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What Caused the Great Inflation of the 1970s? Bad Ideas From Good Economists

Sign me up with Christie Romer: Allan Meltzer's claim the Federal Reserve officials in the 1960s and 1970s did not believe that theycould respond to easy fiscal with tight monetary policies is itself in need of explanation. Meltzer doesn't offer one. Romer does.

Courtesy of Mark Thoma:

Economist's View: What Caused the Great Inflation?: Meltzer’s key theme is that politics were crucial. The Great Inflation began and continued largely because monetary policymakers felt constrained to accommodate expansionary fiscal actions. More generally, monetary policymakers felt they needed to support the administration’s and Congress’s desire for low unemployment above all else. Added to this main idea, Meltzer stresses the impact of operating procedures. The need to maintain an “even-keel” during debt issues and an excessively short-run focus in monetary policymaking made concerted anti-inflation policy difficult.

There is surely truth in Meltzer’s politics hypothesis, especially for the late 1960s. But overall, I feel that Meltzer’s analysis is too narrow. I believe that his painstaking analysis of the day-to-day details of policymaking has caused him to fail to stress the more fundamental determinants of policy mistakes in this era. In the 1960s and 1970s, it was not that the Federal Reserve was narrowly constrained by fiscal policy. Rather, both monetary and fiscal policymakers were constrained or driven by the misguided economic framework of the time.

The view that economic ideas were the key source of the Great Inflation, and indeed most of the policy failures and successes of the postwar era, is one that my coauthor, David Romer, and I documented in a series of papers (see Romer and Romer, 2002a, 2002b, 2004). It is, as Meltzer notes, a view with many proponents, especially for the Great Inflation. Taylor (1997, 1999), Sargent (1999), De Long (1997), Mayer (1998), Orphanides (2003), Nelson (2004a,b), and Nelson and Nikolov (2004) have all provided evidence on the central role of economic beliefs. Since Meltzer argues that beliefs were only a small part of the story, I thought it would be useful to discuss the evidence for this alternative....

In contrast to Meltzer, who views 1950s policymakers as largely rudderless, we find that policymakers in this decade had a basically sound, if relatively unsophisticated, view of how the economy functioned. They believed that inflation resulted when output went above a quite reasonable view of capacity or full employment. They also believed that, while expansionary policy could reduce unemployment below normal in the short run, the resulting inflation would certainly not lower unemployment permanently and might possibly raise it. For example, Federal Reserve Chairman William McChesney Martin said in 1958: “If inflation should begin to develop again, it might be that the number of unemployed would be temporarily reduced…but there would be a larger amount of unemployment for a long time to come” (Federal Open Market Committee [FOMC], Minutes, August 19, 1958, p. 57). Because of these views, both monetary and fiscal policy were carefully tempered in the 1950s. On a number of occasions the Federal Reserve responded to rising inflation by orchestrating serious contraction.

In the 1960s, policymakers clearly adopted a different model. Estimates of a “reasonable and prudent” goal for normal unemployment were substantially reduced by the Kennedy and Johnson administrations and by the Federal Reserve (Council of Economic Advisers, 1962, p. 46). And, as has been stressed by a number of scholars, a belief in a permanent trade-off between inflation and unemployment briefly held sway. These views led to highly expansionary monetary and fiscal policies, and inflation and booming real growth resulted.

Around 1970, policymakers adopted a natural rate framework, but with an overly optimistic estimate of the natural rate. This view led to a half-hearted attempt at disinflation in 1969 and 1970. The result was that inflation was temporarily slowed, but not squelched.

Early in his tenure as Federal Reserve Chairman, Arthur Burns added the idea that inflation was relatively insensitive to slack. He concluded that “monetary policy could do very little to arrest an inflation that rested so heavily on wage-cost pressures. In his judgment a much higher rate of unemployment produced by monetary policy would not moderate such pressures appreciably” (FOMC, Minutes, June 8, 1971, p. 51). If tight monetary policy and the resulting unemployment were ineffective against inflation, there was no reason to pursue it. Because of this view, the Federal Reserve and the Nixon administration ran expansionary macroeconomic policy and advocated dealing with inflation through wage and price controls.

Economic views became substantially more sensible in the mid-1970s and, again, disinflation was attempted. Inflation fell substantially after the 1973-75 recession. However, with the election of Jimmy Carter and the appointment of G. William Miller as Federal Reserve Chairman, estimates of the natural rate were lowered and Burns’s view that inflation was insensitive to slack returned with a vengeance. The first Carter Economic Report of the President stated: “Recent experience has demonstrated that the inflation we have inherited from the past cannot be cured by policies that slow growth and keep unemployment high” (Council of Economic Advisers, 1978, p. 17). The result was fiscal expansion and monetary policy inaction in the face of high and rising inflation.

This brief description of the “ideas view” of the Great Inflation points out a number of important elements. One is the notion of change. A crucial part of any explanation of the Great Inflation must be to show what changed in the 1960s that led the price stability of the 1950s to be replaced by persistent inflation. Our research, along with that of a number of other scholars, clearly shows that the economic framework took a radical turn.

This same notion of change explains why the policy mistakes were so persistent. Meltzer gives as one reason that he rejects the central role of ideas that it is implausible that bad ideas would have lasted 15 years in the face of the obvious continued rise in inflation. But, as we show, policymakers did learn. The Samuelson-Solow permanent trade-off view was rejected at the start of the Nixon administration. However, it was replaced by another flawed model: first by a natural rate framework with a very low natural rate, then by a natural rate framework with an extreme insensitivity of inflation to slack. It was this succession of misguided models that gave rise to repeated policy mistakes and persistent inflation in this period...

The one amendment to Romer's analysis I would make would be to point out that Arthur Burns's view that inflation was relatively unresponsive to unemployment can be traced back to his 1959 Presidential Address to the American Economic Association.