Karl Smith writes,

I tend to think far little attention has been paid to the rapid increase in the work force due to the entrance of baby boomers and women. Economists are so sensitive to any argument against immigration they seem to forget that any growth model that I am aware of will predict a decline in per capita GDP if the population rises fast enough.

He cites a 1999 paper by Athanasios Orphanides, who wriote,

I examine the evolution of estimates of potential output and resulting assessments of the output gap during the 1960s and 1970s. My analysis suggests that the resulting measurement problems could be attributed in large
part to changes in the trend growth of productivity in the economy which, though clearly seen in the data with the benefit of hindsight, was virtually impossible to ascertain in real-time.

I am glad to see folks renewing their interest in the Great Stagflation. I certainly spend a lot of time on it in the book that I am working on. In my case, I am particularly interested in the human dimension of how it affected economists. There was much more professional turmoil back then. For example, consider how quickly the great economists of the 1960s went from the center of the profession to its periphery. In 1968, if you had held a session at the AEA meetings featuring Walter Heller, Arthur Okun, Lawrence Klein, and Otto Eckstein, you would have needed a ballroom to accomodate everyone who wanted to attend. In 1974, you could have held it in a suite.

Contrast that with the impact of the Great Recession. Who were the big names before it hit? Blanchard, Woodford,, Bernanke, Gali. Who are the big names now? Same ones.

So in the 1970s, unexpected macroeconomic events create a dinosaur extinction. Today, nothing. Explain that to me.

Concerning the point raised by Karl Smith and Steve Waldman, as best I recall, economists back then were making adjustments for changes in the composition of the work force in their calculations of trend productivity growth. That was part of the story for poor economic performance, but not all of it. Some points to consider.

1. As I posted a while back, Alan Blinder thinks that much can be accounted for by a series of supply shocks–from oil price increases to Peruvian anchovy disappearances. I would add that I think that price controls were a self-inflicted supply shock, particularly in the oil market. At the time, many economists (Blinder among them) wrongly thought that price controls were a favorable supply shock. But I think that by messing up market adjustments they were an adverse shock.

2. I think that there was a lot of money illusion in financial markets in the 1970s. That is, people looked at high nominal interest rates and treated them as high real interest rates. Thus, as Modigliani and Cohn (you can Google Modigliani Cohn 1979) pointed out, the stock market seemed to be discounting real earnings at nominal rates. But the main problem was that real rates remained very negative. In my view, this was the fault of the private sector, although I think there was money illusion at the Fed as well. But in my view, regardless of what the Fed was doing with short-term rates, nobody was forcing long-term bond investors to take negative real rates. Yet that is what they did.

So the story I would tell is that the high inflation came from these negative real interest rates, and perhaps from the series of supply shocks Blinder discusses. The high unemployment came from the energy shock, exacerbated by the self-inflicted disruption of price controls.

He writes (can anyone find a free, ungated copy?),

The implied short-run unemployment NAIRU is highly stable, staying in the range of 3.9 to 4.4 percent between 1996 and 2013. However, the rise in the extent and duration of long-run employment causes the NAIRU for the total unemployment rate (short-run plus long-run) to increase from 4.8 percent in 2006 to 6.5 percent in 2013:Q1. As a result, this paper supports the recent research that argues that there has been an increase in structural unemployment taking the form of long-run unemployed.

Gordon talks up what he calls the “triangle” approach to the Phillips Curve, as opposed to the New Keynesian approach (NKPC).

The triangle approach differs from the NKPC approach by including long lags on the dependent variable, additional lags on the unemployment gap, and explicit variables to represent the supply shocks…the change in the relative price of non-food non-oil imports, the eight-quarter change in the trend rate of productivity growth, and dummy variables for the effect of the 1971-74 Nixon-era price controls.

This methodology is so reminiscent of the 1970s that it makes me want to wear bell-bottom jeans and listen to disco.

No inflation model has any credibility unless it deals explicitly with the supply shocks that created the positive inflation-unemployment correlation in the 1970s and early 1980s and the lead of inflation ahead of unemployment. But this was not the only episode. Between 1996 and 2000 the unemployment rate descended far below its 5.84 average to less than 4.0 percent, and yet the inflation rate did not speed up as it had done in the late 1960s and late 1980s. The triangle model explains why inflation was so tame, pointing to beneficial supply shocks during the late 1990s – oil prices were low, the dollar was appreciating, and productivity growth was reviving.

He points out that a simple plot of the Phillips relation between 1970 and 2006 looks simply awful (from the point of view of anyone who thought that the 1960s Phillips Curve would persist).

The overall correlation appears to be positive but very weak, close to zero, and the 1970-80 observations in the scatter plot once led Arthur Okun to describe the PC as “an unidentified flying object.”

Gordon’s productivity trend acceleration variable is really important.

Its deceleration into negative territory during 1964-1980 might be as important a cause of accelerating inflation in that period as its post-1995 acceleration was a cause of low inflation in the late 1990s. Note also that the productivity growth trend revival of 1980-85 may have contributed to the success of the “Volcker disinflation,” a link that has been missed in most of the past PC literature. There has been a sharp deceleration of trend productivity growth since 2004, helping to explain the absence of deflation in the past few years.

