Oil price shock fools monetarists at the Economist
Well, once again the Fed has it right and the Economist has it wrong. Gives you at least a bit of confidence in the process of choosing economic policymakers.
In response to the increases in oil prices, and the resulting inflation, the Economist’s ”Economics focus” column says interest rates should rise. Wrong. They do propose taking into account the speed of economic growth and the amount of slack, which means they are not totally out among the planets.
The basic case is explained in my second blog entry ("When supply takes a hit"). A contraction in Aggregate Supply calls, in general, for a decrease in interest rates, not an increase. To conclude otherwise is to mistake “cost-push” inflation for the effect of persistent expansionary monetary policy. I feel a touch of pride at having gotten to the question before they did, but then, that is what academics are for. That, and to get the ideas right. However, the column discusses some interesting ideas and, bravely, raises case history. So, this blog is my reply.
To discuss ideas first, they note accurately that the result for inflation depends on monetary policy. In other words, an oil price increase will only cause inflation if it is “monetized.” If not enough money is available to accommodate the higher cost of living, other sectors will suffer and most likely other prices will fall. If the Central Bank is vicious enough, it can enforce “price stability” or zero increase in overall prices, but the effect on output will be more than a little disturbing.
The Economist staff should have thought further about this principal when looking at another issue they raise, namely whether the price increase will be temporary or a pervasive, longer lasting effect.
To start with the extreme case, for an oil price increase to result in a permanent increase in the inflation rate, the conditions in the market would have to continue tightening on a perpetual basis. Of course it would also require monetizing, but more to the point it is almost exactly what one is not observing when prices jump. Rather they are signaling a “permanent” increase in oil scarcity (it may turn out to be temporary) requiring an ongoing rationing of demand to remain within the new, more limited, supply conditions. There is no basis for thinking that it has a long-term inflationary component.
Therefore, returning to the question of monetization, only if there is a steady increase in money creation, leading to prices rising for all goods, is there reason to think oil prices would continue to rise, and that would be a clearly demand-based change. Therefore the price jump that accompanies tighter supplies is almost by definition a one-time price increase, which is what Greenspan labeled it, rather than a source of inflation. Yet the Economist does not recognize this implication despite declaring “if there is no sign of a rise in the core rate of inflation, then there is no need to raise interest rates.”
In a second interesting line of thought, they turn to analyzing the issue in terms of how much slack there is in the economy, on the principle that slack will restrain inflation. While this is a sensible principle, the Economist makes such a hash of it that the stranglehold of monetarist myopia is made plain for all (trained eyes) to see.
Most seriously, they completely miss the obvious fact that an oil shock will, rather than removing slack as simple AS-AD analysis suggests, actually generate slack in the economy. This is because it has lots of spillover effects on demand (see Blog #2), in an illuminating example of the “short-side rationing” that we had the sense to discuss in the 70s. (It is illuminating because the rationing is not a crisp comparison of demand to capacity, but a messy cluster of sectoral drops in demand created directly by supply constraints but also indirectly by the demand shifts among complements and substitutes, the restriction in future prospects and the siphoning of spending abroad.)
It might be worth giving some thought to the implications of a complete “equilibrium” approach in this situation. The Long-Run Equilibrium story takes the view that the fall in investment following on an oil shock is entirely appropriate because profitable opportunities have in fact declined. While based on a valid point, if left to the market this would imply that any overshooting of investment is strictly a smooth adjustment to the new equilibrium capital level, which just happens to imply a low replacement level until the economy catches up to capacity.
The truth is that individual industries do not know what the long-run equilibrium level will be, and they are in serious danger of mistaking the temporary lull for the long-term prospects and thus confirming their collective pessimism. These are demand spillovers, they are a market failure, and they are at the core of Keynesian analysis. Put another way, slack has a tendency to be self-perpetuating, and the Central Bank has an obligation to lean against it, (though not to go to extremes or pretend that it can always be eliminated).
