When Reagan Did A Nixon

A Benjamin Cole post

Thanks to the White House tape-recording system installed by then-President Richard Nixon, we have transcripts of Nixon ordering then-Fed Chairman Arthur Burns to gun the presses before the pending 1972 election.

Never underestimate Nixon, who had an uncanny sixth sense for national and global politics, as well as monetary policy.

But lately it came to this writer’s attention that President Ronald Reagan was a crafty fellow as well. From David M. Jones’ 2014 book, Understanding Central Banking: The New Era of Activism:

“A second incident—one that, according to Volcker, [Bob] Woodward got right—involved a hush-hush unpublicized meeting at the White House just prior the Reagan’s reelection in 1984. Volcker was ordered by [Reagan’s Treasury Secretary and Chief of Staff] James Baker to attend this highly confidential meeting, which turned out to have only three participants. Volcker, James Baker, and President Reagan. At this meeting, by Volcker’s account, Baker “ordered” Volcker not to tighten Fed policy “under any conditions” prior to Reagan’s reelection (quoted in Woodward 2000). This unprecedented order by Baker in the presence of Reagan was, of course, totally inappropriate. It fundamentally violated the Fed’s independence within government. If revealed, it would have severely damaged Fed credibility and greatly unsettled the global financial markets.

In recounting this incident, Volcker said with a wry smile that what Baker and the President did not know was that Volcker was, at that very time,  urging his fellow policymakers to ease rather than tighten. Specifically, Volcker was worried that the Continental Illinois Bank failure at that time had caused an unintended tightening of bank reserve pressures, accompanied by an unwelcome spike in the federal funds rate…

In any case, Volcker remains shocked to this day be being called to this secret 1984 meeting at the White House, and being ordered directly by Baker—in the presence of the President—not to tighten under any conditions prior to Reagan’s reelection. Not since the days prior to the 1951 Treasury-Federal Reserve Accord had there been such an explicit White House threat to Fed independence.”

Actually, I think the Reagan White House was within its rights, and that the Fed should be a part of the Treasury…as was publicly recommended by Reagan’s Treasury Secretary, Don Regan.

The current arrangement, that of an independent Fed, is undecipherable to the public on many levels. Who knows who is on the 12-member FOMC? The public does not understand who is responsible for monetary policy, and even if it does understand, cannot vote accordingly.

Are surreptitious White House policy meetings—ala Nixon and Regan—a better way?

The early days of the Volcker Adjustment – A reply to Bob Murphy

Bob Murphy has a post, which starts with a parody:

Suppose someone asks you, “What was the stance of US monetary policy in mid-1980? Pretend you are a Market Monetarist answering.”

BOB TRYING TO PASS AS A MARKET MONETARIST:

First thing, we would not look at interest rates; that is a totally misleading indicator. As Sumner tells us in this post, “Interest rates tell us nothing about the stance of monetary policy.” In context, he is saying that the Fed interest rate cuts in the early 1930s were still consistent with very tight policy.

Instead, let’s look at NGDP and unemployment: (and puts up a version of this chart)

Murphy_1

And says:

Oh man, there’s a smoking gun, right? The unemployment rate skyrockets in the middle of 1980, while NGDP growth (blue line) collapses. (The blue line is the level of NGDP, so you can see that it falls way below the previous trend starting in 1980.) Think of all the employers who had signed wage contracts during the late 1970s, and all the consumers who took out home mortgages, expecting NGDP to grow at a brisk pace. The rug was pulled out from them by the tight-fisted Volcker, right around mid-1980.

I said parody, because to a market monetarist it would be: “Let´s look at NGDP growth and inflation”.

Changing the chart above to accommodate (beginning the chart in mid-1979 to coincide with Volcker becoming Fed Chairman and extending to mid-1985 that more or less defines for Volcker “mission accomplished):

Murphy_2

We gather that monetary policy (NGDP growth) was being tightened as the US went into the 1980 recession (Jan-Jul 1980). However inflation was still rising so, in a sense, monetary policy was not “tight enough”.

Coinciding with the end of the 1980 recession monetary policy becomes “expansionary”. NGDP growth rises and inflation still increases for a while. In mid-1981, monetary policy tightens significantly, with both NGDP growth and inflation coming down. At the end of the 1981-82 recession, NGDP growth increases and inflation continues to decline, indicating monetary policy is neither “tight” nor “loose”, but “just right” to stabilize the economy.

