All posts in category Allan Meltzer

David Laidler: “Two Crises, Two Ideas and One Question”

The main founding fathers of monetarism to me always was Milton Friedman, Anna Schwartz, Karl Brunner, Allan Meltzer and David Laidler. The three first have all now passed away and Allan Meltzer to some extent seems to have abandoned monetarism. However, David Laidler is still going strong and maintains his monetarist views. David has just published a new and very interesting paper – “Two Crises, Two Ideas and One Question” – in which he compares the Great Depression and the Great Recession through the lens of history of economic thought.

David’s paper is interesting in a number of respects and any student of economic history and history of economic thought will find it useful to read the paper. I particularly find David’s discussion of the views of Allan Meltzer and other (former!?) monetarists interesting. David makes it clear that he think that they have given up on monetarism or as he express it in footnote 18:

“In this group, with which I would usually expect to find myself in agreement (about the Great Recession), I include, among others, Thomas Humphrey, Allan Meltzer, the late Anna Schwartz, and John Taylor, though the latter does not have quite the same track record as a monetarist as do the others.”

Said in another way David basically thinks that these economists have given up on monetarism. However, according to David monetarism is not dead as another other group of economists today continues to carry the monetarist torch – footnote 18 continues:

“Note that I self-consciously exclude such commentators as Timothy Congdon (2011), Robert Hetzel (2012) and that group of bloggers known as the “market monetarists”, which includes Lars Christensen, Scott Sumner, Nicholas Rowe …. – See Christensen (2011) for a survey of their work – from this list. These have all consistently advocated measures designed to increase money growth in recent years, and have sounded many themes similar to those explored here in theory work.”

I personally think it is a tremendous boost to the intellectual standing of Market Monetarism that no other than David Laidler in this way recognize the work of the Market Monetarists. Furthermore and again from a personal perspective when David recognizes Market Monetarist thinking in this way and further goes on to advocate monetary easing as a respond to the present crisis I must say that it confirms that we (the Market Monetarists) are right in our analysis of the crisis and helps my convince myself that I have not gone completely crazy. But read David’s paper – there is much more to it than praise of Market Monetarism.

PS This year it is exactly 30 years ago David’s book “Monetarist Perspectives” was published. I still would recommend the book to anybody interested in monetary theory. It had a profound impact on me when I first read it in the early 1990s, but I must say that when I reread it a couple of months ago I found myself in even more agreement with it than was the case 20 years ago.

Update: David Glasner also comments on Laidler’s paper.

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6 Comments
by Lars Christensen on September 9, 2012  •  Permalink
Posted in Allan Meltzer, Anna Schwartz, David Laidler, Karl Brunner, Milton Friedman, MM Research agenda, Reading recommendations, The Great Depression, The Great Recession
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Posted by Lars Christensen on September 9, 2012

https://marketmonetarist.com/2012/09/09/david-laidler-two-crises-two-ideas-and-one-question/

Friedman’s Japanese lessons for the ECB

I often ask myself what Milton Friedman would have said about the present crisis and what he would have recommended. I know what the Friedmanite model in my head is telling me, but I don’t know what Milton Friedman actually would have said had he been alive today.

I might confess that when I hear (former?) monetarists like Allan Meltzer argue that Friedman would have said that we were facing huge inflationary risks then I get some doubts about my convictions – not about whether Meltzer is right or not about the perceived inflationary risks (he is of course very wrong), but about whether Milton Friedman would have been on the side of the Market Monetarists and called for monetary easing in the euro zone and the US.

However, today I got an idea about how to “test” indirectly what Friedman would have said. My idea is that there are economies that in the past were similar to the euro zone and the US economies of today and Friedman of course had a view on these economies. Japan naturally comes to mind.

This is what Friedman said about Japan in December 1997:

“Defenders of the Bank of Japan will say, “How? The bank has already cut its discount rate to 0.5 percent. What more can it do to increase the quantity of money?”

The answer is straightforward: The Bank of Japan can buy government bonds on the open market, paying for them with either currency or deposits at the Bank of Japan, what economists call high-powered money. Most of the proceeds will end up in commercial banks, adding to their reserves and enabling them to expand their liabilities by loans and open market purchases. But whether they do so or not, the money supply will increase.

