No, the unemployment rate is not “meaningless”

In March, the economy created 916,000 new jobs and the unemployment rate edged down to 6%. At the same time, total employment remains roughly 10 million below trend.

This leads some people to assume that the unemployment rate is sort of meaningless, and that the total employment figures show the true state of the labor market.

That’s not quite right.  If you want to know how far we are from a full recovery, then the total employment figures are indeed more relevant at the moment.  But if you want to understand how hard it is to find a job, then the unemployment rate is probably the better indicator.

When these two series diverge sharply, it is because there has a been a drop in the total labor force.  Million of people who were employed in early 2020 are currently not even looking for a job.  As a result, the labor market is tighter than you’d normally expect from a situation where employment is 10 million below trend, and indeed far tighter than in 2009:

A record share of U.S. small-business owners reported unfilled positions in March, and firms are starting to boost wages to attract talent, a report by the National Federation of Independent Business showed Thursday. . . .

[A]n overwhelming number of small businesses are having trouble finding qualified applicants to fill open positions. Over 90% of owners looking to hire reported few or no “qualified” applicants for the jobs they were trying to fill last month.

“Where small businesses do have open positions, labor quality remains a significant problem for owners nationwide,” said Bill Dunkelberg, chief economist at NFIB. “Small-business owners are raising compensation to attract the right employees.”

I’m not sure what explains the recent drop in the supply of labor.  Part of the decline might reflect workers that are skittish about contracting Covid-19.  Some workers may be staying home to care for children, as many schools have closed.  The expanded unemployment program pays some workers more in unemployment compensation than they earned on their previous jobs.  I expect these roadblocks to mostly be eliminated by late in the year, and hence I expect a surge in labor force participation.

But as of the moment, it’s easier to find work than would normally be the case when employment is 10 million below trend.

The punch line here, as in so many of my posts, is to avoid thinking exclusively in supply or demand terms.  When it comes to the labor market, both supply and demand matter.  Never reason from a quantity change.


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Proactive and reactive policies

New York magazine has a good article on Covid-19:

“Basically, going back to January, they’d be like, ‘China’s not going to control it; 80 percent of the population is going to get it; all efforts to contain it are going to fail; we have to learn to live with this virus; contact tracing and testing make no sense; this is going to be everywhere; right now we need to build up hospitals’ — which they didn’t even do. But they really didn’t think it was stoppable,” she says. “And then all of a sudden you started to see, in February, South Korea stopping it, Taiwan stopping it, and China stopping it. Then, in March, New Zealand. And then Australia. And then there’s this realization of, ‘Oh, wow. Actually, it is controllable.’”

At the beginning of March, South Korea was averaging more than 550 new daily confirmed cases, compared with just 53 in the U.K. At the end of the month, South Korea had 125; the U.K. was at 4,500 and climbing. “In the UK we have had nine weeks to listen, learn and prepare,” Sridhar wrote angrily in the Guardian, berating the British regime for failing to establish basic systems for supplies, testing, and contact tracing.

Later they point out that things are not quite that simple:

Francois Balloux, an infectious-disease epidemiologist and computational geneticist at the University College of London, goes further. “It’s not obvious that different measures taken in different places have clearly led to different outcomes,” he says. “There’s a lot of idiosyncrasy, and I think it’s simplistic to say that the countries that have controlled or eliminated the virus did things extremely differently. If you just list, for instance, the interventions that places like New Zealand or Australia have implemented, they’re not drastically different — in stringency nor duration — than in some other places. The country that had the strictest lockdown for longest in the world is Peru, and they were absolutely devastated. I think the slightly depressing message,” Balloux says with a sigh, “is that there is not just a set of policies that will bring success and can just be applied to any place in the world.”

So how can we reconcile these two conflicting narratives?  First we need to distinguish between public policy and behavior.  I suspect that the relatively low level of Covid deaths in some areas of the US (Washington, Oregon, Utah, Northern New England and even the SF Bay area of California) has more to do with culture than public policy.  People behave differently in different parts of the US.  If death rates in the Pacific Northwest and northern New England are similar to those in Canada, is it so far-fetched to believe that their culture also resembles Canada more than it does much of the rest of the US?