Most people knew, when Volcker came along, that it wouldn´t be easy to conquer inflation. Over the previous 15 years of high, rising and volatile inflation, inflation expectations had become entrenched. Moreover, since the early 1960s, it was the rate of unemployment that “governed” monetary policy. Also, as clearly stated by Arthur Burns during his tenure as Fed Chairman from 1970 to 1978, inflation was not a monetary phenomenon, being the result of, depending on the circumstances, union power, oligopolies, powerful oil producing countries.

To Burns, monetary policy could only try to mitigate the effect on unemployment of those real (or supply) shocks.

So, when Volcker´s early tightening resulted in a 2-percentage point rise in unemployment, from 5.7% to 7.7% while inflation (due to lack of credibility given the go-stop style of monetary policy over the previous 15 years) continued to rise, the Fed “backtracked”. The attack on inflation one year later proved successful, although costly in terms of unemployment. Lesson: It´s not easy to break inflation expectations!

As the next chart shows, the cost was high, but temporary, because the economy regained its previous real output trend level path.

Murphy_3

From then, until the end of Greenspan´s tenure, the economy experienced a “Great Moderation”. With the mistakes made by Bernanke, and continued with Yellen the economy has been downgraded to “Secular Stagnating”!

“Looking for Wally when there are many Wallies”

That well describes the challenges faced by monetary policymakers according to this piece from Bloomberg Business “Are we tight yet? The Fed´s problem in finding the neutral rate”:

Federal Reserve officials just aren’t sure how much stimulus their zero-interest-rate policy is providing.

At issue is the level of the so-called natural, neutral or equilibrium rate of interest, which is the borrowing cost — adjusted for inflation — that keeps the economy at full employment with stable prices.

Economists from the academic world and even within the central bank are vigorously airing differing views on where the rate lies in the aftermath of the worst recession since the Great Depression. The uncertainty is yet another reason for Fed officials to go slowly as they begin raising interest rates for the first time since 2006.

According to this older piece from Brueguel:

What’s at stake: The natural rate of interest is a key ingredient in the recent discussion of secular stagnation, and more generally in New-Keynesian models of the Great Recession. But the concept is often poorly understood, in part because the term refers to different things for different people.

A couple of examples:

Richard Anderson writes that the Swedish economist Knut Wicksell based his theory on a comparison of the marginal product of capital with the cost of borrowing money. If the money rate of interest was below the natural rate of return on capital, entrepreneurs would borrow at the money rate to purchase capital (equipment and buildings), thereby increasing demand for all types of resources and their prices; the converse would be true if the money rate was greater than the natural rate of return on capital.

Axel Leijonhufvud writes that Erik Lindahl (1939) and Gunnar Myrdal (1939) refined the conceptual apparatus, in particular by introducing the distinction between ex ante plans and ex post realizations and thereby clarifying the relationship between Wicksellian theory and national income analysis.

And there are several others.

In short, the Fed is faced with an “estimation” problem. To make that clear, think of a Taylor-Rule for setting the Fed Fund (FF) rate:

Looking for Wally_1

The circles around the level of “potential output” (y*) and the level of the natural rate (NR) represent the “uncertainty” about their estimated values.

For example, San Francisco Fed senior economist Vasco Cúrdia argued in a paper published earlier this month that the equilibrium rate may have dropped so much that “monetary conditions remain relatively tight despite the near-zero federal funds rate.” He provides a chart which indicates that at present the “natural rate” could be anywhere from -3% to 6%!

Looking for Wally_2

Similar uncertainty surrounds the value of “potential” output.

In essence, facing the “estimation” problem, the situation of monetary policy makers is well captured by this picture!

Looking for Wally_3

An alternative, to try to overcome the “estimation” problem would be for the Fed to try some “experimentation”.

That has happened before. In March 1933, in the depths of the Great Depression, President Roosevelt decided to “innovate” and free the economy from the “gold standard shackles”, delinking from gold. The effect was immediate as illustrated below.

More recently, in the heights of the Great Inflation, Paul Volcker also decided to innovate:

On Oct. 6, 1979, the Federal Open Market Committee—under the leadership of Paul Volcker—made a decision that would come to be known as a key moment in U.S. economic policymaking, a turning point in the history of the Federal Reserve that would forever alter central banking. And those are the understatements.

A defining moment may shape the direction of an institution for decades to come. In the modern history of the Federal Reserve, the action it took on October 6, 1979, stands out as such a milestone and arguably as a turning point in our nation’s economic history.(A Greenspan)

So, what did the FOMC do? It made a short-term change in the method used to conduct monetary policy, from making adjustments in the federal funds rate to containing growth in the monetary aggregates. (Yes, the Fed now targets the funds rate again—the 1979 change was reversed in 1982—but more on that in a minute.) This meant the Fed would focus on controlling the amount of reserves provided to the banking system, which would ultimately limit the supply of money.

