September 14, 2003

Note: Strong Views Weakly Held

In comments, A. Pressler asks:

I've always wondered why inflation is such a huge bugaboo to AG and many corporate economists (other than their tendency to see things from the POV of lending institutions.) In my relatively short life, the only serious inflation problem was the supply-shock inflations created by energy costs in the 1970s.... I understand the theoretical arguments, but what is the worry when the inflation rates are still under 5% (as they were in the late '80s) or under 3% as for most of the Clinton administration?

Well, the argument that inflation above 10% per year does serious harm to resource allocation and economic growth (as incentives get scrambled by an inflexible tax system, as nobody is sure what relative prices really are, and as perceptions of risk rise substantially) seems solid. And then you can argue that you need to keep inflation at 5% or below in order to eliminate the risk that a couple of bad shocks will land you in the bad zone of more than 10% annual inflation.

You can also argue (and Larry Summers and I did argue back in 1992) that you want to avoid deflation and the liquidity trap--you want very badly to avoid deflation and the liquidity trap) and in order to eliminate the risk that a couple of bad shocks will land you in deflation or in a liquidity trap you need to keep annual inflation at 3% or higher.

That leaves a very narrow range: 3% to 5% as an annual inflation rate. I think that is the right answer. It's not that you need to panic and take immediate action when inflation drifts lower or higher, but if inflation drifts below 3% or above 5% you do need to make returning it to its target zone one of your principal policy priorities.

One of my interesting dinner discussions at Jackson Hole was with a group looking back at the Volcker disinflation: 1979-1984. Inflation comes down from 9% per year to 4% per year. The price? 10% unemployment for two years, and over those five years at least a quarter of a year's economic output was simply not there because production was depressed by the deep recession. At today's prices and moved forward in time by the interest rate, that's some $2.5 trillion that we in America spent "buying" 4% rather than 9% inflation.

Was it worth it? There were two answers proposed: (i) It was worth it, because 9% inflation has a big risk of jumping significantly higher, and that would have imposed costs on the American economy that would have dwarfed the $2.5 trillion cost of the Volcker disinflation. (ii) It was worth it, because voters really hate even moderate inflation, and good economic policy works to satisfy and meet household preferences, and does not inquire into where those preferences come from.

There were two positions that had few supporters (although I tried to stir up some trouble). The first was that economists failed at the end of the 1970s: had we taught voters that moderate inflation was annoying but not disastrous, they would not have hated inflation as much, and we could have had $2.5 trillion more in real wealth to use as we would see fit. The second was that even if the Volcker disinflation was a good thing in the U.S., it was surely a bad thing in Europe: unemployment went up from 5% to 9% and stayed there. It is one thing to have unemployment rise from 6% to 10% and stay up there for 2 1/2 years before coming down--that is an expensive but finite $2.5 trillion bill to pay. In Europe, however, they have been paying for the end-of-the-seventies disinflation for two and a half decades: relative price stability might be worth $2.5 trillion in lost production, but could it possibly be worth the $25 trillion that high European unemployment suggests that it has cost in Europe?

I need to have a dog in this fight before I can put the draft of my twentieth century economic history book to bed. And so I am annoyed at the moment to find that my beliefs are still weak, and are still shifting from day to day.

Posted by DeLong at September 14, 2003 02:04 AM | TrackBack

Comments

According to Paul Krugman, Milton Friedman discovered that the Central Bank can't pick an arbitrary rate of inflation and succeed in holding it there. Above a certain figure, inflation accelerates out of control. How does that fit into the story?

Isn't there a near consensus that the high rate of unemployment in Europe is due to rigidities in the labor market? The Germans have recently made tenative moves that suggest that they believe that such is the case.

Posted by: Joe Willingham on September 13, 2003 11:54 PM

Brad DeLong writes, "In Europe, however, they have been paying for the end-of-the-seventies disinflation for two and a half decades:..."

Joe Willingham responds, "Isn't there a near consensus that the high rate of unemployment in Europe is due to rigidities in the labor market?"

It seems easier to me to look for other factors, than to think that the Europeans curing a relatively small amount of inflation (we're not talking Chilean pre-Pinochet levels here) could cause 2.5+ decades of unemployment.

