Remembering Ronald Reagan, Federal Budgets And Inflation-Fighting. John Cochrane Fights Economic History Again?

A Benjamin Cole post

Some say Allan Meltzer, the right-wing economist, Carnegie Mellon professor, and author of the well-regarded A History of the Federal Reserve is an acerbic fellow. Maybe so.

Nearly forgotten today, a younger version of Meltzer served as an Acting Member of President Ronald Reagan’s Council of Economic Advisers in 1988-9. Ten years after his stint on the CEA, Meltzer recounted the Reagan Days (1981-1989), in a piece entitled, Economic policies and actions in the Reagan administration.

Meltzer’s chastising study reads in part—

“Uncertainty and lack of a coherent monetary policy were not limited to 1981-82. During the years 1984-87, the Reagan administration shifted from a freely fluctuating exchange rate to encouraging dollar devaluation first by talk and then, in 1986, by increasing money growth. These actions were followed by a decision at the Louvre in January 1987 to set a band for the exchange rate against principal currencies. Within a few months, the dollar was overvalued relative to the agreed-upon rates, so maintenance of the band required increased money growth in Germany and Japan and lower money growth in the United States. The band required higher interest rates. Between July and October 1987 interest rates on long-term U.S. government bonds increased approximately 25 percent (from 8 1/2% to about 10 1/2%). When anticipations of further increases in interest rates contributed to a rather dramatic decline of prices on the world’s stock exchanges, the administration shifted its position again. The dollar declined about 8 to 10 percent below the presumed bottom of the previous band.

It is difficult to find a consistent pattern, much less a coherent policy, in these shifts within less than one year from efforts to force devaluation by raising money growth and lowering market interest rates to a program of stabilizing exchange rates, lowering money growth, and raising interest rates and then to a program of lowering interest rates and allowing the dollar to fall. The shifts suggest an extremely short-term focus….” (boldface added.)

From Meltzer’s perspective, the Reaganauts stomped on the monetary brakes in 1981, then once inflation slipped towards 5%, they gunned the accelerator again. Thereafter, they had an incoherent policy.

Okay, monetary policy was a mess, by Meltzer’s lights, although the curious placement of monetary policy within the Reagan Administration, and not within Chairman Paul Volcker’s somewhat independent Federal Reserve, is puzzling. Meltzer seems to imply Reagan called the shots, and Volcker complied. As in Fed Chairman Arthur Burns’ compliant dance with President Nixon.

But what about Reagan’s fiscal policy?

Here, Meltzer is again the scold.

“Why did the Reagan administration choose to run deficits that are large relative to previous peacetime experience in the United States? One possibility is that the deficits were not anticipated. This is improbable….”

Meltzer concludes the Big Reagan Deficits stemmed from increased spending, as tax receipts as a fraction of GDP stayed within historical ranges.

As a final slap, Meltzer also concludes Reagan “did very little to implement a deregulation policy. If we include protectionist actions affecting imports with deregulation, the Reagan administration’s record on deregulation is poor.”

Meltzer is a tough, even acid critic. But John Cochrane, University of Chicago scholar? Not so much.

Enter John Cochrane

Today Cochrane hails the Reagan-Volcker Team as Dynamic Duo Inflation-Busters.

At first blush, this is puzzling; Cochrane’s recent “Neo-Fisherite” stance declares the Fed can fight inflation by lowering interest rates, which sets off lower inflationary expectations—and voila!  You get lower inflation.

In the comments section of his blog, I asked Cochrane about the accepted Fed Chairman Paul Volcker story, that an indomitable Volcker mightily raised rates and thereby broke the back of inflation.

That is not a Neo-Fisherite story line.

Cochrane replied, “The 1980s were a classic joint fiscal-monetary contraction….Tax reform, growth, led to large surpluses that paid off a handsome present to bondholders, and paid for a decade of high interest costs. Many monetary tightenings have failed without this fiscal support.”

No doubt, the reader is thinking, “What the beans is Cochrane thinking about? Reagan ran red ink like water over Niagara!”

Cochrane has a nifty definition of federal surplus that is kin to what business people would call an “operating budget.” That is, what is the profit or loss a business makes on operations, before debt payments. Cochrane’s point is that Reagan ran an operating surplus, also called a primary surplus—taxes were greater than operating outlays.