But the big international differences may require an additional explanation.  Reading the NY magazine article, I was immediately reminded of the global recession of 2008-09.  I’ve argued that the recession was caused by tight money policies, especially in the US and Europe.  But why was Australia able to avoid a recession?  Their central bank didn’t do any QE, and didn’t even cut interest rates to zero.

In fact, what to the average person looks like an “easy money” policy is often the exactly opposite.  It’s precisely because Australia had a more expansionary policy early in the recession that they were able to avoid some of the more “reactive” policy measures employed elsewhere during the 2010s.  Similarly, the US was a bit more (proactively) aggressive than the ECB during 2009-10, and as a result the ECB ended up being forced to do aggressive (reactive) QE and negative interest rates in the middle 2010s.

So if you see news stories of positive interest rates in Australia during the global recession of 2008-09, do not conclude that easy money is not stimulative.  And if you see news stories of restaurants being open in Taiwan, Australia and New Zealand during the Covid pandemic, do not conclude that social distancing is not helpful.  Rather the positive interest rates are a sign that Australia took proactive steps to prevent a deep fall in NGDP growth, and the open restaurants are a sign that they got on top of the pandemic early on, with an aggressive policy aimed at driving Covid rates down close to zero.

There’s another interesting comparison between Covid and the 2008-09 recession.  In both cases, bloggers were often ahead of the experts in diagnosing the problem and recommending appropriate policies.  Bloggers pointed out that the Fed’s October 2008 decision to begin paying interest on reserves would have a contractionary effect.  Today, that criticism is widely understood as being correct.  Indeed in his memoir, Ben Bernanke acknowledges that monetary policy was too tight after Lehman failed.  Similarly, bloggers like Alex Tabarrok and Tyler Cowen have been consistently right in their criticism of the public policy response to Covid.

PS.  The US is currently at 1670/million Covid deaths.  Canada is at 595/million, or halfway between Utah and Oregon.  Here are the lowest 7 states:

Note:  The 15 highest Covid death rates are in both northern and southern states, as well as both urban and rural.


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The professor vs. the markets

Turkey’s authoritarian leader sacked the central bank head just months after appointing him to the position:

When Turkey raised interest rates more than market expectations last week, Naci Agbal was cheered by investors who viewed the move as more evidence that the central bank governor was willing and able to pursue a conventional monetary policy.

Two days later, he was out of a job — the third governor President Recep Tayyip Erdogan has sacked in less than two years — and the currency was set to tumble as much as 14 per cent.

The shock decision announced in the early hours of Saturday has rattled investors who hoped the appointment of Agbal, a market-friendly economist, four months ago meant Erdogan was ready to cede a degree of autonomy to the bank.

The fact that Turkey’s currency depreciated does not necessarily mean it was a bad decision.  It would be good news if the yen depreciated 14% on news of new leadership at the Bank of Japan, an indication that the new central bank chief was likely to make progress toward Japan’s 2% inflation target.  But Turkey has 15% inflation, and doesn’t need monetary stimulus.

Sahap Kavcioglu, who has replaced Agbal, said in a statement on Sunday that monetary policy instruments would “continue to be used in an effective way towards the fundamental goal of a permanent decline in inflation”. He said the Monetary Policy Committee would meet as scheduled on April 15, suggesting there would no extraordinary MPC meetings.

But Kavcioglu, a little-known professor of banking, shares the president’s unconventional view that high interest rates cause inflation.

High interest rate don’t cause inflation, just as low interest rates do not cause inflation.

It’s one thing to advocate NeoFisherian ideas as a college professor.  But markets are quite efficient, too smart to engage in the fallacy of “reasoning from a price change”.  Mr. Kavcioglu is about to discover that the world doesn’t work the way he thinks it works.