Posted by: Mark Bahner on September 14, 2003 12:07 AM

Mark, do you agree with the theory that rigidities in the labor market are the culprit?

We had low inflation and low unemployment in this country in the nineties. And also from about 1954-1967 if I remember correctly.

Posted by: Joe Willingham on September 14, 2003 12:57 AM

I always have a little doubt about the unemployment discussion in Europe and its relation to inflation/ economic growth / productivity growth. The comparison with the US hammers in our minds that basically the same interactions are in place. But two points can explain - in my opinion- a part of the difference in the rates.1. The negotiating power of the unions makes them able to obtain always that little bit more than what's economically payable. The only way to argue that this is a job detructive policy is force the member states to follow the stability pact so that they can use the "maximum increase" argument in the wage negotiations. That seems to me the most obvious reason of the "stubborn " adoration of the EBC towards this sacred cow called inflation. An second element in the discussion is that in a lot of European countries unemployment doesn't mean a total disaster. On top of he social security coverage many unemployed try to increase their net income by all types of small jobs, so that they gather an net income somewhere around 1.500 euro a month. This "gray or black labor market is really important and reduces partly the gap between the official European statistics and the US reality.

Posted by: F. De Keyser - Brussels on September 14, 2003 03:09 AM

during the late 1970's in australia left-wing economists (- of the cambribge educated sraffa/joan robinson ilk-) were proposing a negotiated national incomes policy as a response to the then swirling waves of inflation. (since australia is a highly import/export exposed economy, it tended to import the then widespread international inflationary tendencies.) yes, you say: high transaction costs! free rider problem!
the advantage of raising interest ratesto induce a recession and thus squeeze out inflation is that it appears to be a natural event, reducible to well-worn principles of causality and not a political decision. the not inconsiderable disadvantage is all that lost output and correspondingly, the lost wage income. systems theorists speak of "functionally equivalent solutions". of course, economists understand this?
e.g. tax cuts and public goods expenditures are both forms of fiscal stimulus to a recessionary economy. "but politicians are ignorant and corrupt; they simply don't underatand our theories". perhaps you should access niklas luhman's account of "self-legitimating political elites": a thoroughly cynical and completely disinterested approach. is it not time that economists relinquish their reductionism toward the political and acknowledge the political mortgages and vulnerabilities of their theoretical accounts? the idea that politics is reducible to "households" and centers of governance is only an economist's idea. maggie thather's nominalist/psychotic declaration that "society" does not exist, presumably because there is no such identifiable/observable substance to correspond to the noun, is very much to the point. what we have seen since the late 1970's is a concerted attempt to de-politicise social conflict through the use of "naturalistic" economic theories. that these matters, in the range between the holy family and the sacred state, so beloved by authoritarian fundamentalists and so instrumentalised by corporate interests, are amenable to public choice and rational discourse has become the burden of economic discourse to deny.

Posted by: john c. halasz on September 14, 2003 04:37 AM

Brad
Thanks for your website..esp. the blog! I recently purchased a copy of Blanchard's macro, in an effort to educate myself.
Your book is not available here in Mumbai . ;)
Your posts and the discussions have been marvellous complements. esp. Loved the discussion of hedonic pricing.
Looking forward to lots more!!
Regards
Rajeev

Posted by: rajeev on September 14, 2003 06:44 AM

"...good economic policy works to satisfy and meet household preferences, and does not inquire into where those preferences come from...."

There's your answer. Let your dog hunt THAT poisonous little piece of pseudo-populism, and come back with its neck broken in at least one place.

Posted by: Frank Wilhoit on September 14, 2003 06:59 AM

There is no reason to believe that were Europe or Japan to strongly lessen labor force protections there would be a corresponding increase in hiring. Demand drives employers to expand production capacity. Were Japan to allow employment to decline significantly, where would the domestic demand come from to generate more employment? Cheaper, less protected labor in Europe would not simply mean more consumption and more hiring.

The problem is how to generate more demand in Europe and Japan so that employers will need to hire. Hopefully, labor market rigidities can be strongly reduced as demand for labor increases but not before.

Posted by: anne on September 14, 2003 08:25 AM

how about a range that coincides with population growth on the low end and its sum with productivity growth on the top end?

it's awfully facile, but for some reason the idea attracts me. almost has to be wrong. could someone please shoot it down for me? thanks.

