Economics / History

Aggregate Demand Dominance: False Foundations

With the Fed continuing to taper (even as inflation keeps coming in below target), I’m reminded how a few days ago Dean Baker once again trotted out a period in history that still befuddles economists of all stripes:

This is a great history that should be tattooed on the forehead of everyone involved in the current debate on how low the unemployment rate can go without kicking off a wage price spiral. Back in the mid-1990s all right thinking economists thought that the NAIRU was in the neighborhood of 6.0 percent. This meant that if the unemployment rate was below 6.0 percent the inflation rate would begin to increase. And, it would keep increasing as long as the unemployment rate stayed below 6.0 percent.

While there was some difference on the precise number (the usual range went from 5.6 percent to 6.4 percent), there was almost no dispute on the basic point. As O’Brien notes, even Janet Yellen adhered to this view, expressing concerns in 1996 that if the Fed didn’t raise interest rates inflation would be a big problem. (Paul Krugman also expressed a similar view at the time.)

The Maestro disagreed, and the results are difficult to explain to this day…

Thanks to the eccentricities of Alan Greenspan, the Fed did not raise interest rates. Instead it allowed the unemployment to continue to fall. It fell below 5.0 percent in 1997, it crossed 4.5 in 1998, and reached 4.0 percent as a year-round average. And inflation remained tame. The result was that millions of people had jobs who would not have otherwise. Tens of millions of workers at the middle and bottom of the wage distribution saw substantial real wage gains for the first time in a quarter century.

And, for the folks fixated on budget deficits, we saw a large surplus for the first time in decades. As much as the Clintonites like to boast of their great surpluses, the reality is that the budget would have remained in deficit if Clinton’s Fed appointees (Janet Yellen and Lawrence Meyer) had gotten their way. It is only because the Fed allowed the unemployment rate to fall far lower than these folks thought wise that the budget shifted from deficit to surplus. (In 1996 the Congressional Budget Office projected a deficit of $240 billion [2.5 percent of GDP] for 2000. In fact, we ran a surplus of roughly the same amount. According to CBO, the legislative changes over this four year period went a small amount in the wrong direction.)

Anyhow, all of this should be a good reminder that the whole of the economics profession can be completely wrong on the most important issues affecting the economy. But that isn’t why I brought you here today.

My main reason for doing this post is that O’Brien reminded me of one of my pet peeves about the NAIRU history. When we didn’t see the predicted acceleration of inflation, the surprised economists went running around looking for explanations for why their theory had failed. This issue is discussed at some length in a book by Janet Yellen and Alan Blinder, The Fabulous Decade.

One of the explanations they give for inflation not rising is that there were changes in the measured rate of inflation that lowered the CPI relative to the actual rate of inflation. In other words, because changes in the methodology used to construct the CPI, if the true rate of inflation was 2.5 percent throughout the decade the CPI might show a 3.0 percent rate of inflation in 1994, but a 2.5 percent rate of inflation in 2000. If workers don’t recognize that the way to measure the CPI has changed, then they may not adjust their wage expectations accordingly.

This means that if they were expecting wage increases that were 1.0 percentage point above the CPI measure of inflation in 1994, then they were expecting wage increases that were 1.5 percentage points above the true rate of inflation. However if they expected wage increases that were 1.0 percentage point above the measured rate of inflation in 2000, then they were expecting wage increases that were just 1.0 percentage points above the true rate of inflation. Yellen and Blinder argue that this could be a reason that inflation did not take off as they had predicted. (Their measure of inflation uses the same methodology over the whole period.)

I think there can be some plausibility to the Blinder-Yellen story, albeit not very much. The reality is that the measured rate of inflation did not change all that much during this period. The gap between the inflation rate shown by the CPI and the currently used measure peaked at around 0.5 percentage points for six years, from 1988 to 1993. It had previously been less than 0.3 percentage points. The Bureau of Labor Statistics then introduced a series of changes that lowered the gap to less than 0.2 percentage points by 1997 and to 0.0 by 2000. Insofar as the CPI provides a reference point for wage increases, these changes could have some moderating effect, but the impact would be very limited compared to the predicted inflation.

…or there could be another explanation entirely, stemming directly from supply and demand.

How Short is Long?

