Central Banks are never to blame. That´s as true if inflation is too high/rising or too low/falling!

That´s what I gather from this Dean Baker piece in Beat the Press:

A Washington Post piece on the Fed and the presidential elections told readers:

“A strong economy tends to boost the party currently in power, which is why President Nixon installed confidante Arthur Burns as head of the Fed in 1970, urging him to keep interest rates low to stoke the job market. The result was a decade of runaway inflation that was tamed only by a painful recession.”

This is a very strong and implausible claim. The inflation in the 1970s was fueled in large part by two huge rises in the price of oil. The first was associated with an OPEC oil embargo directed against the United States, which led to a quadrupling in the price of oil between 1973 and 1974. The second was associated with the Iranian revolution, which essentially stopped Iran’s oil exports. At the time, Iran was the world’s second largest oil exporter. There was also a sharp surge in food prices associated with massive sales of wheat to the Soviet Union in 1973.

I refer the reader to Robert Hetzel´s classic article “Arthur Burns and Inflation”:

How did Burns view macroeconomic policy as an economist? Most generally, Burns had a credit view of monetary policy. That is, monetary policy worked through its influence on the credit market. However, monetary policy was only one factor affecting credit markets. At times, in its influence on inflation, monetary policy could be overwhelmed by other factors.

More specifically, Burns had a real or nonmonetary view of inflation. That is, inflation could arise from a variety of sources other than just money. He believed that a central bank could cause inflation by monetizing government deficits but did not attribute inflation to that source in the early 1970s. Instead, he attributed it to the exercise of monopoly power by unions and large corporations.

If conventional monetary policy weapons were powerless to deal with these forces, then perhaps direct controls might work. Accordingly, President Nixon imposed wage and price controls August 15, 1971. The experience with such constraints offered a tailor-made experiment of Burns’s views.

The controls worked as intended in that they held down wage growth and the price increases of large corporations (see Kosters [1975]). Nevertheless, inflation rose to double digits by the end of 1973. So Burns attributed inflation to special factors, such as increases in food prices due to poor harvests and in oil prices due to the restriction of oil production. However, special factors are by nature one-time events. In 1974, inflation should have fallen as the effect of these one-time events dissipated, but it remained at double-digit levels that year. Burns then blamed inflation on government deficits. Although those deficits were small in 1973 and 1974, Burns was able to make them look larger by adding in the lending of government-sponsored enterprises like the Federal National Mortgage Association.

For Burns, the source of inflation changed regularly. He believed this view only reflected the complexity of a changing world. As a consequence, he did not have a model of inflation that could be contradicted by experience.

The chart gives an illuminating overview

  1. Inflation began to rise long before the oil shock of 1973. The effect of Nixon´s price controls is evident.
  2. Who can say that a large part of the decision of oil producers (dominated by Saudi Arabia) to restrain supply and increase prices was not a reaction to (a) the persistent rise in US inflation which began in 1965, given that oil was priced in dollars and (b) to the strong dollar depreciation that took place after Nixon closed the gold window in August 1971?

Dean Baker Burns_1

Note that both PCE Headline and PCE Core (which excludes food and energy) rose in tandem throughout the 1970s.

This, for example, does not happen during 2003-08 when there was an oil shock of comparable magnitude to the one in the 1970s. Note, especially, that headline inflation climbs somewhat and fluctuates to the beat of oil prices, while core inflation remains low and stable. That´s a very different picture from the 1970s. Who´s responsible?

Quite likely the Fed, who, under Volker and Greenspan had learned that inflation is a monetary phenomenon and that the Fed controls it through its control of nominal spending (NGDP) growth.

The chart below shows the behavior of NGDP growth.

Dean Baker Burns_2

Trending up during the “Great Inflation”, pulled down during the “Volcker Adjustment”, nominal stability during the “Great Moderation” which was lost under Bernanke, giving rise to the “Great Recession”.

Interesting bit:

Burns had a “credit view” of monetary policy. Presided over the “Great Inflation”.

Bernanke also had a credit view of monetary policy. Presided over the “Great Recession”

What´s Yellen´s view? Apparently a “Phillips Curve view” of monetary policy. The “GR” is still ongoing, maybe she´ll contribute to deepen it!

Needed, a central banker with a “monetary view” of monetary policy!

4 thoughts on “Central Banks are never to blame. That´s as true if inflation is too high/rising or too low/falling!

  1. On Burns’s view of the causes of 1970s inflation:
    (a) Did he have an explanation for why (as he must have believed) unions and corporations were exercising their monopoly power *more than they had in previous decades*?
    (b) Since he admitted that the Fed could *create* inflation by sufficiently increasing the money supply (“monetizing the debt*), must he not have admitted that the Fed could have *prevented* (or, at least, mitigated) the inflation by *reducing* the money supply; in other words, while insisting that the Fed was not *causing* the inflation, did he not have to admit that it was *failing to exercise its power to prevent it*?

  2. Very interesting post. It leaves me wondering what the correct theory as to the cause of inflation is. The last graph seems to indicate that a stable rate of NGDP growth correlates with steady inflation, but only because sections are labeled “Great inflation”, and “Volker adjustment”. And NGDP growth consists of the inflation rate and real growth, so its not apparent to me that its useful to describe it as a cause of itself. Anyway, Burns was wrong, but what is the better theory?

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