Stagflation Analysis: Proper Policy

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Recall Eugene Farmer’s (2010b, p.60) succinct description of the modern textbook explanation of the stagnation decade: “During the 1970s, the U.S. economy experienced high inflation and high unemployment at the same time and the data did not lie anywhere near the [original Keynesian] Phillips curve…. The Phillips curve broke down because firms and workers began to increase wages and prices in an inflationary spiral. Wages went up because workers believed that prices would rise. Prices went up because higher wages were passed on to consumers.” Macroeconomists today are confident that the engine of the 1970s stagflation is the un-anchoring of workers’ anticipations of inflation. They believe that the price-wage-price spiral and high joblessness were caused by a less-than-credible commitment by the monetary-authority to low inflation. New Keynesians believe that, if robust central-bank nominal credibility had existed in the 1970s, it would have prevented the stagflation-decade instability and its attendant welfare loss.

NK thinking, heavily influenced by the rational-expectations revolution, motivated the macro academy’s post-stagflation advice to central bankers: Pursue a single goal of low, stable product-price inflation. In arguing that the corresponding real-side objective little matters, mainstream theorists are asserting that the whatever-it-takes use of tight credit to control inflation will quickly break any price-wage spiral, short-circuiting the damaging macrodynamics of the stagflation decade. Understanding the wrong-headiness of that policy prescription, and what to do instead, is facilitated by another GEM Project contribution to how highly specialized economies actually behave: its rational-behavior model of extreme instability.

GEM Extreme Instability Model

Shani Schechter and I constructed the GEM Project’s extreme-instability model to aid in our responsibilities advising the Federal Reserve Board during Great Recession. It seemed to us that the biggest clue to a useful theory in the circumstances of the nonstationary contraction in total spending organizing itself after the Lehman bankruptcy was collapsing financial-asset prices. Aggregate human and physical capital, the powerful market-oriented organization of the economy, and the robust capacity to generate and assimilate technological innovation supported the pre-crisis level of asset prices – think of them as the fundamental determinants of value. They were little altered by the financial meltdown. Impaired investor/lender confidence had superseded the economic fundamentals. In particular, investors and lenders were no longer confident that the U.S. would avoid a 21st-century version of the 1930s Great Depression.

We also identified a theoretical contribution by Nancy Stokey as critical to the explanation of extreme instability. She demonstrated that, as investors/lenders become less certain about macro prospects, simple inaction becomes increasingly rational. Acquirers of financial assets respond to uncertainty about the credibility of stabilization authorities’ commitment to trend full employment by moving to the sidelines, waiting for the emergence of a credible bottom for asset prices. Spreading investor/lender inaction combined with spending multipliers to become the driving force in collapsing investment outlays and total demand. The GEM Project’s lynchpin, meaningful wage rigidity (MWR), rationally translates contracting demand into forced layoffs and reductions in production. Shrinking total spending, if not contravened, rationally results in depression.

The heart of our theory models the alternative determinants of asset pricing, economic fundamentals versus contracting investor/lender confidence. The crucial instability question becomes the credibility that investors/lenders assign to stabilization authorities’ commitment to trend full employment, denoted in our model by Ƈ, that calibrates relevant investor/lender sentiment. The model’s principal policy implication is that the Fed, faced with collapsing asset prices and nominal spending, should pull out all the stops to restore its real-side credibility.

The extreme-instability model identifies the macro academy’s decades-long near-exclusive focus on inflation prevention as a huge mistake. The blunder is reinforced by GEM modeling that makes clear that the behavior of product-price inflation is a poor real-time indicator of the behavior of layoffs and production. Any stabilization-authority belief that, once provided low, stable inflation, markets can always restore full employment on their own with little need for demand intervention is badly wrong.

Getting Stagflation Policy Right

It surprises New Keynesian theorists that contemporaneous Federal Reserve stagflation policy-making got it right. Then Chairman Arthur Burns – having closely  studied mistakes made in the Great Depression – was centrally concerned with not pushing recession so deep that, using the GEM term, Ƈ would be damaged. His cautious attack on high inflation paid particular attention to investor perceptions of trend real-side credibility of the central bank and the associated threat of depression. He did not need GEM modeling to understand that reducing structural inflation caused by the 1970s price-wage-price spiral was not a short-term, cyclical problem. GEM theory, however, can help the rest of us, correcting the badly off-base New Neoclassical critique of Burns’s performance.

To reiterate, how investors/lenders assess central-bank credibility with respect to its trend full-employment, not low inflation, commitment is what most worried the Fed Chairman in the 1970s. He understood that an all-out credit-tightening war on the price-wage-price spiral, structurally resistant to joblessness, unacceptably threatened a loss of real-side credibility and a consequent nonstationary contraction of total spending – the path to depression. Instead, he pursued a more measured policy that allowed substantial, albeit gradually weakening, inflation pressures to coexist with high unemployment. Time was needed for the structural consequences of the early 1970s labor-adverse shifts in the terms of trade to sufficiently play out.

I know what Burns was trying to do. I was there, supervising the economists charged with figuring out the economics of stagflation and what the Fed should do about it. Burns anticipated what the GEM Project would rigorously model decades later. He understood what the soon-to-become-mainstream neoclassical theorists were advising him to do – quickly achieve the single objective of low price inflation – was dangerously wrong. The Project has demonstrated 1970’s price-wage-price spiral was the product of rational behavior much more deeply rooted than Robert Lucas and his colleagues realized. Attempting to stop the nominal spiral in its tracks would have required a huge squeeze on total spending and employment, output, and income, putting the credibility of the Fed’s real-side objective at great risk. Generalized-exchange analysis indicates that Burns’ much maligned caution prevented a 1970s depression.

Why Do Mainstream Theorists Persist in Getting Stagflation Wrong?

NK theorists’ analysis of the stagflation decade is both incorrect and remains today one of the mainstream academy’s most serious errors.  Generalized-exchange modeling not only rescues Arthur Burns’s reputation, bestowing credit that it is long overdue, it also obliterates the persisting argument for the adequacy of a single (low-inflation) objective for the central bank.

Why do NK theorists continue to believe the flimsy un-anchored expectations explanation for the stagflation decade? The answer is familiar. That story is consistent with the market-centric general-equilibrium framework that the macro academy insists is finished theory. It does not matter that its implications for stagflation analysis is inconsistent with both the evidence and rational behavior; what matters is its consistency with finished theory. Adding a second workplace venue of rational exchange, despite its extraordinary incremental power to explain what actually goes on in highly specialized economies, is not worth the cost of upsetting the established market-centric order. The academy’s revealed preference is to be wrong about a lot of important stuff.

Blog Type: Wonkish Saint Joseph, Michigan


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