The Premature Kingdom

Monday Smackdown: Robert Lucas Ignores the Volcker Deflation, and Paul Romer Comments...

Clown Show

With no high-quality smackdowns of DeLong on offer, let us turn to Robert Lucas's extremely bizarre reaction to the Volcker Disinflation...

I find myself thinking about this right now because of two recent conferences: one of which I attended in person, INET in Edinburgh: Reawakening, the other of which I attended virtually, PIIE in Washington: Rethinking Macro. At both the vibe was that the rough working model of macro was still IS-LM with institutionally and expectationally sticky prices, that that was inadequate, and that the breakdown of 2005-present was very strong proof that we urgently needed to do better. And I found myself thinking: Bback to the late 1970s, when I got into this business, and when the the vibe was that the rough working model of macro was still IS-LM with institutionally and expectationally sticky prices, that that was inadequate, and that we would shortly do better.

So how is it that the macroeconomics community has essentially wasted my entire professional lifetime so far?

Who should we blame.

And I think it is time we blamed Robert Lucas—not for the very clever Lucas (1969, published 1972): Expectations and the Neutrality of Money (although the assumption that economic actors can only observe the price of what they produce and are ignorant of other prices is rather silly)—but for subsequent profound uncuriosity.

As the issue—the policy, the methodological, the scientific issue—was presented to the young student me in 1979-1980, the question at issue between on the one side Lucas, Sargent, Barro, Prescott and company, and on the other side the alliance of the MIT neoclassical synthesis types with the old-line Chicago monetarists was this: Could an aggressive, credible, well-signaled change in the pattern of monetary policy—a "régime change"—produce a permanent shift in the level of the inflation rate without incurring the costs in terms of high unemployment and idle factories—persistent high unemployment and idle factories—that the "adaptive" models were then predicting? Or would the inflation rate fall with little real economic upset, because only unanticipated monetary shocks had significant real effects?

The answer was provided by reality: Volcker tried. That was the Volcker disinflation. The output and unemployment cost was in line with the adaptive expectations models. And Robert Lucas... ignored it.

Here is Paul Romer on the Volcker Disinflation, saying smart things:

Paul Romer: The Trouble with Macroeconomics: "Facts: If you want a clean test of the claim that monetary policy does not matter...

...the Volcker deflation is the episode to consider. Recall that the Federal Reserve has direct control over the monetary base.... Figure 1 plots annual data on the monetary base and the consumer price index (CPI) for roughly 20 years on either side of the Volcker deflation. The solid line in the top panel (blue if you read this online) plots the base. The dashed (red) line just below is the CPI. They are both defined to start at 1 in 1960 and plotted on a ratio scale so that moving up one grid line means an increase by a factor of 2. Because of the ratio scale, the rate of inflation is the slope of the CPI curve.

The Volcker Disinflation

The bottom panel allows a more detailed year-by-year look at the inflation rate, which is plotted using long dashes. The straight dashed lines show the fit of a linear trend to the rate of inflation before and after the Volcker deflation. Both panels use shaded regions to show the NBER dates for business cycle contractions. I highlighted the two recessions of the Volcker deflation with darker shading. In both the upper and lower panels, it is obvious that the level and trend of inflation changed abruptly around the time of these two recessions....

The best indicator of monetary policy is the real federal funds rate – the nominal rate minus the inflation rate. This real rate was higher during Volcker’s term as Chairman of the Fed than at any other time in the post-war era. Two months into his term, Volcker took the unusual step of holding a press conference to announce changes that the Fed would adopt in its operating procedures. Romer and Romer (1989) summarize the internal discussion at the Fed that led up to this change. Fed officials expected that the change would cause a "prompt increase in the Fed Funds rate" and would "dampen inflationary forces in the economy"...

Here is Robert Lucas writing a retrospective early in this millennium, ignoring the Volcker Disinflation.

Robert Lucas: Professional Memoir: In October, 1978—leaf season—the Federal Reserve Bank of Boston sponsored a conference at the Bald Peak Colony Club in New Hampshire...

...Ed Prescott and I rented a car at Logan Airport and drove up together. Night fell before we reached the conference center and we got lost on country roads. We stopped for directions at a crossroads store, but after a few minutes of laconic “Nope, yep” New England conversation we realized that the two old men in the store were amusing themselves at our expense, conveying no information. We left in disgust and anger. The incident heightened my sense of entering foreign territory....

Though I did not see it at the time, the Bald Peak conference also marked the beginning of the end for my attempts to account for the business cycle in terms of monetary shocks.... Through numerical simulations of their Bald Peak model, Kydland and Prescott found that the monetary shocks were just not pulling their weight: By removing all monetary aspects of the theory, they obtained a far simpler and more comprehensible structure that fit postwar U.S. time series data just as well as the original version. Besides introducing an important substantive refocusing of business cycle research, Kydland and Prescott introduced a new style of comparing theory to evidence that has had an enormous, beneficial effect on empirical work in the field...

The "new style of comparing theory to evidence" amounted to "pretending that statistical tests have not already strongly rejected your theory".

The "fit[ting] postwar U.S. time series data just as well" amounted to "taking an error term and claiming it as an exogenous independent variable".

Neither of these ever passed the laugh test. On so many levels.

And I do note that when Murphy, Shleifer, and Vishny (1989): Building Blocks of Market Clearing Business Cycle Models tried to develop the research program beyond "taking an error term and claiming it as an exogenous independent variable", the response was to kick them in the teeth...

And I do note that as people try to build better models of expectational misperceptions than Lucas could build in 1969 with ridiculous assumptions about what people could observe, the response is still to kick them in the teeth...

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