Cowen and Tabarrok on Inflation

2024 09 26

Tyler Cowen and Alax Tabarrok have a new podcast podcast

and the initial episode is stimulating and informative and frustrating in the extreme.  Neither of these guys has any institutional allegiance to bad ideas (Cochrane) or need to pander to a public (Krugman).  So why are they still so far from the bull’s eye? 

To some extent this is a perfect example of why you should not try to make complex arguments on a podcast.  Podcasts are fine for transmitting information.  And this one does transmit information, but it leaves the person who wants to join the discussion, to engage with the arguments, at a disadvantage.  Even with a transcript (to their credit Cowen and Tabarrok do provide one) all one can do is comment on the transcript

And that’s what I’m going to do.

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TABARROK: We do know maybe a little bit about inflation. Let’s see. Inflation absolutely did take off in the 1970s.

…

I think one of the surprising things is that the public actually hates inflation more than economists do, or more than economists expected.

This discrepancy would have been an interesting topic to explore, but they did not.  My explanation is that economists count the net costs of inflation only as whether a given rate of inflation is _inefficient. _ Does x% inflation make it more or less difficult for the economy to discover the evolving income-maximizing structure of relative prices?  And in particular is the rate so low, given some prices that are sticky downward, as to produce the maximum inefficiency of markets failing to clear, of resources, especially labor, becoming unemployed. 

The public, OTOH, sees _any_ noticeable inflation as a reduction in their real income and is presumably unaware of the benefits of a certain amount of inflation. 

What led to the 1970s inflation?

TABARROK: Now we’re getting ahead of ourselves. Let’s go back and look at the beginnings of inflation. I actually would blame inflation on the Keynesians. I would blame it on the Kennedy Johnson tax cuts of 1962 and 1964. Now, not because these tax cuts themselves were inflationary, but rather because these tax cuts were really the first truly Keynesian fiscal policy in US history.

He does not elaborate, but Tabarrok implicitly is saying that fiscal policy “in itself” can be inflationary.  If this is taken to mean that fiscal policy without central bank accommodation can be inflationary, this is mistaken.

TABARROK: Now, Keynes had argued, of course, in 1936 in The General Theory that we should use deficit financing to combat a recession, the Great Depression.

He did, but I would argue he did so in the context of monetary policy under a gold standard being difficult if not impossible as Freidman-Swartz showed in “A Monetary History of the United States.”  Let’s not castigate Keynes for not advocating FIAT.

TABARROK: Really in the United States at the time, the idea of a balanced budget, that still had held sway among both Republicans and Democrats. A government might run a deficit in a recession. That was accidental. Your taxes go down, your spending stays the same, you run a deficit, but then they would run surpluses to pay down the debt.

You had a war so your spending goes up, but then you pay down, you have surpluses. Surpluses were the norm. Frugality and prudence were the words of the day. Then along comes Kennedy. Kennedy, the new Camelot, the new guy, the young guy, he brings the new economics. He brings the new economics to the White House. He brings people like Walter Heller, James Tobin, Robert Solow, future Nobel Prize winners.

Tobin, future Nobel Prize winner, he argues that one of the big goals of the new economics was to get rid of the taboo on deficit spending. Walter Heller, he was in charge of all this, he says, “John F. Kennedy, and Lyndon Johnson stand out as the first modern economists of the American presidency. Their administrations were largely free of the old mythology, and wrongheaded economics, which had viewed government deficits as synonymous with inflation, government spending increases as a likely source of depressions, and government debts as an immoral burden on our grandchildren.”

And getting rid of the “taboo” was good.  “Accidental” deficits that Tabarrok describes are not optimal.  The optimal deficit equals Σ (expenditures with NPV>0).And note that the NPV falls, the optimal deficit rises, when unemployment reduces the marginal cost of public expenditures.  This rule is automatically “countercyclical.”

