Archive for the 'Olivier Blanchard' Category

Dangerous Metaphors

A couple of days ago, I wrote post gently (I hope) chiding Olivier Blanchard for what seemed to me to be a muddled attempt to attribute inflation to conflicts between various interest groups (labor, capital, creditors, debtors) that the political system is unable, or unwilling, to resolve,leavin, those conflicts to be addressed, albeit implicitly, by the monetary authority. In those circumstances, groups seek to protect, or even advance their interests, by seeking prices increases for their goods or services, triggering a continuing cycle of price and wage increases, aka a wage-price spiral.

My criticism of Blanchard wasn’t that the distributional conflicts that worry him don’t exist — they obviously do — or are irrelevant — they clearly aren’t, but that focusing attention on those conflicts tells us very little about the mechanisms that generate inflation: the macroeconomic policies (monetary or fiscal) under the control of governments and central banks. We live in complex societies consisting of many diverse and independent, yett deeply interrelated and interdependent, agents. Macroeconomic polilcies are adopted and implemented in an economic and social environment shaped by the various, and possibly conflicting, interests of these agents, so it would be absurd to argue that the conflicts and tensions that inevitably arise between those agents do not influence, or even dictate, the policy choices of governments and monetary authorities responsible for adopting and implementing macroeconomic policies.

Because distributional conflicts are inherent in any economy composed of a diverse set of agents pursuing their own inconsistent self-interests, so it seems quixotic to suppose or even imagine that distributional conflicts can be resolved by a formal negotiating process in the way that Blanchard seems to be suggesting. There are too many interests at play, too many conflicts to reconcile, too many terms to negotiate, too many uncertain conditions and too many unforeseen events requiring previously reached agreements to be renegotiated for these deep-seated conflicts to be resolved by any conceivable negotiation process.

The point that I tried to make is that, because it is unrealistic to think that the fundamental conflicts of interest characteristic of any modern economy can be reconciled by negotiation, the monetary authority should aim to adopt a policy on which economic agents can rely on in forming their expectations about the future. The best policy that the monetary authority can hope to achieve is one that aims for total nominal spending and total nominal income to increase at a predictable rate consistent with an inflation rate low enough to be politically uncontroversial. If such a policy is implemented, with nominal spending and income increasing at roughly the target rate, private expectations would likely converge toward that targeted rate, thereby contributing to the mutual consistency of private expectaions that would allow inflation to remain at an acceptably low rate.

Brad Delong kindly noticed my comment about Blanchard on his substack blog and on Twitter, opining that Blanchard and I were not really disagreeing but were talking past each other.

I don’t necessarily disagree with Brad’s take, but I’m not sure that I agree either, because I’m not sure that I understand what Blanchard is actually saying. I actually tried to hint at my uncertainty about what Blanchard’s argument actually is (and whether I disagree with it) by borrowing (with slight modification) the lyric of George and Ira Gershwin’s standard “Let’s Call the Whole Thing Off.” (Or, try out this version.)

Paul Krugman also weighed in, defending Blanchard’s analysis against the argument which he attributes to John Cochrane and to me that inflation is always the result of excessive demand.

Although Blanchard is nobody’s idea of a leftist (OK, Republicans seem to consider anyone more liberal than Attila the Hun a Marxist, but still), he nonetheless got immediate pushback from economists who insisted that inflation is always the result of excessive demand, of too much money chasing too few goods or, what is roughly the same thing, the consequence of an excessively hot economy.

https://www.nytimes.com/2023/01/03/opinion/inflation-economy.html?searchResultPosition=1

I’m always grateful to be noticed by Krugman, but I’ll just note in passing that he’s not quite correct in attributing to me the view that inflation is always the consequence of an excessively hot economy; I was simply working with Blanchard’s own framing in his original Twitter thread.

But the point in Krugman’s post that I want to comment on is his football metaphor.

At one level, of course Blanchard is right. Companies that charge higher prices and workers who demand higher wages aren’t doing so because the money supply has increased; they’re trying to increase their incomes (or offset declines in their incomes caused by, say, rising energy prices). And inflation happens when the attempts of firms and workers to claim a bigger share of the economic pie are inconsistent, when the additional purchasing power being demanded exceeds what the economy can deliver.