Posted by: wcw on September 14, 2003 09:12 AM

Even if economists made a convincing case for a radical lessening of labor protections in Europe and Japan, there is no chance. Japan is a democracy as is Germany as is France, and labor protections can be slightly modified but there are no prospects of radical change. There is a remarkable degree of contentment with middle class life styles in Europe and Japan, for all the complaining of American or British economists.

Posted by: anne on September 14, 2003 09:19 AM

"This "gray or black labor market is really important and reduces partly the gap between the official European statistics and the US reality."

I read somewhere that in Italy the underground economy is larger than the official economy.

Posted by: Joe Willingham on September 14, 2003 09:43 AM

Approaching inflation from a political rather than a strictly economic perspective -which is how representative democracies have to approach economic problems -even moderate degrees of inflation have debilitating economic effects.

The primary reason for this is large segments of the electorate are psychologically stressed by the erosion of purchasing power on their household income ( esp. when progressive income tax rates are not indexed for inflation and " bracket creep" emerges as a " double-punishment"). While in the midst of a disaster we reach for a life preserver when merely made uncomfortable we lash out for someone to blame, circle the wagons, demand action whther or not it makes any sense. U.S. economic policy from Nixon through Carter was essentially unable to make the choices required to tame inflationary pressures, often substituting high-profile gimmicks and rhetoric( " Whip Inflation Now !" remember that one ?) which when they inevitably fail, reinforce the impression of governmental incompetence and economic insecurity.

This lack of voter confidence inevitably affects investors and markets which begin reacting to take into account the assumptions that fiscal and monetary policy will be lurchingly erratic and ineffective. This effect is probably more pronounced abroad in nations like Argentina or Russia where hyperinflation is a living memory.

Not being an economist I'm not certain how one would measure this kind of ripple effect distortion but as a historian I'm fairly confident it exists.

Posted by: mark safranski on September 14, 2003 09:59 AM

I wonder if the 5% threshold could not be too high for more corporatist economies with more powerful unions?

Posted by: Tobias on September 14, 2003 10:04 AM

Very good points indeed. However, the key-word volatility went missing from Brad's blog post. High inflation is bad exactly when it leads to volatile inflation, which hampers planning and imposes unnecessary risks on the economy.

Posted by: Mats on September 14, 2003 10:08 AM

We have a perfect test case in public perception not of low inflation but deflation in Japan. I suggest that while there is much for economists to worry about with deflation, the Japanese public has worried little about. Savers gain with low inflation or deflation, and the Japanese are significant savers.

China has had low inflation and deflation with no special problems as a result. China has been able to grow at a terrific clip with no inflation pressures that can not be toned down quickly with a modest interest rate increase.

Posted by: anne on September 14, 2003 10:10 AM

"We had low inflation and low unemployment in this country in the nineties. Generally from 1950 to 1967."

The problem however does not become labor market rigidities! Why always focus on workers as the culprit? Why not ask whether low demand is the problem? Why should workers be squeezed and squeezed? I do not find the economics of squeezing labor sound.

Posted by: anne on September 14, 2003 10:56 AM

Anne keeps auggesting that we change the shape of the argument from how do we simply toss away labor market protections to how do we generate enough demand to fully employ labor in a high productivity and globalizing environment. I like entertaining the change.

Posted by: jd on September 14, 2003 11:04 AM

Regarding Europe and its middle class "contentment" . . . . . that may be well and good for the present, but over the past 10-15 years the Euro-economies have grown notably slower than the U.S. Looking forward, given their slow growth and rapidly aging populations, the contented middle class of Europe is in for one heck of a shock - because the retirement benefits they've been counting on as "entitlements" are going to turn out to be unaffordable to society as a whole. They may be content now, but it's an entirely false and short lived contentment.

Also, someone suggested that "insufficient demand" may be the reason behind Europe's high and lingering unemployment rate. That may be true in a cyclical sense, but Europe's problem isn't cyclical unemployment, it's structural or secular unemployment. And a big part of it is because the labor markets in Euroland have lots of hidden costs - benefits, difficulties in reducing workforce size, etc. Those hidden costs make the total cost of Eurolabor relatively expensive - as a result, CAPITAL is substituted for labor to a greater extent in Europe than in lower labor cost regions - also, labor intensive (ie, high job creating) projects and businesses tend to get moved out of Europe over time.