There is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so. Higher monetary growth will have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately. A return to the conditions of the late 1980s would rejuvenate Japan and help shore up the rest of Asia.”

So Friedman was basically telling the Bank of Japan to do quantitative easing – print money to buy government bonds (not to “bail out” the government, but to increase the money base).

What were the economic conditions of Japan at that time? The graph below illustrates this. I am looking at numbers for Q3 1997 (which would have been the data available when Friedman recommended QE to BoJ) and I am looking at things the central bank can influence (or rather can determine) according to traditional monetarist thinking: nominal GDP growth, inflation and money supply growth. The blue bars are the Japanese numbers.

Now compare the Japanese numbers with the similar data for the euro zone today (Q1 2012). The euro zone numbers are the red bars.

Isn’t striking how similar the numbers are? Inflation around 2-2.5%, nominal GDP growth of 1-1.5% and broad money growth around 3%. That was the story in Japan in 1997 and that is the story in the euro zone today.

Obviously there are many differences between Japan in 1997 and the euro zone today (unemployment is for example much higher in the euro zone today than it was in Japan in 1997), but judging alone from factors under the direct control of the central bank – NGDP, inflation and the money supply – Japan 1997 and the euro zone 2012 are very similar.

Therefore, I think it is pretty obvious. If Friedman had been alive today then his analysis would have been similar to his analysis of Japan in 1997 and his conclusion would have been the same: Monetary policy in the euro zone is far too tight and the ECB needs to do QE to “rejuvenate” the European economy. Any other view would have been terribly inconsistent and I would not like to think that Friedman could be so inconsistent. Allan Meltzer could be, but not Milton Friedman.

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* Broad money is M2 for Japan and M3 for the euro zone.

Related posts:

Meltzer’s transformation
Allan Meltzer’s great advice for the Federal Reserve
Failed monetary policy – (another) one graph version
Jens Weidmann, do you remember the second pillar?

16 Comments
by Lars Christensen on August 15, 2012  •  Permalink
Posted in Allan Meltzer, ECB, euro crisis, Japan, Milton Friedman, Monetary institutions, Monetary policy, MV=PY, QE
Tagged , , , , ,

Posted by Lars Christensen on August 15, 2012

https://marketmonetarist.com/2012/08/15/friedmans-japanese-lessons-for-the-ecb/

Arthur Laffer you’re embarrassing yourself

During George W. Bush’s years as president I most say that I lost a lot of respect for Paul Krugman. It was very clear that he was suffering from what Charles Krauthammer called the “Bush Derangement Syndrome” (BDS). BDS undoubtedly made Krugman write crackpot articles about all kind of subjects. Krugman for example on numerous occasions has argued in favour of protectionism – something the pre-Bush Krugman would never have done.

Unfortunately, this President Derangement Syndrome (PDS) has infected a number of US right-wing economists who used to be clever economists, but today seem to have forgotten everything about economics – mostly as a result of an apparent hatred of President Obama. I am no fan of President Obama, but I do not let that change my view of economics.

I have earlier highlighted that I think that Allan Meltzer who is one of my great monetarist heroes seems to have forgotten everything about monetary theory that he once preached exactly because of PDS. Unfortunately he is not the only right-wing US economist to suffer from PDS. The latest example is supply-side hero Arthur Laffer who frankly is embarrassing himself in a recent Wall Street Journal article.

The stated purpose of Laffer’s article is to show that “in country after country, increased government spending acted more like a depressant than a stimulant.”

Anybody who reads my blog would know that I am certainly no fan of “fiscal stimulus” and that I believe that fiscal policy can not “overrule” monetary policy. Hence, I believe in the so-called Sumner Critique. Furthermore, I strongly believe that there is good empirical evidence that a larger government is a drag on the economy and that more government spending in general will tend to reduce productivity growth in the longer run. Hence, I strongly agree with Laffer in terms of the overall view that fiscal stimulus is unlikely to be helpful in getting us out of this crisis and in the long run a larger public sector is likely to hamper growth.

However, even though I agree on Laffer’s skeptical view of fiscal stimulus I nonetheless find his “analysis” to be shockingly bad.

