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