Posted by: Anarchus on September 14, 2003 11:10 AM

Reply to Ann:

If you set an artificially high price for X, you get a surplus of X. There is no way around it.

The high unemployment rate in Europe does enormous damage to society despite all the government benefits for the employed. In France there are whole classes of people, not all of them immigrants by any means, who live in desolate housing projects, who have never worked, and who have no sense of participation in society. In Great Britain there is a white underclass whose members grow up close to feral. Many are them are malnourished because not because they can't afford to buy food but because they have never learned to eat properly. Their diet consists of junk food and drugs. They are capable of committing hideous crimes without the slightest sense that they have done anything wrong.

The welfare state has a dark underside from which the better off generally prefer to avert their gaze.

Posted by: Joe Willingham on September 14, 2003 11:35 AM

" If you set an artificially high price for X, you get a surplus of X. There is no way around it."

Exactly, and even worse, if you are so foolish to buy once at price X in many European countries, you are legally forced to continue to buy at that price.

Anne should talk to some European businessmen, she might have her eyes opened. Although "I could be wrong".

Posted by: Patrick R. Sullivan on September 14, 2003 12:09 PM

The preceeding comments about France and England reflect no more than hateful ignorant prejudice. Shame.

Posted by: Ari on September 14, 2003 01:36 PM

I would like to hear the professor talk more about how a cyclical downturn in Europe caused intentionally to lower inflation led to structurally high unemployment lasting decades. For example, does any political event stand out, or were there already welfare programs in effect which would make any temporary spike in unemployment permanent? Is it possible to trace the current restrictive labor laws to a political climate which took hold decades ago?

Anne, Europe generates increasing inflation even at quite high levels of unemployment (unlike the US and Japan), suggesting the problems in Europe are mainly not cyclical. They do have cycles as well, but at a higher level. I agree with you that it is in general best to wait for a cyclical upturn before fixing their labor laws, but it's such a slow process I don't see how you can time something like that.

Posted by: snsterling on September 14, 2003 01:41 PM

Would the hateful comments about the British apply to those brave British men and women who fought with us for a century? Are they the ones who are referred to so meanly? What would possess a person to think such thoughts? Please apologize for your sake.

Posted by: Ari on September 14, 2003 01:50 PM

SN Sterling -

Good observation about an inflation propensity in Europe that is beyond Japan's. I can agree, there should be progressive liberalization in labor markets. I am thinking along the lines of the Netherlands and Switzerland. But, there are political realities that will make liberalization gradual and increasingly feasible with an improving growth cycle.

Posted by: anne on September 14, 2003 02:12 PM

"... even if the Volcker disinflation was a good thing in the U.S., it was surely a bad thing in Europe: unemployment went up from 5% to 9% and stayed there."

Inflation in Germany peaked in 1971, before the oil price shock and at a much lower level than was reached in the US. So how could there have been a "Volcker disinflation" in Germany?

Moreover, disinflation is a temporary process. So why would it lead to any permanent increase in unemployment?

