The Great Inflation from 1965 to 1984 is the climactic monetary event of the last part of the 20th century. This paper analyzes why it started and why it continued for many years. Like others, it attributes the start of inflation to analytic errors, particularly the widespread acceptance of the simple Keynesian model with its implication that monetary and fiscal policy should be coordinated. In practice, that meant that the Federal Reserve financed a large part of the fiscal deficit. This paper gives a large role to political decision making. Continuation of inflation depended on political choices, analytic errors, and the entrenched belief that inflation would continue.
Both of them properly note that the excess fiscal stimulus during the late 1960’s combined with the monetary accommodation of this stimulus was the cause of the acceleration of inflation. Romer attributes this policy mistake to an Ideas Hypothesis aka a “misguided economic framework”, which means the supposed Keynesian view put forth by Bruce Bartlett. Mark has extensively covered the blog debate as to what Keynesians supposedly believed versus what supply-siders alleged contributed. Rather than rehash this debate, let me humbly suggest that Metzler’s political hypothesis has a lot of merit. As a backdrop, let me echo what Brad DeLong said with respect to policy making during the Reagan Administration:
But in practice… it seemed to me that Bruce’s political masters like Jack Kemp were excessively eager to throw the “budget in balance or surplus on average over the business cycle,” and that the eager embrace of deficits and their crowding-out of investment did more harm than the focus on reducing marginal tax rates did good.
I suspect Bruce agrees with this statement. His version of supply-side economics does not promise the free lunch version that folks like Jack Kemp and Art Laffer hype. In Bruce’s version, reducing marginal tax rates in a fiscally neutral fashion could encourage more savings. But fiscal neutrality either requires some other tax rate has to go up or government spending has to go down. Alas, the modern version of the Republican Party – which dates back to the Reagan years – do not wish to face the tough decisions. So they promise lower tax rates for everyone without any significant reductions in government spending. How did this play out during the Reagan-Bush41 years? The record clearly shows the fiscal stimulus lead to less national savings and a reduction in the long-term growth rate. While we can blame Kemp and Laffer with their serial dishonesty about the aftermath of the Reagan fiscal fiasco, this should not indict the views of sensible supply-siders like Bruce.
Fairness requires that we look at the advise given by the Council of Economic Advisors to President Johnson at the advent of the Great Inflation. In a way, Bruce Bartlett did me a bit of a favor by emailing me after he saw this post of President Kennedy making a Keynesian case of the tax cut ultimately signed by President Johnson in 1964. Bruce was trying to make the case that the 1964 tax cut was not done for Keynesian reasons – an odd claim in my opinion. Bruce mentions two other people that were very important in the policy deliberations starting around 1966: Wilbur Mills who chaired the House Ways & Means Committee and Norman Ture – an advisor to Congressman Mills and the mentor for most supply-siders. While supply-siders love to praise JFK for the tax cut that LBJ signed in 1964, they tend to omit what really happened during the rest of the decade. Sure the tax cut seemed like a great success through 1964 and 1965 with real GDP being 5.8% in 1964 and 6.4% in 1965 and the unemployment rate dropping from 5.5% in December 1963 to 4.0% in December 1965.
But we should recall the meeting that the CEA had with President Johnson during December 1965 where they expressed grave concern with a triple-whammy fiscal stimulus – the tax cut, the increase in transfer payments from the Great Society programs and the increase in defense purchases from the escalation of our involvement in the Vietnam War. They warned LBJ that if this excessive fiscal stimulus was not reversed, the Federal Reserve would face the Faustian choice of raising interest rates (and crowding out investment) or watching inflation accelerate. While some rightwing critics of this Keynesian CEA claim they wanted a bigger government, this claim is highly unfair. The CEA suggested to the President that he curb government spending. LBJ rejected this advice as the War on Poverty was to be his political legacy and he still had the naïve view that Vietnam was winnable. Sort of sounds like George W. Bush with his Iraq War, prescription drug benefit, and his zeal for tax cuts – doesn’t it?
But to be fair to LBJ, he did listen to the CEA about reversing the 1964 tax cut. Of course, he gave the CEA a stern lecture about how this tax cut helped the Democrats during the 1964 election and that reversing it would be political suicide. The economists on the CEA were not impressed so LBJ agreed to discuss this with Chairman Mills. But here is where some really bad advice reared its ugly head. Norman Ture told his client that the CEA was crazy and the U.S. economy had plenty of room to grow. Ture was as wrong as the village idiots at the National Review such as Lawrence Kudlow, but we never here this from the supply-side crowd.
Real GDP grew by 6.5% in 1966 and inflation did accelerate. But to its credit, the Federal Reserve did increase interest rates in 1966 causing the 1966 Credit Crunch. Funny – we never hear about this from the supply-siders. But why should they bother to admit that fiscal stimulus crowds out investment? Intellectual honesty gets in the way of their religion. In 1967, real GDP grew by only 2.5% and inflation moderated. But as Christina Romer notes, the Federal Reserve did not adhere to this tight monetary policy regime – in part because LBJ was quite unhappy with high interest rates. Of course, his own CEA had told the President that the Federal Reserve should have implemented tight money. But who do the supply-siders blame for this mix of expansionary fiscal policy and easy money that resulting in the Great Inflation. While they should give joint blame to the politicians and to their mentor, they don’t. They blame the Council of Economic Advisors. Excuse me for saying this – but their attempts to shift blame are the height of intellectual dishonesty.
While we have covered the after-math of the 1964 tax cut and Brad covers the fiscal fiasco of the Reagan years – both episodes pointing out that fiscal stimulus does indeed lower national savings – and if sustained would reduce long-term growth, the current policy debate centers on the desire of certain Republicans (including alas that hack we call President) of making the 2001 and 2003 tax cuts permanent. Now Bruce Bartlett may wish we paid for these tax cuts with a much smaller government, we all know that the modern Republican Party doesn’t even have the courage to advocate a truly small government agenda. And we also know that no respectable economist – be (s)he classical or Keynesian can deny the reality that the long-run impact of sustained fiscal stimulus is to reduce savings and reduce long-term growth. There is no debate on this truism among serious economists – just the abuse of the nuances we struggle with by our political masters and pseudo economists like Lawrence Kudlow to push upon us absurd agendas that have nothing to do with pro-growth policies.
Update: Brad DeLong goes with the Ideas Hypothesis:
The one amendment to Romer’s analysis I would make would be to point out that Arthur Burns’s view that inflation was relatively unresponsive to unemployment can be traced back to his 1959 Presidential Address to the American Economic Association.
We have graphed the Federal Funds rate from 1959 to 1979 as I have a few questions about Brad’s comment. Is he saying the FED did not worry about demand-pull inflation? Then why did it ever raise interest rates? Why not lower interest rates even more – if the FED really believed this? Or was it only the Burns FED – which began in 1970 – that believed this? It is true that the FED pursued expansionary monetary policies in the lead-up to the 1972 campaign. But I always thought that this was driven by political pressure from Richard Nixon who blamed the tight monetary policies in 1960 for his loss to John Kennedy. And notice that the FED pursued tight monetary policies as part of Gerald Ford’s misguided Whip Inflation Now episode, which led to the 1974 recession. Of course, I let this graph go through 1979 to get my digs into the Volcker FED for round II of excessively tight monetary policies, which led to the Carter recession and the election of spend and borrow Ronald Reagan.