It is an interesting vessel of an idea, the only problem it also leaks water like Niagara. The Reagan deficits were so vast that even without debt payments The Gipper ran rivers of red ink.


Year   Net Interest Payments    Deficit

1981                   $68.8                  $  79.9 billion

1982                   $85.0                  $128.0

1983                   $89.8                  $207.8

1984                   $111.1                $185.4

1985                   $129.5                $212.3

1986                   $136.0                $221.2

1987                   $138.6                $149.7

1988                   $151.8                $155.2

2000                   $222.9                +$236.2

Well, Reagan came close to a balanced operating budget in 1988, but no cigar, and most of his Presidency was a gathering ocean of red ink, even his primary budget.

The year 2000, btw, was President Clinton’s last year in office, in which he ran an operating surplus, or primary surplus, of $459.1 billion. One might ponder if any organization ever in history ran such a large operating gain.

Economic History

Cochrane has been pushing a Neo-Fisherite stance, but too often he seems to run headlong into a granite wall of opposing empirical and historical facts.

As Meltzer points out, there was no coordination, or joint contraction, of fiscal and monetary policy in the Reagan Administration; Reagan ran big deficits and Volcker raised interest rates to the moon in 1980.

By luck or otherwise, inflation cracked quickly to under 5%, so Volcker eased up, as is seen in sliding interest rates and bulging M1 and M2 supplies in the 1980s. Meanwhile, Reagan kept running huge deficits.

This is not a Neo-Fisherite story. Monetary policy erratically eased and was joined at the hip with big federal deficits after 1981.

The Real Story

But the real story remains lost to Cochrane, and others, I fear.

The first real story is that the U.S. economy has evolved over the decades to one that is much less inflation-prone than the 1960s and 1970s. The last gasp of inflation was in the early 1980s, when Volcker slay it.

Now, Big Labor is dead, Big Steel too, Big Telecommunications, Big Oil, Big Autos, Big Anything.

International trade has exploded, reducing supply side bottlenecks and the possibility that an economy can “overheat.” The Wal-Mart import-a-rama scheme is the norm.

Americans would have to buy a lot of cars to allow global automakers to engage in price gouging. More than they could ever buy. Multiply that example a thousand times over, in every product category.

Meanwhile, top marginal tax rates have been cut in half, while financial, telecommunications and transportation industries have been deregulated. Capital is everywhere, gluts of it.

The Internet has made sourcing easy and global, and simultaneously opened local markets—second and grey-market goods are easily traded now.

The real story is inflation is dead.

The second real story is the one Market Monetarists know: A central bank that fixates on inflation or interest rates is not doing its job, which is properly focused on economic growth. Oh, that?

Yes, that. A central bank best obtains a good result on that by trying to keep nominal GDP growth on a steady growth path.

I guess that is just too easy.

PS: On May 6, Meltzer penned an op-ed in The Wall Street Journal to the effect that “Never in history has a country that financed big budget deficits with large amounts of central-bank money avoided inflation. Yet the U.S. has been printing money—and in a reckless fashion—for years.”

Inflation will wreck America, suggests Meltzer.

Some things never change.

In a perpetual “state of readiness”

And still failing miserably!

That´s the story of the ECB:

FRANKFURT—European Central Bank President Mario Draghi sent a strong signal Friday that the central bank is ready to “step up the pressure” and expand its asset-purchase programs if inflation fails to show signs of quickly returning to the ECB’s target.

“We will continue(!) to meet our responsibility—we will do what we must[“whatever it takes”, again?] to raise inflation and inflation expectations as fast as possible, as our price stability mandate requires of us,” Mr. Draghi said in a speech to a banking conference.

If(!) on its current trajectory our policy is not effective enough to achieve this, or further(!) risks to the inflation outlook materialize, we would step up the pressure and broaden even more the channels through which we intervene, by altering accordingly the size, pace and composition of our purchases,” Mr. Draghi said.



“Nothing ado about inflation”

There was very little said about today´s CPI release. Funny that when inflation remains below target we don´t hear much, unlike earlier this year when it was thought that inflation was climbing towards the 2% target!

The Fed targets PCE inflation, which on average comes about 0.4 points below CPI inflation. The charts below give a pretty good indication that inflation has not been a problem for quite some time, particularly if you track the Core versions of the indices, which take out the noise from things like oil and commodity shocks!

