The Accidental Theorist (10 page)

But that’s not how serious economics is done. A real economist starts not with a policy view but with a
story about how the world works.
That story almost always takes the form of a model—a simplified representation of the world, which helps you cut through the complexities. Once you have a model, you can ask how well it fits the facts; if it fits them reasonably well, you can ask what sorts of magnitudes, what sort of tradeoffs, it implies. Your policy opinions then flow from the model, not the other way around. The reason economists at the Fed think that the economy can’t achieve 4 percent growth is not because they like slow growth, or because they are locked into a mindless orthodoxy: it is because they have a model of the U.S. economy that fits the facts very well and that tells them that 4 percent is a completely unrealistic target. They might be wrong—but to make a credible case for much faster growth you must counter the orthodox model with a better model, or you are engaged in an exercise in rhetoric rather than economics.

Let me also say something else. Anyone who has ever made the effort to understand a really useful economic model (like the simple models on which economists base their argument for free trade) learns something important: The model is often smarter than you are. What I mean by that is that the act of putting your thoughts together into a coherent model often forces you into conclusions you never intended, forces you to give up fondly held beliefs. The result is that people who have understood even the simplest, most trivial-sounding economic models are often far more sophisticated than people who know thousands of facts and hundreds of anecdotes, who can use plenty of big words, but have no coherent framework to organize their thoughts. If you really understood my story about the baby-sitting co-op, congratulations: You now know more about the nature of monetary policy and the business cycle than 99 percent of the attendees at Renaissance Weekend. If you have taken the time to understand the story about England trading cloth for Portuguese wine that we teach to every freshman in Econ 1, I guarantee you that you know more about the nature of the global economy than the current U.S. Trade Representative (or most of his predecessors).

I might as well raise another point. One thing that usually happens when I try to talk about the difference between serious economics and the kind of glib rhetoric that passes for sophistication is that people accuse me of being arrogant, of thinking that I know everything. I can’t imagine why. No, seriously—think about it. What someone like Felix Rohatyn is in effect saying is “I don’t need to make an effort to understand where the conventional views of economists come from; I don’t need to understand the stuff that’s in every undergraduate textbook; I’m such a smart guy that I can make up my own version of macroeconomics off the top of my head, and it will be much better than anything
they
have come up with.” Then along comes this irritating economist who points out a few gaping holes in his argument, basic errors that anyone who
had
bothered to understand the stuff in the undergraduate textbook would not have made. And people’s response is “That Krugman—he’s so arrogant.”

Well, what can we do about this kind of thing? Let me be the first to admit that economists have not made it easy for smart people who don’t want to get too deep into the technicalities to understand the basics. Mathematics is a wonderful tool, but there are far too few attempts to explain the fundamental models of economics with a minimum of math; we need to make a real effort to write in English, and skip the differential topology. I’m trying, but the profession has a long way to go.

But it’s also important for non-economists—people who want to be sophisticated about economic policy without getting Ph.D.s—to make an effort. As I said earlier, it’s not a matter of time, it’s a matter of attitude. The biggest problem with many businesspeople, political leaders, and others is that while they are willing to talk and read about economics ad nauseam, they are not willing to do anything that feels like going back to school. They would rather read five books by David Halberstam than one chapter in an undergraduate textbook; and they absolutely hate the idea that they need to work their way through whimsical stories about cloth and wine and baby-sitting rather than get right into pontificating about globalization and the new economy.

But there is no way around it. If you want to be truly well-informed about economics (or anything else), you must go back to school—and keep going back, again and again. You must be prepared to work through little models before you can use the big words—in fact, it is usually a good idea to try to avoid the big words altogether. If you balk at this task—if you think that you are too grown-up for this sort of thing—then you may sound impressive and sophisticated, but you will have no idea what you are talking about.

Many years ago, Paul Samuelson memorably cautioned against basing economic policy on “shibboleths,” by which he meant slogans that take the place of hard thinking. Strictly speaking, this was an incorrect use of the word: The OED defines a shibboleth as “A catchword or formula adopted by a party or sect, by which their adherents or followers may be discerned, or those not their followers may be excluded.” But in a deeper sense Samuelson probably had it right: Simplistic ideas in economics often become badges of identity for groups of like-minded people, who repeat certain phrases to each other, and eventually mistake repetition for self-evident truth.

Excerpted from “Fast Growth and Stable Prices: Just Say No,”
Economist,
August 1996.