And why would a much milder disinflation in Germany lead to a much larger permanent increase in unemployment than a much more severe disinflation in the US? Is it really just disinflation here? Or is something missing from this picture.
~~~~

"There is no reason to believe that were Europe or Japan to strongly lessen labor force protections there would be a corresponding increase in hiring."

Increasing the cost of dismissing workers increases the cost of hiring them. Increasing the cost of something gives you less of it. Decreasing the cost of something gives you more of it.

So the law of supply and demand gives a simple and good reason why eliminating constrictive labor regulations to decrease the cost of hiring will lead to more employment.

Those job protections don't help "workers", they help only some workers at the cost of others -- those who have jobs at the cost of those who need them.

Just like rent control helps tenants who have apartments at the cost of those who need them -- and like any form of protectionism protects the haves at the cost of the have nots.

"Demand drives employers to expand production capacity. Were Japan to allow employment to decline significantly, where would the domestic demand come from to generate more employment? "

OTOH, what effect would be the effect of increasing employment by reducing regulatory obstructions to hiring?

Compare the number of jobs created in the private sector over the last 25 years in Western Europe and the US. With them and that 9% European unemployment rate in mind it will take quite a stretch of the imagination to say European regulatory policy has protected high employment while US policy has reduced it.

Posted by: Jim Glass on September 14, 2003 02:15 PM

"Compare the number of jobs created in the private sector over the last 25 years in Western Europe and the US. With them and that 9% European unemployment rate in mind it will take quite a stretch of the imagination to say European regulatory policy has protected high employment while US policy has reduced it."

Agreed completely. The point is European workers are proud of the gains they have made over the years in wages and benefits, and are determined to protect these gains. There will be compromises but I have respect for gains that French and German workers have secured. Changes will be a slow compromise.

Posted by: anne on September 14, 2003 02:36 PM

I understand that in the Netherlands representatives of business, labor, and the environmental movement are meeting to discuss the right balance between the need for full employment via a vibrant entrepreneurial economy, the need for a social safety net, and the need for a clean environment. As Jorge Luis Borges said of the Swiss, the Dutch are a people who have chosen to be rational.

Posted by: Joe Willingham on September 14, 2003 03:30 PM

i did not mean to suggest last night that a antional income negotiation policy be adopted or was actually practicable, certainly not for the u.s.a. suchn a policy would only be conceivable with a leftwing government with strong popular support and strong backing from both formally and informally organized labor (brazil?). the point i was making was that economic policy decisions are also always political decisions and with respect to high inflation, that high inflation both provokes and reflects underlying social conflicts over distribution. the high inflation of the late 1970's and its self-accelerating threat was caused by the overhang from untaxed vietman war expenses, expanded government social welfare programs, and oil price shocks. but also by the amplification of these factors through wage expectations derived from the long post-war boom period. ever since official policy, cheered on by the rise of "free market" ideology and the tax cutting crowd, has been obsessively focused on keeping the inflation rate low, when moderate inflation is actually a healthy thing, like a glass of wine with dinner which stimulates digestion, since it indicates the presence of adequate demand, (hyper-inflation would be getting raving drunk after dinner.) as a result of 30 years of this we now have an income distribution skewed heavily toward the wealthiest percentiles, discretionary social spending as a %of the federal budget has sharply decreased (as reported in today's krugman article in the ny times), real wages have scarcely grown, deflation threatens, the discretionary spending power of the median family has actually shrunk (from $17,800 to $17,000 in real$), and we lack adequate employment to absorb recent large gains in productivity, (though productivity growth was low throughout much of this period). "opportunity cost" is not soley a micro-economic concept, for all the triumphant harumphing of panglossian economic positivism. and labor is not simply a commodity whose "price" is determined by the ubiqutous law of supply and demand; its "price" can not exceed its productivity level within the overall structure of the cost of production, but its "price" is indeed "artificially" determined a host of social factors irreducible to the pure operations of markets. (and are ceo's actually woth those megamillions or do they simply have their hands in the cookie jar? how would one measure the productivity of ceo labor?) pardon my ignorance, but markets are not purely and simply and necessarily maximal optimizers of "resource" allocation, but rather markets are aggregators of dispersed human decision-making, and since human decisions are liable to errors, so are markets, sometimes to large ones. the "power" of markets lies in that they are an error reduction mechanism, often for a great many cases the best and clearly most efficient one humanly known. but they are not the only, nor the exclusively legitimate way in which human decisions can be collectively made. and they cannot dissolve our responsibility for the decisions that we collectively make. especially, as to how we collectively allocate our "resources. the volcker inflation fighting policy was also an ideological effort to "punish" labor and thereby permanently disciple wage expectations and the social terms of labor. and we are still living with the consequences of that.