By many, that “experiment” was seen as a failure. Nevertheless, judging by the results it worked, in that inflation was permanently brought down.

In what follows I´ll give a “liberal” interpretation of the experimentation, based on NGDP. The interpretation is not so farfetched because the NGDP targeting concept was extensively discussed both by the Volcker Fed in 1982 and by the Greenspan Fed in 1992.

The first charts show how rising core inflation was the outcome of a rising NGDP growth. The follow up shows that by “downsizing” NGDP growth inflation was brought down.

Looking for Wally_4

This was followed by Greenspan´s “consolidation” in 1987-92 and almost “smooth sailing” from then to the end of his mandate in January 2006. These last two periods came to be known as the “Great Moderation”.

Looking for Wally_5

I interpret the “experiment” as trying to find first the level and then the stable growth path for NGDP. As the next chart shows, by 1987 the Fed had “hit” on the NGDP level and from then onwards NGDP growth rate was stabilized, i.e. kept close to the trend path.

Looking for Wally_6

There were “mistakes” along the way, notably in 1998-03, when NGDP first rose above trend and then fell below, but by the end of 2005, NGDP was back on trend.

Looking for Wally_7

Soon after taking the Fed´s helm, Bernanke allowed NGDP to begin once more to fall below trend. This was magnified in 2008, probably because of the Fed´s exclusive focus on headline inflation, which was being propelled by an oil and commodity price shock. In an environment where the financial system was “wounded”, allowing NGDP to crumble is mortal!

Looking for Wally_8

At present we have the opposite situation of the 1970s. Instead of high/rising inflation due to rising NGDP growth, we have low/falling inflation due to low/falling NGDP growth. So this time around it may be fruitful to devise an NGDP based experiment in reverse. Try to establish a higher level of NGDP that when attained is “consolidated” through a stable NGDP growth rate.

This “experimentation” would be much more helpful than spending time on “estimation” of the “natural rate of interest” or the “potential level of output”.

PS In the comments, bill writes:

“I need to go see the correlation between corporate spreads and NGDP growth. I think those spreads have been widening which I take as a good sign that the market expects less than optimal choices by the Fed in the near future.”

The chart shows how the recent fall in NGDP growth has been accompanied by a rise in less than stellar bond spreads over 10yr treasuries:

Looking for Wally_9

Monetary Policymakers don´t lack the tools, they lack the will!

From Larry Summers:

Global economy: The case for expansion: …The problem of secular stagnation — the inability of the industrial world to grow at satisfactory rates even with very loose monetary policies — is growing worse in the wake of problems in most big emerging markets, starting with China. … Industrialised economies that are barely running above stall speed can ill-afford a negative global shock. Policymakers badly underestimate the risks… If a recession were to occur, monetary policymakers lack the tools to respond. …

This is no time for complacency. The idea that slow growth is only a temporary consequence of the 2008 financial crisis is absurd. …

Long-term low interest rates radically alter how we should think about fiscal policy. Just as homeowners can afford larger mortgages when rates are low, government can also sustain higher deficits. …

First off: the level of interest rates do not define the stance of monetary policy. This and reasoning from a price (or quantity) change are the most common conceptual errors made by economists of all stripes, including Prizewinners!

Even those like Bernanke, who know best, having stated very clearly in 2003 that interest rates are not a good indicator of the monetary policy stance, saying we should look at NGDP (or inflation, but let us leave that one aside, not only because it is far below “target” everywhere that counts).

The chart indicates that for a significant fraction of “industrialized economies”, monetary policy has been “tight”, certainly not “very loose”!

Lack of will

Prior to the crisis, nominal spending growth was the same in the US and UK (around 5.4%) and much lower in the EZ (4.2%).

Note that after the initial pullback from the deep recession, the ECB under Trichet pulled the brakes hard in early 2011, throwing the EZ economy back into hell. Meanwhile, in tandem, the US and UK said “that´s enough nominal spending growth” (4%). No wander inflation languishes (as does real growth and employment).

Why did all those central banks, the ECB more radically, put a premature stop to the recovery? The obvious answer is fear of breaching their inflation target, even for a “moment”!

In that they sorely lacked what came to be called a “Volcker moment” (or, to paraphrase FDR, a “Volckerian Resolve”). Ironically, or maybe not, the country that has been in hell for longer, Japan, is now trying to get back to savoring some “worldly goods”. Let´s hope the others “get smart” more quickly!