Reading the discussion, I found myself remembering a remark made way back in the 1970s by William Nordhaus, another eminent economist (and Nobel laureate) who happens to have been my first mentor in the field. Nordhaus compared inflation to what happens in a football stadium when the action on the field is especially exciting. (If you don’t find American football exciting, think of it as a soccer match.) Everyone stands up to get a better view, but this is collectively self-defeating — your view doesn’t improve because the people in front of you are also standing, and you’re less comfortable besides.

Nordhaus’s football metaphor is very apt as far as it goes. You can imagine that inflation starts as the result of an attempt by agents to increase their prices (wages) that turns out to be self-defeating because everyone’s attempt to increase his price or wage relative to everyone else’s turns out to be self-defeating when everyone else does the same thing, so that no one really improves his position compared to everyone else.

I will just observe parenthetically that it is not strictly true that no one improves his view of the field, because people who are taller than average likely will improve their view of the field, especially if they are sitting behind short people. But that is likely a second-order effect. Similarly, some people raising their prices may be well-positioned to increase their prices more than average, so that they may be net gainers from the process. But again those are likely second-order effects.

But here is where the football metaphor breaks down. Blanchard is not worried about a once and for all increase in the price level, which is what the football metaphor translates into. People standing up in a football game do not keep growing taller once they stand up. The process comes to an end, and is eventually reversed after people sit down again.

But inflation is unpopular because it supposedly is a continuing process of increasing prices. Larry Summers and Blanchard have been invoking the experience of the 1970s in which there was supposedly a self-generating or self-reinforcing wage-price spiral that could only be stopped by a brutal monetary tightening administered by Paul Volcker causing a severe recession with double-digit unemployment. To avoid another such catastrophic recession, Blanchard is urging everyone to be reasonable and not to try to increase prices or wages in a likely futile attempt to gain at the expense of others.

The problem with football metaphor is that it can’t explain how the inflation process can continue if it is not enabled by macroeconomic policies that cause the rate of nominal spending and income to keep increasing. Maybe Blanchard and Krugman believe that total nominal spending and total nominal income can keep increasing even if macroeconomic policies aren’t causing nominal spending and nominal income to increase.

I don’t think that’s what they believe, but if they do believe that, then they should explain how continuing increases in nominal spending and income can be generated without corresponding macroeconomic policies that promote those increases in nominal spending and income. As long as macroeconomic policy is focused on keeping the rate of increase in nominal spending at a rate consistent with the target rate of inflation, inflation will be just as transitory as episodes of standing by fans at football games.

You Say Potato, I Say Potahto; You Say Tomato, I Say Tomahto; You Say Distribution, I Say Expectation

Once again, the estimable Olivier Blanchard is weighing in on the question of inflation, expressing fears about an impending wage-price spiral that cannot be controlled by conventional monetary policy unless the monetary authority is prepared to impose sufficiently tight monetary conditions that would entail substantially higher unemployment than we have experienced since the aftermath of the 2008 financial crisis and Little Depression (aka Great Recession). Several months ago, Blanchard, supporting Larry Summers’s warnings that rising inflation was not likely to be transitory and instead would likely remain high and possibly increase over time, I tried to explain why his fears of high and rising inflation were likely exaggerated. Unpersuaded, he now returns to provide a deeper explanation of his belief that, unless the deep systemic forces that cause inflation are addressed politically rather than left, by default, to be handled by the monetary authority, inflation will remain a persistent and vexing problem.

I’m sorry to say that Professor Blanchard starts off with a massive overstatement. While I don’t discount the possibility — even the reality — that inflation may sometimes be triggered by the attempt of a particular sector of the economy to increase the relative price of the goods or services that it provides, thereby increasing its share of total income at the expense of other sectors, I seriously question whether this is a typical, or even frequent, source of inflation. For example, oil-price increases in the 1970s and wage increases in France after the May 1968 student uprisings did trigger substantial inflation. Inflation served as a method of (1) mitigating ing adverse macroeconomic effects on output and employment and (2) diluting the size of the resulting wealth transfer from other sectors.