TABARROK: All of that is gone. What happens? Well, there’s two problems. In theory, Keynesian’s policy is supposed to be countercyclical, increase spending and cut taxes during a recession, and cut spending and raise taxes during a boom. Of course, politicians, they only like half of this rule.

What politician wants to raise taxes and cut spending? My view of what generated the inflation of the 1970s is that, the politicians took from the Keynesian economists this idea that spending increases and tax cuts could stimulate an economy, and they just ran with it and they didn’t stop.

Incorrect arm chair political science!  We have not gotten to our structural, full-employment deficit through ratchetting up of countercyclical, “Keynesian” deficits but a) decisions to reduce taxes and create deficits so as to transfer income to high-income taxpayers and b) demographic changes that have raised the cost of Social Security and Medicare.

COWEN: Wait, I like these tax cuts, let me try to defend them.

TABARROK: All right.

COWEN: First, they had some positive supply side effects, overexaggerated by the supply siders themselves. There’s always something to be said for better incentives. That’s the first lesson of economics.

There is little evidence that reducing personal income tax rates, the principal deficit-creating drivers in the Regan, GWB and Ryan/Trump tax cuts, increase supply of effort and innovation, so there is not much for Cowen to like.  The Regan and Ryan/Trump cuts DID reduce business taxation with increases efficiency, but did not offset the revenue lost with higher personal taxes, so that deficits reduced investment even as the reduction in taxation of business income increased the efficiency of business of investment.

COWEN: The key point I think, is about geopolitics and also the collapse of Bretton Woods.

If you’re moving from a world where the dollar is partly backed by gold, in a complicated way, to a world of fiat currency, you’re going to have higher inflation rates. If you think of John Cochrane Fiscal Theory of the Price Level, you don’t have to buy the whole theory to see a dollar that is less backed by commodities is going to be worth less in the equilibrium one way or the other. You’re going to get there.

This elides monetary policy.  It is not inevitable that monetary policy will be more inflationary under a fiat regime than the sorta-kinda-“complicated” gold backing of Bretton Woods.  The difference in performance of central banks in recent decades compared to the ‘70’s demonstrates this.

COWEN: A problem under Bretton Woods for such a long time was, there’s just a dollar shortage in the world. US dollar was, is, and should be the global reserve currency. You need to come up with a way of supplying more liquidity to the world and T-bills are that. They’re a form of dollars for the world. The United States should run a deficit to boost the supply of liquidity. I think that’s an old Michael Woodford argument, if memory serves, and it’s just inevitable. Otherwise, the global economy is just choked off by not having enough dollar-based assets.

And this elides exchange rate policy by the countries using the US dollar as reserves.  Under the Bretton Woods gold exchange standard, countries don’t need large international reserves.  The international economy did not “need” lots of “scarce” US T-bills, a point that Tabarrok makes subsequently.

TABARROK: I agree with what you say about the collapse of Bretton Woods, but I see that as a further Keynesian idea to get rid of the old bugaboos and the old taboos. Gold is—what was Keynesian’s term?

COWEN: “Barbarous relic.” Look, we had to get rid of the gold standard. 

TABARROK: No, no, we did not.

COWEN: It’s not an accident that it collapsed.

TABARROK: No, no, no. It definitely wasn’t an accident. No, it was done on purpose. It was done on purpose so that the politicians could further stimulate the economy. You think about all of the things which were holding them back. One of them was this idea of prudence and frugality. Then the Keynesians come along and it’s like Chesterton’s Fence. They say, “Oh, what’s this fence doing here? We don’t need that.” 

They didn’t understand what the fence was doing in the first place. The purpose of the fence was to hold back the political inclinations to spend more and to try and stimulate the economy to win reelection. You got rid of the prudence and frugality, and then you got rid of the gold standard, which was also holding them back. That was like the second fence, which was eliminated.

More of the same incorrect arm chair political science plus poor international economics.  The Bretton Woods system need not and in fact DID NOT restrain politicians who wish to run deficits because exchange rates can be adjusted.  Chesterton speed bump, perhaps.        

