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August 24, 2006
Mostly Good Sense...
... from Arthur Laffer, writing in the opinion page of today's Wall Street Journal. First, what could be read as an implicit defense of core inflation measures:
Prices of goods in fixed supply do tend to rise relative to all prices as the global economy accelerates. In the short run, increases in demand for products in relatively fixed supply result in higher prices rather than more output. And, of course, those products that are typically in fixed supply include commodities such as oil, gold, copper and agricultural products. But to confuse an increase in commodity prices with general inflation is a serious mistake...
In my own comments on core inflation I have emphasized the apparent superiority of core measures in forecasting future headline inflation (here and here, for example). But it is also true, as Dr. Laffer implies, that temporary accelerations in inflation generated by fluctuations in particular relative prices are just not all that bothersome, as long as they do not translate into an ongoing increase in the growth rate of prices more generally. Bothersome from the point of view of economic conditions that a central bank can genuinely affect, that is. Increases in the price of oil relative to all other goods and services are certainly costly, but fixing that problem is outside central bankers' sphere of influence.
It is true that it is within the power of monetary policy to lower the level prices on average, thus neutralizing the impact of rising commodity prices on headline inflation rates. But this will not change the fact of those commodity prices rising relative to all other prices, would do nothing alleviate the pain associated with those relative price increases, and may well exacerbate disruptions in the short run if the monetary policy course is excessively tight at precisely the time the commodity-price shocks are themselves tending to weaken the economy.
I do have a few quibbles. Although I always appreciate perspective in discussions of the dollar's value in exchange for foreign currencies...
With today's U.S. global capital surplus (i.e., trade deficit) equaling almost 6% of U.S. GDP -- an all-time high -- it's only natural that with improving economic conditions abroad, global investors would allocate more of their assets to foreign investments. Hence, the decline in the dollar. Over the years we've seen this type of currency move time and again.
... I suspect the emphasis on specific tax policies...
From 1978 to 1985, the foreign exchange value of the dollar doubled in response to the tax cuts and sound money of Ronald Reagan and Paul Volcker; then, from 1985 to 1993, with the end of the Reagan era and George Bush's and Bill Clinton's original tax increases, it halved back to about where it was in 1978; finally, from 1993 through 2002, the dollar once again appreciated back to its former highs because of the great economics of Presidents Bill Clinton and George W. Bush.
... draws things a little too finely. (Did I miss those tax cuts in the last half of the 90s?) I also think that this statement, which opens the article, is too strong:
You'd have to dig pretty far down in the duffle bag of economists to find one who actually believes in the Philips Curve-- the idea that rapid growth causes inflation.
In fact, most economists agree that there is no long-run tradeoff between inflation and output. But the notion of a short-run Phillips curve, with the embedded idea that inflation falls when GDP falls below its potential, is very much the conventional wisdom. (This book, by economist Michael Woodford, is the bible of current orthodoxy, although, like the real Bible, there are probably more people who adhere to its tenants than who have actually read it.)
Still, the unrepentant monetarist in me can't help but applaud this statement:
In truth, rapid growth in conjunction with restrained monetary base growth is a surefire prescription for stable low inflation. The old saw that too much money chasing too few goods results in inflation couldn't be more accurate.
UPDATE: In the comment section, Mike Woodford -- yes, that Mike Woodford -- defends Laffer's comment about the Philips curve, noting that economists no longer believe that growth is inflationary per se. Since that is one of Dave's 5 Essential Macroeconomic Truths, I would be hard-pressed to disagree. And, in fact, I did take pains to say "inflation falls when GDP falls below its potential", emphasis added this time. But to me that is pretty much the old Philips curve idea. The main difference between thinking now and thinking back in the day is that our view of "potential" is more sophisticated, drawing as it does on the ideas of real business cycle theory channeled through the Mike's good (and enormously influential) work. But as long as we replace "the idea that rapid growth causes inflation" with "the idea that rapid growth that drives GDP above its potential causes inflation", it seems to me the Philips curve notion survives. If that is what Dr. Laffer had in mind, I retract my statement.
UPDATE: Gabriel Mihalache has more thoughts on the topic. (And to answer Gabriel's question, Lucas' famous "island model" -- in his 1972 JET article "Expectations and the neutrality of money" -- is indeed a Philips curve model.)
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Ye'Olde Phillips Curve
Arthur Laffer made some weird and vague statements in his WSJ.com commentary regarding the quality of economics who still use the Phillips curve: Youd have to dig pretty far down in the duffle bag of economists to find one who actually believes ... [Read More]
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