Blanchard continues:

2/8. The source of the conflict may be too hot an economy: In the labor market, workers may be in a stronger position to bargain for higher wages given prices. But, in the goods market, firms may also be in a stronger position to increase prices given wages. And, on, it goes.


Again, I’m sorry to say that I find this remark incomprehensible. Blanchard says “the source of the conflict may be too hot an economy,” and in the very next breath says that in the labor market (as if it made sense to view the labor market, accounting for more than half the nominal income of the economy, as a single homogeneous market with stable supply and demand curves), “workers may be in a strong position to bargain for higher wages given prices,” while in the goods market firms may be in a strong position to bargain for higher prices relative to wages. What kind of bargaining position is Blanchard talking about? Is it real, reflecting underlying economic conditions, or is it nominal, reflecting macroeconomic conditions. He doesn’t seem to know. And if he does know, he’s not saying. But he began by saying that the source of the conflict “may be too hot an economy,” suggesting that the source of the conflict is macroeconomic, not a conflict over shares. So I’m confused. We can only follow him a bit further to see what he may be thinking.

3/8. The source of the conflict may be in too high prices of commodities, such as energy. Firms want to increase prices given wages, to reflect the higher cost of intermediate inputs. Workers want to resist the decrease in the real wage, and ask for higher wages. And on it goes.

Now Blanchard seems to be attributing the conflict to an exogenous — and unexmplained — increase in commodity prices. One sector presumably enjoys an improvement in its bargaining position relative to the rest of the economy, thereby being enabled to increase its share of total income. Rather than consider the appropriate response to such an exercise of raw market power, Blanchard simply assumes that, but doesn’t explain how, this increase in share triggers a vicious cycle of compensating increases in the prices and wages of other sectors, rather than a one-off distributional change to reflect a new balance of economic power. This is a complicated story with interesting macroeconomic implications, but Blanchard doesn’t bother to do more than assert that the disturbance sets in motion an ongoing, possibly unlimited, cycle of price and wage increases.

4/8. The state can play various roles. Through fiscal policy, it can slow down the economy and eliminate the overheating. It can subsidize the cost of energy, limiting the decrease in the real wage and the pressure on nominal wages.

5/8. It can finance the subsidies by increasing taxes on some current taxpayers, say exceptional profit taxes, or through deficits and eventual taxes on future taxpayers (who have little say in the process…)

These two statements from the thread are largely innocuous and contribute little or nothing to an understanding of the cause or causes of inflation or of the policies that might mitigate inflation or its effect,

6/8. But, in the end, forcing the players to accept the outcome, and thus stabilizing inflation, is typically left to the central bank. By slowing down the economy, it can force firms to accept lower prices given wages, and workers to accept lower wages given prices.

It’s not clear to me what constitutes “acceptance” of the outcome. Under any circumstance, the players will presumably still seek to choose and execute what, given the situation in which they find themselves, they regard as an optimal plan. Whether the players can execute the plan that they choose will depend on the plans chosen by other players and on the policies adopted by the central bank and other policy makers. If policy makers adopt a consistent set of policies that are feasible and are aligned with the outcomes expected by the players, then the players will likely succeed in implementing what they regard as optimal plans. If the policies that are followed are not consistent and not feasible, then those policies will not be aligned with the outcomes expected by the players. In the latter case, matters will likely get worse not better.

7/8. It is a highly inefficient way to deal with distributional conflicts. One can/should dream of a negotiation between workers, firms, and the state, in which the outcome is achieved without triggering inflation and requiring a painful slowdown.

