It the 1970s, without the inflation - InvestingChannel

It the 1970s, without the inflation

During the fourth quarter of 1980 and the first quarter of 1981, America’s NGDP soared at an annual rate of more than 19%.  And yet unemployment hardly budged, slipping from 7.5% in September 1980 to 7.4% in March 1981.  What went wrong?

I’d like to suggest that the past decade is basically the 1970s without the inflation, at least in one important respect.  Before explaining why, let’s first consider the differences.  The period from 1971 to 1981 saw roughly 11% NGDP growth, which included about 3% real growth and 8% inflation.  That’s a lot more real growth than today.  In addition, labor force participation was rising sharply, whereas in recent decades it has been falling.  On the unemployment front, however, we are doing better today.

Now let’s imagine a policy counterfactual where, beginning in 1965, the Fed keeps inflation close to 2%.  Here are my claims:

1.  Under that monetary policy, we would have had roughly 5% NGDP growth from 1971 to 1981.

2.  Real growth would have still been about 3%, with inflation about 2%.

3.  The unemployment rate in late 1980 and early 1981 would have still been about 7.5%.

All of these predictions are based on the assumption that money is roughly neutral in the long run, that the Natural Rate Hypothesis is roughly (not exactly) true when NGDP growth avoids deep declines.  And most importantly:

4.  In that counterfactual, I believe that economists would have misdiagnosed the unemployment problem, assuming it reflected a sort of secular stagnation, a lack of aggregate demand.

We now know that what actually happened is that the natural rate of unemployment rose by a couple points between the late 1960s and the early 1980s.  We don’t know exactly why (theories includes more women and minorities and young people in the labor force, oil shocks, deindustrialization, environmentalism, more generous benefits for not working, etc.), but clearly the natural rate was increasing.  If 19% NGDP growth isn’t enough to make a dent, it’s fair to say that the high unemployment is not due to a “demand shortfall”.

Today, America is not faced with a higher natural rate of unemployment—it’s probably back around 4.5% to 5%.  Instead, we are faced with a different structural problem—a decline in the labor force participation rate (LFPR). Among men, this rate has been trending lower for at least 5o years.  We don’t know all the causes, but it’s clearly not just the Great Recession.  And once again, people are assuming that a structural problem is due to a lack of demand.

I believe they will once again be disappointed.  Our problems are much deeper than a demand shortfall.  That’s not to say that monetary policy should not be more expansionary.  Perhaps the economy still has a bit of slack, and the inflation rate has recently undershot its 2% target.  I’m making a broader claim.  The broad outlines of the 2016 economy are not going to change substantially with monetary stimulus.  We might get unemployment down to 4.5%, and the LFPR might rise a bit more.  And those would be very good things.  But we are still going to be stuck with a trend rate of RGDP growth of barely over 1%, and a LFPR rate (for men) that is quite disappointing by historical standards.  And that’s not even factoring in the lousy supply-side policies of the next president.

In the 1970s, we discovered the structural nature of the problem more quickly than today, because we had such high NGDP growth.  Our current sub 2% inflation rate has indeed represented a modest demand shortfall, and that is a small part of the problem.  But it doesn’t really come close to explaining the extent to which growth has slowed.  Inflation also averaged about 1.5% during the first half of the 1960s, but growth was fine.  “Lowflation” is a problem because it means the Fed is not hitting its target.  But it explains at most only a small fraction of the very low RGDP growth rate since 2006, as well as the current very low LFPR.

PS.  I believe that the Great Inflation is best described in terms of NGDP growth, not price inflation.  That makes it easier to see that it was a 100% demand-side problem; RGDP growth was fine.  Today I was pleased to see the Financial Times also using that metric:

According to Bank of America Merrill Lynch, the current global recovery is the least inflationary of all time, with nominal GDP (growth plus inflation) growing just 11 per cent in the last seven years.

That’s total!  (Not the annual average.)

That was from an article discussing the new Chinese growth data.  At the same time, there are a few “green shoots” for the global nominal economy.  Chinese NGDP growth is up to 7.8%, from a low of (I think) about 5.8% at the end of last year.  Chinese PPI inflation turned positive for the first time since early 2012, and CPI inflation is up to 1.9%.  The overvaluation of the yuan seems to be ending. Eurozone inflation also has been rising, albeit from a very low level.  I’m most pessimistic about Japan; they need to sharply depreciate the yen if they are serious about their 2% inflation target.  Will they?

Chinese growth is expected to slow to 6% in 2017, as the housing boom cools.  That’s still an excellent figure for a middle-income country with near-zero population growth.  Consumption will lead the way next year, as housing construction slows.  But China is by no means out of the woods. They still face a very tricky transition from a housing construction economy to a services economy.  Lots could still go wrong–just not yet.