Less drastically, the Economist gets it wrong by waffling on whether Europe is more subject to broad-based inflation caused by cost increases than America is. On the one hand, Europe has more slack, they say, so that it is in less danger of the oil price increases becoming systemic. On the other hand, Europe has more labor market rigidities which will cause the higher cost of living to be turned into higher wages. Ignore, for the moment, that they express it in terms of this funny idea that a change in one key market can turn into ongoing inflation.
What else is missing here is a sense that wage (or price) rigidities create a ratchet that policymakers should be taking into account. In a time of falling real exchange rates, adjustment for the nation requires either falling prices of non-tradables (such as land and labor) or falling nominal exchange rates. But rigidities in wages will necessarily cause the fall in demand for local labor to translate mainly into unemployment rather than falling wages. There are two simple fixes - higher prices and lower nominal exchange rates. Lower interest rates promote both. These will not solve the problems on the real side of the economy, but they will prevent those real problems from being compounded by unnecessary extra contraction.
It is very useful to think of an oil shock as a decline in the real exchange rate. (The Economist recognizes this dimension in micro terms, and goes on to note the fall in demand from transferring income abroad. Pity they do not acknowledge any except the “real equilibrium” demand effects.) It is different in kind from a fall in the demand for a country’s exports, but the implications for macroeconomic policy are very similar. World goods become, on balance, more expensive. A given amount of consumption is therefore more expensive too. While the initial effect is not a fall in demand, as would be the case with exports declining, what we might call “real demand” (i.e. adjusted for prices) will have fallen. As I have written before, if you are not fixated on zero inflation, it is obvious that credit should loosen, not tighten.
Think of the situation of a small country under a world gold standard (or a state in the U.S.) whose products sell less. Real estate prices tend to fall, wages tend to fall. Capital flows out, as investors seek areas with higher returns. But since wages tend to resist downward pressure, employers compound the problem by laying off workers during the period of adjustment of wages. If instead of a fixed currency, a general loosening of credit specific to the area could occur, causing its currency to decline and its prices to rise, then no unnecessary closings would result. In the U.S., a region in decline sees considerable outmigration, but it also sees big falls in real estate prices and some attraction of financial capital to occupy the newly available physical capital. Why not give first call on the physical capital to local entrepreneurs, who will have more understanding of the area’s comparative advantages and will have more positive demand spillovers? A loosening of credit in the area would do that.
Interestingly, the Economist also takes up the issue of world slack. Their conclusion is that since oil prices are rising due to rising demand worldwide, especially in China but they should have mentioned Asia generally, then there is no scope for a stimulative policy. As I hope the preceding paragraphs indicated, this confuses the issue of appropriate world monetary conditions with that of appropriate U.S. monetary conditions. Although the Fed may be the closest thing the world has to a world Central Bank (the IMF has specifically been denied this role), it still has control and responsibility mainly within the US economy. It is true that demand in the outside world is raising the cost of natural resources, that some internal uses will be outbid and that the real exchange rate will fall. But again it is dangerous to try to force stable prices on the situation, and least disruptive to adjust with a declining currency and rising prices.
The Economist puts the matter in a different light by noting the rising exports to China that are resulting from world expansion, and the reduced slack that will result within the industrialized West. To that extent they have a valid point, and the core issue is exactly that - whether overall demand in the U.S. is rising so fast that interest rates need to rise to restrain it. I will return to this point at the end.
The example they cite from recent policy history is the oil shock of 1974. The story they tell is that the Fed first accommodated the rise with lower interest rates (sending short term rates lower than inflation for a negative real interest rate) and then found that interest rates and unemployment had to rise even more than they would have otherwise, as a result of the extra inflation that had been produced. In fact the picture is even worse than they paint it, but very little of the damage is to be attributed to accommodation of the oil shock in 1973-74, except as a part of the larger pattern of policy over the 12 years from 1966 to 1978. To see why, one should compare with Japan’s response to the same crisis. Japan fully monetized the oil price increase, saw inflation spike at a much higher level than in the U.S., but then saw it return to its normal low levels.