In his analysis Laffer compares the change in real GDP growth from 2006-2007 to 2008-2009 with the change in government spending in the same period in different OECD countries. (By the way look Laffer’s numbers look very odd – David Glasner discusses that in his post on Laffer here.) Here is Laffer’s somewhat surprising conclusion:

“The four nations—Estonia, Ireland, the Slovak Republic and Finland—with the biggest stimulus programs had the steepest declines in growth.”

Are you joking Art?? Estonia? Biggest stimulus program? You can’t seriously think so. I think Prime Minister Ansip of Estonia would be rather upset that you say that his government apparently has conducted some kind of Keynesian fiscal stimulus. I know for a fact that Mr. Ansip has no respect for Keynesian fiscal stimulus. In fact his government has rightly been praised for its conservative fiscal stance.

Mr. Ansip’s government has since the crisis hit in 2008 (in fact it already started in 2007 in Estonia) passed significant austerity measures such as cutting public sector wages and pensions. Mr. Ansip’s government has shown an enormous commitment to reducing the budget deficit and reining in the public debt. In fact by saying what you are saying Mr. Laffer you are making a mockery of the truly remarkable fiscal consolidation in Estonia.

I don’t know where Mr. Laffer has been recently – didn’t he notice that THE KEYNESIAN Paul Krugman has been highly critical of Estonia’s fiscal consolidation and that has upset Estonian policy makers a great deal (and rightly so). Mr. Laffer would of course have known this if he had read the WALL STREET JOURNAL!!!

Estonia by far has the lowest debt-to-GDP ratio in the OECD area so how Mr. Laffer can claim that Estonia is an example of an evil Keynesian experiment is somewhat of a puzzle to me. The limit for public debt in the EU is 60% of GDP. Estonia’s public debt is 6% (!) of GDP. And Estonia is running a public finance SURPLUS!

But ok, lets say that Mr. Laffer made one mistakes in his assessment. The three other countries have to be irresponsible countries. No! They are certainly not. In fact Finland and Slovakia are both in the group of the most fiscally conservative countries in the EU and the markets agree. Just look at Finnish and Slovakian bond yields. In fact few market participants would question the creditworthiness of Finland. After all Finland has a BETTER credit rating than Germany! Finnish government bond yields is basically at the same level as German bond yields.

So how about Ireland? It is true that the country has seen a sharp rise in public debt since 2008. However, that can hardly been seen as a result of “fiscal stimulus”. The rise in public debt is mostly due to banking rescues in 2008 and 2009, which of course can be questioned whether that has been a good idea, but you can hardly say that Ireland has conducted keyensian style fiscal stimulus. Furthermore, after the sharp rise in public debt consecutive Irish governments have put a lot of effort into fiscal consolidation and Ireland has rightly been praised for its effort to curb public debt. As a result Ireland is generally perceived more positively by the markets and credit rating agencies than the other so-called PIIGS countries.

So we can easily conclude that Arthur Laffer got it completely wrong. So why is that? Well, maybe he never heard about cyclically adjusted government spending. It should be no surprise to anybody who just spent one hour reading an intermediate textbook on public finances that government spending tend to increase in cyclical downturns and tax revenues drop when the economy slumps.

Estonia in 2007-2010 went through a Great Depression sized collapse in economic activity and hence it is no surprise that that led to an increase in public spending as outlays to unemployment benefits and other social benefits rose sharply. To its credit the Estonian government reacted to this worsening of public finances by putting through significant austerity measures. Mr. Laffer, however, in his eagerness to badmouth President Obama’s fiscal policies forgets this and knowingly or unknowingly trashes the heroic fiscal performance of Mr. Ansip’s Estonian government. I think an excuse would be in order.

I am sorry to say it, but Mr. Laffer’s article is yet another example of right-wing US economists that for the sake of partisan politics completely trash all economic logic. That is too bad, because Mr. Laffer could instead have told the story of the great example of Estonia, a country that is gradually coming out of this crisis WITHOUT fiscal stimulus. He could also have told the story about Greece’s and Spain’s fiscal stimulus packages of 2009 that did a lot to increase these countries’ public debt levels. He could also have told the story about how fiscally conservative policies have ensured that Finland is the country in Europe with the best credit rating.