On October 6 1979, the Fed made an announcement (HT David Andolfatto):

Lack of will_1

We know that didn´t cut it. Inflation was only brought down permanently when NGDP growth was adjusted down:

Lack of will_2

Now the Fed (and others) have to adjust NGDP growth up. But please, not through more government (which Japan´s experience also shows doesn´t have lasting effects).

“Forensic evidence that Bernanke drove the car off the road”

Since Bernanke began blogging I have complained that he doesn´t go to the “heart of the matter”. That is, recognize that the Fed, under his command, bungled.

In fact, the mess-up is likely due to his “love affair” with inflation targeting, with that “love” manifesting itself at the worst possible moment, because the rise in headline inflation that occurred at the time was the result of a negative supply shock, which should not have unduly worried the “lover”.

Bernanke has a deep knowledge of economic history, so he knew about the thought process on economic stabilization that evolved over the decades since the early 1970s. To recall, on becoming chairman of the Fed, Volker challenged the Keynesian orthodoxy which held that the high unemployment high inflation combination of the 1970´s demonstrated that inflation arose from cost-push and supply shocks – a situation dubbed “stagflation”.

Volker´s challenge placed inflation as the FOMC´s top priority. He also brought to the fore of policy discussions the ideas developed during the previous 12 years – since Friedman´s address to the 1967 AEA meetings – on the importance of inflation expectations.

To Volker, the policy adopted by the FOMC “rests on a simple premise, documented by centuries of experience, that the inflation process is ultimately related to excessive growth in money and credit”.

This view, an overhaul of Fed doctrine, implicitly accepts that rising inflation is caused by “demand-pull” or excess aggregate demand or nominal spending.

Now, why is this new “doctrine” consistent with the observed increase in economic stability?

Given the cost-push “doctrine” on the inflation of the 1970´s, the Fed would compensate the fall in AS with an increase in AD, an expansionary monetary policy. This followed from the perceived flatness of the SAS curve below potential output. Since this was a flawed doctrine, over time we should observe trend growth in AD (or nominal expenditures).

Volker, on the other hand, believed that inflation was the result of excessive AD. So nothing more natural than to assume that the Fed should increase its responsiveness to the growth in nominal spending. How would this change in “doctrine” (from regarding inflation as a “cost-push” to “demand-pull” phenomenon) show up in the data?

Recall that under the cost-push “doctrine” the Fed would react vigorously to negative output gaps making policy expansionary, so nominal spending would grow. Under the new “doctrine” the Fed doesn´t react much to supply shocks since a negative supply shock, for example, would decrease real output an increase prices with little effect on nominal spending, but would react vigorously to AD or nominal spending shocks.

Therefore, under the new “doctrine”, policy would make AD growth stationary, in which case AD growth will not show a rising trend as under the cost-push “doctrine”. The chart illustrates.

Forensic Evidence_1

The main difference between the two “doctrines” is not the change in the Fed´s responsiveness to inflation as argued by, among others, John Taylor and Bernanke, but the changed responsiveness to aggregate demand or nominal income growth. A collateral effect of the change in “doctrine” shows up in the reduction and stabilization of inflation and decreased volatility in real output.

The Fed never explicitly targeted anything – inflation or nominal income (AD) growth – but implicitly you could say it targeted nominal AD along a 5.5% growth path growth with Volcker and Greenspan.

The chart below provides, to my mind, compelling evidence about the change in doctrine and its stabilizing consequences. One implication is that during all this time, “Inflation Targeting” was just a red herring!

Forensic Evidence_2

And the biggest victim of the “red herring” was Bernanke himself. Since forever he has been a great defender of the “IT modus operandi”, and exactly when he put it in practice he “pushed the car off the road” and got a “depression” as the result. Later, by making the “red herring” @2% official policy target, he showed he was clueless about the true cause of the monetary policy foul-up!

Krugman is frequently inconsistent

Krugman misses a step in “Democratic Booms

But does this say anything about the presidents in question? Both the Reagan expansion and the Clinton expansion had much more to do with Federal Reserve policy than anything coming from the White House, and Obama’s macroeconomic policy has been hamstrung by GOP opposition almost from the beginning. There are presidents, and sometimes there are job booms when they are president, but the booms aren’t their doing.

If the Reagan and Clinton expansions had much more to do with Volcker and Greenspan, why not conclude that the dismal Obama economy has much more to do with Bernanke and Yellen than with “Obama´s macroeconomic policy being hamstrung by the GOP opposition”?