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Will the Fed follow its rhetoric or its rule?

In recent years, the Fed has increasingly adopted the rhetoric of 1960s Keynesianism.  Go for growth.  Don’t worry about a bit more inflation.  Jobs are much more important.  Given that 1960s Keynesianism gave us the Great Inflation, should we be worried about today’s rhetoric?

Oddly, at roughly the same time that they adopted all this expansionary rhetoric, the Fed switched to average inflation targeting, which makes 1960s-style expansionary monetary policy totally impossible to implement.

So what will the Fed do in the 2020s?  Will inflation average 2%, or will it average 4%, 6%, or 8%?  I don’t know, but my hunch is that a portion of this Keynesian rhetoric is just the Fed trying to be PC, trying to keep up with a generally leftward shift in public opinion on stimulus.  Another part might be the Fed’s perceived need to create “credibility” for its 2% inflation target, given that inflation ran below 2% over the previous decade, and given that (until recently) market indicators have been skeptical that we’d reach 2% inflation, on average.

One way or another, we’ll soon find out.

Some people seem concerned by the fact that the markets expect interest rates to rise faster than the Fed itself current predicts.

But this isn’t actually a problem at all, at least if you take the Fed’s 2% average inflation target seriously.  At the moment, markets expect a modest overshoot of inflation over the next 5 years, to make up for the undershoot during 2020.  Then roughly 2% inflation for as far as the eye can see.  But that’s exactly what the Fed says it wants!  If the markets think that this good outcome will require higher interest rates than the Fed currently expects, that’s not a lack of policy credibility, it’s just a difference of opinion on the future path of the natural rate of interest.  A lack of policy credibility would occur if the markets didn’t expect inflation to average 2% during the 2020s.  More likely, rising rates reflect increased confidence that the Fed will achieve its goals.

Don’t confuse the rhetoric with the policy rule.  The rule is the actual Fed policy—the rhetoric is just a bunch of pretty words.

PS.  Of course the other problem with the tweet that Yglesias links to is that Perli is reasoning from a price change, assuming that rising longer-term yields reflect predictions of a tighter monetary policy stance.

PPS.  People often ask me about “yield curve control”.  That would be like a ship captain announcing “steering wheel control”, a commitment to hold the ship’s steering wheel at a fixed position for days on end, regardless of changes in wind and currents.  What do you think?  Does that sound like a good idea?


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The Damage Yet to Come from the “Stimulus”

In my previous Defining Ideas article, “An Unnecessary ‘Stimulus’ ” (March 5), I laid out why the about-to-be-passed $1.9 trillion federal spending bill was unnecessary. I also pointed to a few major spending items in the budget that were clearly unjustified, such as the unneeded bailout of state and local governments. But I didn’t point out that the bill will also cause harm in the long run. The harm will be of two kinds. The first is in the realm of ideas: many people will learn the wrong lessons from the spending. The second is in the realm of policy and the effects of policies: dependence on government and irresponsibility will increase, and economic freedom and long-run economic growth will fall.

This is from David R. Henderson, “The ‘Stimulus’ And The Damage Yet to Come,Defining Ideas, March 18, 2021.

At a distance, the $1.9 trillion measure is awful; up close, it’s ugly.

Another segment:

A major piece of the spending bill is a $3,600 annual tax credit for each child under age six and a $3,000 tax credit for children ages six to seventeen. The credit is, in tax speak, “refundable.” Normally one can get a refund only of something one has paid. But the term “refundable” is now widely used to describe a tax credit that goes to someone who otherwise would have a tax liability that is less than the credit. For some people, these tax credits will amount to a huge increase in their income. And the tax credit is granted regardless of whether the recipients work. Thus, the measure undoes, to some extent, the highly successful welfare reform of the mid-1990s, passed by a Republican Congress and signed into law by Democratic President Bill Clinton. Economist Scott Winship of the American Enterprise Institute points out that a non-working mother with three children could get $10,800 a year, as well as food stamps and Medicaid. That’s not a lot, but it would reduce her incentive to get married and/or to get a job.