Nothing Ado_1

Nothing Ado_2

The final chart illustrates how (CPI) long-term inflation expectations have behaved. Interesting to note that before the crisis hit, both the TIPS and Cleveland Fed measures of expected inflation were quite similar. I have no idea why that changed after 2008, but maybe they are “joining-up” again.

Nothing Ado_3

The charts seem to indicate that what the Fed has wanted for some time is really to keep inflation within a 1%-2% (1.4%-2.4%) band for the Core PCE (Core CPI). And they are doing a damn fine job, no matter what else is (not) happening!

The Federal Justice System is a lot better at parsing evidence!

In economics you usually get “hung juries”.

Parsing Evidence_0Two examples:

1A. Labor market slack is “low”

Alan Krueger, former chairman of President Barack Obama’s Council of Economic Advisers and a professor at Princeton University, wrote an influential paper earlier this year arguing the long-term jobless face such unusual challenges in finding work that policy makers should count them out when trying to gauge potential unused capacity in the labor market – also known as slack—and its effect on inflation pressures.

“Overall, there is little evidence in the cross-state data that the long-term unemployed exert less pressure on wages,” the five New York Fed researchers counter, referring to people out of work for more than six months. “This finding, as well as the differences between the labor market outcomes of long-term unemployed workers and nonparticipants, suggests that the long-term unemployed should not be dismissed when considering labor market slack.”

1B. Labor market slack is “high”

New York Fed: “The results suggest that there is little difference in how long-term and short-term unemployment affect wages, and as a consequence, the long-term unemployed shouldn’t be dismissed when evaluating labor market slack,” the New York Fed authors say.

  1. From Board of Governors we “learn” that Recessions permanently lower RGDP:

The economic collapse in the wake of the global financial crises (GFC) and the weaker-than-expected recovery in many countries have led to questions about the impact of severe downturns on economic potential. Indeed, for several major economies, the level of output is nowhere near returning to pre-crisis trend (figure 1). Such developments have resulted in repeated downward revisions to estimates of potential output by private- and public-sector forecasters. In addition, this disappointment in post-recession growth has contributed to concerns that the U.S. economy, among others, is entering an era of secular stagnation. However, the historical experience of advanced economies around recessions indicates that the current experience is less unusual than one might think. First, output typically does not return to pre-crisis trend following recessions, especially deep ones. Second, in response, forecasters repeatedly revise down measures of trend.

But maybe that´s not what the evidence shows, at least for the US. In the chart below we observe that the 3.3% trend growth formed in the 1870-1928 period remained true going forward. Even after the “Great Depression” real output returned to the original trend level path! Under Bernanke´s watch RGDP dropped well below trend and shows no signs of returning to it (actually it is growing at a rate significantly below (2.2%) the trend rate (3.3%).

Parsing Evidence_1

The next chart shows the more recent (from start of the “Great Moderation”) behavior of RGDP relative to the “centenary trend”.

Parsing Evidence_2

The Bernanke´s Fed failure is starker in the more recent version of the chart.

The last chart indicates the “culprit” was the Fed by first allowing NGDP (because of oil price-inflation worries) to deviate persistently from trend and then tumble.

Parsing Evidence_3

Policymakers seem to be making the best efforts, for the first time in at least one century and a half, to keep real output permanently below trend, and increasingly so!

The Fed´s “two-step” dance

From today´s Minutes:

The information on economic activity received since the staff prepared its forecast for the September FOMC meeting was close to expectations, and therefore, the staff’s projection for real GDP growth over the remainder of the year was little revised. However, in response to a further rise in the foreign exchange value of the dollar, a deterioration in global growth prospects, and a decline in equity prices, the staff revised down its projection for real GDP growth a little over the medium term.

Even with the slower expansion of economic activity in this projection, real GDP was still expected to rise faster than potential output in 2015 and 2016, supported by accommodative monetary policy and a further easing of the restraint on spending from changes in fiscal policy; in 2017, real GDP growth was projected to step down toward the rate of potential output growth. As a result, resource slack was anticipated to decline steadily, albeit at a slightly slower rate than in the previous projection, and the unemployment rate was expected to gradually improve and to be at the staff’s estimate of its longer-run natural rate in 2017.