I strongly believe that less public spending is positive for long-term growth (and that is a supply-side argument Mr. Laffer!) and I doubt that fiscal stimulus (without monetary stimulus) will do much to increase growth in the short-run, but I have far better arguments than Mr. Laffer.

I think it is about time that my fellow free market economist friends in the US start to behave as economists rather than playing party politics. That would strengthen the case for free markets and less government intervention. By playing party politics economists like Allan Meltzer and Arthur Laffer are not doing the cause much service.

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PS I use the term “right-wing” economist above to mean an economist who generally is in favour of free markets and generally opposes government intervention in the economy. In that sense I am obviously a right-wing economist myself.

PPS I also suspect John Cochrane and Casey Mulligan of suffering from PDS.

Update: Brad DeLong also has a comment on Laffer’s WSJ piece. I am getting tired of agreeing with him and Krugman in their criticism of (certain!) “right-wing” economists.
Update 2: Karl Smith joins the debate.
Update 3: And here is Matt O’Brien on the same topic – with a golden quote: “He really is the anti-Keynes. When the facts change, Laffer changes the facts back, so he won’t have to change his mind.”

24 Comments
by Lars Christensen on August 6, 2012  •  Permalink
Posted in Allan Meltzer, President Derangement Syndrome, Uncategorized
Tagged ,

Posted by Lars Christensen on August 6, 2012

https://marketmonetarist.com/2012/08/06/arthur-laffer-youre-embarrassing-yourself/

Meltzer’s transformation

Allan Meltzer was one of the founding fathers of monetarism and he has always been one of my favourite economists. However, I must admit that that is no longer the case. His commentary over the last couple of years has had very little to do with monetarism. In fact most of Meltzer’s commentary reminds me of “internet Austrianism”. His latest comment in the Wall Street Journal is certainly not better, but it quite well illustrates his transformation from monetarist to crypto-Austrian. In fact I think it is too depressing even to comment on it (or link to it). However, David Glasner has a very good comment on Meltzer. I suggest you all read it.

If you want to read something Meltzer once wrote that really makes a lot of sense I suggest you take a look at this. That to me is the real Meltzer and the Meltzer I will think of when I take down one of his excellent books on monetary theory and history from my bookshelf.

9 Comments
by Lars Christensen on July 10, 2012  •  Permalink
Posted in Allan Meltzer
Tagged

Posted by Lars Christensen on July 10, 2012

https://marketmonetarist.com/2012/07/10/meltzers-transformation/

Allan Meltzer’s great advice for the Federal Reserve

Here is Allan Meltzer’s great advice on US monetary policy:

“Repeatedly, the message has been to reduce tax rates permanently… A permanent tax cut was supposed to do what previous fiscal efforts had failed to do — generate sustained expansion of the American economy. 

No one should doubt that an expansion is desirable for US… and the rest of the world…The US government has watched the economy stagnate much too long. A policy change is long overdue. 

The problem with the advice (about fiscal easing) is that few would, and none should, believe that the US can reduce tax rates permanently. US has run big budget deficits for the past five years and accumulated a large debt that must be serviced at considerably higher interest rates in the future … And the US must soon start to finance large prospective deficits for old age pensions and health care. There is no way to finance these current and future liabilities that will not involve higher future tax rates… 

It is wrong when somebody tells the American to maintain the value of the dollar…The fluctuating rate system should work both ways. Strong economies appreciate; weak economies depreciate. 

What is the alternative? Deregulation is desirable, but it will do its work slowly. If temporary tax cuts are saved, not spent, and permanent tax cuts are impossible, the US choice is between devaluation and renewed deflation. The deflationary solution runs grave risks. Asset prices would continue to fall. Investors anticipating further asset price declines would have every reason to hold cash and wait for better prices. The fragile banking system would face larger losses as asset prices fell. 

Monetary expansion and devaluation is a much better solution. An announcement by the Federal Reserve and the government that the aim of policy is to prevent deflation and restore growth by providing enough money to raise asset prices would change beliefs and anticipations. Rising asset prices, including land and property prices, would revive markets for these assets once the public became convinced that the policy would be sustained. 

The volume of “bad loans” at US banks is not a fixed sum. Rising asset prices would change some loans from bad to good, thereby improving the position of the banking system. Faster money growth would add to the banks’ ability to make new loans, encouraging business expansion.

