Another Angry Bear attack

Every few months I get attacked by the Angry Bear blog.  Here Mike Kimel questions my interpretation of the 1933-34 inflation, which I attribute to dollar depreciation:

I see a much simpler story.

1.Aggregate demand was very slack when FDR took office.

2.FDR showed up in Washington with a plan to start spending a lot of money and thus boost aggregate demand.

3.The immediate effect was to convince factories they’d be running down their inventories. That boosted producer prices. It had a much smaller effect on consumer prices because everyone knew the gubmint was going to buy a heck of a lot more producer goods than consumer goods. (The government did buy some consumer goods for the various programs, plus there was a spillover effect, but as the graph clearly shows, the action was on the producer side.)

4.After a bit of time, the public realized FDR wasn’t planning just a one-off, but rather a sustained program of purchases of industrial items. That led them to start using some of their idle capacity, which meant not just selling the fixed amount that was in inventory. The rate of price increases thus dropped.

5.GDP increased at the fastest rate in the United States peacetime history since data has been kept. There was a big hiccup, of course, in 1937 when the government cut back on spending for a while.

There are all sorts of the problems with the argument that the inflation of 1933-34 was caused by expectations of fiscal stimulus.  First of all, it’s completely at variance with Keynesian theory, which Kimel seems to be trying to defend.  Keynesian theory says demand stimulus doesn’t raise prices when there is “slack,” and there has never been more slack in all of American history than in 1933.

But put that problem aside; assume the Keynesian theory did predict inflation.  Prices didn’t start rising when FDR came to Washington with spending plans; they started rising when he began depreciating the dollar.  Furthermore, the weekly rise in the WPI index was highly correlated with weekly increases in the dollar price of gold (i.e. currency depreciation.)  And those changes (in gold prices) were caused by explicit statements and actions by FDR.  Not by fiscal stimulus, which would be expected to appreciate the dollar.

In addition, the fiscal stimulus was far too small to produce the more than 20% WPI inflation observed in the 12 months after March 1933.  So the fiscal stimulus theory of 1933-34 inflation fails on all counts.  Indeed I’m almost certainly that Keynes himself would acknowledge that it was dollar depreciation that boosted prices in 1933 (he favored the policy), despite the fact that it conflicted with his “bottleneck” theory of inflation.

I don’t have time to fully address all his comments, but a few brief points.  Kimel says:

So…. his story requires the devaluation of the currency to worsen the trade balance, and rational expectations to cause a one time explosion in industrial prices and a rather smaller recovery in consumer prices. Rational expectations, however, that came an abrupt halt, at roughly the same amount of time one would predict companies might decide that demand will be sustained enough to start producing more rather than just selling off inventory sitting in warehouses. And his story doesn’t explain why growth was so much faster during the New Deal era than any other period of peacetime since the US began keeping data, nor why there was the big hiccup in 1937.

No, my story doesn’t require devaluation to worsen the deficit, but economic theory suggests it can do so via the income effect.  Lars Svensson has written on this subject.  And my story does explain 1937, but I don’t have time to write a 400 page blog post on the Depression every time I comment on it.  I’ve published numerous articles on the topic over the years.  The 1937 downturn was caused by a combination of falling prices (due to gold hoarding) and rising nominal wages (due to the post-Wagner Act unionization drives.)  I have no idea what the phrase “rational expectations . . . that came to an abrupt halt” means.

The growth in the New Deal period was very uneven.  During March to July 1933 industrial production rose 57%.  That ended with the NIRA wage shock, and IP was no higher in mid-1935 (when the NIRA was repealed) than in July 1933.   If IP had continued rising after July 1933 at the rate of the fast 1921-22 recovery, the Depression would have been essentially over by the end of 1934.

When output falls sharply due to a demand shock, it’s possible to have very fast “catch-up” growth.  Since the hole in 1933 was much deeper than at any time in US history, it’s not surprising that the growth rates during the recovery were quite rapid.  But as late as mid-1940 the US economy was still deeply depressed.  So it’s a glass half full/half empty situation.  There were both good and bad aspects of FDR’s policies.  Monthly data shows those effects quite clearly.