Note that there are other ways to arrive at a negative correlation between productivity growth and inflation. You could have measurement error in the rate of inflation (if you overstate price increases, you understate productivity growth, and conversely). You could have the Fed following a policy that approximately targets nominal GDP, so that when productivity goes up inflation goes down, and conversely.

From a modern perspective (meaning any graduate macro syllabus after 1975), the “triangle” model is hard to swallow. In Gordon’s model, the only way for money to affect inflation is through the “output gap.” My guess is that this makes hyperinflation a mathematical impossibility in the Gordon model–to get to 100 percent inflation rates would probably require decades of a negative output gap, which is not what preceded any of the many actual hyperinflations in the world.

For me, the important point is to keep in mind is that there is no unique interpretation of the path of nominal GDP, employment, productivity, and inflation. Take any three of those as given, and you arrive at the fourth. Arithmetically,

[1] growth in nominal GDP minus growth in inflation = growth in employment plus growth in productivity

Scott Sumner says “tell me the path of nominal GDP, and I will tell you the path of employment.” He is bound to be right, as long as you do not have to worry about how inflation and productivity move in the short run. And they will move in opposite directions to the extent that inflation is measured with error.

Robert Gordon says “tell me productivity growth and the rate of short-term unemployment, and I will tell you the rate of inflation.” He is bound to be right about productivity growth, since if we hold nominal GDP growth and employment constant, productivity growth and inflation vary inversely. His problem is that, arithmetically, employment and inflation should be negatively related. But if you eliminate all instances of positive relationships between unemployment and inflation by calling them “supply shocks” (which differ from time-varying productivity), then by golly, the Phillips Curve is indeed “alive and well.”

I say that in order to claim to have a macroeconomic model, you have to treat nominal GDP, employment, inflation, and variations in trend productivity all as endogenous. Otherwise, you are just choosing one interpretation from among many.

Alan s. Blinder and Jeremy B. Rudd write,

This paper reexamines the impacts of the supply shocks of the 1970s in the light of the new data, new events, new theories, and new econometric studies that have accumulated over the past quarter century. We find that the classic supply-shock explanation holds up very well; in particular, neither data revisions nor updated econometric estimates substantially change the evaluations of the 1972-1983 period that were made 25 years (or more) ago. We also rebut several variants of the claim that monetary policy, rather than supply shocks, was really to blame for the inflation spikes.

In his 1967 AEA Presidential address (published in 1968), Milton Friedman predicted the death of the Phillips Curve. When this prediction apparently came true a few years later, most of the profession shifted toward the view that inflation is a monetary phenomenon. A few economists remained unconvinced, and Blinder appears to be one of them. Blinder has always blamed the high inflation of the 1970s on rising food and energy prices and the removal of the wage-price controls of 1971-73. He and his co-author write,

a permanent increase in the level of energy prices should cause a quick burst of inflation which mostly, but not quite (because of pass-through to the core), disappears of its own accord. Once again, headline inflation quickly converges to core, but now core inflation remains persistently higher than it was before the shock.

This sentence would horrify anyone who took macro at MIT when I was there, by which point there was a monetarist influence, coming from Dornbusch and Fischer. Blinder is saying that a one-shot increase in the relative price of oil will cause a permanent increase in the rate of inflation. And he is ignoring the money supply. As an aside, he seems to be casually equating a the level of prices with the rate of change of prices.

I actually admire this willingness to go against prevailing fashion. Moreover, he may be right. It is an article of faith among economists that the 1970s inflation and the 1980s disinflation both came from monetary policy, but that does not make it a proven fact. Maybe we have too much faith. Instead, we should be willing to examine data and adopt a skeptical perspective.

In any case, this is a must-read paper for anyone interested in macroeconomic history. It reminds us of the “food shocks” that took place. It reminds us that the CPI used to include the mortgage interest rate. It reminds us that

the main effect of the OPEC I production cuts, which were neither exceptionally large nor long-lasting, was to create significant uncertainties about oil supply, which induced a surge in precautionary demand for oil.

In fact, I wonder if the first oil shock might have been more U.S.-based than OPEC-based. The Democratic Congress and Presidents Nixon and Ford were obsessed with trying to keep consumer energy prices and oil company profits down. They concocted a Byzantine scheme of price controls, oil allocation, and “windfall profits” taxes. The technocrats spoke of “old oil” (oil that had been discovered in the U.S. prior to the fall of 1973) “new oil” (oil discovered since that date), and “imported oil.” Their goal was to try to make the energy market work as if oil companies were selling “old oil” at pre-1973 prices. Perhaps it was these attempts to centrally administer oil production that were the real supply shock.

The authors continue,

Similarly, the rise in prices associated with the second OPEC shock appears to have been driven more by fear of future shortages than by actual reductions in supply.

Or perhaps the oil industry anticipated another round of byzantine regulation and punitive taxes. Recall that instead, when President Reagan took office in 1981, one of his first acts was to get rid of the remaining price controls in the energy market.

Blinder comments on the puzzle that subsequent energy price shocks had less effect on both inflation and unemployment. He cites a number of possible explanations: a less energy-intensive economy; more flexible wages; more public confidence that the Fed will hold down inflation. I think that the answer might be less attempts to regulate prices and profits in the domestic oil market.