-rate household tax on wages.  The tax would completely replace the individual and corporate income tax, the estate and gift taxes, and the Unearned Income Medicare Contribution tax slated to take effect in 2013.

This is basically a progressive consumption tax.  The GOP gets the hated personal and corporate income taxes abolished, and GOP gives in on higher revenues and a fairly progressive tax on wage income (and hence consumption.)

I know what people will say; “Look at the bi-partisan vote in 1986.  That was before the US became a banana republic.”  Yes, but one can’t help dreaming that someday our representatives might start actually trying to help the country.

Younger blog readers who rely heavily on the NYT for  information might be under the impression that the 1980s tax cuts for the rich were enacted due to the evil Republicans.  Actually, almost every single developed country cut its top MTR during the 1980s and 1990s.  And liberal Democrats in America also supported the cuts.  The past is another country—you had to be there to understand.

HT:  Tyler Cowen

In a recent interview Paul Krugman expressed concern that under NGDP targeting an increase in the trend rate of RGDP growth would force the central bank to lower the rate of inflation.  I replied something to the effect that this isn’t a bug, it’s a feature.  BTW, Nick Rowe did a better job of explaining why this is so.

The reverse is also true; a period of low RGDP growth would lead to above average inflation.  Why is “the worst of both worlds” deserving of praise?  Because the alternative would be even worse.  If higher inflation accompanies a growth slowdown, then the stagnation obviously is due to a real shock, not a fall in AD.  If AD had declined, you’d have lower inflation during the period of stagnation.  And when the economy is hit by a real shock, workers need to accept lower real incomes.  You could do that by tearing up and renegotiating all wage contracts; or you could simply accept a bit more inflation.

Why does stagflation have such a bad rap?  I think it’s because stagflation is often misdiagnosed.  Under a NGDP growth target of 5%, stagflation is likely to be about 1% RGDP growth and 4% inflation—something like late 2007 and early 2008.  Not good, but not the end of the world.

In one of yesterday’s posts I pointed out that we can’t trust any of the economic history that we learned in school–citing the 1929 stock market crash (which actually had no impact on the economy.)  Another example is that “decade of stagflation;” the 1970s.  The only problem with this commonly held view is that the 1970s were not a decade of stagflation; rather we saw an extraordinary surge in aggregate demand:

NGDP growth averaged:  10.4%

RGDP growth averaged:   3.2%

Growth was normal, and inflation was very high.  Rapid growth in AD explains roughly 100% of the inflation during the 1970s.  There was no stagflation, just inflation.

Now a purist can find a few individual years of stagflation, such as 1974.  This occurred for two reasons.  OPEC sharply cut oil output in late 1973, which was a severe real shock to the economy.  And price controls were being phased out, meaning that part of the measured inflation of 1974 actually occurred in 1972-73, but was covered up to facilitate Richard Nixon’s re-election.  (Actually that’s not quite fair—in those days many of the best and the brightest progressive economists supported wage-price controls.)

So the “stagflationary 1970s” is a big myth—almost as big a myth as the claim that the inflation of the 1960s was caused by LBJ’s refusal to pay for his guns and butter policies with higher taxes.  Or the claim that the evil Republicans sharply cut the top MTR on the rich during the 1980s.   Those are even bigger myths, something for future posts.

I have often commented on how conservatives seem so opposed to slightly higher inflation that they’ll often end up tacitly or explicitly supporting much more statist policies instead.  The example I always think of was 1933, when conservatives were apoplectic over FDR’s attempts to bring prices back up to 1929 levels, but were OK with outrageously destructive statist policies like the NIRA.  We saw many such examples in the last year of the Bush administration, with its fiscal stimulus, auto bailouts, bank bailouts, etc, etc.  And now we see the same dynamic playing out in Britain, where the Conservatives refuse to raise the BOE’s mandate to 3% inflation, or 5% NGDP growth, but seem quite willing to socialize the banking system:

Chancellor of the Exchequer George Osborne and Bank of England Governor Mervyn King are preparing two programs to increase the flow of credit amid a deteriorating outlook in the euro area.

The U.K. central bank will activate an unused plan to inject at least 5 billion pounds ($7.8 billion) a month into the financial system. Another plan will allow lenders to swap assets with the central bank in return for money to be lent to companies and households. The Treasury will indemnify the bank for any losses.