Inflation in the U.S. was systemic at the time, based on the Fed accommodating Keynesian fiscal policy. Because the inflationary result had been systematically underestimated, there was a catch-up process underway at the same time oil prices jumped. (It would not be too farfetched to label the oil price jump as part of the same catch-up process: as economic agents saw others turning to price increases, they began to view their options differently and raise prices themselves.) But economic policymakers had not expected such a big jump to materialize at once, and failed to anticipate the effect on the mortgage market.
In 1974 the Savings and Loan industry essentially shut down new lending, based on the first taste of the trouble that would later create the S & L crisis of the 80s. The problem was that their portfolio of loans was at low mortgage rates, often 6 to 7 percent, but they could not get funds except at higher rates. So they were buying money dear and selling it cheap, and had no way of escaping their previous loans. (This was before Fannie Mae began bundling mortgages into marketable "mortgage-backed securities", but even if that had been possible the losses might have wiped out the capital at most S&Ls). At first they treated the jump in (nominal) interest rates as temporary, and just waited it out by shutting off new loans. But as the higher inflation rates persisted, they eventually resumed lending - at high nominal rates.
By that time the U.S. economy had undergone the shockingly high unemployment rate of 11% in 1975. But the unemployment was created in housing and the heavy industries challenged by Japan’s economic emergence (made more dramatic by the demand shift to smaller cars). It was not the Fed “slamming on the brakes” so much as a convergence of serious shocks (add in demographic shifts in the labor market, environmental limits, industry shifting South, productivity slowing and the end of the Vietnam conflict) that caused the pain of 1975. By the time of the 1974 oil shock it would have been too late for the Fed to avoid a serious recession by raising interest rates (what a sentence! What a strange proposition to be rebutting!).
It is probably true that if the Fed had shifted earlier to fighting the built up demand pressures for inflation it could have avoided some of the trouble. The S & L adjustment would have been more gradual, and investment would have downshifted sooner, so that wage demands would not be out of line with the sudden new reality of competition from abroad. But this amounts to saying that hindsight is better than foresight. The problem was not the monetization of the oil shock per se.
That we are still going over the story of the 70s is not so surprising. The 30s live on in economic discussions as well. But it is sad to note that economists have generally bought into the most extreme version reinterpreting the experience, the Milton Friedman version that sees the short run as meaningless and markets as perfectly able to anticipate opportunities. To my mind this is a result of the disconnect between the world of policy economics, where only simple answers will have any effect, and the world of academic economics, where only mathematical modeling will be accepted. The most tractable models take over among academics (Gresham’s Law), so that more nuanced views are not allowed to be heard, and of course the nuanced views would sound too complicated for legislators anyway. It is ironic that Walter Heller, the Keynesian maven who sold Kennedy on tax cuts as a solution to economic stagnation, also argued for tax increases when government deficits rose and the economic slack was gone. There was a time when nuance was understood, at least by Ph.D.’s, and economists had more than one hand.
No doubt policy circles needed to be told “control your deficits” in clear terms. Maybe Keynesian doctrine is just too tempting for politicians, amounting to a soft budget constraint. But when we begin interpreting the experiences that do not fit neatly into the monetarist paradigm, and surely an Aggregate Supply contraction is chief among these, it is important not to try to force the round peg into our square theory.
So - is the U.S. economy growing so fast that interest rates need to rise? Of course. The yield curve is all out of whack. Short term rates are below inflation, and the recovery has taken hold not only in hiring but also, wonder of wonders, in Japan. It is time, as Greenspan said, to take a neutral stance rather than one that promotes growth.
I think it is also time to give Greenspan the first “Two-Handed Economist” award. We should give one every four years to the economist in policy circles who shows the most ability to think clearly about the real world. I am ready to nominate the next, once the obvious Mr. G. receives his.