The staff’s forecast for inflation this quarter and early next year was reduced in response to further declines in crude oil prices, but the forecast for inflation over the medium term was only a touch lower. Consumer price inflation was projected to be lower in the second half of this year than in the first half and to remain below the Committee’s longer-run objective of 2 percent over the next few years. With resource slack projected to diminish slowly and changes in commodity and import prices anticipated to be subdued, inflation was projected to rise gradually and to reach the Committee’s objective in the longer run.


Expansion of economic activity is expected to be slower but RGDP was still expected to rise faster than potential in 2015-16!

Resource slack is expected to diminish slowly. This seems inconsistent with RGDP expected to rise faster than potential!

They say 2% inflation is years away!

And they think monetary policy is supportive!

To repeat a chart from yesterday´s post, monetary policy is supportive if by supportive you mean it is successful in keeping the economy in a depressed state (of (too) low real growth, (too) low inflation and low employment).

But even that will look good if the Fed engages in the “two-step”!

Two Step

The unending (and frustrated) search for inflation

In The Risks to the Inflation Outlook SF Fed researcher Vasco Cúrdia writes:

Figure 1 shows that the median inflation forecast is not expected to return to the FOMC target of 2% until after the end of 2016. The uptick in inflation in the first half of 2014 could lead one to believe inflation is finally on the path back toward its target. However, inflation has shown similar patterns several times before and each time the uptick has never lasted very long. According to this model, we should not see inflation begin to recover more firmly until around the end of 2015.

The model explains that persistent effects from the financial crisis are the main reason inflation is expected to remain low for so long. The financial crisis disrupted the credit market, leading to underinvestment and underutilization of resources in the economy. This slowed the economic recovery and pushed inflation down more than 2 percentage points, according to the model.

In contrast, the model suggests monetary policy pushed inflation up by 0.8 percentage point. This is expected to fall to zero by the end of 2016. Comparatively speaking, monetary policy appears to be far from causing excessive inflation under present circumstances.

Frustrated Search_1

It´s much more straightforward than that. It all boils down to how the Fed handles nominal spending (NGDP). The set of charts illustrate for different periods.

The 1970s harbored the “Great Inflation” because the Fed “manned” NGDP growth on an upward trend. Things get “shaky” when an oil shock hits, but the inflation trend is basically determined by the NGDP growth trend.

Frustrated Search_2

The 2001 recession saw NGDP growth fall way below the trend growth level. When the Fed became “smart” it decreed “forward guidance”, letting everyone know that spending growth would be such as to take NGDP back to the trend level.

Frustrated Search_3

Going into the “Great Recession” the Fed gets “confused” by the oil price shock and lets NGDP growth slide (and then tumble) down, bringing both real output AND inflation down with it!

Frustrated Search_4

The recovery starts off with the Fed introducing QE1. The NGDP “airplane” takes off, but “levels-off” long before reaching the previous “height”.

Frustrated Search_5

So that, at the new lower “cruise level”, we get “phony” nominal stability, which is associated with lower RGDP growth and lower inflation, sometimes temporarily disturbed by oil (supply) shocks.

Frustrated Search_6

Bottom line: If the Fed does not “recalibrate” the “plane´s height”, and accelerates towards it, inflation will simply not get back to target!

John Cochrane Defiantly Takes On Economic History

A Benjamin Cole post

As I predicted, the right-wing has gone past its fixation on absolutely dead prices as an economic cure-all and moral imperative, to the even-better nirvana of…deflation.

I wish I was making this up.

But comes now University of Chicago scholar John Cochrane, path-breaking with stalwart allies such a FOMC member Charles Plosser, that deflation is an economic elixir, not a sign of stagnation. Cochrane authored a recent The Wall Street Journal op-ed genuflecting to southerly price drifts.

I just don’t get it.

Recent Economic History

Okay, let’s look at the United States, 1982-2007. That’s a 25-year stretch, and recent too. In 1982 the U.S. GDP was $5,865.9 billion. It rose to 13,206.4 billion in 2007 (both figures in 2005 dollars).

That is a real increase of 125.1%, or an annual compounded rate of 3.3% real, for 25 years running, with all the imperfections and structural impediments that the U.S. economy has.

In the real world, the U.S. economy performed well 1982-2007. That is not debatable.