It seems economists of most stripes agree this is an accurate depiction of aggregate supply:

Explanations for the vertical turn vary, but usually relate an inability to increase production…

http://www2.yk.psu.edu/~dxl31/econ14/aggregate_supply.png

…and a belief that supply constrictions are a long-run trend:

File:Aggregate supply.svg

Aggregate supply curve showing the three ranges: Keynesian, Intermediate, and Classical. In the Classical range, the economy is producing at full employment.

The short run AS curve is drawn given some nominal variables such as the nominal wage rate, which is assumed fixed in the short run. Thus, a higher price level P implies a lower real wage rate and thus an incentive to produce more output. In the neoclassical long run, on the other hand, the nominal wage rate varies with economic conditions. (High unemployment leads to falling nominal wages which restore full employment.) Hence in the long run the aggregate supply curve is vertical.

In other words, in the long-term real GDP stops expanding and inflation takes off when the economy passes the NAIRU. I may have already tipped my hat, but is this really why the aggregate supply curve turns vertical?

Aggregate supply is quite obviously finite: factories and farms can produce only so much per day.  The aggregate supply curve, which mathematically must run infinitely in the positive direction, turns vertical to reflect the reality that prices rise much faster than marginal output when total output begins to abut the maximum capacity of the current economy’s infrastructure.  However, this is also clearly only an issue in the short-term, because increasing factory and farm capacity (not to mention constructing more factories and farms) is very much an option over a longer time horizon.  In sum, short-term supply becoming a set value reflects the fact that economies have capacity constraints.

For almost a year, I’ve argued the actual physical limitations of supply are a far better explanation for this mathematical depiction, which is decidedly short-term. Prices pick up, producers expand capacity. But what happens if the Fed slams on the breaks and raises interest rates when inflation ticks up a little (otherwise known as the price signal)?

Firms contract, shed workers, unemployment jumps, and a recession begins. In the late 1990s, Greenspan hit the accelerator instead, and the tech explosion continued unabated until the bubble burst in 2000-01. SRAS kept expanding—shifting rightward, which both accommodated rising aggregate demand and abated price increases. Why isn’t this Econ 101 knowledge?

Microfoundations Maleficence

Because stagflation sold two generations of economists a bill of goods. Inflation is a supply-side problem, ranging from short-run aggregate supply not expanding rapidly enough to SRAS actually contracting or being destroyed (in the case of hyperinflation). In the 1970s, however, inflation was branded a demand-side issue with the emergence of rational expectations and the consequent dismissal of Keynesian economic concepts and all other non-Austrian/non-Chicago School thought processes until the present day (the very concept of demand is so toxic to freshwater schools that conservative economists such as John Mueller substitute the term “utility”).

Dean Baker is right to ask about the breakdown that began in the late 1960s:

We all know about how we had a wage-price spiral back in the bad old days of the late 1960s and 1970s. That was when our links between the unemployment rate and inflation were supposed to be really tight. Well, it turns out that this was also a period in which we had large gaps between the inflation rate as shown by the CPI and what we would now view as the actual rate of inflation using current methods.

The gaps in those years were several times larger than the gaps that concerned Yellen and Blinder. In 1969 and 1970 the gap between the inflation rates shown by the official CPI and the CPI-UX1 that we now view as more accurate were 1.0 percentage point and 0.9 percentage points, respectively. The gap reached 1.1 percentage points in 1974 and averaged almost 2.0 percentage points in 1979 and 1980, as double digit inflation was ravaging the land.

I could just say 7.6 megatons (i.e.: the largest bombing campaign in history) and leave well enough alone, but warfare is an incomplete explanation. Bretton Woods’ P=$35 price controls broke down beginning on 15 March 1968 before completely shattering on 19 March 1973. Perhaps this requires a bit more elaboration, which I’m due to write anyway as my history of the fantastically stupid gold and silver standards left off on the Ides of March 2,012 years after Caesar’s assassination.

***Update: I elaborate in these two posts.***

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2 thoughts on “Aggregate Demand Dominance: False Foundations

  1. Asked Dean Baker what he thought of your post–he said “I thnk he agrees that the NAIRU estimates were grossly off” and “The reduction in defense spending following Vietnam was an order of magnitude smaller than WWII.”

  2. Pingback: Welcome to the Dark Side | In The Corner, Mumbling and Drooling

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