Public discussion of monetary policy is increasingly dominated by two such sects. The shibboleth of one sect is “growth” that of the other is “stable prices.” Those who belong to neither sect find it hard to get a hearing; indeed, journalists and politicians often seem baffled by economists who do not fit into these categories. Surely you must believe either that central banks should aim for zero inflation to the exclusion of all other goals (and that stable prices will bring huge economic benefits) or that central banks should stop worrying about inflation altogether and go for growth (and that by so doing they can bring back the growth rates of the 1960s).

But we need not make this choice. We can and should reject both fatuous promises of easy growth and mystical faith in the virtues of stable prices.

“Four Percent Follies” made the case against growth; so let me make myself even more unpopular, by making the case against stable prices.

The Economic Growth and Stability Act, proposed in 1995 by Senator Connie Mack, declares that price stability “is a key condition to maintaining the highest possible levels of productivity, real incomes, living standards, employment and global competititiveness,” and enjoins the Federal Reserve to make such stability its primary goal. It’s a confident declaration: You would never guess that there is hardly any reason to believe that it is true.

The fact, however, is that the costs of inflation at the low single-digit rates that now prevail in advanced countries have proved theoretically and empirically elusive. Very high inflation, which leads people into costly efforts to avoid holding cash, is one thing; but we are not remotely in that situation. Moreover, it is fairly certain that the costs of inflation, such as they are, are nonlinear in the actual rate: 3 percent inflation does much less than one-third as much harm as 9 percent.

Still, even if the gains from price stability are nowhere near as large as Senator Mack imagines, why not go for them? Because to do so would be very expensive. The great disinflation of the 1980s, which brought inflation rates down from around 10 percent to around 4, was achieved only through a prolonged period of high unemployment rates and excess capacity—in the United States, the unemployment rate did not fall back to its 1979 level until 1988, and the cumulative loss of output was more than a trillion dollars. There is every reason to expect that a push to zero inflation would involve a comparable “sacrifice ratio”—that it would cost as much as half a trillion dollars in foregone output to wring the remaining 3 points or so of inflation out of the system. This is a huge short-term pain for a small and elusive long-term gain.

And even this may not be the whole story: There is some evidence that a push to zero inflation may lead not just to a temporary sacrifice of output but to a permanently higher rate of unemployment. This is still controversial—the standard view, embodied in the concept of the NAIRU (non-accelerating-inflation rate of unemployment) is that there is no long-run tradeoff between inflation and unemployment—but recent work by George Akerlof, William Dickens, and George Perry makes a compelling case that this no-tradeoff view breaks down at very low inflation rates.

The NAIRU hypothesis is based on the reasonable proposition that people can figure out the effects of inflation—that both workers and employers realize that an 11 percent wage increase in the face of 10 percent inflation is the same thing as a 6 percent increase in the face of 5 percent inflation, and therefore that any sustained rate of inflation will simply get built into price and wage decisions. There is overwhelming evidence that this hypothesis is right—that 10 percent inflation does not buy a long-term unemployment rate significantly lower than that which can be sustained with 5 percent inflation.

But suppose that the inflation rate is very low, and that market forces are “trying” to reduce the real wages of some workers. (Even if average real wages are rising, there will usually be some industries and some categories of labor in which real wages must decline in order to maintain full employment). Is a 2 percent wage increase in the face of 5 percent inflation the same thing as a 3 percent wage fall in the face of stable prices? To hyperrational workers, it might be; but common sense suggests that in practice there is a big psychological difference between a wage rise that fails to keep pace with inflation and an explicit wage reduction. Akerlof, Dickens, and Perry have produced compelling evidence that workers are indeed very reluctant to accept nominal wage cuts: The distribution of nominal wage changes shows very few actual declines but a large concentration at precisely zero, a clear indication that there are a substantial number of workers whose real wages “should” be falling more rapidly than the inflation rate but cannot because to do so would require unacceptable nominal wage cuts.

