Luncheon address to the American Economic Association/American Finance Association Annual Joint Meeting, January 4, 1997, New Orleans, Louisiana.
I am pleased to be here today and honored to be included among such a distinguished list of former superstar speakers--Bob Merton, Steve Ross, Joe Stiglitz, Larry Summers, and Alan Greenspan, to name but a few. I am especially honored that you have invited me back for a second speech. I last spoke at this luncheon when I was chairman of the Council of Economic Advisers, and my topic at that time was "The Benefits of Financial Innovation." My conclusions at that time--that financial market innovation, much of it made possible by analytic developments in finance, such as Black-Scholes option pricing, have been enormously beneficial to the functioning of the American and world financial markets and economies and that the proclivity of the government to regulate should be limited primarily to disclosure and transparency--remain valid today. Let me also in this spirit congratulate Secretary Rubin and the Treasury for the soon-to-be issued indexed bonds.
Today I want to talk about another subject of immense importance both to finance and to the rest of economics--inflation. As we move from 1996 to 1997, history reminds us that inflation is ignored at our peril. This is the hundredth anniversary of William Jennings Bryan's "Cross of Gold" speech in the 1896 election; the seventy-fifth anniversary of Weimar hyperinflation and the publication of Irving Fisher's classic The Making of Index Numbers; the fiftieth anniversary of the first American double-digit inflation of modern times after the removal of price controls following World War II; and the twenty-fifth anniversary of President Nixon's wage and price controls. Perhaps it is particularly important for us to be thinking about inflation now, despite its relatively low level, to avoid complacency and future problems.
I've been thinking a lot about inflation lately or, more accurately, about how to measure it and the implications of its mismeasurement. I will return to that topic in a moment. I want to emphasize today how far we have come in understanding inflation, its costs, and its role in the long-term performance of the economy. Indeed, it would be difficult to find any subject about which the consensus of economists has changed more in the time since I was in graduate school.
At that time--the late 1960s and early 1970s--inflation was just starting to accelerate from the relatively benign levels of the 1950s to late 1960s. Milton Friedman and Ned Phelps were publishing their seminal works on the natural rate of unemployment. When I first came to Stanford University as an assistant professor, President Nixon was about to freeze wages and prices and to close the gold window, ending the Bretton Woods era. As Alan Blinder demonstrated, the wage and price controls actually worsened subsequent inflation.
At that time, in all but a few places, it was standard to teach an augmented Keynesian macroeconomics--there was no Lucas critique, let alone a whole school of rational expectations, no credit/liquidity constraint neo-Keynesianism. Of course, Milton Friedman and other monetarists emphasized the importance of low inflation and of rules rather than discretion in monetary policy, based in part on the perceived empirical stability of velocity.
More important, the conventional wisdom was that the cost of inflation was low, negligible in fact. A true giant of our profession--and one of the founders of modern finance--Jim Tobin, and his colleagues at the Cowles Foundation summarized this widely held view by saying that the cost of high inflation was primarily shoe leather--the need to hoof it down to the bank to get more cash (recall that this era predates ATM machines).
Of course, at that time we had experienced high inflation only temporarily, after the removal of price controls, usually after wars. Social Security and other budgetary outlays had not yet been explicitly indexed, and the tax brackets would not be indexed for another decade.
Finally, and most important, we had not yet experienced the trauma of the high, accelerating, and widely fluctuating inflation that occurred in the 1970s. Nor had we had the gross historical experiment of the 1970s, which brought rising inflation and unemployment simultaneously, something that caused all economists to rethink the relationship between inflation and unemployment.
There were, of course, those who had warned of the dangers of high inflation. Hayek, for example, emphasized that high inflation was inevitably followed by recession. High inflation was accompanied by speculative excesses and confusion in relative price signals that would have to be adjusted at significant cost.
The neutrality of money of classical economics was increasingly coming under attack from other quarters. For example, public finance economists, myself included but especially Martin Feldstein, emphasized that when tax rules are not perfectly indexed--the definition of income is nominal rather than real with historic cost depreciation, nominal capital gains and losses, and nominal interest, all taxed or deducted or both--higher inflation will lead to tax-induced distortions in capital accumulation.
Flash forward a decade, from circa 1970 to 1980. Inflation, as officially measured, is running at more than 13 percent. The overwhelming bulk of leading economists argues that we should learn to live with this high inflation, indexing more contracts and government programs, and attempt to stabilize the inflation rate at around 10 percent. The thinking at the time was that the substantial cost of disinflation was unbearable. There were, of course, people with different views--Tom Sargent and William Fellner, for example, who emphasized the possibility of a lower cost disinflation if the Federal Reserve policy was widely viewed as credible. I was in this camp and vividly recall a debate I had with the late Walter Heller on this issue in 1978--he still believed in jawboning as an effective inflation remedy!
When the Volcker Federal Reserve put on the brakes, velocity collapsed, and we had rapid disinflation accompanied by the worst recession since World War II. The cost of that disinflation in terms of lost output was substantially less than the simple Okun's law calculation implied. My own personal opinion is that the Federal Reserve has been gaining substantial credibility--gradually--ever since and that this is enormously valuable social capital that should not be readily squandered. Let's take a closer look at the two rounds of disinflation.