Washington Post columnist Greg Sargent, in an op-ed titled “The GOP scam is getting worse—for Republican voters. A new study shows how,” March 8, 2021, finds puzzling the fact that all Republicans in Congress voted against the bill even though the tax credit would help a lot of low-income people in the states they represent. I don’t find it puzzling at all. In fact, given how dismal the performance of Republicans in Congress has been this century, it’s slightly heartening. Why would so many Republicans vote against a bill that helps so many of their constituents? Could it be that they actually believe some of their own rhetoric, the rhetoric about keeping people off welfare and not having them depend so much on the federal government? Maybe.

Read the whole thing.




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Did people eat two dinners in the 1970s?

This Yahoo article made me smile:

And so simply put, the Fed does not believe any pricing pressures in the economy will warrant a change in its interest rate policy for the next three years.

To help explain this thinking, Fed Chair Jay Powell cited dinner norms in his press conference on Wednesday afternoon.

“There very likely will be a step-up in inflation as March and April of last year drop out of the 12-month window, because they were very low inflation numbers,” Powell said. “Those will be a fairly significant pop in inflation, but those will wear off quickly because [of the way] the numbers are calculated.”

“Past that,” Powell added, “as the economy re-opens, people will start spending more. You can only go out to dinner once per night, but a lot of people can go out to dinner. And they’re not doing that now, they’re not going to restaurants, they’re not going to theaters…and travel, and hotels, that part of the economy is really not functioning at full capacity.” (Emphasis ours.)

And while the Twitter commentariat had fun with Powell’s exact phrasing — apparently the kind of person who watches the entirety of a Fed press conference is also a multiple-dinner enthusiast — the point the Fed chair makes is economically sound.

I’m actually not sure what point Powell is making.  Is it a point about aggregate demand (which can rise at trillions of percent per year, as we saw in Zimbabwe), or aggregate supply, which is limited by labor, capital, and technology?

Yahoo continues:

The anticipated increase in growth, inflation, and a recovery in the labor market is all part of a one-time recovery story in the U.S. economy. A demand surge against stressed supply chains or understaffed restaurants and bars that results in higher prices this year will not last.

The dinner is a metaphor.

No one thinks the economy will grow at 6% for years to come. No one thinks the 7 million or 8 million jobs added back to the economy this year will be repeated next year. And Powell does not think any inflation pressures that result from this unlocking of activity will re-set the current inflation regime.

This is the Keynesian fallacy on steroids—the idea that inflation is caused by fast RGDP growth.  In fact, it is precisely because economies can’t grow at 6% forever that inflation is a threat if NGDP grows too fast.  I don’t currently fear high inflation, but not because of the reluctance of people to eat two dinners.  In 2008, Zimbabweans often lacked even one dinner.  Rather, I don’t currently fear high inflation because I expect the Fed to limit growth in aggregate demand to a path consistent with 2% long run PCE inflation.

Inflation is caused by too much money chasing too few goods—NGDP growth minus RGDP growth.


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How much should we borrow?

A commenter directed me to a Noah Smith post that begins as follows:

One of the most important questions in macroeconomics is one that economists have curiously chosen not to study. That question is: “How much can the government safely borrow?”

In my view, this is the wrong question.  The right question is: How much should the government borrow?

The term “safely” is quite vague.  Safe from what?  From default?  From hyperinflation?  From future tax rates that are punishingly high?

In contrast, we have a great deal of research on the optimal level of public borrowing.  In a 1979 JPE paper, Robert Barro argues that the budget deficit should fluctuate in such a way as the minimize the long run deadweight cost of taxation.  Here is the abstract:

A public debt theory is constructed in which the Ricardian invariance theorem is valid as a first-order proposition but where the dependence of excess burden on the timing of taxation implies an optimal time path of debt issue. A central proposition is that deficits are varied in order to maintain expected constancy in tax rates. This behavior implies a positive effect on debt issue of temporary increases in government spending (as in wartime) a countercyclical response of debt to temporary income movements, and a one-to-one effect of expected inflation on nominal debt growth. Debt issue would be invariant with the outstanding debt-income ratio and, except for a minor effect, with the level of government spending. Hypotheses are tested on U.S. data since World War 1. Results are basically in accord with the theory. It also turns out that a small set of explanatory variables can account for the principal movements in interest-bearing federal debt since the 1920s.