This program can work only if the exchange rate is allowed to depreciate. Five years of lowering interest rates has shown that there is no way to maintain the exchange rate and generate monetary expansion…

…Some will see devaluation as an attempt by the US to expand through exporting. This is a half-truth. Devaluation will initially increase US exports and reduce imports. As the economy recovers, incomes will rise. Rising incomes are the surest way of generating imports of raw materials and sub-assemblies from US trading partners.

Let money growth increase until asset prices start to rise.”

I think Allan Meltzer as a true monetarist presents a very strong case for US monetary easing and at the same time acknowledges that fiscal policy is irrelevant. Furthermore, Meltzer makes a forceful argument that if monetary policy is eased then that would significantly ease financial sector distress. The readers of my blog should not be surprised that Allan Meltzer always have been one of my favourite economists.

Meltzer indirectly hints that he wants the Federal Reserve to target asset prices. I am not sure how good an idea that is. After all what asset prices are we talking about? Stock prices? Bond prices? Or property prices? Much better to target the nominal GDP target level, but ok stock prices do indeed tend to forecast the future NGDP level pretty well.

OK, I admit it…I have been cheating! Allan Meltzer did indeed write this (or most of it), but he as not writing about the US. He was writing about Japan in 1999 (So I changed the text a little). It would be very interesting hearing why Dr. Meltzer thinks monetary easing is wrong for the US today, but right for Japan in 1999. Why would Allan Meltzer be against a NGDP target rule that would bring the US NGDP level back to the pre-crisis trend and then there after target a 3%, 4% or 5% growth path as suggested by US Market Monetarists such as Scott Sumner, Bill Woolsey and David Beckworth?

 

12 Comments
by Lars Christensen on January 22, 2012  •  Permalink
Posted in Allan Meltzer, Bill Woolsey, David Beckworth, Federal Reserve, Japan, Monetary institutions, Monetary policy, NGDP Targeting, Nominal Income Targeting, QE, Scott Sumner
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Posted by Lars Christensen on January 22, 2012

https://marketmonetarist.com/2012/01/22/allan-meltzers-great-advice-for-the-federal-reserve/

Central banks should set up prediction markets

I have spend my entire career as an economist doing forecasting – both of macroeconomic numbers and of financial markets. First as a government economist and then later as a financial sector economist. I think I have done quite well, but I also know that I only rarely am able to beat the market “consensus”. If I beat the market 51% of the time then I think I am worth my money. This probably is a surprise to most none-economists, but it is common knowledge to economists that we really can’t beat the markets consistently.

My point is that the “average” forecast of the market often is a better forecast than the forecast of the individual forecaster. Furthermore, I know of no macroeconomic forecaster who has consistently over long periods been better than the “consensus” expectation. If my readers know of any such super forecaster I will be happy to know about them.

I truly believe in the wisdom of the crowd as manifested in free markets. So-called behavioural economists have another view than I have. They think that the “average” is often wrong and that different biases distort market pricing. I agree that the market is far from perfect. In fact market participants are often wrong, but they are not systematically wrong and markets tend to be unbiased. The profit motive after all is the best incentive to ensure objectivity.

Unlike the market where the profit motive rules central banks and governments are not guided by an objective profit motive but rather than by political motives – that might or might not be noble and objective.

It is well known among academic economists and market participants that the forecasts of government institutions are biased. For example Karl Brunner and Allan Meltzer have demonstrated that the IMF consistently are biased in a too optimistic direction in their forecasts.

I remember once talking to a top central banker in a Central and Eastern European central bank about forecasting. He complained to me that he frankly was tired of the research department in the central bank in which he was in the top management. The reason for his dissatisfaction was that the research department in his view was too optimistic that the central bank would be able to fulfil its inflation target in the near term. He on the other hand had the view that monetary policy needed to be tightened so the research department’s forecast was “inconvenient” for him. Said in another way he was basically unhappy that the research department was not biased enough.

Luckily that particular central bank has maintained a relatively objective and unbiased research department, but the example illustrates that central bank forecasts in no are guaranteed to be unbiased. In fact some banks are open about the fact that their forecasts are biased. Hence, today some central bank assumes in their “forecast” that their target (normally an inflation target) is reached within a given period typically in 2-3 years.