I’m actually pretty sympathetic to the Cameron government.  They are trying to do the right thing; fiscal austerity and monetary stimulus.  Perhaps it’s simply impossible for them to sell a 5% NGDP target, level targeting.  Maybe their political base would revolt—I’m in no position to judge.  But whatever the reason, it’s very discouraging to see conservatives over and over again finding themselves forced to support outrageous statist policies, because they were unable to implement the free market solution to full employment—enough money to keep NGDP growing at a steady rate.

Conservatives need to realize that 5% NGDP growth isn’t the end of the world.  There are much worse things.  Australia has averaged 7% NGDP growth for decades and they have a very small government, virtually no national debt, and the healthiest economy in the Western world.  There are worse things than steady 5% NGDP growth.  Seriously, conservatives need to end their obsession with hard money, before there’s no more free enterprise system left to save.

Five percent NGDP growth, level targeting.

That’s all.

HT:  Evan Soltas, 123

Arnold Kling recently had this to say:

I will excerpt from the Meltzer paper. But first, let me quote from the media release of Macdonald-Laurier.

“In a period of runaway monetary stimulus by the industrialized world…”

I do not think that Scott Sumner would characterize the monetary situation that way.

I use the Bernanke criterion from 2003, discussed in my previous post.  According to the Bernanke metric, monetary policy since mid-2008 has been tighter than any time since Herbert Hoover was President.  Kling continues:

In fact, while we are talking about non-monetary factors in economic performance, I might mention the much-discussed Fed study suggesting a 40 percent decline in median household wealth between 2007 and 2010. Timothy Taylor has the link and some helpful analysis.

I think that economists who believe that aggregate demand was a big factor in the recession (which means most economists, just not necessarily including me) are inclined to view this wealth decline as the cause, rather than taking Scott Sumner’s view that this was a monetary contraction. To rescue a role for money, you could try to argue that the wealth decline was the result of monetary austerity (impossible to disprove, but I do not believe it) or, more plausibly, that a vigorous monetary expansion could have maintained nominal GDP in the face of the huge decline in the relative price of houses and bank stocks.

Not surprisingly, I have all sorts of problems here.  Start with the decline in wealth.  It seems clear to me that something on the order of 70% of the decline was due to tight money.  That’s just a ball park estimate, but the exact percentage isn’t critical for my argument.  I base this on 60% of the wealth decline being residential housing, and 40% being other assets like commercial RE and stocks.  I also estimate that the first half of the housing price decline was mostly autonomous, and the second half mostly reflected falling NGDP–i.e. tight money.

But let’s say I’m wrong about tight money causing the fall in wealth, even though previous big falls like 1929-33 were also due to tight money.  Say that Kling is right.  There is no reason why a big fall in wealth should have any impact on AD, as long as the central bank is following some sort of stable monetary policy: inflation targeting, NGDP targeting, whatever.

In late 1987 there was a stock market crash as big as 1929.  I’m not arguing that it was identical to the recent wealth crash; it was much smaller, and more concentrated among the wealthy.  Nonetheless because the Fed was targeting NGDP or inflation, there wasn’t even a tiny fall in AD.  Not even a minuscule fall in AD, following a 1929-style stock market calamity.  I mention that because I think a lot of average people have the 1929 crash in the back of their minds, and think it somehow contributed to the Great Depression.  That false impression, which we got from believing what we were taught in our economics and history classes, has led many to be way too easily accepting of wealth explanations for the current recession.

I can’t emphasize enough that we need to purge from our minds almost everything we learned about economic history.  Our teachers had flawed models, and never updated them when the 1987 crash showed the standard model of the Great Depression was completely bogus.

There is a way to test whether I am right.  If we do the policy that Arnold and I favor:

I presume Meltzer would prefer a rule fixing the growth rate of a monetary aggregate (the monetary base seems to be his choice). On this issue, I tend to side with the market monetarists, but for non-monetarist reasons. A nominal GDP target will be imperfect because of forecasting errors. A monetary aggregate target will be imperfect because of velocity instability. I think I would rather take my chances on the forecasting errors.

then I claim future wealth crashes would not cause serious recessions–at least not through a demand side channel.  (No one would dispute that a huge supply shock such as an asteroid impact would reduce both wealth and RGDP.)

HT:  Saturos