I can’t help but observe the vagueness associated with the pronoun “it” and its unidentified antecedent. The outcome of a complex economic process cannot be achieved by a negotiation between workers,firms and the state. Things don’t work that way. Whatever negotiation Professor Blanchard is dreaming about, no negotiation can possibly determine the details of an outcome. What is possible is some agreement on policy goals or targets for inflation and some feasible set of policies aimed at achieving, or coming close to, a target rate of inflation. The key variable over which policy makers have some control is total aggregate demand for the economy measured either as a rate of nominal spending and nominal income over a year or as a rate of growth in spending and income compared to the previous year. Since inflation is itself a rate of change, presumaby the relevant target should be a rate of change in total nominal spending and nominal income. Thus, the appropriate target for policy makers to aim for is the yearly rate of growth in total nominal spending and total nominal income.

Given some reasonable expectation about the rate of technical progress (labor productivity) and the rate of increase in the labor force, a target rate of inflation implies a target rate of increase in total nominal spending and total nominal income. Given expectations about the increase in labor productivity, there is an implied rate of increase in nominal wages that is broadly consistent with the inflation target. But that average rate of increase in nominal wages can hardly be expected to be uniform for all industries and all firms and all workers, and it would be folly, on purely technical reasons, to attempt to enforce such a target in average nominal wage growth. And for legal and political reasons, it would be an even greater folly to try to do so.

Besides announcing the underlying basis for the targeted rate of nominal income growth, and encouraging workers and firms to take those targets seriously when negotiating wage contracts and setting prices, while recognizing that deviations from those targets are often reasonable and appropriate in the light of the specific circumstances in which particular firms and industries and labor unions are operating, policy makers have no constructive role to play in the setting of prices or wages for individual firms industries or labor contracts. But providing useful benchmarks for private agents to use as a basis for forming their own expectations about the future to guide their planning for the future is entirely appropriate and useful.

I should acknowledge that, as I have done previously, that the approach to policy making summarized here is based on the analysis developed by Ralph Hawtrey over the course of more than a half century as both a monetary theorist and a policy advisor, and, especially, as Hawtrey explained over a half-century ago in his final book, Incomes and Money.

8/8. But, unfortunately, this requires more trust than can be hoped for and just does not happen. Still, this way of thinking inflation shows what the problem is, and how to think of the least painful solution.

Insofar as policymakers can show that they are coming reasonably close to meeting their announced targets, they will encourage private actors to take those announced targets seriously when forming their own expectations and when negotiating with counterparties on the terms of their economic relationships. The least painful solutions are those in which economic agents align their expectations with the policy targets announced — and achieved — by policy makers.

Originally tweeted by Olivier Blanchard (@ojblanchard1) on December 30, 2022.

Wherein I Try to Calm Professor Blanchard’s Nerves

Olivier Blanchard is rightly counted among the most eminent macroeconomists of our time, and his pronouncements on macroeconomic matters should not be dismissed casually. So his commentary yesterday for the Peterson Institute of International Economics, responding to a previous policy brief, by David Reifschneider and David Wilcox, arguing that the recent burst of inflation is likely to recede, bears close attention.

Blanchard does not reject the analysis of Reifschneider and Wilcox outright, but he argues that they overlook factors that could cause inflation to remain high unless policy makers take more aggressive action to bring inflation down than is recommended by Reifschneider and Wilcox. Rather than go through the details of Blanchard’s argument, I address the two primary concerns he identifies: (1) the potential for inflation expectations to become unanchored, as they were in the 1970s and early 1980s, by persistent high inflation, and (2) the potential inflationary implications of wage catchup after the erosion of real wages by the recent burst of inflation.

Unanchored Inflation Expectations and the Added Cost of a Delayed Response to Inflation

Blanchard cites a forthcoming book by Alan Blinder on soft and hard landings from inflation in which Blinder examines nine Fed tightening episodes in which tightening was the primary cause of a slowdown or a recession. Based on the historical record, Blinder is optimistic that the Fed can manage a soft landing if it needs to reduce inflation. Blanchard doesn’t share Blinder’s confidence.

[I]n most of the episodes Blinder has identified, the movements in inflation to which the Fed reacted were too small to be of direct relevance to the current situation, and the only comparable episode to today, if any, is the episode that ended with the Volcker disinflation of the early 1980s.

I find that a scary comparison. . . .

[I]t shows what happened when the Fed got seriously “behind the curve” in 1974–75. . . . It then took 8 years, from 1975 to 1983, to reduce inflation to 4 percent.