When central banks publish forecasts in which they assume the reach their targets within a given timeframe they at the same time have to say how the will be able to reach this target. This has lead some central banks to publish what is called the “interest rate path” – meaning how interest rates should be expected to be changed in the forecasting period to ensure that particular target. This is problematic in many ways. One is that it normally the research department in the central bank making the forecasts, while it is the management in the central bank (for example the FOMC in the Federal Reserve or the MPC in the Bank of England) that makes the decisions on monetary policy. Furthermore, we all know that monetary policy is exactly not about interest rates. Interest rates do not tell us much about whether monetary policy is tight or loose. Any Market Monetarists will tell you that.

Instead of relying on in-house forecasts central banks could consult the market about the outlook for the economy and markets. Scott Sumner has for example argued that monetary policy should be conducted by targeting NGDP futures. I think that is an excellent idea. However, first of all it could be hard to set-up a genuine NGDP futures markets. Second, the experience with inflation linked bonds shows that the prices on these bonds often are distorted by for example lack of liquidity in the particular markets.

I believe that these problems can be solved and I think Scott’s suggestion ideally is the right one. However, there is a more simple solution, which in principle is the same thing, but which would be much less costly and complicated to operate. My suggestion is the central bank simply set-up a prediction market for key macroeconomic variables – including of the variables that the central bank targets (or could target) such as NGDP level and growth, inflation, the price level.

So how do prediction markets work? Prediction markets are basically betting on the outcome of different events – for example presidential elections in the US or macroeconomic data.

Lets say the Federal Reserve organised a prediction market for the nominal GDP level (NGDP). It would organise “bet” on the level of NGDP for every for example for the next decade. Then market participants buy and sell the NGDP “future” for any given year and then the market pricing would tell the Fed what was the market expectation for NGDP at any given time. If market pricing of NGDP was lower than the targeted level of NGDP then monetary policy is too tight and need to be ease and if market expectation for NGDP above the targeted level then monetary policy is too loose. It really pretty simple, but I am convinced it would work.

The experience with prediction markets is quite good and prediction markets have been used to forecast everything from the outcome of elections to how much a movie will bring in at the box office. A clear advantage with prediction markets is that they are quite easy to set-up and run. Furthermore, it has been shown that even relatively small size bets give good and reliable predictions. This mean that if a central bank set up a prediction market then the average citizen in the country could easily participate in the “monetary policy market”.

I hence believe that prediction markets could be a very useful tool for central banks – both as a forecasting tool but also as a communication tool. A truly credible central bank would have no problem relying on market forecasts rather than on internal forecast.

I of course understand that central banks for all kind of reasons would be very reluctant to base monetary policy on market predictions, but imagine that the Federal Reserve had had a prediction market for NGDP (or inflation for that matter) in 2007-8. Then there is no doubt that it would have had a real-time indication of how much monetary conditions had tightened and that likely would caused the Fed into action much earlier than was actually the case. A problem with traditional macroeconomic forecasts is that they take time to do and hence are not available to policy makers before sometime has gone by.

This might all seem a little bit too farfetched but central banks already to some extent rely on market forecasts. Hence, it is normal that central banks do survey of professional forecasters and most central banks use for example futures prices to predict oil prices when they do their inflation forecasts. Using prediction markets would just take this praxis to a new level.

So I challenge central banks that want to strengthen their credibility to introduce prediction markets on key macroeconomic variables including the variables they target and to communicate clearly about the implications for monetary policy of the forecasts from these predictions markets.

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See my earlier comment on prediction markets and monetary policy here.

Update: If you are interested in predictions markets you should have a look at Robin Hanson’s blog Overcoming Bias and Chris Masse’s blog Midas Oracle.

17 Comments
by Lars Christensen on January 11, 2012  •  Permalink
Posted in Allan Meltzer, Luck, MM Research agenda, Monetary institutions, Monetary policy, NGDP Targeting, Nominal Income Targeting, Prediction markets, Scott Sumner
Tagged ,

Posted by Lars Christensen on January 11, 2012

https://marketmonetarist.com/2012/01/11/central-banks-should-set-up-prediction-markets/

US Monetary History – The QRPI perspective: The Volcker disinflation

I am continuing my mini-series on modern US monetary history through the lens of my decomposition of supply inflation and demand inflation based on what I inspired by David Eagle have termed a Quasi-Real Price Index (QRPI). In this post I will have a look at the early 1980s and what have been termed the Volcker disinflation.