Posted by: john c. halasz on September 14, 2003 05:30 PM

Well, we have a living laboratory in which to test the merits of liberalism versus socialism. Let's see how well the US does in comparison with the EU over the next decade.

The contest is partly over economic theory, but it's also about values. Most Americans would never accept the degree of regimentation and state control of the individual they have in Europe.

There is another point to keep in mind. The EU benefits from the US in that they can adopt the technological innovations and discoveries that occur under the American system.

Posted by: Joe Willingham on September 14, 2003 07:40 PM

"Mark, do you agree with the theory that rigidities in the labor market are the culprit?"

Well, thinking about it, I'm not even sure what "Western Europe" means. I'm terrible at remembering things, but I vaguely recall from an issue of The Economist of a few months ago that Nordic countries actually seemed to have pretty decent unemployment numbers.

Then, you've got the German reunification of only a decade-and-a-half ago. Swallowing another country that's basically an economic basket case has to have major effects in a lot of areas, I'd think.

And as pointed out already here, most Western European unemployment arrangements are more generous than in the U.S.

So I can think of a whole lot of different reasons, depending on the countries involved. But certainly rigidities in labor arrangements would seem to be a factor in Germany and France. In Germany and France, I'd certainly look for those things more than the fact that they may have had to cut down on inflation a bit a few decades ago.

Posted by: Mark Bahner on September 14, 2003 08:45 PM

"Mark, do you agree with the theory that rigidities in the labor market are the culprit?"

Well, thinking about it, I'm not even sure what "Western Europe" means. I'm terrible at remembering things, but I vaguely recall from an issue of The Economist of a few months ago that Nordic countries actually seemed to have pretty decent unemployment numbers.

Then, you've got the German reunification of only a decade-and-a-half ago. Swallowing another country that's basically an economic basket case has to have major effects in a lot of areas, I'd think.

And as pointed out already here, most Western European unemployment arrangements are more generous than in the U.S.

So I can think of a whole lot of different reasons, depending on the countries involved. But certainly rigidities in labor arrangements would seem to be a factor in Germany and France. In Germany and France, I'd certainly look for those things more than the fact that they may have had to cut down on inflation a bit a few decades ago.

Posted by: Mark Bahner on September 14, 2003 08:51 PM

People seem to be assuming that there is a problem to fix here. If an additional 2-3% unemployment is the cost of more humane labor laws, shorter working hours and overall higher quality of life, those labor market rigidities seem worth hanging on to. Especially when the life of the european unemployed compares favorably with that of the american working poor.

If lower unemployment rates are the be all and end all, we should presumably further reduce labor market rigidities in the US - eliminate unions, overtime pay, child labor laws, OSHA, etc. If we make US working life miserable enough, we can probably shave another point or two off our unemployment rate.

"There is another point to keep in mind. The EU benefits from the US in that they can adopt the technological innovations and discoveries that occur under the American system."

And vice versa. What's your point?

msw

Posted by: msw on September 14, 2003 10:01 PM

"In Great Britain ... diet consists of junk food and drugs. They are capable of committing hideous crimes without the slightest sense that they have done anything wrong."

Boy, I hope American never goes down the path of junk food and senseless violence.

msw

Posted by: msw on September 14, 2003 10:08 PM

" 'There is another point to keep in mind. The EU benefits from the US in that they can adopt the technological innovations and discoveries that occur under the American system.'

"And vice versa. What's your point?"

The point is that most of the technological innovations come from the US. In the game of technological progress the Europeans are free riders.

Posted by: Joe Willingham on September 14, 2003 11:15 PM

>The point is that most of the technological
>innovations come from the US.

So difficult to count or evaluate. But I'd rather doubt this (note: more, probably. most, no) I suppose there is a huge perception-reality gap caused by socialised perceptions on both sides of the pond.

Posted by: Tobias on September 15, 2003 04:55 AM

">The point is that most of the technological
>innovations come from the US.

So difficult to count or evaluate. But I'd rather doubt this (note: more, probably. most, no)[...]"

I cannot be sure but reckon that:
One problem here is that many innovation are marketed first in the USA, even when they originate in Europe.
Where would you try to position your products first, where people have incomes in the 30000+ or 15000+ ?
One must have in mind that most innovations are not breakthroughs, so having the latest widget is rather conspicuous consumption.

DSW

Posted by: Antoni Jaume on September 15, 2003 01:50 PM

snsterling,

I don't know Brad's answer to your question about the European inflation/jobless link, but I know he has read the Blanchard piece on the issue. To see what he had to say, you can start here:

http://www.j-bradford-delong.net/movable_type/2003_archives/000332.html,

or go down the list of links on Brad's page to "Economists: Blanchard".

The second route takes a while longer, but has its own rewards.

Posted by: K Harris on September 15, 2003 03:11 PM
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