And I find Blanchard’s comparison of the 1975-1983 period with the current situation problematic. First, he ignores the fact that the 1975-1983 episode did not display a steady rate of inflation or a uniform increase in inflation from 1975 until Volcker finally tamed it by way of the brutal 1981-82 recession. As I’ve explained previously in posts on the 1970s and 1980s (here, here, and here), and in chapters 7 and 8 of my book Studies in the History of Monetary Theory the 1970s inflation was the product of a series of inflationary demand-side and supply-shocks and misguided policy responses by the Fed, guided by politically motivated misconceptions, with little comprehension of the consequences of its actions.

It would be unwise to assume that the Fed will never embark on a similar march of folly, but it would be at least as unwise to adopt a proposed policy on the assumption that the alternative to that policy would be a repetition of the earlier march. What commentary on the 1970s largely overlooks is that there was an enormous expansion of the US labor force in that period as baby boomers came of age and as women began seeking and finding employment in steadily increasing numbers. The labor-force participation rate in the 1950s and 1960s fluctuated between about 58% to about 60%, mirroring fluctuations in the unemployment rate. Between 1970 and 1980 the labor force participation rate rose from just over 60% to just over 64% even as the unemployment rate rose from about 5% to over 7%. The 1970s were not, for the most part, a period of stagflation, but a period of inflation and strong growth interrupted by one deep recession (1974-75) and bookended by two minor recessions (1969-70) and (1979-80). But the rising trend of unemployment during the decade was largely attributable not to stagnation but to a rapidly expanding labor force and a rising labor participation rate.

The rapid increase in inflation in 1973 was largely a policy-driven error of the Nixon/Burns collaboration to ensure Nixon’s reelection in 1972 without bothering to taper the stimulus in 1973 after full employment was restored just in time for Nixon’s 1972 re-election. The oil shock of 1973-74 would have justified allowing a transitory period of increased inflation to cushion the negative effect of the increase in energy prices and to dilute the real magnitude of the nominal increase in oil prices. But the combined effect of excess aggregate demand and a negative supply shock led to an exaggerated compensatory tightening of monetary policy that led to the unnecessarily deep and prolonged recession in 1974-75.

A strong recovery ensued after the recession which, not surprisingly, was associated with declining inflation that fell below 5% in 1976. However, owing to the historically high rate of unemployment, only partially attributable to the previous recession, the incoming Carter administration promoted expansionary fiscal and monetary policies, which Arthur Burns, hoping to be reappointed by Carter to another term as Fed Chairman, willingly implemented. Rather than continue on the downward inflationary trend inherited from the previous administration, inflation resumed its upward trend in 1977.

Burns’s hopes to be reappointed by Carter were disappointed, but his replacement G. William Miller made no effort to tighten monetary policy to reverse the upward trend in inflation. A second oil shock in 1979 associated with the Iranian Revolution and the taking of US hostages in Iran caused crude oil prices over the course in 1979 to more than double. Again, the appropriate monetary-policy response was not to tighten monetary policy but to accommodate the price increase without causing a recession.

However, by the time of the second oil shock in 1979, inflation was already in the high single digits. The second oil shock, combined with the disastrous effects of the controls on petroleum prices carried over from the Nixon administration, created a crisis atmosphere that allowed the Reagan administration, with the cooperation of Paul Volcker, to implement a radical Monetarist anti-inflation policy. The policy was based on the misguided presumption that keeping the rate of growth of some measure of the money stock below a 5% annual rate would cure inflation with little effect on the overall economy if it were credibly implemented.

Volcker’s reputation was such that it was thought by supporters of the policy that his commitment would be relied upon by the public, so that a smooth transition to a lower rate of inflation would follow, and any downturn would be mild and short-lived. But the result was an unexpectedly deep and long-lasting recession.