When Paul Volcker became Federal Reserve chairman in August 1979 US inflation was on the way to 10% and the fight against inflation had more or less been given up and there was certainly no consensus even among economists that inflation was a monetary phenomenon. Volcker set out to defeat inflation. Volcker is widely credited with achieving this goal and even though one can question US monetary policy in a number of ways in the period that Volcker was Fed chairman there is no doubt in mind my that Volcker succeed and by doing so laid the foundation for the great stability of the Great Moderation that followed from the mid-80s and lasted until 2008.

Below you see my decomposition of US inflation in the 1980s between demand inflation (which the central bank controls) and supply inflation.

As the graph shows – and as I spelled out in my earlier post on the 1970s inflationary outburst – the main cause of the rise in US inflation in 1970s was excessive loose monetary policy. This was particularly the case in late 1970s and when Volcker became Fed chairman demand inflation was well above 10%.

Volcker early on set out to reduce inflation by implementing (quasi) money supply targeting. It is obviously that the Volcker’s Fed had some operational problems with this strategy and it effectively (unfairly?) undermined the idea of a monetary policy based on Friedman style money supply targeting, but it nonetheless clearly was what brought inflation down.

The first year of Volcker’s tenure undoubtedly was extremely challenging and Volcker hardly can say to have been lucky with the timing. More or less as he became Fed chairman the second oil crisis hit and oil prices spiked dramatically in the wake of the Iranian revolution in 1979. The spike in oil prices boosted supply inflation dramatically and that pushed headline inflation well above 10% – hardly a good start point for Volcker.

Quasi-Real Price Index and the decomposition of the inflation data seem very clearly to illustrate all the key factors in the Volcker disinflation:

1)   Initially Volker dictated disinflation by introducing money supply targeting. The impact on demand inflation seems to have been nearly immediate. As the graph shows demand inflation dropped sharply in1980 and the only reason headline inflation did not decrease was the sharp rise in oil prices that pushed up supply inflation.

2)   The significant monetary tightening sent the US economy into recession in 1980 and this lead Volcker & Co. to abandon the policy of monetary tightening and “re-eased” monetary policy in the summer of 1980. Again the impact seems to have been immediate – demand inflation picked up sharply going into 1981.

3)   Over the summer the Fed moved to hike interest rates dramatically and slow money supply growth sharply. That caused demand inflation to ease off significantly and inflation had finally been beaten.

4)   The Fed allowed demand inflation to pick up once again in 1984-85, but at that time Volcker was more lucky as supply factors helped curb headline inflation.

The zigzagging in monetary policy in the early 1980s is clearly captured by my decomposition of inflation. To me shows how relatively useful these measures are and I think they could be help tools for both analysts and central bankers.

This post in no way is a full account of the Volcker disinflation. Rather it is meant as an illustration of the Quasi-Real Price Index and my suggested decomposition of inflation.

My two main sources on modern US monetary history is Robert Hetzel’s “The Monetary Policy and the Federal Reserve – A History” and Allan Meltzer’s “A History of the Federal Reserve”. However, for a critical account of the first years of the Volcker disinflation I can clearly recommend our friend David Glasner’s “Free Banking and Monetary Reform”. I am significantly less critical about money supply targeting than David, but I think his account of the Volcker disinflation clear give some insight to the problems of money supply targeting.

7 Comments
by Lars Christensen on December 29, 2011  •  Permalink
Posted in Allan Meltzer, David Eagle, David Glasner, Economic and monetary history, Federal Reserve, Monetary institutions, Monetary policy, Monetary policy rules, Paul Volcker, Quasi-Real Price Index, Robert Hetzel
Tagged , , , , , , ,

Posted by Lars Christensen on December 29, 2011

https://marketmonetarist.com/2011/12/29/us-monetary-history-the-qrpi-perspective-the-volcker-disinflation/

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