The Krugman-Summers 1982 Inflation Memo
As members of the Reagan CEA, Paul Krugman and Lawrence Summers wrote a memo to Martin Feldstein and Willam Poole on 9/9/1982 with the first section entitled “The Inflation Time Bomb”. Don Luskin’s latest tirade at NRO links to it (alas, he links only to the first page of the memo, whereas the memo’s analysis entitled “How Much Real Progress Has Been Made Against Inflation” is cut short so if anyone has the rest of this memo, that would be useful). Luskin’s tirade has a dual purpose: (1) to once again attack Paul Krugman, and (2) distort the record of Reaganomics as NRO does so well.
Since Ragout has already done a nice job of noting how Luskin has misrepresented what the memo says, let me focus on the substantive issues.
I can recall various discussions on the inflation issue back in 1982 and this limited portion of this memo that Luskin provides captures what I would have said as well as what many economists were saying back then. The contrast of what economists were saying then versus what the Reagan bandwagon is claiming now is striking. Luskin quotes from the 1982 memo:
We believe that it is reasonable to expect a significant reacceleration of inflation in the near future. Much of the apparent progress against inflation has resulted from the temporary side effects of tight money and high real interest rates. These side effects must be expected to reverse themselves as real interest rates decline and the economy expands. … Our very rough guess is that correction of … distorted relative prices will add at least 5 percentage points to future increases in consumer prices … This estimate is conservative …
Luskin then shows the consumer price inflation rate through 1989 and writes:
In the very next month after the memo appeared, inflation dropped by more than one full percentage point, and for the rest of the Reagan presidency it was never even close to the same level as when the message was written – never mind being “at least 5 percentage points” higher than that. Krugman was never less wrong than about 6 percentage points of inflation. At his worst, he was almost 10 percentage points wrong…In 1982 Krugman thought inflation was caused by the exchange rate of the U.S. dollar, the price of commodities, and the price of oil. But as anybody with a lick of common sense could tell him, he had it completely backward – these things are the effect of inflation, not the cause. Krugman noted that in 1982 the real foreign-exchange rate of the U.S. dollar was sharply higher – and real commodity prices were sharply lower – than they had been over the last decade. He concluded from this that as “the economy recovers, we can expect the real exchange rate and real commodity prices to return to approximately their historical levels.” He couldn’t have been more wrong in both cases.
While it is true that consumer price inflation near 4% from 1982 to 1985 and then dropped temporarily to just over 1% in 1986, the concern in 1982 was that a return to full employment and a reversal of the massive dollar appreciation would indeed increase inflation. But let’s set the record straight.
The dramatic decline in oil prices were certainly not due to either the Reagan tax cuts or Volcker’s tight monetary policy. But the tug of war between these two policies certainly led to the massive dollar appreciation, which certainly had to be reversed eventually. The Federal Reserve’s broad measure of real exchange rates had increased from 86.24 (index set at 100 for 1973) to 109.6 by September 1982. Few at the time would have expected the currency to continue to appreciate through March 1985 when it reached 128.1, but one cannot blame Dr. Krugman and Summers for not realizing that this fiscal stimulus/tight money tug of war would have remained so severe. In fact, the memo notes twice on the first page that they expected real interest rates to decline and the economy to recover.
Luskin and his NRO colleagues might be uncomfortable with any premise “that the collapse of inflation in the 1980s played out just as left-wing Keynesian economics predicted”, but a review of the unemployment rates (BLS figures from December of each year) show the Reagan recession was both deep and prolonged:
In other words, it was not until the latter Reagan years that the economy got close to full employment. Also note that the real exchange rate did finally devalue reaching 89.39 by December 1988. And inflation? It accelerated to above 4% for the 1987-1989 period and was near 6.3% by 1990. And people wonder why the Greenspan Federal Reserve allowed interest rates to rise during the early part of Bush41’s term.