The recession was needlessly prolonged by the grave misunderstanding of the causal relationship between the monetary aggregates and macroeconomic performance that had been perpetrated by Milton Friedman’s anti-Keynesian Monetarist counterrevolution. After triggering the sharpest downturn of the postwar era, the Monetarist anti-inflation strategy adopted by Volcker was, in the summer of 1982, on the verge of causing a financial crisis before Volcker announced that the Fed would no longer try to target any of the monetary aggregates, an announcement that triggered an immediate stock-market boom and, within a few months, the start of an economic recovery.

Thus, Blanchard is wrong to compare our current situation to the entire 1975-1983 period. The current situation, rather, is similar to the situation in 1973, when an economy, in the late stages of a recovery with rising inflation, was subjected to a severe supply shock. The appropriate response to that supply shock was not to tighten monetary policy, but merely to draw down the monetary stimulus of the previous two years. However, the Fed, perhaps shamed by the excessive, and politically motivated, monetary expansion of the previous two years, overcompensated by tightening monetary policy to counter the combined inflationary impact of its own previous policy and the recent oil price increase, immediately triggering the sharpest downturn of the postwar era. That is the lesson to draw from the 1970s, and it’s a mistake that the Fed ought not repeat now.

The Catch-Up Problem: Are Rapidly Rising Wages a Ticking Time-Bomb

Blanchard is worried that, because price increases exceeded wage increases in 2021, causing real wages to fall in 2021, workers will rationally assume, and demand, that their nominal wages will rise in 2022 to compensate for the decline in real wages, thereby fueling a further increase in inflation. This is a familiar argument based on the famous short-run Phillips-Curve trade-off between inflation and unemployment. Reduced unemployment resulting from the real-wage reduction associated with inflation will cause inflation to increase.

This argument is problematic on at least two levels. First, it presumes that the Phillips Curve represents a structural relationship, when it is merely a reduced form, just as an observed relationship between the price of a commodity and sales of that commodity is a reduced form, not a demand curve. Inferences cannot be made from a reduced form about the effect of a price change, nor can inferences about the effect of inflation be made from the Phillips Curve.

But one needn’t resort to a somewhat sophisticated argument to see why Blanchard’s fears that wage catchup will lead to a further round of inflation are not well-grounded. Blanchard argues that business firms, having pocketed windfall profits from rising prices that have outpaced wage increases, will grant workers compensatory wage increases to restore workers’ real wages, while also increasing prices to compensate themselves for the increased wages that they have agreed to pay their workers.

I’m sorry, but with all due respect to Professor Blanchard, that argument makes no sense. Evidently, firms have generally enjoyed a windfall when market conditions allowed them to raise prices without raising wages. Why, if wages finally catch up to prices, will they raise prices again? Either firms can choose, at will, how much profit to make when they set prices or their prices are constrained by market forces. If Professor Blanchard believes that firms can simply choose how much profit they make when they set prices, then he seems to be subscribing to Senator Warren’s theory of inflation: that inflation is caused by corporate greed. If he believes that, in setting prices, firms are constrained by market forces, then the mere fact that market conditions allowed them to increase prices faster than wages rose in 2021 does not mean that, if market conditions cause wages to rise at a faster rate than they did in 2022, firms, after absorbing those wage increases, will automatically be able to maintain their elevated profit margins in 2022 by raising prices in 2022 correspondingly.

The market conditions facing firms in 2022 will be determined by, among other things, the monetary policy of the Fed. Whether firms are able to raise prices in 2022 as fast as wages rise in 2022 will depend on the monetary policy adopted by the Fed. If the Fed’s monetary policy aims at gradually slowing down the rate of increase in nominal GDP in 2022 from the 2021 rate of increase, firms overall will not easily be able to raise prices as fast as wages rise in 2022. But why should anyone expect that firms that enjoyed windfall profits from inflation in 2021 will be able to continue enjoying those elevated profits in perpetuity?

Professor Blanchard posits simple sectoral equations for the determination of the rate of wage increases and for the rate of price increases given the rate of wage increases. This sort of one-way causality is much too simplified and ignores the fundamental fact all prices and wages and expectations of future prices and wages are mutually determined in a simultaneous system. One can’t reason from a change in a single variable and extrapolate from that change how the rest of the system will adjust.


About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner

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