COWEN: Look, I don’t like the Keynesians, but Friedman for one, was very happy to see the gold standard go. Had we stayed on the gold standard, given subsequent volatility in the price of gold, there would’ve been phenomenal macroeconomic volatility. In fact, we would’ve just cut the tie anyway. It was never going to last.

There was this fundamental contradiction that Europe in particular relied on the US to keep on increasing the supply of dollars, because there was a dollar shortage over there, and it was their reserve currency. The other economies weren’t strong enough, and there was no euro. Yet at the same time, the dollar was to be convertible into gold.

In the short run, we solved that “problem” by just twisting the arms of them, especially the French, and saying, “We’re not actually going to let you convert your dollars into gold, and we’re going to keep on sending you dollars.” At some point, the French just said like, “No way.” They started converting and the thing collapsed. There was never a way to keep it going that I can see. Unless you just pose a lot of deflation on the global economy, which would’ve been worse than what we did.

Cowen here is conflating the gold standard, which _does_ constrain adjustment in the relative values of national currencies, with Bretton Woods that did not

TABARROK: No, the increase in the volatility of the price of gold, that was endogenous, that was caused by going off the gold standard.

Correct but irrelevant.

COWEN: At first but later on it was China, other demands, right?

TABARROK: Maybe. Moreover, the reason why Bretton Woods came under attack was that all these other countries, including France, which were holding dollars, they realized that the US government is inflating. The US government is destroying the value of the dollars.

Other countries realized that the US was reaping gains from seigniorage on the dollar reserves they were holding.

COWEN: They also demanded that we inflate. They needed more dollars.

TABARROK: I don’t see it that way. I don’t see it that way.

Tabarrok right, Cowen wrong.

COWEN: Let’s say the US had been on some kind of a 100% reserve fractional banking, just to take an extreme case. Not saying that was under consideration at the time really. You agree that would have been too deflationary for the global economy, right?

TABARROK: I don’t see the inflation as being a response to potential deflation. We never saw the deflation to which inflation might have been a response. We just saw the inflation.

No, because, again, under Bretton Woods countries did not need US inflation to avoid deflation.  They retained monetary independence.

COWEN: Europe is booming. Japan is on the verge of booming.

TABARROK: That’s a huge counterfactual. I don’t see how the naked self-interest of the politicians somehow led, via a political invisible hand, to solving the safe asset problem, which you’re also talking about.

COWEN: I think Keynes set up a booby-trapped system. He knew it was booby-trapped. In the long run, we’re all dead, another Keynesian remark. He just figured when we got to it, people would sort it all out. I think he would have been quite pleased to see that his Tract on Monetary Reform proposals, fiat currencies with floating rates, where he and Friedman more or less agree in that work at least—that that’s where we would end up, because what else was there?

Bretton woods had no _advantages_ over the system of fiat currencies with floating rates that Keynes _and Friedman_ wanted, but it had few disadvantages either. 

COWEN: I think Keynes saw this all. Yes, along the way we inflated far more than we should have. That was stupid. Nixon intimidating Arthur Burns was stupid, but something like that probably had to happen given that Bretton Woods was always booby-trapped and never could have just continued as it was. What’s this weird thing? A gold standard, but only foreigners can convert. It makes no sense.

TABARROK: Sure.

COWEN: It was always geopolitical. We’re not actually going to let you convert from the beginning. Only in very limited doses.

No.  Bretton Woods _could_ have continued with counties exercising the exchange rate flexibility they retained.   “No harm, no foul”

TABARROK: It was built upon the premise that the United States wouldn’t inflate, and the United States started to inflate so it fell apart.

It fell apart because the French found it inélégante.

TABARROK: Look, we can also see what was going on by looking at Arthur Burns—

COWEN: Sure.

TABARROK: —and Nixon.

COWEN: That was terrible.

TABARROK: You say it was terrible. Was it terrible or was it the invisible hand working itself out to solve this problem of deflation and the need for liquid assets? I think it was just terrible. Moreover, the political control of the Fed was a logical necessity for Keynesian policy, as well as being highly desirable to politicians.