The First Disinflation
By 1979, inflation had once again reached double digits in the United States and many other industrialized countries. The sharp rise in inflation--for the second time in the 1970s--outpaced the growth of wages for most American workers, drove millions of Americans into higher tax brackets (which were not yet indexed for inflation), wiped out a large fraction of the value of the assets of many financial institutions, clobbered the life savings of many families, and required a disinflation that had as a byproduct the worst recession since World War II (the unemployment rate reached 10.8 percent). Importantly, although the 1981–82 recession was severe, it was only about one-third as bad as typical Keynesian econometric models predicted would occur with that large a fall in inflation. Recall that many leading economists back then argued that it would be better to learn to live with inflation than to disinflate.
Starting with 13 percent inflation in 1980, what would have been considered successful inflation outcomes? Since inflation had risen at corresponding points in each postwar business cycle, the initial goal might be to prevent this from happening again or to keep inflation in the post-1982 expansion no higher than in the 1975–79 expansion, an average of more than 7 percent. Many would have thought this remarkable, reversing a thirty-year trend. Perhaps the United States could match its longer-term historical average for the post–Bretton Woods era, almost 8 percent, or do better than the inflation forecasts of the main econometric models--DRI, Wharton, and Chase--which were predicting 8 percent or higher in the 1980s and almost 7 percent in the 1990s (as of 1981). Or perhaps the United States could match the best of the major industrialized countries' post–Bretton Woods experience--Germany's at more than 5 percent--or do better than the inflation rates implicit in long-term Treasury Bond yields for the period of the late 1970s and early 1980s (using a conservative assumption of long-run real interest rates implied an average inflation rate of 6 percent in the 1980s and 1990s).
The Federal Reserve bettered each of these commonsense goals in times of rapid financial innovation, technical change and globalization, which rendered the making of monetary policy more complex. For example, the traditional relationships between changes in reserve positions and the money supply and gross domestic product became less reliable, globalization rendered traditional measures of capacity utilization suspect, and technological change drove down the prices of important inputs.
The Second Round of Disinflation
Inflation was reduced to the 4.5 percent range for most of the 1980s, much lower than the 1970s but still at a level that caused a conservative Republican president, Richard Nixon, to impose wage and price controls. Worse yet, that level risked becoming the floor, with nowhere to go but up. Hence, the Greenspan Federal Reserve, starting in early 1988, launched a second round of disinflation, trying to achieve the practical equivalent of "price stability" by engineering a so-called soft landing. A combination of factors--some not foreseeable when the Federal Reserve began to raise interest rates, such as Saddam Hussein's invasion of Kuwait in 1990 and the resulting oil price shock and an immense and accelerated defense drawdown following the collapse of the former Soviet Union, some more predictable, such as the impending recession in Europe and Japan and the credit crunch--hardened the landing, but it was far less severe than in any other major industrial country, each of which had a far worse recession than that of the United States. American economic growth has been by far the strongest among the Group of 7 nations since 1992, and inflation remains low.
Relative to the economic problems that the country has confronted over the past decade and a half, the Federal Reserve has done a remarkable job of engineering two rounds of disinflation with considerably less cost than many thought possible at the time, laying a foundation for longer-lived expansions. Indeed, growth was at least as strong in the decade of the 1980s, when inflation fell by 9 percentage points, as in the 1970s, when it rose by 9 percentage points (a fact conveniently ignored by the decryers of the 1980s).
The Volcker and the Greenspan Federal Reserves have been, by a substantial margin, the stars of economic policy in recent times (unfortunately, this followed one of the worst Federal Reserve performances by their predecessors in the 1970s).
Although it is always dangerous to talk about a consensus among economists, I believe it is fair to say that most economists today would argue that low and stable inflation is an important pillar of maximizing long-run real economic growth and rising living standards. That contrasts remarkably with the notion that the cost of inflation is trivial or that it is often desirable to increase inflation to reduce unemployment. We now know that is likely to be unsuccessful, as we are likely to accelerate inflation without permanently affecting the level of unemployment in relatively normal times. We also know that the higher level of inflation will not be neutral in the long run but will damage capital formation and growth.
Let me briefly mention something that has occupied a disproportionate amount of my time not only in the last eighteen months, when I chaired the Congressional Commission on the Consumer Price Index (CPI), but for many years, as I've thought about and worked to try to improve the quality of our economic statistics. We know that our usual measures of inflation overstate changes in the cost of living because of the failure of some indexes, such as the CPI, to allow for consumer substitution among commodities, which partially insulates consumers from increases in relative prices of goods. Despite continuing improvements by government statisticians, we are not keeping up with the pace of introduction of new products and quality change in existing products. Our CPI commission concluded that this was an important source of bias (and we did not even fully include the Hicksian reservation price/consumer surplus for new products). We focused primarily on introducing new products--such as VCR's, microwave ovens, and personal computers--a decade or more after they entered the market and after their price had fallen 80 or 90 percent. (Cellular telephones will enter the index in 1998.) In a complex, dynamic market economy with hundreds of thousands of goods, many thousands of which are being introduced, produced, and consumed each year and others of which are leaving the market; the quality change in many products; and an ever-growing share of what the nation produces and consumes in areas where it is much harder to measure output as compared to the traditional tons of steel and bushels of wheat, these issues have profound ramifications.