This nominal wage rigidity means that trying to get the inflation rate very low impairs real wage flexibility, and therefore increases the unemployment rate even in the long run. Consider, for example, the case of Canada, a nation whose central bank is intensely committed to the goal of price stability (the current inflation rate is less than 1 percent). In the 1960s Canada used to have about the same unemployment rate as the United States. When it started to run persistently higher rates in the 1970s and 1980s, many economists attributed the differential to a more generous unemployment insurance system. But even as that system has become less generous, the unemployment gap has continued to widen—Canada’s current rate is 10 percent. Why? The Canadian economist Pierre Fortin points out that from 1992 to 1994 a startling 47 percent of his country’s collective bargaining agreements involved wage freezes—that is, precisely zero nominal wage change. Most economists would agree that high-unemployment economies like Canada suffer from inadequate real wage flexibility; Fortin’s evidence suggests, however, that the cause of that inflexibility lies not in structual, microeconomic problems but in the Bank of Canada’s excessive anti-inflationary zeal.

In short, the belief that absolute price stability is a huge blessing, that it brings large benefits with few if any costs, rests not on evidence but on faith. The evidence actually points strongly the other way: The benefits of price stability are elusive, the costs of getting there are large, and zero inflation may not be a good thing even in the long run.

Suppose you reject both the miracle cures of the growth sect and the old-time religion of the stable-price sect. What policies would you advocate?

A shibboleth-free policy might look like this: First, adopt as an ultimate target fairly low but not zero inflation, say 3 or 4 percent. This is high enough to accommodate most of the real wage cuts that markets impose, while the costs of the inflation itself will still be very small. However, monetary policy affects inflation only with a long lag, so it is necessary to have some more operational intermediate target. A reasonable strategy is to try to stabilize unemployment around your best estimate of the level consistent with stable inflation at the desired rate, even while recognizing that such estimates are imperfect and that the structure of the economy changes over time in any case; so you should be prepared to adjust the target unemployment rate gradually down or up if inflation performance is better or worse than you expected. And of course if past misjudgments have caused inflation to move above—or below!—the target range, policy must endeavor to bring it back into line.

This policy proposal will presumably bring angry objections from both sides. The growth sect will denounce it as an acceptance of defeat, insisting that we need higher growth to raise living standards and solve our budget problems. Unfortunately, economics is not only about what you want—it is also about what you can get. Growth may be good, but achieving it requires more than simply declaring inflation dead.

Meanwhile, the stable-price sect will denounce this strategy as irresponsible, a return to the bad old inflationary ways of the 1970s. But the strategy is not outlandish—on the contrary, it is intended to be a description of the actual policies followed by several of the world’s major central banks. In particular, what I have descibed is very close to the behavior predicted by the “Taylor rule,” which successfully tracks the policies of the Federal Reserve. (It is ironic that the Fed, whose policies are in fact more growth-and employment-oriented than any other Western central bank, is the target of most of the growth sect’s attacks.) But the strategy described is also arguably a pretty good description of the behavior of other central banks, including the Bank of England and—dare we say it?—the Bundesbank, which talks a monetarist game but rarely meets its own announced targets.

Of course these sensible central banks will deny that they follow any such strategy. This is understandable. Anyone who has watched the press pounce on a novice central banker naive enough to speak plainly realizes why more experienced hands, however well-intentioned and clear-headed, prefer to cloak their actions in obscurantism and hypocrisy. But while hypocrisy has its uses, it also has its dangers—above all, the danger that you may start to believe the things you hear yourself saying. This is not a hypothetical possibility. Right now there are important central banks—the Banks of Canada and France are the obvious examples—which really seem to believe what they say about wanting stable prices; their sincerity is costing their nations hundreds of thousands of jobs.

It is disturbingly easy to imagine a future in which each of the great monetary shibboleths becomes the basis of policy in a major part of the advanced world. In the United States, powerful groups on both left and right now propagandize incessantly for the belief that we can grow our problems away; aside from creating the possibility that we will rediscover the joys of stagflation, this campaign seriously weakens our already faltering resolve to put our fiscal house in order. But the bigger risk is probably in Europe, where—despite a far worse employment performance than in the United States—the rhetoric of price stability goes largely unchallenged, and is likely to have growing influence over actual policy.

In particular, what will happen if EMU comes to pass? The new European Central Bank will operate under a constitution that honors price stability above all else; more important, it will feel that it must demonstrate itself a worthy successor to the Bundesbank, which means that it will try to implement in practice the kind of policy the Bundesbank follows only in theory. The result will be that Europe’s unemployment problem, which would be severe in any case, will be seriously aggravated.

Shibboleths make people feel good. Not only are they an alternative to the pain of hard thinking, but because so many people repeat them, they offer a reassuring sense of community. But we must go beyond the shibboleths, however comfortable they make us feel: Monetary policy is too serious a business to be conducted on the basis of simplistic slogans.