Can we safely borrow as much as we are currently borrowing?  I’d say yes.  Should we be borrowing as much as we are currently borrowing?  I’d say no.  After all, I don’t think anyone in their right mind expects a “constancy in tax rates” in the coming decades.  Tax rates are going to increase.

PS.  If you don’t believe that tax rates are set to increase, consider today’s news:

House Republicans voted to allow their members to request dedicated-spending projects, known as earmarks, following that same move by Democrats, in a positive sign for President Joe Biden’s hopes for a bipartisan infrastructure bill.

So remind me, which one is the party that favors small government?


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Suggestions for the Reserve Bank of New Zealand?

The government of New Zealand recently added housing prices to their central bank’s mandate. (I put the mandate at the bottom of this post).  Previously, the RBNZ mandate was pretty similar to that of the Fed, 2% CPI inflation and maximum sustainable employment.  Not surprisingly, I don’t believe adding housing is a good idea. Nonetheless, it is possible to address the government’s request in a way that would actually improve monetary policy.

I’ve never understood why central banks target consumer prices.  Why not all prices?  Thus during 2002-06, the CPI did not reflect the fast rise in house prices, because houses are considered an investment good.  Then, between 2006 and 2012 the CPI did not reflect the huge decline in house prices.  Indeed during some of those years the CPI actually reported housing prices rising faster than the price of other goods, even as the price of new homes was plunging rapidly.  Consumer prices are not a good indicator of the state of the economy, to put it mildly.  They aren’t even a good indicator of the price of domestically made goods.

Instead of targeting the CPI or the PCE, why not target the GDP deflator, which includes the prices of all goods produced in the domestic economy—including new homes?  This sort of index would call for slightly tighter policy during dramatic housing price bubbles, and slightly easier policy when house prices are plunging.  This might slightly moderate the volatility of house prices, which is consistent with the goals of the new government policy.

Of course the RBNZ has a dual mandate, and thus also cares a lot about employment and hence real GDP growth.  Thus they might want to consider a target that somehow incorporates both the rate of growth in the GDP deflator and also the rate of growth in real output.

Questions for readers:  Can you recommend a new target for the RBNZ that would reflect both changes in consumer prices and changes in new home prices, as well as changes in output/employment.  Any ideas?

New Zealand was the first country to adopt inflation targeting; maybe they can once again lead the world to a new era of improved monetary policy

PS.  Here’s a home in beautiful Queenstown NZ:

Operational Objectives
1. For the purpose of this remit, the MPC’s operational objectives shall be to:
a. keep future annual inflation between 1 and 3 percent over the medium term, with a focus on keeping future inflation near the 2 percent midpoint. This target will be defined in terms of the All Groups Consumers Price Index, as published by Statistics New Zealand; and
b. support maximum sustainable employment. The MPC should consider a broad range of labour market indicators to form a view of where employment is relative to its maximum sustainable level, taking into account that the level of maximum sustainable employment is largely determined by non-monetary factors that affect the structure and dynamics of the labour market and is not directly measurable.

2. In pursuing the operational objectives, the MPC shall:
a. have regard to the efficiency and soundness of the financial system; and
b. seek to avoid unnecessary instability in output, interest rates, and the exchange rate; and
c. discount events that have only transitory effects on inflation, setting policy with a medium-term orientation; and
d. assess the effect of its monetary policy decisions on the Government’s policy set out in subclause (3).

3. The Government’s policy is to support more sustainable house prices, including by dampening investor demand for existing housing stock, which would improve affordability for first-home buyers.