If our CPI commission's estimate--which we believe to be prudent, even conservative--of an overstatement of about 1.1 percentage points a year is correct, it implies that the federal budget will be an extra trillion dollars in the red over the next dozen years just as a result of this overstatement, which by itself will be the fourth-largest item in the budget after Social Security, health care, and defense. It also means that we are mismeasuring economic progress, not just misstating the contemporaneous inflation rate. Instead of falling in the last quarter century, real wages have risen--obviously, more slowly than in the previous quarter century, but risen nonetheless. Likewise, real median family income has gone up modestly, rather than stagnated. And the poverty rate would be closer to 9 percent than almost 14 percent. Of course, there are issues in the other aspects of measuring each of these variables--fringe benefits, bonuses, compositional shifts such as changes in family size, and so on.
The finance types in the audience may now look forward to an expanded Ibbotson1 with an adjusted inflation measure to help you get to real rates of return, inflation risk premia, and so on.
But getting back to my main theme, inflation--at least as approximated by a cost-of-living index, which must be the starting point for measures of a consumer and social welfare notion of why we want to keep inflation low and stable--is now running around 2 percent a year. Our estimate of the bias is roughly invariant to modest changes in the rate of inflation, that is, about the first percentage point or so of measured inflation is really other things rather than true inflation--for example, quality change and introduction of new products. Thus, if the inflation rate accelerates, as conventionally measured, from 3 to 5 percent, it is really likely accelerating from 2 to 4 percent. As you can infer from my earlier remarks, except under extremely unusual and rare circumstances, I would expect the Federal Reserve to be as diligent against a rise in inflation from 2 to 4 percent as against that from 3 to 5 percent. Keeping inflation low and steady is important and a major achievement. It is also a major achievement of our profession--perhaps somewhat forced on us by historical events in addition to our own analysis--that we now view low and stable inflation as an input to longer expansions and stronger growth, rather than an impediment to some other social goal such as full employment.
Let me conclude, then, by saying that although much progress has been made, we must not be complacent. Increasingly we hear what I would consider to be a complacent attitude about the economy--accepting too modest economic growth, wishfully believing that the business cycle is obsolete--rather than demanding fiscal, regulatory, legal, and tax policy changes that could improve long-run economic performance. (I remember a paper titled "The Business Cycle is Obsolete" written in the late 1960s just before the outbreak of higher inflation and a subsequent recession.) Surely our private economy has developed various institutions and behavior that in many ways will mitigate some types of shocks to the economy. And, it is hoped, our policymakers will continue to do a better job than their predecessors a generation or two or three ago. We also hear that the Federal Reserve should be probing much lower interest rates to see if we can get the unemployment rate down still further and that, if inflation heats up, we can deal with it later. Although I believe the economy can and should grow more rapidly, and in fact is doing somewhat better than the conventional statistics report--after all, the problems in the consumer price index I mentioned spill over into the national income accounts, perhaps lowering real gross domestic product growth about a half a percentage point from a more accurate measure--we certainly don't want to let the inflation genie out of the bottle. We've tried that in the past, and it has caused serious problems, wreaked enormous hardship, which took more than a decade to work out of the economy.
I also get suspicious whenever I hear some new law of economics that seems to violate known historical experience. Let me close with an example. How many people here remember the phrase "The coasts are recession proof"? That was the phrase used to describe the economy in the 1980s because the recession of the early 1980s, which ravaged the industrial Midwest, the oil patch, and the farm belt, left the coasts relatively unscathed. I said at the time, and I always firmly believed, that such a view was simply nonsense. Well, unfortunately, residents of California and the Northeast discovered that they were not recession-proof and were clobbered at a pace much worse than the national average in the early 1990s.
So, in conclusion, while cautiously optimistic, let us remain vigilant. Low and stable inflation has been hard-won at substantial cost, and the Federal Reserve's credibility should not be squandered. We must seek to raise the nation's long-run growth potential--even a few tenths of a percent a year will make an enormous difference to long-run improvements in living standards. But let us seek the policy changes where they are likely to strengthen noninflationary growth: a simpler, broader, flatter rate tax system less inimical to saving, investment, and entrepreneurship; slowing the growth of government spending, reforming entitlements, and moving to budget balance at least on average over business cycles; less and more-flexible regulation; expanded open rules–based trade; incentives in the civil justice system to reduce the prevalence of frivolous lawsuits dramatically; private market-style reform incentives to strengthen and improve elementary and secondary education and job training. If these reforms together with the natural evolution of the private economy can raise the nation's growth potential substantially--and I believe they can--I have no doubt the Federal Reserve can and will be able to adjust monetary policy accordingly to accommodate the more rapid noninflationary growth.
1 See R. Ibbotson, Stocks, Bonds, Bills and Inflation Yearbook, 1997, which is the classic historical reference on bond yields, stock returns, and so forth.