It was necessary for politicians to feel THEY were stimulating the economy, but it was not necessary for a central bank to conduct macroeconomic management (or, in the case of Bernanke in 2008- _mismanagement._)  Moreover, the optimal deficit rule gives results that look like “Keynesian” fiscal policy, anyway.  Politicians can claim credit for providing “relief” during recessions; they do not need to claim (indeed it can be dangerous to claim) to be stimulating the economy.     

TABARROK: Johnson, even before Nixon, Johnson was furious at the Fed chair, William McChesney. He summoned him to his ranch. Alan Blinder has a great line on this. He says, “Do I imagine that Texas beef was served? The real purpose was to barbecue Martin.” Then you have Nixon. Nixon, to his credit, totally understood monetary policy, right?

COWEN: Yes.

TABARROK: Better than perhaps any president certainly since, maybe even before. He was the king of the political business cycle. He appoints his friend, Arthur Burns. He appoints him first as a special adviser, and then to the chair of the Fed. Burns is swearing in—this is incredible—Nixon jokes that, “I respect his independence. However, I hope that independently he will conclude that my views are the ones that should be followed.” He puts all this pressure on Burns. This is all in Burns’ diaries that Nixon is calling him up and demanding to loosen monetary policy. In fact, it’s in the news. This is not a secret.

COWEN: I think you’re yanking this out of context. The US has never had much of an independent Fed, especially back then. When Roosevelt cuts the tie to gold, that’s not an independent Fed. World War II, of course, the Fed wasn’t close to independent. 1951, Fed Treasury Accord. The Fed is literally, on paper, not at all independent.

You have this brief window of time with some partial independence, which was fine, to be clear. And Nixon comes along and does something bad, but it was not really breaking some earlier well-established social contract. It was quite in tune with broader paths of American history, which is we’ve not mostly had an independent central bank. It’s a miracle we got a bit of one later, which probably we’re back to now.

TABARROK: Yes. That just goes to show that a central bank is one of these institutions which is only maintained as a barbarous relic. It is only maintained because of ethical views that to break this idea would be bad. That equilibrium is something which has to be fought for. That equilibrium is something which needs to be protected, maybe by some mythology, but it’s an important mythology to protect because what we’ve seen with independent central banks is that inflation is lower and unemployment is no higher.

To have an independent central bank is almost a free lunch because you get lower inflation, but the dependent central bank does not actually reduce business cycles in the way that Keynesian theory supposes that it should.

We see that neither a gold standard or Bretton Woods (“barbarous relics” or not) are necessary or sufficient to have an independent central bank. 

COWEN: You would agree, though, it’s a good thing that we run budget deficits, though admittedly, not at current levels, which I think are close to 6 percent of GDP in 2024, because you create another safe asset, right?

TABARROK: No.

COWEN: David Beckworth’s point. There’s this shortage of safe assets. The world needs more of them. There’s not anything else you can use. Not at the moment.

TABARROK: We can create safe assets.

COWEN: Well, they’re called T-bills. What else are they?

TABARROK: Well, we can also create lots of safe assets using tranching of corporate bonds and using real estate. There’s lots of ways to create safe assets.

COWEN: They’re much less safe. They’re much, much less focal.

TABARROK: They’re not much less safe.

COWEN: There’s not one of them that everyone coordinates around.

TABARROK: The US has been unusual in its ability to create what in the world context is relatively safe assets, but I don’t think that’s necessary for the world economy.

They are safe enough IFF the Fed is on its game.  In 2008 it was not. Beckworth, BTW, did _not_ argue that the US needed higher fiscal deficits to provide the safe assets markets were demanding.  The Fed was not constrained by too small federal deficits if providing the liquidity needed to head off the financial crisis and to keep inflation on target.  The failure was the Fed’s alone.