In response to the increases in oil prices, and the resulting inflation, the Economist’s ”Economics focus” column says interest rates should rise. Wrong. They do propose taking into account the speed of economic growth and the amount of slack, which means they are not totally out among the planets.
The basic case is explained in my second blog entry ("When supply takes a hit"). A contraction in Aggregate Supply calls, in general, for a decrease in interest rates, not an increase. To conclude otherwise is to mistake “cost-push” inflation for the effect of persistent expansionary monetary policy. I feel a touch of pride at having gotten to the question before they did, but then, that is what academics are for. That, and to get the ideas right. However, the column discusses some interesting ideas and, bravely, raises case history. So, this blog is my reply.
To discuss ideas first, they note accurately that the result for inflation depends on monetary policy. In other words, an oil price increase will only cause inflation if it is “monetized.” If not enough money is available to accommodate the higher cost of living, other sectors will suffer and most likely other prices will fall. If the Central Bank is vicious enough, it can enforce “price stability” or zero increase in overall prices, but the effect on output will be more than a little disturbing.
The Economist staff should have thought further about this principal when looking at another issue they raise, namely whether the price increase will be temporary or a pervasive, longer lasting effect.
To start with the extreme case, for an oil price increase to result in a permanent increase in the inflation rate, the conditions in the market would have to continue tightening on a perpetual basis. Of course it would also require monetizing, but more to the point it is almost exactly what one is not observing when prices jump. Rather they are signaling a “permanent” increase in oil scarcity (it may turn out to be temporary) requiring an ongoing rationing of demand to remain within the new, more limited, supply conditions. There is no basis for thinking that it has a long-term inflationary component.
Therefore, returning to the question of monetization, only if there is a steady increase in money creation, leading to prices rising for all goods, is there reason to think oil prices would continue to rise, and that would be a clearly demand-based change. Therefore the price jump that accompanies tighter supplies is almost by definition a one-time price increase, which is what Greenspan labeled it, rather than a source of inflation. Yet the Economist does not recognize this implication despite declaring “if there is no sign of a rise in the core rate of inflation, then there is no need to raise interest rates.”
In a second interesting line of thought, they turn to analyzing the issue in terms of how much slack there is in the economy, on the principle that slack will restrain inflation. While this is a sensible principle, the Economist makes such a hash of it that the stranglehold of monetarist myopia is made plain for all (trained eyes) to see.
Most seriously, they completely miss the obvious fact that an oil shock will, rather than removing slack as simple AS-AD analysis suggests, actually generate slack in the economy. This is because it has lots of spillover effects on demand (see Blog #2), in an illuminating example of the “short-side rationing” that we had the sense to discuss in the 70s. (It is illuminating because the rationing is not a crisp comparison of demand to capacity, but a messy cluster of sectoral drops in demand created directly by supply constraints but also indirectly by the demand shifts among complements and substitutes, the restriction in future prospects and the siphoning of spending abroad.)
It might be worth giving some thought to the implications of a complete “equilibrium” approach in this situation. The Long-Run Equilibrium story takes the view that the fall in investment following on an oil shock is entirely appropriate because profitable opportunities have in fact declined. While based on a valid point, if left to the market this would imply that any overshooting of investment is strictly a smooth adjustment to the new equilibrium capital level, which just happens to imply a low replacement level until the economy catches up to capacity.
The truth is that individual industries do not know what the long-run equilibrium level will be, and they are in serious danger of mistaking the temporary lull for the long-term prospects and thus confirming their collective pessimism. These are demand spillovers, they are a market failure, and they are at the core of Keynesian analysis. Put another way, slack has a tendency to be self-perpetuating, and the Central Bank has an obligation to lean against it, (though not to go to extremes or pretend that it can always be eliminated).