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When is fiscal stimulus appropriate?

Greg Mankiw recently presented a graph showing that the US is doing much more fiscal stimulus than other big economies during the Covid crisis, even as a share of GDP:

I was struck by the big difference between the US and major European economies such as Germany, France and Italy.  According to mainstream macroeconomic theory, the Eurozone economies should have been doing far more fiscal stimulus than the US.

The standard model suggests that monetary policy should steer demand during normal times.  According to this view, there might be two situations where fiscal stimulus is appropriate:

1. If a country lacks an independent monetary policy.

2. If a country is stuck at the zero bound, and monetary policy is ineffective.

Both the US and the Eurozone have near-zero short-term rates.  In contrast to the Eurozone, however, longer-term rates are well above zero in the US.  So the case for monetary policy ineffectiveness is stronger in the Eurozone.

The US has an independent monetary authority that can provide stimulus when needed.  Individual Eurozone countries lack such an authority, and thus might benefit more from fiscal stimulus.

This is not to suggest that I believe Eurozone countries should have done more fiscal stimulus.  I’m skeptical of the efficacy of fiscal stimulus, and countries without an independent bank have less margin for error in terms of avoiding a debt crisis.  Rather my point is that for whatever reason, developed countries are not following the playbook suggested by the standard model of fiscal policy.  The US would be expected to do far less fiscal stimulus than the Eurozone countries.

PS.  For those interesting in long run debt sustainability issues, I strong recommend David Beckworth’s podcast with Ricardo Reis.  It’s a bit technical, but highly informative.



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Hume, hockey sticks, and The Great Forgetting

In the 21st century, macroeconomics is entering a new Dark Ages. We seem to be forgetting much of what we learned in the last half of the 20th century.

That judgment may be harsh, but if I’m wrong then you should no longer read anything I write (including the book I have coming out this year), because in that case I wouldn’t actually know anything useful about macroeconomics.

Perhaps the most firmly established proposition in late 20th century macroeconomics is that the Great Inflation of 1966-81 was caused by central banks printing too much money. If that proposition is wrong, then I might just as well give up. Everything else I believe about macro hinges on that being true. If the Great Inflation wasn’t caused by too much money, then what can macroeconomics tell us about the world?

1. Hockey sticks, wherever you look

People often talk about “hockey stick” graphs.  Deirdre McCloskey using that metaphor for the explosion in real incomes in recent centuries.  Demographers use it for the Earth’s population.  Environmentalists use it for carbon emissions.  Tech people for gigabits of information.  And there’s also a hockey stick graph for the US price level, as well as the price level of many other developed countries.  The US price level was fairly flat during the first 150 years of US history, and then exploded upward 20-fold after 1933.

Back in 1752, this was all explained by David Hume.  Out-of-sample forecasting is the gold standard of model success, and by that standard Hume might be the greatest macroeconomist of all time.  Of course he didn’t use modern terminology like “nominal GDP”, but if you translate his core argument into modern lingo, it goes something like this (my words):

A large exogenous increase in the money supply will cause a roughly proportional increase in NGDP.  There would not be a precise correlation, as velocity moves around as well.  Because real growth is caused by non-monetary factors, excessive growth in money will simply lead to inflation, as NGDP growth outpaces RGDP growth.

During the first 150 years of US history, the monetary system was commodity based (bimetallic and then a gold standard.)  That kept money growth close to the rate of growth in RGDP, and hence there was almost no long run inflation (although prices moved up and down erratically around a near-zero inflation trend line.)

Then we tried Hume’s experiment.  After many decades of fixing the price of gold at $20.67/ounce, we let it rise sharply.  Today it’s over $1800/oz.  We used that freedom to print lots of money, and as the monetary base began rising much faster than RGDP, inflation also took off.  The numbers were pretty much what Hume would have predicted.  And most of the “anomalies” were explained during the 1950s, 1960s and 1970s by economists doing technical research into what caused shifts in money demand.  The one thing Hume didn’t predict is the advent of interest on bank reserves in 2008, which caused the relationship between the money supply and inflation to weaken.  But that wasn’t a factor during the Great Inflation.