COWEN: Like FANG plus NVIDIA, those are our safe assets? They’re commercial paper? They’re not mainly in debt those companies. They issue commercial paper. In terms of how much there is there, I’m not even sure what the number would be.

TABARROK: I have no doubt that our incredibly innovative and evolutionary financial system will create safe assets in abundance if that is what the market demands. We have an incredibly complex and sophisticated financial system, the most sophisticated financial system the world has ever seen. We have options. We have tranches. We have lots of different ways of combining assets in order to create safe assets. That is what our financial system does. That is what we want a sophisticated financial system to do. Leaves the creation of safe assets to New York, Manhattan, Wall Street. We don’t necessarily need them created by the US government.

COWEN: Maybe those safe liquid assets are a public good. As you know, following the financial crisis, we took this enormous push forward to create a lot more safe assets that bear interest return by paying interest on bank reserves held at the Fed. In a way, that was like issuing a lot, lot, lot more T-bills, in a mini way. We don’t call them T-bills, but it’s also another example of how central banking has never so much been independent. What we saw in the ’70s—again, there’s plenty I don’t want to make excuses for—but I view it as much more inevitable than a lot of commentators want to think.

Safe public asserts ARE a public good but they do not need to be created by fiscal policy.  A central bank can create any amount of safe assets

TABARROK: Let me ask then, Tyler, what were the causes of the inflation of the 1970s?

COWEN: I think there’s several causes. First, in Scott Sumner’s terminology, the Fed let nominal GDP grow at too high a rate. You could rephrase that in terms of the money supply.

However you phrase it, the Fed “done it.”

TABARROK: What do you mean the Fed "let"? I mean the Fed made nominal GDP grow too quickly.

COWEN: It’s jointly determined by the private sector and the Fed given political constraints and acting in cahoots, so to speak. NGDP is growing at way too high rates or you could rephrase that in terms of the monetary aggregates. M2 also being jointly determined with the private sector, to be clear, but mostly it’s the Fed, but then you have, on the fiscal side, the dollar is simply not being backed the way it used to be. Of course, it’s going to end up being worth less.

Exactly how you get there, you could say, well, fiscal theory of the price level is weak on that, I would agree, but it’s what you should expect. I also think it was a good thing we got off gold when we did. I’m not upset about that, even though I clearly would admit the concomitant inflation was bad for the economy.

TABARROK: I think we agree that going off the gold standard was one of the causes of the inflation.

Tabarrok is talking about the Aristotelian “material” cause, where Cowen is talking about the “efficient” cause.  The latter is more useful.

COWEN: And that was good.

TABARROK: No. You think it was fortuitous. I think it was a dastardly deed done by Nixon. 

COWEN: The motives may have been bad from Nixon, that’s fine, but in terms of the actual effects. Again, say, we’d stayed on gold if that’s even imaginable. South Africa is a major supplier of gold. That turned out to be more stable than many people expected. Everyone at the time was quite worried, like, “Oh, so much gold from South Africa, what’s going to happen there?” Then just the rise of China, commodity prices go haywire. What, starting about 25 years ago, we couldn’t have gotten through that.

TABARROK: There are many other things which could have happened, but we could have done a Robert Hall ANCAP standard or something like that. Who knows? The world certainly would not have remained in exactly the state that it was. We didn’t have to go down the path of inflation.

Or we could have just had better monetary policy, in which central banks chose real income maximizing inflation rates.  😊

TABARROK: Now, we haven’t actually talked yet about supply shocks. We’re going to do a whole episode on price controls and also on the two energy shocks. What is your view on how the energy shocks in ’73 and ’79 added to inflation?

COWEN: Oh, of course. That you just see in the numbers, it’s the same as our more recent inflation. Some of that was from COVID-related shocks, some from shocks related to the war in Ukraine. That’s not controversial, I think. It’s just how it happened. It happened twice.