Less drastically, the Economist gets it wrong by waffling on whether Europe is more subject to broad-based inflation caused by cost increases than America is. On the one hand, Europe has more slack, they say, so that it is in less danger of the oil price increases becoming systemic. On the other hand, Europe has more labor market rigidities which will cause the higher cost of living to be turned into higher wages. Ignore, for the moment, that they express it in terms of this funny idea that a change in one key market can turn into ongoing inflation.
What else is missing here is a sense that wage (or price) rigidities create a ratchet that policymakers should be taking into account. In a time of falling real exchange rates, adjustment for the nation requires either falling prices of non-tradables (such as land and labor) or falling nominal exchange rates. But rigidities in wages will necessarily cause the fall in demand for local labor to translate mainly into unemployment rather than falling wages. There are two simple fixes - higher prices and lower nominal exchange rates. Lower interest rates promote both. These will not solve the problems on the real side of the economy, but they will prevent those real problems from being compounded by unnecessary extra contraction.
It is very useful to think of an oil shock as a decline in the real exchange rate. (The Economist recognizes this dimension in micro terms, and goes on to note the fall in demand from transferring income abroad. Pity they do not acknowledge any except the “real equilibrium” demand effects.) It is different in kind from a fall in the demand for a country’s exports, but the implications for macroeconomic policy are very similar. World goods become, on balance, more expensive. A given amount of consumption is therefore more expensive too. While the initial effect is not a fall in demand, as would be the case with exports declining, what we might call “real demand” (i.e. adjusted for prices) will have fallen. As I have written before, if you are not fixated on zero inflation, it is obvious that credit should loosen, not tighten.
Think of the situation of a small country under a world gold standard (or a state in the U.S.) whose products sell less. Real estate prices tend to fall, wages tend to fall. Capital flows out, as investors seek areas with higher returns. But since wages tend to resist downward pressure, employers compound the problem by laying off workers during the period of adjustment of wages. If instead of a fixed currency, a general loosening of credit specific to the area could occur, causing its currency to decline and its prices to rise, then no unnecessary closings would result. In the U.S., a region in decline sees considerable outmigration, but it also sees big falls in real estate prices and some attraction of financial capital to occupy the newly available physical capital. Why not give first call on the physical capital to local entrepreneurs, who will have more understanding of the area’s comparative advantages and will have more positive demand spillovers? A loosening of credit in the area would do that.
Interestingly, the Economist also takes up the issue of world slack. Their conclusion is that since oil prices are rising due to rising demand worldwide, especially in China but they should have mentioned Asia generally, then there is no scope for a stimulative policy. As I hope the preceding paragraphs indicated, this confuses the issue of appropriate world monetary conditions with that of appropriate U.S. monetary conditions. Although the Fed may be the closest thing the world has to a world Central Bank (the IMF has specifically been denied this role), it still has control and responsibility mainly within the US economy. It is true that demand in the outside world is raising the cost of natural resources, that some internal uses will be outbid and that the real exchange rate will fall. But again it is dangerous to try to force stable prices on the situation, and least disruptive to adjust with a declining currency and rising prices.
The Economist puts the matter in a different light by noting the rising exports to China that are resulting from world expansion, and the reduced slack that will result within the industrialized West. To that extent they have a valid point, and the core issue is exactly that - whether overall demand in the U.S. is rising so fast that interest rates need to rise to restrain it. I will return to this point at the end.
The example they cite from recent policy history is the oil shock of 1974. The story they tell is that the Fed first accommodated the rise with lower interest rates (sending short term rates lower than inflation for a negative real interest rate) and then found that interest rates and unemployment had to rise even more than they would have otherwise, as a result of the extra inflation that had been produced. In fact the picture is even worse than they paint it, but very little of the damage is to be attributed to accommodation of the oil shock in 1973-74, except as a part of the larger pattern of policy over the 12 years from 1966 to 1978. To see why, one should compare with Japan’s response to the same crisis. Japan fully monetized the oil price increase, saw inflation spike at a much higher level than in the U.S., but then saw it return to its normal low levels.
