Bad Luck

As Bruce Bartlett will tell you, the conventional wisdom among Keynesians during the 1970s was that the rising inflation rate in the US during that decade was primarily the result of a string of unlucky events – oil shocks, a bad anchovy harvest, and so on. Among Keynesians today, the conventional wisdom is that their predecessors were wrong and that the rising inflation rate during the 1970s resulted from excessively loose policy. The problem is, from a Keynesian point of view, today’s conventional wisdom doesn’t make quantitative sense.

Under the Keynesian paradigm, a loose policy can be defined as one that tends to push the unemployment rate below the non-accelerating inflation rate of unemployment (NAIRU), so that inflation will tend to accelerate. Conversely, a tight policy can be defined as one that tends to push the unemployment rate above the NAIRU, so that inflation will tend to decelerate. Whether the unemployment rate is in “loose” or “tight” territory, the economy will be subject to shocks (bad luck – or good luck), which may cause the inflation rate to do something else, but these shocks cannot be blamed on (or credited to) policy. (Also, there may be shocks in the policy transmission process that prevent the unemployment rate from reaching its intended level in the first place, but these aren’t the type of shocks that people have in mind when discussing the 1970s.)

The average unemployment rate for the US during the 1970s was 6.2%. Until the mid-1990s, conventional estimates put the NAIRU at about 6%. Using the conventional linear approximation to the Phillips curve, this means that policy, on average, managed to push the unemployment rate to a level that should have resulted in a slight decline in the inflation rate. On average, policy was tight, not loose.

If anything, this simple analysis underestimates the extent to which policy was tight. The 6% NAIRU estimate came with full benefit of hindsight. An estimate produced using data available during the mid-70s would put the NAIRU somewhat lower. So if we describe policy in terms of its actual intentions, rather than the results that might have been anticipated with benefit of hindsight, it was more than a little tight.

This is not to say that policymakers (meaning the Fed) necessarily acted appropriately during the 1970s. Perhaps, in the interest of restoring the credibility they lost during the Johnson-Nixon years, they should subsequently have been even tighter than they were. Perhaps high inflation is just bad and should have been met aggressively at every turn, even when it was not the result of recent policy. But leaving these normative issues aside, it’s hard (at least if we accept the Keynesian paradigm) to see how, in the absence of considerable bad luck, the inflation rate at the end of the 1970s could have been so much higher than it was at the beginning. Did anyone notice a black cat on Constitution Avenue?

The Debate Burns On

Greg Mankiw challenges my interpretation of Arthur Burns’ legacy. Monetary policy, he points out, affects inflation with a lag. Once you take the lag into account, Burns looks quite bad, since the inflation rate fell a bit during the first year of his term (presumably due to his predecessor’s efforts) and rose dramatically during the year after he left.

At first, my quant hand was pretty much convinced by Greg’s argument. After all, when you run the numbers, it’s quite unambiguous: monetary policy variables have only a slight impact on contemporaneous inflation; most of the impact comes later. But my rational economist hand wasn’t so sure, and in the end, it managed to convince my quant hand that Burns was, as I had originally suggested, more a victim of his predecessor’s excesses than a contributor to runaway inflation.

To illustrate, let’s start with a comment from Greg’s post. Happyjuggler0 writes:

All I'll say to that is that Milton Friedman publicly predicted the stagflation of the 70's before it happened, indeed before the word was even coined. It was a nonexistent phenomenon before then. It is not Dr. Friedman's fault that both Burns and the 70's presidents ignored him. It is not like Friedman was quiet about his views either....

Fair enough, maybe Burns should have paid more attention to what Friedman said. But what I notice is that Friedman made his statements (beginning with his 1968 American Economic Association presidential address) long before Burns took office. If Friedman could already see, two years earlier, that the Fed was losing its credibility, how could that loss of credibility have been Burns’ fault? (That line of reasoning is actually what got me thinking about this question in the first place.)

What’s particularly puzzling is the rapidity with which inflation accelerated during the year after Burns left. The inflation rate rose by almost 3 percentage points within less than a year, and that was with the unemployment rate around 6%, hardly a level one would normally associate with a dramatically overheating economy. The data don’t offer me any obvious clues as to what’s going on, but I would suggest that the credibility of monetary policy under then-current chirman G. William Miller may have had more to do with the problem than excessive ease during Burns’ final year.

If we look at Burns’ overall period of chairmanship, it does not appear that he was, on average, pushing the economy beyond its limit. Consider this blowup of part of a chart that appeared in an earlier post. You can quarrel with my NAIRU methodology, but I don’t think the estimates are very far from the consensus. And what it shows is that, in terms of the employment gap, the weakness during the second half of Burns’ chairmanship roughly compensated for the strength during the first half, whereas during the years before Burns took over, there was a persistent period of inflationary high employment.

The implications of this chart are quite specific, given the coefficients of my Phillips curve. If we assume a 6-month lag in the effect of monetary policy on employment, then the years prior to Burns added 6.4 percentage points to the inflation rate, whereas Burns added only 0.4 percentage points.

Rethinking the Burns Legacy

Arthur Burns, who chaired the Federal Reserve Board of Governors from 1970 to 1978, is commonly held up as an example of a bad little central banker, the kind that parties instead of doing his homework and corrupts the younger kids with his spiked punch. I’ve made my own share of snide insinuations about Burns, but a recent look at the data has made me wonder if he really deserves the level of scorn he has received.

It seems pretty clear that Burns did succumb to political pressure from President Nixon for easy money during the time that Nixon was up for reelection; at the very least, Burns made some large errors in judgment at a time when those errors happened to benefit the man who appointed him. But Burns was certainly not the only central banker to be swayed by politics. In the eyes of history, Nixon turned out to be a particularly bad politician with whom to be associated. But if Burns gave the Republicans a free ride in 1972, they certainly paid for it in 1976.

One particular statistic interests me: for the 12 months ending in February 1970, when Burns began his chairmanship, the CPI inflation rate was 6.3%. For the 12 months ending January 1978, when Burns ended his chairmanship, the rate was 6.7%. On balance, that hardly looks to me like letting inflation get out of hand. Granted, the unemployment rate was considerably higher (6.4% vs. 4.2%), but it would be a stretch to blame Burns for that, considering the role of OPEC, and considering that many economists subsequently began to think 6.4% was, if anything, still too low.

Burns was no saint, but it now looks to me like his problem was largely an inherited one. The former Fed chairman, William McChesney Martin, had already allowed inflation to rise to an uncomfortable level. Martin later acknowledged (to his “everlasting shame”) having given in to political bullying himself. As a matter of personal character, I give Martin a lot of credit for confessing his sin, and perhaps history was right to absolve him and to open to him the pearly gates of that great Open Market in the sky. But just so we have the record straight, it looks like Johnson’s influence on Martin deserves as much blame for the subsequent high inflation rates as does Nixon’s influence on Burns.