TABARROK: I agree with that. I would say, and I think it’s important to point out, that inflation began before the supply shocks. The energy crisis contributed to it in the short run. Now, in the long run, you have an increase in the price of oil that should only affect relative prices. There’s no particular reason that it’s going to affect inflation for very long. In the short run, yes, some prices are sticky and you get an increase in inflation with an increase in the price of oil. We had bad luck.

COWEN: Absolutely. Very bad timing.

TABARROK: To have these things.

COWEN: Bretton Woods, floating rates, fiat currency, oil shocks in the same decade was really very bad. 

None of the “supply shock” factors cited cause excessive (greater than the real income -maximizing rate) inflation without central bank policy.  None were unknow to Fed policy makers when it was choosing values for its monetary policy instruments.

Some good ol' economist bashing

COWEN: I want to do some economist bashing and blame a lot of famous economists, which you were doing a bit earlier. You go back and you read these people at the time, and I did this quite closely for Paul Samuelson because of my GOAT project, and they believed the Keynesians in wage push inflation, which is not so much the case today, though it’s in a weird way coming back a bit, and that was just wrong.

When you look at how decisions were made, monetary policy decisions were made on the basis of people giving advice, “Inflation is about wage push. If you have a good incomes policy, you can get away with this monetary policy in the works.” That was just flat-out wrong. The greatness of Milton Friedman was to convince people that was wrong. There’s this paper by Edward Nelson, “How Did It Happen?: The Great Inflation of the 1970s and Lessons for Today,” where he goes through in great detail that the top economists back then—and these are mostly the Keynesians—they were just wrong.

Agreed.  The Keynesian economists were wrong, but so too were the Anti-Keynesians.  The fundamental problem of both was not realizing that “wages” is not a single price and wages are not the only relative prices that matter. 

TABARROK: I’d agree with that. The whole idea of the cost-push inflation seems crazy to me. It is true, of course, that the price of oil influences the price of steel, but steel is used to produce oil as well. Which one is cost when which one is pushed? You have a simultaneous equation system here. You got your input-output matrices, and everything’s an input and everything’s an output. Why pick one thing out of that, and say, “This is the cost pusher,” rather than just following along in a simultaneous equation system?

Correct.  But this does not imply that we should have zero inflation.  On the contrary, it means there are multiple relative prices that a supply or demand shock will push out of equilibrium and whose adjustment a central bank will need to facilitate with temporarily over-target inflation. 

COWEN: Here’s my question. I want to try to steelman these people because we know they were very high IQ, right?

TABARROK: Yes.

COWEN: Samuelson, Tobin, all of them. They did build models of their claims. Not as good as current models, you might say, but models nonetheless. What exactly did they get wrong? Did they have some weird view that the demand for money is so stretchable or elastic that it just runs after wage demands from labor unions? Was that the mistake? 

If you look at demand for money in the early to mid-’60s, it’s not that stable. It’s not actually fitting the Friedmanite model. Were they in a sense right, but ultimately wrong, or were they just flat out wrong? Or, what is our model of the demand for money at that time, say, the ’60s leading up to the ’70s inflation? It’s far from clear to me what the best model of that is.

TABARROK: They were dealing with very simplified models of macro aggregates, instead of thinking about the price system and the operations of the price system. I agree, it is peculiar that they should go so wrong on these questions. After all, they also understood general equilibrium. Now, you could argue that labor is a big commodity, labor is a big factor in the economy, obviously. Maybe there are fixed-price, fixed-wage contracts.

COWEN: A lot more unions, back then.

TABARROK: A lot more unions, back then. However, that might hold if you’re in the Netherlands or Denmark and you’re making one labor plan for the entire economy. In the US context, even when there were fixed-wage contracts over a period of years, they’re not all established in the same month.

COWEN: Or forced by law to be the same, in some ways has been the case in France.

TABARROK: Exactly. They’re not forced to be the same. What happens then is, there’s some fixed-wage contracts, but some of them are made in January and others are made in July, and yet others are made in December. Actually, overall, it’s not even obvious that labor is fixed in price longer than some of the other commodities, which are fluctuating in price more on a daily basis. Still, the price of labor is fluctuating a lot over a year. I don’t see any reason to pick labor out and say, “This is the cost pusher.”