Inflation in the U.S. was systemic at the time, based on the Fed accommodating Keynesian fiscal policy. Because the inflationary result had been systematically underestimated, there was a catch-up process underway at the same time oil prices jumped. (It would not be too farfetched to label the oil price jump as part of the same catch-up process: as economic agents saw others turning to price increases, they began to view their options differently and raise prices themselves.) But economic policymakers had not expected such a big jump to materialize at once, and failed to anticipate the effect on the mortgage market.
In 1974 the Savings and Loan industry essentially shut down new lending, based on the first taste of the trouble that would later create the S & L crisis of the 80s. The problem was that their portfolio of loans was at low mortgage rates, often 6 to 7 percent, but they could not get funds except at higher rates. So they were buying money dear and selling it cheap, and had no way of escaping their previous loans. (This was before Fannie Mae began bundling mortgages into marketable "mortgage-backed securities", but even if that had been possible the losses might have wiped out the capital at most S&Ls). At first they treated the jump in (nominal) interest rates as temporary, and just waited it out by shutting off new loans. But as the higher inflation rates persisted, they eventually resumed lending - at high nominal rates.
By that time the U.S. economy had undergone the shockingly high unemployment rate of 11% in 1975. But the unemployment was created in housing and the heavy industries challenged by Japan’s economic emergence (made more dramatic by the demand shift to smaller cars). It was not the Fed “slamming on the brakes” so much as a convergence of serious shocks (add in demographic shifts in the labor market, environmental limits, industry shifting South, productivity slowing and the end of the Vietnam conflict) that caused the pain of 1975. By the time of the 1974 oil shock it would have been too late for the Fed to avoid a serious recession by raising interest rates (what a sentence! What a strange proposition to be rebutting!).
It is probably true that if the Fed had shifted earlier to fighting the built up demand pressures for inflation it could have avoided some of the trouble. The S & L adjustment would have been more gradual, and investment would have downshifted sooner, so that wage demands would not be out of line with the sudden new reality of competition from abroad. But this amounts to saying that hindsight is better than foresight. The problem was not the monetization of the oil shock per se.
That we are still going over the story of the 70s is not so surprising. The 30s live on in economic discussions as well. But it is sad to note that economists have generally bought into the most extreme version reinterpreting the experience, the Milton Friedman version that sees the short run as meaningless and markets as perfectly able to anticipate opportunities. To my mind this is a result of the disconnect between the world of policy economics, where only simple answers will have any effect, and the world of academic economics, where only mathematical modeling will be accepted. The most tractable models take over among academics (Gresham’s Law), so that more nuanced views are not allowed to be heard, and of course the nuanced views would sound too complicated for legislators anyway. It is ironic that Walter Heller, the Keynesian maven who sold Kennedy on tax cuts as a solution to economic stagnation, also argued for tax increases when government deficits rose and the economic slack was gone. There was a time when nuance was understood, at least by Ph.D.’s, and economists had more than one hand.
No doubt policy circles needed to be told “control your deficits” in clear terms. Maybe Keynesian doctrine is just too tempting for politicians, amounting to a soft budget constraint. But when we begin interpreting the experiences that do not fit neatly into the monetarist paradigm, and surely an Aggregate Supply contraction is chief among these, it is important not to try to force the round peg into our square theory.
So - is the U.S. economy growing so fast that interest rates need to rise? Of course. The yield curve is all out of whack. Short term rates are below inflation, and the recovery has taken hold not only in hiring but also, wonder of wonders, in Japan. It is time, as Greenspan said, to take a neutral stance rather than one that promotes growth.
I think it is also time to give Greenspan the first “Two-Handed Economist” award. We should give one every four years to the economist in policy circles who shows the most ability to think clearly about the real world. I am ready to nominate the next, once the obvious Mr. G. receives his.
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