The rate of inflation? In the 25-year period prices rose 114.8%, so the inflation rate was about 3% a year. Except for 1982, inflation was always below 6% and, and only twice below 2% in the 25 years. In other words, moderate inflation in the 2% to 4% range was the norm. It worked.

For most of that period of prosperity, moderate inflation was accepted across the political spectrum. And why not?


There was a modern nation that passed through deflation, which regular readers know was Japan. From 1992 to 2012, Japan had mild deflation.

Looking to the St Louis Fred series, we have to go with 1990 to 2011 figures (due to data discontinuations), and we find Japan had a real annually compounded GDP growth of less than 1%, or 0.91%, through that 21-year period.

Japan’s real growth rate was one-third of that of the United States, when we compare their mildly deflationary period (1990-2011) to the mild-to-moderately inflationary period (1982-2007) of the United States.

If you are old enough, you remember in the 1980s when Japan was hailed for its lack of structural impediments, for its cooperation of government and business that created the biggest business boom of all history. By the 2000s, some economists said it was structural impediments holding Japan back.

In fact looking at the yen’s exchange rate and deflation, it seems much more likely the Bank of Japan held Japan back.


Cochrane is correct in some regards; mild deflation does not coincide with recession, only with very, very sluggish real growth. Yes, the U.S. can probably go to mild deflation, and it will only look somewhat slower than 2008-2012. If you have a sinecure at an academic institution, maybe that is fine.

But Cochrane ignores the bigger picture: Robust growth is associated with moderate inflation.

In the end, based on recent and cogent historical experience, it comes down to this: Should we forego trillions of dollars of real output just to bring a subjective index of prices (CPI or PCE) to a dead halt, or even into deflation territory?


Zimbabwe: “Show-case” for “Neo Fisherites”

Lately, Nick Rowe has given a lot of time and thought to get a handle on “Neo Fisherism”. I think that at the end of his latest post on the subject he nails it:

I am of the view that the Bank of Canada targets 2% inflation (or NGDP or whatever), and it adjusts the nominal interest rate (or base money or whatever) to hit that target, and its actions affect its profits, and those profits affect the government’s spending and taxation decisions. In the long run, the government adjusts its budget to be consistent with the Bank of Canada’s actions. Not vice versa. We saw that adjustment in 1995.

Zimbabwe, under Mugabe, is different. The guy with the AK47 chooses how much currency you print for him to spend, even though he does give you a bond in return. And the higher the price level the more currency he wants you to print for him. Raising the nominal rate of interest on bonds lets you sell more bonds and withdraw currency from circulation, but also means you must print currency even faster to pay the higher interest. Because the guy with the AK47 is going to make you print enough additional currency to pay the interest on the bonds he issued. That’s a Neo-Fisherite world.

The “show-case” for Market Monetarists is quite different (and much more palatable). You can choose from things like the “Great Moderation” or Australia´s quarter century absence of recession!

Keynes returns. In fact, he should be “sanctified”…

´´´so that economists could claim having a patron saint taken from their ranks!

Peter Temin and David Vines make a contribution to that effort in Why Keynes is important today:

Ricardian Equivalence is a theory that concludes that any expansion of public spending will be offset by an equal and opposite decline in private spending. The theory is based on a few important assumptions. It assumes forward-looking consumers who adjust their current spending in anticipation of future taxes to pay for the spending. Under these conditions, any increase in current spending leads consumers to anticipate a rise in future taxes and decrease their current spending to save for this.

This theory dominates current macroeconomic discussion. It fits into the form of current macroeconomics that assumes not just forward-looking consumers, but flexible prices as well. And if a Keynesian suggests fiscal policy in current conditions, a modern economist is likely to invoke Ricardian Equivalence.

Remembering the past

Keynes faced exactly this opposition in 1930. He was a member of the Macmillan Committee convened by the British government to analyse the worsening economic conditions of that time. His recommendation for increased government spending – what we now call expansive fiscal policy – was opposed by Norman and other representatives from the Bank of England. They did not invoke Ricardian Equivalence because it had not yet been formulated; instead they simply denied that increased government spending would have any beneficial effect.

Keynes opposed this view, but he did not have an alternate theory with which to refute it. The result was confusion in which Keynes was unable to convince a single other member of the Macmillan Committee to support his conclusions. It took five years for Keynes to formulate what we now call Keynesian economics and publish it in what he called The General Theory.

