The F story about the Great Inflation

Here F could stand for folk. The story that is often told by economists to their students goes as follows. After Phillips discovered his curve, which relates inflation to unemployment, Samuelson and Solow in 1960 suggested this implied a trade-off that policymakers could use. They could permanently have a bit less unemployment at the cost of a bit more inflation. Policymakers took up that option, but then could not understand why inflation didn’t just go up a bit, but kept on going up and up. Along came Milton Friedman to the rescue, who in a 1968 presidential address argued that inflation also depended on inflation expectations, which meant the long run Phillips curve was vertical and there was no permanent inflation unemployment trade-off. Policymakers then saw the light, and the steady rise in inflation seen in the 1960s and 1970s came to an end.

This is a neat little story, particularly if you like the idea that all great macroeconomic disasters stem from errors in mainstream macroeconomics. However even a half awake student should spot one small difficulty with this tale. Why did it take over 10 years for Friedman’s wisdom to be adopted by policymakers, while Samuelson and Solow’s alleged mistake seems to have been adopted quickly? Even if you think that the inflation problem only really started in the 1970s that imparts a 10 year lag into the knowledge transmission mechanism, which is a little strange.

However none of that matters, because this folk story is simply untrue. There has been some discussion of this in blogs (by Robert Waldmann in particular - see Mark Thoma here), and the best source on this is another F: James Forder. There are papers (e.g. here), but the most comprehensive source is now his book, which presents an exhaustive study of this folk story. It is, he argues, untrue in every respect. Not only did Samuelson and Solow not argue that there was a permanent inflation unemployment trade-off that policymakers could exploit, policymakers never believed there was such a trade-off. So how did this folk story arise? Quite simply from another F: Friedman himself, in his Nobel Prize lecture in 1977.

Forder discusses much else in his book, including the extent to which Friedman’s 1968 emphasis on the importance of expectations was particularly original (it wasn’t). He also describes how and why he thinks Friedman’s story became so embedded that it became folklore. The reason I write about this now is that I’m in the process of finishing a paper on the knowledge transmission mechanism and the 2010 switch to austerity, and I wanted to look back at previous macroeconomic crises.

If it wasn’t a belief in a long run inflation unemployment trade-off, what was it that allowed inflation to gradually rise during those two decades? Forder has a lot to say on this, but the following is my own take. I think two things were critical: the idea that demand management was primarily designed to achieve full employment, and that full employment had primacy over the objective of price stability. Although more and more economists over that period began to see the policy problem within a Phillips curve framework, many still hoped that other measures like prices and incomes policies (in the UK in particular but also in the US) could override the Phillips curve logic. The primacy of the full employment objective meant the problem was often described as ‘cost-push inflation’ rather than a rise in the natural rate of unemployment.

If you find this hard to imagine, think about historians discussing the current period in a possible future in 2050. By then nonlinearities in the Phillips curve and the power the inflation target had in anchoring inflation expectations were firmly entrenched in mainstream thinking. Imagine that partly as a result in 2050 the inflation target has been replaced by a level of nominal income target. With the benefit of hindsight these historians were amazed to calculate the extent to which resources were lost decades earlier because policy had become fixated by a 2% inflation target and budget deficits. They will recount with amusement at the number of economists and policymakers who thought that the way to deal with deficient demand was by ‘structural reform’. Rather than construct folk tales, they will observe that even when most economists realised what was required to avoid being misled again policymakers were extremely reluctant to change the inflation target.

Understanding the New Classical revolution

In the account of the history of macroeconomic thought I gave here, the New Classical counter revolution was both methodological and ideological in nature. It was successful, I suggested, because too many economists were unhappy with the gulf between the methodology used in much of microeconomics, and the methodology of macroeconomics at the time.

There is a much simpler reading. Just as the original Keynesian revolution was caused by massive empirical failure (the Great Depression), the New Classical revolution was caused by the Keynesian failure of the 1970s: stagflation. An example of this reading is in this piece by the philosopher Alex Rosenberg (HT Diane Coyle). He writes: “Back then it was the New Classical macrotheory that gave the right answers and explained what the matter with the Keynesian models was.”

I just do not think that is right. Stagflation is very easily explained: you just need an ‘accelerationist’ Phillips curve (i.e. where the coefficient on expected inflation is one), plus a period in which monetary policymakers systematically underestimate the natural rate of unemployment. You do not need rational expectations, or any of the other innovations introduced by New Classical economists.