Powerful evidence that the big problem is demand, not structural

It’s easy to find a correlation between two macro variables, as the same sort of factors (inflation, output growth, interest rates) tend to affect all sorts of financial and macro variables.  For that reason, one of the most useful statistical tools is time-varying correlations.

For example, when I studied the Great Depression I recall reading a year end summary of the 1931 stock market in the New York Times.  They summarized the US stock market month by month, and mentioned German problems in all the summaries of the last 7 months, but none of the first 5 months.  And sure enough, during the last half of 1931 the price of German war bonds was highly correlated with US stock prices.

But how can one prove cause and effect?  Lots of things might have affected both German war bond prices, and US stock prices.  For example, signs of a strong economic recovery worldwide might boost the value of both assets.  On the other hand, if German problems were depressing US equity markets, then you’d expect a strong correlation between German war bond prices and US equity prices during periods when there were lots of problems in Germany (late 1931), but essentially no correlation during periods when German problems were not particularly significant (early 1931.)  And that’s exactly what I found.  Or to take another example, Steve Silver and I found that US industrial production became negatively correlated with nominal wages after 1933, precisely when New Deal programs began to artificially raise nominal wages.

Almost a year ago David Glasner mentioned that he was working on a similar study, this time estimating the time-varying correlation between US inflation expectations and US equity prices.  He has frequently sent me very significant results, but I held back from mentioning them in order to let him get the project completed before publicizing the results.  He has now placed the paper at the SSRN web site, where others can read it.  In the meantime I notice that others have observed this pattern, indeed the commenter Gregor Bush recently mentioned some similar results.

It is well known that there is normally little correlation between US inflation expectations and US stock prices.  Higher inflation might boost stock prices if associated with growing aggregate demand, but higher inflation can also lead to expectations of tight money, or higher taxes on capital, since capital income is not indexed.  Indeed the high inflation of the 1970s seems to have depressed real stock and bond prices.  In general, the stock market seems content with the low and stable inflation of recent decades, at least judging by reactions to changes in inflation expectations.

David looked at 8 years of data, from January 2003 until December 2010, and divided the sample up into 10 sub-periods.  He found almost no significant correlation between inflation expectations (TIPS spreads) and stock prices (S&P 500) until March 2008.  (Actually, there was a modest positive correlation during the first half of 2003, another period when people worried about excessively low inflation.)  After March 2008, the correlation was highly significant, and positive.  Right about the time where the US began suffering from a severe AD shortfall, the stock market began rooting strongly for higher inflation.  And it still is, even in the most recent period.  Money is still too tight.

There is no way to overstate the importance of these these findings.  The obvious explanation (and indeed the only explanation I can think of) is that low inflation was not a major problem before mid-2008, but has since become a big problem.  Bernanke’s right and the hawks at the Fed are wrong.

Arnold Kling noted that the AS/AD approach can sometimes verge on the tautological.  When inflation and output both fall, demand-side economists are likely to infer that AD is lower.  And they are also likely to claim that the fall in AD caused both the drop in inflation and the drop in output.  Of course that’s not the only evidence demand-side economists have, but in many cases it’s hard to find definitive evidence of causation.

In my view the time-varying correlations between inflation expectations and stock prices are one of the most important pieces of evidence we have that AD became a problem after mid-2008.  It will be interesting to see if those economists who are skeptical of demand-side explanations can come up with a plausible alternative explanation for this pattern.

PS.  If anyone knows how to estimate a continuous time-varying correlation, it would be interesting to find out precisely when in 2008 US equity markets started rooting for higher inflation.

PPS.  I’ve been asked to comment on the very weak performance of NGDP and the very strong performance in final sales during 2010:4.  If I had any confidence in the government numbers I would comment.  Let’s wait a few more quarters, look at lots of different data, and see where we are.  Again, my test of a policy is its effect on expected NGDP, not the actual movements in NGDP (which reflect all sorts of factors.)