He based his new theory on several assumptions, two of which are relevant here. He assumed that consumers are only forward-looking part of the time, being restrained by a lack of income at other times, and that many prices are not flexible in the short run wages in particular are ‘sticky’. These assumptions give rise to involuntary (Keynesian) unemployment which expansive fiscal policy can decrease.

Which theory is relevant today? We know that wages are sticky – countries in Southern Europe have found it impossible to implement requests from their creditors that they reduce wages swiftly. And we know that not all private actors in the economy are forward-looking. Before the crisis, borrowing and spending increased in ways that could not be sustained;  now consumers are not spending and business firms are not investing even though interest rates are close to zero.

Those are the conditions described by Keynes in which expansive fiscal policy works well. They also are the conditions in which monetary policy does not, even though modern macroeconomic policymakers came to rely entirely on monetary policy for stabilisation. There is a disconnect between the needs of current economies and theories of current macroeconomists.

Doomed to repeat it?

What to do? In many applied disciplines, like medicine, practitioners go back to basics when the facts change. If their current practice fails to produce the desired result, they search their armamentarium for others.  If their assumptions prove wrong, they look for more appropriate ones. But not modern macroeconomists – they say we must simply endure what they call secular stagnation.

This is an unhappy prediction. Monetary policy does not work today; instead, this is the perfect time for fiscal policy. There are immediate needs to repair roads and bridges, rebuild energy grids, and modernise other means of travel. Expansive Keynesian fiscal policy will benefit the economy in both the short and long run.

A quarter century ago, however, Peter Temin teamed up with Barrie Wigmore to write “The end of one Big Deflation”:

This paper provides a new account of the recovery from the Great Depression in the second quarter of 1933. Our argument is that President Roosevelt established a new macroeconomic policy regime shortly after his inauguration in March 1933 that altered expectations and stimulated investment. The key to this change was Roosevelt´s devaluation of the dollar and the resulting rise in farm prices and incomes….

So monetary policy was effective at a time (Great Depression) where the economic situation was an order of magnitude worse than today? What made Temin change his mind?

Interestingly, Cassel had explained, before the fact, both how a country could get into a Great Depression AND how it could come out of it. “Going into and getting out of” was the consequence of monetary policy!

I think economists should look for their “patron saint” elsewhere!

Deflation targeting @2%

“Neo Fisherite” John Cochran writes in the WSJ “Who’s Afraid of a Little Deflation?”:

According to the conventional worldview, the economy is inherently unstable. Central banks control inflation the way you balance an upside-down broom, with interest rates on the bottom and inflation on top. Central banks have to actively move interest rates around to keep inflation and deflation from breaking out. And if they want more inflation, they must temporarily move interest rates the wrong way, let the inflation increase, and then move quickly to stabilize it.

Hence the zero-bound worry. When interest rates hit zero and the Fed can’t move the broom handle any more, the top of the broom must topple into deflation. Except we hit the zero bound, and almost nothing happe

“The danger now is inflation,” warned University of Chicago economist and Paul Ryan dinner companion John Cochrane in 2009. He warned of this again in 2010.

And again in 2012(“Inflation Should Be Feared”).

Inflation has stayed very low. And look, here is John Cochrane in today’sWall Street Journal editorial page, no longer warning of inflation. Now he is arguing that deflation might be coming, but it’s not so bad.

Yes, that is Professor Cochrane tearing down the goalposts and moving them several miles back.

ned. Maybe the economy isn’t so inherently unstable and in need of constant guidance after all.

Bottom line? Relax. Every few months we hear a new “biggest economic problem” from which our “policy makers” must save us. Wait for the next one.

Maybe being 1990-2012 Japan is every country´s dream (except Japan´s)!

Update: And here´s Jonathan Chait on John Cochrane the “inflacionista”:

“The danger now is inflation,” warned University of Chicago economist and Paul Ryan dinner companion John Cochrane in 2009. He warned of this again in 2010.

And again in 2012(“Inflation Should Be Feared”).

Inflation has stayed very low. And look, here is John Cochrane in today’sWall Street Journal editorial page, no longer warning of inflation. Now he is arguing that deflation might be coming, but it’s not so bad.

Yes, that is Professor Cochrane tearing down the goalposts and moving them several miles back.