Must-Read: Mark Thoma: The Triumph of Backward-Looking Economics
Must-Read: When I have to teach my students policy-oriented macro, I look for cases of moderate inflation in which expectations relevant to the Phillips curve and the inflation-unemployment “tradeoff” turn out to be neither anchored nor adaptive but rational. The only historical example I have found in a major North Atlantic country that even partly fits the bill is the accession of Francois Mitterand to the French presidency in the early 1980s–and even there the expectations that look rational are not workers’ or bosses’ but rather foreign-exchange traders…
: The Triumph of Backward-Looking Economics: “In response to Paul Krugman’s recent post, “The Triumph of Backward-Looking Economics”…
…let me offer this from Blanchard and Johnson’s intermediate macroeconomics text….
Fighting inflation implied tightening monetary policy, decreasing output growth, and thus accepting higher unemployment for some time. The question arose of how much unemployment, and for how long, would likely be needed to achieve a lower level of inflation, say 4%–which is the rate Volcker wanted to achieve. Some economists argued that such a disinflation would likely be very costly…. [But] Lucas argued: Why shouldn’t wage setters take policy changes directly into account? If wage setters believed that the Fed was committed to lower inflation, they might well expect inflation to be lower in the future than in the past…. The essential ingredient of successful disinflation, he argued, was credibility…. Furthermore, [Sargent] argued, a clear and quick disinflation program was more likely to be credible than a protracted one….
[Starting] September 1979… from 9%… the three-month Treasury bill rate was increased to 15% in August 1981…. There was no credibility miracle: Disinflation was associated with a sharp recession…. Does this settle the issue of how much credibility matters? Not really. Those who argued before the fact that credibility would help argued after the fact that Volcker had not been fully credible…
If Volcker’s disinflation was not a “fully credible” attempt to curb a moderate inflation, then nothing short of a replacement of a currency will ever be credible. And the question of how to stop a moderate inflation via credible policies is simply without interest.