2.  The Great Forgetting

Doug Irwin directed me to a recent paper by Itamar Drechsler, Alexi Savov, and Philipp Schnabl on the Great Inflation.  Here’s the abstract:

We propose and test a new explanation for the rise and fall of the Great Inflation, a defining event in macroeconomics. We argue that its rise was due to the imposition of binding deposit rate ceilings under the law known as Regulation Q, and that its fall was due to the removal of these ceilings once the law was repealed. Deposits were the dominant form of saving at the time, hence Regulation Q suppressed the return to saving. This drove up aggregate demand, which pushed up inflation and further lowered the real return to saving, setting off an inflation spiral. The repeal of Regulation Q broke the spiral by sending deposit rates sharply higher. We document that the rise and fall of the Great Inflation lines up closely with the imposition and repeal of Regulation Q and the enormous changes in deposit rates and quantities it produced. We further test this explanation in the cross section using detailed data on local deposit markets and inflation. By exploiting four different sources of geographic variation, we show that the degree to which Regulation Q was binding has a large impact on local inflation, consistent with the hypothesis that Regulation Q explains the observed variation in aggregate inflation. We conclude that in the presence of financial frictions the Fed may be unable to control inflation regardless of its policy rule.

I’m going to annoy almost everyone here, so let me apologize in advance.  I realize that these authors are now in the mainstream and that I’m a hopeless dinosaur.  It’s a perfectly fine paper by conventional standards. Nonetheless, I can’t get past the very first sentence of the abstract.  Why do economists think it’s a good idea to propose a new explanation for the Great Inflation?  Imagine a physics paper that began by noting that while Isaac Newton had already proposed a theory for why feathers and steel balls fall at the same rate in a vacuum tube, the authors were about to provide a “new explanation”.  Why?

As I got into the paper, my frustration only increased.  I expected them to push back on what I thought was the standard theory, the idea that the Great Inflation was caused by the Fed aggressively increasing the money supply.  Instead, they suggest that the standard explanation is that the Fed failed to act aggressively to stop the Great Inflation, which presumably happened for some other unnamed reason:

The standard narrative of the Great Inflation places much of the blame on the Federal Reserve. By failing to act aggressively enough, the Fed had allowed inflation to get out of hand and squandered its credibility with the public (Clarida, Gali and Gertler, 1999). The loss of credibility raised inflation expectations, which made inflation accelerate further.

Now you might argue that an aggressive rise in interest rates would have reduced money growth, but that just annoys me in two other ways.  First, it confuses cause and effect.  Prior to 2008, the Fed raised interest rates by reducing money growth, not vice versa.  Second, it ignores the income and Fisher effect, and more broadly the NeoFisherian perspective.  The Great Inflation happened partly because the Fed had forgotten Humean economics, the idea that inflation is caused by printing too much money.  Instead, the Fed wrongly thought that the high interest rates of the late 1960s and the 1970s were a tight money policy.  It was not.

And it’s not just these three economists.  A week ago I quoted Paul Krugman:

The truth is that I’ve always been a bit uneasy about the standard story of inflation in the 1970s, even though it seemed to fit the prediction of clockwise spirals. My uneasiness came from the sense that the economy never seemed to run hot enough to explain such a big rise in inflation. I actually remember the 70s! And while there were years of good job markets, they never felt as good as the 60s, the late 90s, or 2019.

Krugman’s “standard story” is not printing money, it’s not an unaggressive Fed, it’s not even Regulation Q.  Rather Krugman suggests that the standard story of the Great Inflation is the Phillips curve model—high inflation is caused by low unemployment (a hot economy).  But while the Phillips curve may have some limited ability to account for negative inflation/unemployment correlations at business cycle frequencies, it tells us precisely nothing about long run inflation dynamics (or, as Lucas (1975) showed, cross sectional differences in inflation.)  And the Great Inflation was a long run phenomenon.  There were four recessions between 1966 and 1982.  The economy certainly ran “hot enough” in NGDP growth terms to fully explain the Great Inflation.