Update: Krugman´s “inconsistency” derives from the fact that he believes in a ‘liquidity trap’ which makes monetary policy impotent. So it would be up to Obama and fiscal policy. But that´s “hamstrung by GOP opposition”

TV’s Larry Kudlow Pulls Two Big Historical Boners In One Column

A Benjamin Cole post

TV pundit Larry Kudlow recently opined that it has never been proved that President Richard Nixon (1969-74) pushed for loose money, and that President Ronald Reagan (1981-89) “backed” then Fed Chairman Paul Volcker in his epic battles against inflation.

The old CCCP historical rehabilitationists and revisionists were pikers next to our hagiographer Kudlow.

Unfortunately for Kudlow, and even more unfortunately for Nixon, that president tape-recorded himself. So we have this conversation between Nixon and Fed Chairman Arthur Burns was caught on tape on March 19, 1971, in the White House Oval Office:

Nixon: Arthur, the main thing is next year [1972, election year]…let’s don’t let it [unemployment] get any higher. I hope we can—

Burns: That’s what I have my eye on.

Nixon: Yeah. But I think we really got to think of goosing it.

Burns: Yes.

Nixon: Shall we say late summer and fall this year in order to affect next year?”

Burns: Exactly.

BTW, inflation during Burns-Nixon duet was just under 5 percent, on the CPI.

Then there is Nixon telling aides, “I’ve told [Treasury Secretary John B] Connally to find the easiest money man he can find in the country and one that will do exactly what Connally wants and one that will speak up to Burns…Connally is searching the goddamned hills of Texas, California, Ohio,” Nixon said. “We’ll get a populist spender on the board one way or another.”

The UPI reported on July 28, 1971 that, “President Nixon is considering a proposal to double the size of the Federal Reserve Board, it was learned today. The suggestion, if put before Congress, could touch off a controversy rivaling President Franklin D. Roosevelt’s attempt to ‘pack’ the Supreme Court.”

Okay, enough on Nixon.

President Reagan

Where to start? Fed Chairman Volcker, it is now usually forgotten, was first appointed by President Jimmy Carter—and was largely viewed by Reaganauts as a tight-money D-Party Trojan Horse, determined to wreck the GOP.

At one point, the Reaganauts, like Nixon before them, were looking at institutional myrmidons to shackle the Fed, while the money-presses were kept wide open. As the AP reported in December of 1984, “’The Reagan Administration is considering a plan that would place the now autonomous US Federal Reserve under some form of administrative control,’ the US Treasury Secretary, Don Regan, said yesterday. ‘The United States is the only country in the world that has a totally independent central bank.’”

And President Reagan? Speaking before the National Association of Realtors in December 1984, Reagan echoed the Regan assault on the Fed. “Let me assure you we are not pleased with the recent increases in interest rates,” said the Gipper. “And frankly there is no satisfactory reason for them.”

Here are the national columnist GOP attack-dogs Rowland Evans and Robert Novak (back then, writing a national column was big stuff, btw) in July 8, 1984 column: “When Paul Volcker and his central bank colleagues decide later this month whether to further tighten the screws on a dangerously deflationary economy, President Reagan’s policymakers will be offstage as impotent….”

Of course, the 1984 elections were up to bat.

Evans and Nowak continue, “The Federal Reserve’s staff…monomaniacal fear of resurgent inflation ignores sliding commodity prices which connote deflation rather than inflation.”

The column-penners darkly continue, “Their (tight-money) position is being pressed by Lyle Gramley, a former Fed staffer named to the board by Jimmy Carter in 1980.”

And Evans and Nowak were the Kudlows of their era!

Things Have Changed

In fact, right-wingers were not always daft-kooky-nuts about the money supply, gold, inflation and interest rates. In 1958 famed economist Milton Friedman testified before the Joint Economic Committee, and told the august body that the Federal Reserve had caused the 1957 recession by…being too tight.

The right-wing today would exile Milton Friedman.

Today’s Misguided Right Wing

It is sad to see Kudlow and other wahoos tub-thumb for tight-money, but they could at least be truthful about their antecedents.

Well, scratch that, today’s righty-tighties have no antecedents. Nixon and Reagan were far too shrewd to let the self-destructive dogma of tight money gain control over policy levers.

Nixon and Reagan wanted prosperity, and I say good for them.

What does the GOP want today? Has some sort of auriferous theology replaced monetary realism?

Maybe so. But maybe not. The GOP, once again in control of White House in 2016, may do what R-Party forefathers have always done: Run big deficits and browbeat the Fed for loose money.

Because, you know, prosperity does trump genuflecting to piles of gold, and we want to get re-elected.