No doubt the inflation of the 1970s made the macroeconomic status quo unattractive. But I do not think the basic appeal of New Classical ideas lay in their better predictive ability. The attraction of rational expectations was not that it explained actual expectations data better than some form of adaptive scheme. Instead it just seemed more consistent with the general idea of rationality that economists used all the time. Ricardian Equivalence was not successful because the data revealed that tax cuts had no impact on consumption - in fact study after study have shown that tax cuts do have a significant impact on consumption.

Stagflation did not kill IS-LM. In fact, because empirical validity was so central to the methodology of macroeconomics at the time, it adapted to stagflation very quickly. This gave a boost to the policy of monetarism, but this used the same IS-LM framework. If you want to find the decisive event that led to New Classical economists winning their counterrevolution, it was the theoretical realisation that if expectations were rational, but inflation was described by an accelerationist Phillips curve with expectations about current inflation on the right hand side, then deviations from the natural rate had to be random. The fatal flaw in the Keynesian/Monetarist theory of the 1970s was theoretical rather than empirical.

Myths and Realities of the 1970s

I have been pondering why inflation targeting is so popular, as opposed to the more natural idea of a dual mandate. I say more natural for two reasons. First, because the dual mandate corresponds to the two roles of monetary policy: short run demand management and determining medium/long term inflation. Second, because it maps naturally to the objectives that macroeconomists typically assume or derive when modelling monetary policy: minimising both excess inflation and the output gap.

I think a big reason for the popularity of inflation targeting is the 1970s. A common story for why inflation was allowed to rise so high for so long in that decade is that monetary policy was targeting the output gap, and policy makers got their estimate of the natural rate very wrong. (A classic reference is Orphanides (2002). [1]) A dual mandate, it is suggested, encouraged that mistake, and could lead to the same mistake being made again. So central banks given independence since the 1970s tend to have low inflation or price stability as their primary goal, rather than a dual mandate.

There is an obvious rejoinder to that argument. The US Fed maintains its dual mandate, yet it shows no signs of acquiescing to the kind of increases in inflation we saw in the 1970s. Its latest forward guidance says it will tolerate inflation up to 2.5% (as long as unemployment stays high) before it considers raising interest rates. That is hardly going back to the 1970s. There are people who think that QE will, any moment now, open the inflation floodgates, but I want to keep to serious macro in this post.  

So current experience shows there is no reason why a dual mandate should inevitably lead to rising inflation. I think there were three important contributory factors to what happened in the 1970s that are just not present today. First, our knowledge of inflation output trade-offs, although hardly complete now, was much weaker back then. Second, the Fed and other monetary policy makers did not have clear inflation targets that they were publicly committed to. Third, there appeared to be an alternative instrument for dealing with inflation: direct controls on prices and wages. [Postscript: see comment from Robert Waldmann and my reply below.] The 1970s really was a different world in terms of the understanding of macroeconomic policy.

I’m reminded of all this by a fascinating chapter (released today) in the forthcoming IMF World Economic Outlook. The main focus of the chapter is on how the Phillips curve has shifted over time. There are two clear findings. The first is that the sensitivity of inflation to the output gap is much lower now than in the 1970s. Second, the importance of expectations about future inflation (compared to past inflation) is much greater. An obvious way of interpreting both results is that inflation expectations are now much more firmly anchored.

However the chapter also contains an interesting comparison between the behaviour of 1970s inflation and monetary policy in the United States and Germany. We all know that the US had to wait until Volcker in 1979 before inflation control was restored. However the Bundesbank did this much earlier: inflation was brought down to below 3% in 1978. While it could hardly be immune from the impact of the oil price shocks and high inflation elsewhere, its record in keeping inflation anchored looks much better than other countries. Here is the relevant chart from the chapter.

Now there is a popular story about this as well, which is that the Bundesbank was practicing monetary targeting during this period. But, as the WEO chapter points out, this is also a bit of a myth. Studies suggest [2] that in practice the Bundesbank was not a rigid money supply targeter in the way both the US and UK attempted to be in the early 1980s, but instead adopted a more flexible approach which can be characterised by some form of Taylor rule. Furthermore the output gap played an important role in that rule, and the Bundesbank also got its estimates of the output gap wrong.

To quote from the WEO chapter:

“the Bundesbank’s success was not linked to meticulously meeting the monetary targets, which it actually missed throughout the 1970s, or to focusing on inflation with no regard for output developments. Rather the Bundesbank’s success was a reflection of the robust framework it developed, which allowed it to keep longer-term inflation expectations anchored while flexibly responding to shorter-term output shocks.”