More broadly, the Great Inflation is clearly just an extreme event embedded within a much greater Great Inflation of 1933-2020, when the CPI rose 20-fold.  I cannot emphasize enough that this was a monetary event.  Unemployment wasn’t substantially different during the gold standard era than during modern times, indeed it was lower during 1923-29 (a period of roughly zero inflation) than during the 1970s, a period of high inflation.  The price level is 20 times higher in 2020 than 1933 (after essentially no change in the previous 150 years) because we printed a lot of money, not because of anything to do with Phillips curves or Regulation Q.

3.  Cognitive illusions, everywhere you look

Since the high inflation on the right side of the price level hockey stick was clearly due to monetary policy, why wouldn’t we have expected a sharp acceleration of money growth in the 1960s to lead to a sharp acceleration of inflation?  Why did we forget the monetary theory of inflation and begin seeking other explanations?

I see three explanations, each of which plays a role:

1. Too much focus on Phillips curve models, which should not be used to explain persistent changes in inflation.

2.  Too much focus on interest rates as an indicator of whether money is easy or tight.  This makes it look like monetary policy doesn’t play much of a role, as high interest rates usually occur during periods of high inflation, and vice versa.

3.  Incorrect predictions of inflation by monetarists and others when the Fed adopted quantitative easing, as pointed out by the authors of the Regulation Q study:

Scholars of the Great Inflation, such as Allan Meltzer (2009; 2013) and John Taylor (2009), worried that low interest rates and Quantitative Easing would lead to a repeat of the 1970s.

Lots of monetarists underestimated the impact of the 2008 decision to begin paying interest on bank reserves, which weakened the link between money growth and inflation.  Hume’s amazing “out-of-sample” success that had lasted for 256 years came to an end in 2008.

I can’t really blame younger economists for finding the monetarist view of inflation to be hopelessly outdated.  Even before 2008, the Fed was already targeting interest rates.  Lots of economists don’t even know that (prior to 2008) the monetary base was 98% currency (the stuff in your wallet) and that the Fed moved interest rates by adjusting the quantity of base money, which as a practical matter meant adjusting the supply of currency.

Almost every aspect of our monetary system was designed to hide what’s actually happening.  Even though the base was 98% currency in 2007, and even though almost all new base money quickly went out into circulation as currency, the new money did initially enter the system as electronic bank reserves.  And even though the Fed controlled inflation by controlling the monetary base, they did so by moving the base to a position that moved interest rates to a position that was expected to lead to 2% inflation.  In that regime, it’s easy to ignore money entirely, even though it was the money printing that was actually causing the inflation.

After 2008, it became even easier to ignore money.  With the payment of interest on reserves the Fed no longer even had to adjust the monetary base in the background in order to move interest rates.  Now they could simply adjust IOR to move rates directly.

Like journalists, economists are seduced by power.  Once the powerful central bankers decided to focus on interest rates, macroeconomists decided that interest rates were the appropriate monetary variable for their models.  The more “money-less” your model, the more sophisticated and up to date it seemed.  What sounds more appealing to young economists, Michael Woodford’s futuristic vision of a cashless economy, or my reactionary obsession with the old days when the currency stock was more important?

Again, if you can show me that this post is wrong, and that the Great Inflation was not caused by printing money, then I’ll just give up.  I’ll quit my job, I’ll stop blogging, and I’ll publicly apologize to all my former Bentley students, as it would mean that almost everything I taught them for 30 years was wrong.  My entire view of macroeconomics is predicated on monetary policy driving nominal aggregates.

In my view, the “money printing caused the Great Inflation” hypothesis is not a theory in the sense that the man on the street uses the term theory (unproven hypothesis), it’s a theory in the sense that scientists use the term when discussing well established models like evolution.


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