Sunday, June 17, 2012

1970's Sumner-time Stagnation

Recently, Scott Sumner and Karl Smith have debated to what extent was the 1970's an era characterized by "stagnation" (AS shock), or just overexpansionary monetary policy. For Scott, much this debate seemed to be about retelling the stories that we learned in introductory economics. Scott reframes the issue in terms of above trend nominal GDP growth, and, along with other data about the labor markets, argues that the decade of inflation came about not because of stagflation or supply shocks, but rather because of overly loose monetary policy.

From the most basic AS/AD perspective, robust real growth in the 1970's is no indication that there was no stagnation. Given the accelerated NGDP growth, real GDP growth should have been higher, for reasons ranging from money illusion to sticky wages to sticky prices. In other words, the higher rates of nominal change meant that a short run equilibrium with higher real growth could be maintained. Had NGDP growth been slower, then we would not have been able to squeeze 3.2% RGDP growth out of the economy. In short, I disagree with the statement that:
I think Karl and I would both agree that (whether or not there was stagflation during the 1970s) under 5% NGDP targeting there definitely would not have been any stagflation."
Is there any reason for this? Scott's argument presupposes that you can decouple nominal growth from real growth. So when he says:
Growth was normal, and inflation was very high.  Rapid growth in AD explains roughly 100% of the inflation during the 1970s.  There was no stagflation, just inflation.
He presupposes the high real growth was not explained by the higher inflation. While, in the long run, higher inflation does not lead to a permanently higher level of growth, there is still a positive relationship between inflation and output in the short run. In introductory terms, this trade-off is the aggregate supply curve, and the correlation arises from increases in aggregate demand. If the high level of aggregate demand is the reason why inflation is high, the high level of AD is also the reason output is high. I don't see how they can be separated.

There are also many places one can look for data to support this hypothesis. The first is the classic shifting of the Philips curve. If the Philips curve moved outwards in the 1970's era, that meant you needed a higher level of inflation to reach any given unemployment rate. If the unemployment rate is a proxy for real growth, then this directly leads to the conclusion that higher levels of inflation allowed higher levels of real growth.

However, Scott prefers to focus on real GDP ("I had thought the word ‘stagflation’ meant high inflation plus slow output growth (due to slow growth in AS.)"), and on this issue the data still suggests that the higher NGDP growth could not be disentangled from the higher RGDP growth. The first graph is a scatterplot of 1960's data, with NGDP YoY growth on the x-axis, and RGDP YoY growth on the y-axis.

The following grpah is a scatterplot of 1970's data, with the same x and y axis data.

Looking at these two graphs, one can see that the relationship between NGDP and RDGP was very tight in both periods. While correlation does not prove causation, it's hard to think of any theoretical mechanism that could have decoupled NGDP from RGDP in either period.. Another interesting note is that the x-intercept of the 1970's data is much larger than the 1960's data. This suggests that you needed a higher level of nominal growth to hold RGDP steady in the 1970's than you needed in the 1960's. the 1970's was suffering from an overall supply shock relative to the 1960's.

As an interesting corollary to all of this, given the lack of a long-run relationship between higher nominal and real growth, you need accelerating nominal growth to prevent real growth from falling down. In a sense, in addition to the positive relationship between the first derivatives of NGDP and RGDP, there should also be a  positive relationship between the second derivatives of NGDP and RGDP.

Notably, these correlations are even stronger than the first two graphs. This lends more evidence to the argument that, had the Fed decided to decrease YoY NGDP growth, RGDP would have taken a hit. For all the power that lies within expectations, they can't take away all of the pain away from a NGDP disinflation.

What seems unexplained is why the 1970's slope is higher (with greater than 95 confidence) than the 1960's slope. If agents adapt, the same increase in NGDP growth should result in a lower increase in RGDP growth. By that theory, the 1970's slope should be less than the 1960's slope. This will be an interesting topic for future investigation.

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