I think you can argue that what monetary targets did was proxy a dual mandate. Inflation would not be allowed to rise unchecked for too long, but equally movements in output would be offset by interest rate changes, in the classic IS-LM manner.

So I think the lesson of the 1970s is that it is important to have publicly stated inflation targets, but not that the short term output stabilisation role should be subordinate to hitting those targets. In the future there will surely be a similar IMF WEO chapter looking back at the divergent behaviour of US and Eurozone output in the 2010s (see Ryan Avent here). I’m sure one of its arguments will be that the US did so much better in part because monetary policy had a dual mandate, while the ECB acted as if all that mattered was inflation.

 

[1] Orphanides, Athanasios, 2002, “Monetary-Policy Rules and the Great Inflation,” American Economic Review, Vol. 92, No. 2, pp. 115–20.

[2] The WEO chapter notes Clarida, R.H. and Gertler, M. (1997) “How the Bundesbank Conducts Monetary Policy” in Reducing Inflation: Motivation and Strategy eds Romer and Romer, Chicago University Press, pp 363-412 and Gerberding, C., Seitz, F. and Worms, A. (2005) “How the Bundesbank Really Conducted Monetary Policy” North American Journal of Economics and Finance, 16, 277-92. The second study reconstructs the real time data set that would have actually been available to policy makers, and finds as a result that it is the change rather than the level of the output gap that was important in their Taylor rule, and that a term in excess money growth is also significant. This slightly earlier paper by Clausen and Meier does something similar, but with results closer to a traditional Taylor rule.

The inflation dragon is just around the corner

People who believe this are not confined to the US. In articles in the Telegraph and the FT (HT Frances Coppola), Andrew Sentance says the job of the new Governor of the Bank of England should not involve messing with the inflation target, but to “reassure the British public that under his governorship they can expect stable prices”, which he thinks probably means putting up interest rates and withdrawing QE this year. The article contains the inevitable reference to the 1960/70s: “We have been here before in the UK. A creeping tolerance of higher inflation in the 1960s paved the way for double-digit inflation in the 1970s and early 1980s.”

I would not bother with this if it was not for two things. First, Andrew Sentance was on the Monetary Policy Committee, and his persistent warnings then and since that CPI inflation would be higher than expected have been largely right. Second, the factors that have been helping to keep CPI growth high – commodity prices and fiscal austerity – are not obviously about to disappear, so the Bank of England may still be having to explain why they are ‘ignoring’ above target inflation through 2013.

There is a genuine puzzle about why the influence of the recession has not dominated the impact of these commodity and fiscal effects. Paul Krugman stresses the role of wage rigidity. My own pet theory for the UK is the influence of the financial crisis, but that is for another post. What has to be laid to rest is the idea that we are about to experience the 1960/70s all over again. Have a look at this chart.

It shows UK wage[1] and consumer price inflation over that period. For nearly every quarter before the inflation peak in 1974 it shows wage inflation above price inflation. We do not need to worry about whether one series leads the other as inflation increased – we can just say that both measures of inflation rose together. Hence the phrase ‘wage price spiral’ to describe what happened over that period. Now look at the same series since 2005.

Since the recession hit, we have seen a marked reversal: consumer price inflation has been above wage inflation. There is absolutely no sign of an imminent wage price spiral. (The data for wage inflation I use here comes from the OECD, but if we use the ONS’s average earnings index the latest numbers for Aug-Oct 2012 show wage inflation of only 1.8%.) The only remotely similar period since 1955 was the early 1980s, when inflation was rapidly falling. (Whether the behaviour of real wages over the recent period is unusual given unemployment is examined here.)

I can put the same point another way. If the Bank of England had been given a target for wage inflation as well as its price inflation target, that target would probably have been 4%, reflecting the normal (pre recession) divergence between the two series. If it had only been given a 4% wage inflation target (and there is no clear reason why this should not have happened), then given the numbers above I assume Andrew Sentance  would be complaining that the Bank of England had been doing too little to stimulate the economy. This just shows the danger of having a mandated target for just one inflation measure that I talked about here.

I suggested in a post a month back that if the Chancellor really wanted to stimulate the economy, he should replace the Bank’s 2% CPI inflation target by a 4% average earnings target. He has the power to do that today, and does not need to wait until the new Governor takes over. But the broader point is that any suggestion that current tolerance of above target inflation is leading us back into the 1970s is about as realistic as a world with dragons.

[1] Compensation of employees, source OECD via FRED. It is a real shame that the ONS website is not as user friendly as FRED.