A central bank can use temporary over-target inflation to facilitate the discovery of a new income maximizing equilibrium of relative prices when some nominal prices (not just wages) are sticky downward.  Inflationary expectations make relative prices sticky.

COWEN: Reading those people, sometimes I get the impression the model was this. What really matters is inflationary expectations. What drives those are satisfied wage demands, which is not what a modern would say. People then, they in fact didn’t know much about the money supply. It just wasn’t tracked the way it started to be tracked with Milton Friedman.

If inflationary expectations drive the demand for money, and those expectations come from the agreed-upon labor bargains, I’m not at all going to endorse that. It’s just ugly and jammed together and only picking out one possible causal chain. Maybe that’s what they actually had in mind.

TABARROK: Maybe.

Wages (some specific wages) are not the only relative price that can be made stickier by expectations.

1970s inflation versus 2020s inflation 

TABARROK:  Let’s take a look at a more recent experience, which I think is also puzzling but inflation expectations have a lot to do with it. We did manage to reduce inflation a lot from 2021, 2022, when inflation was, I think, 7 percent at its highest, and we’re now down—

COWEN: No, it is 8.9 percent I think was the highest number.

TABARROK: —8.9 percent. We’re now down, to 3 percent. We managed to do that without an increase in unemployment.

COWEN: That’s right.

Without a BIG increase in unemployment, but unemployment did increase.

TABARROK: What's your take on how this happened in the 2020s? Also, what implications do you draw from that for our inflation experience of the 1970s, why was it so different? We started out in 1981, 1982, the Volcker recession was a brutal recession. Unemployment increased a lot. We seemed to need that recession in order to decrease inflation. Increases in unemployment, decrease in inflation. Yet much later, 2022, we were able to decrease inflation without a big increase in unemployment.

COWEN: It’s interesting, in the last two years, as you know, all these people start coming out of the woodwork and saying, “Maybe the recession won’t be so bad because wage demands have remained moderate.” It’s this reemergence of the 1960s idea that I’d been scorning basically for my whole life. Then it’s like one relevant factor, again, maybe slightly rehabilitates the Keynesian view from the ’60s, but I think there are a few factors as to your question, why did we have a disinflation that wasn’t so bad?

One is just the initial setup in macro terms, maybe was more like World War II and post-World War II than like the 1970s. Because of the pandemic, you had an implied rationing and then a lot of pent-up savings and also a lot of pent-up borrowing. The tightening didn’t alter plans that much, and a lot of nominal demand flows could be pretty stable even with the tightening. Maybe there’s some question begging in there, but it’s a factor.

The other factor is just we’ve had roughly 2 percent inflation for a long time and people were thinking it’s going to reemerge. The expectations were rooted in a way that was not directly tied to the money supply, the way Milton Friedman might have predicted. That’s this, again, slight concession in the direction of these weirder 1960s theories where inflationary expectations come from the real side of the economy. These moderate wage demands, credibility of the Fed, but also related to the fiscal theory of the price level. Fiscal policy has been a disaster, and yet we got inflation under control. The people who are full-blown fiscal advocates for a theory of inflation, I don’t see how they rationalize that.

I’d say the Fed was just a lot better than in the 70’s. It was operating a Flexible Average Inflation Target regime that called for it to do exactly what it did, engineer over-target inflation to facilitate adjustment to COVID and then disinflate to bring inflation back to target.  It was only about 9 months too late (March 2022 instead of September 2021) in starting to disinflate.  It probably could have moved quicker if it did not have the protocol of relatively large, infrequent, unidirectional movements in its policy instruments.  The same thing probably contributed to its being slow to ease off of disinflation.  [https://thomaslhutcheson.substack.com/p/improving-fed-decisions]

TABARROK: Must be a lot of taxes coming in the future, if you believe the fiscal theory. Maybe there’s multiple reasons for that.

COWEN: Your budget gets worse, and you go 9 percent inflation to something, 2.5 percent, 3 percent. That’s weird even if you’re not a dogmatic fiscal theorist, right?

TABARROK: Yes.

COWEN: You expect some monetization at some point. In fact, we did it for a while right after the pandemic.

TABARROK: Absolutely. There was no fiscal tightening, which explained the reduction in inflation.

COWEN: That’s right.

TABARROK: If anything, the contrary. Exactly.

COWEN: No politicians are talking about the big bipartisan commission to have the grand bargain et cetera. Neither party.

Deficit generating tax cuts are part of the Republican DNA.  Democrats will have to do it alone.

·       TABARROK: I would agree with most of that. Again, I don’t buy into the wage moderation theory just because I don’t see the idea of just picking out one commodity and saying this is the important one, which drives all the others in a simultaneous equation system, that’s just not true. Wage moderation itself is an example of inflation not getting out of control. It’s not a reason, it is a factor. Just like you wouldn’t say, tuna prices didn’t get out of control and that’s what reduced inflation because the tuna prices were really low. I don’t see any reason to privilege wages.

Correct:

COWEN: If we’re trying to steelman this, is there a partial move we can make and be Keynesian and say, at least for workers, spending is determined by the flows, not the stock. Corporations maybe—it’s like the net asset position in some more sophisticated way. If workers spending is just from the flow, maybe the wage demands that are satisfied are predicting the flow of spending for the next few quarters. That’s where flows are ruling the economy and the other parts of the economy at stocks. I don’t want to push that too hard, but again, if we’re always trying to think what grain of truth can we pull from this?

TABARROK: The grain of truth that I would focus on would be expectations. If you think that Jerome Powell, the Fed, is going to get inflation under control, then you don’t have to raise your prices so much and so forth. I think expectations are important, and that is, I must admit a funny thing to say because expectations are one of the things which economists understand the least.

COWEN: That’s right, and there is something circular about it.

Not “circular” but “self-catalyzing.”

[Skip some observations I don’t disagree with but which do not lead anywhere.]

The Bottom Line

TABARROK: Let’s sum up, let me give you my bottom line, which you won’t agree with, but I’ll give you my bottom line. That is that, in the 1960s, in the 1970s, the Keynesian economists abandoned things like balanced budgets, they abandoned the mythology of balanced budgets and they were proud of it. The problem is that abandoning balanced budgets doesn’t lead to countercyclical fiscal policy and economic stabilization, but rather to political business cycles, bigger governments, and perpetual deficits. That’s my bottom line take from this, Tyler.

Proves too much and not enough.

COWEN: Here’s my bottom line, Alex. A, it was good that we abandoned balanced budgets, though we’ve gone way, way too far in the wrong direction. The question is, could we have moderated that somewhat?

Sure, if economist had better models and politicians had a keener appreciation the growth inhibiting effects of deficits ≠ Σ(expenditures with NPV>0)

.

COWEN: Also, inflation was quite a bit due to the inevitable collapse of Bretton Woods. With that process, we also went way, way too far, because the Fed was badly advised and, for political reasons, made a bunch of mistakes.

The collapse of Bretton was neither necessary nor sufficient to have led to the monetary policy mistakes that gave us excessive inflation 

COWEN: The question again is, could we have then moderated that better? The overall lesson I think I would draw is a bunch of things that are bad are sometimes inevitable. The key questions are, can we get some more moderated versions of these things? It seems to me that’s not discussed and researched enough. That’s one of my bottom lines from all this.

Exactly the issues that Cowen and Tabarrok did NOT discuss here.

[Standard bleg:  Although my style is know-it-all-ism, I do sometime entertain the thought that, here and there, I might be mistaken on some minor detail.  I would welcome comments on these views.]

Image Prompt: Cowen and Tabarrok arguing.  Question marks and dollar signs surrounding them.  [I am not responsible for Bing’s instantiation of Cown and Tabarrok.  😊]