Saturday, June 18, 2011

Reagan, Volcker, Art Laffer, and the Monetary Policy Debate of 1980 (or "Once Upon a Time, the OMB Had a Preferred NGNP Target")

This is a continuation of my reading of Supply-Side Economics: A Critical Appraisal, a 1982 collection of essays published by George Mason University. My previous post examined the 1980 debate over fiscal policy and the "Laffer Curve." Today, I look at the monetary policy debates in the book and try to examine the evidence of what actually occurred.

Missing from many of the essays was the pressing issue of inflation and the role of the Federal Reserve given the Reagan tax cuts-- the central bank is always the second-mover. A couple authors noted that the Fed would have to dampen demand as a result of the potential deficits, which would make Laffer's tax revenue projections a moot point. Manuel H. Johnson's essay "Are Monetarism and Supply-Side Economics Compatible?" gives the political context of 1980-- Reagan's advisers were divided between monetarists and supply-siders, and there were probably at least two camps in each group (Pg. 405). Both groups agreed on the need for tighter monetary policy. The Volcker Fed was (supposedly) targeting the growth rate of M1. Reagan's OMB Director, David Stockman, even testified before Congress as to what the Reagan administration's preferred growth rate targets of M1 were, targets even more strenuous than what the Volcker Fed was supposedly pursuing.

The Fed's stated policy was to reduce the annual growth of M1-B from 7.3 percent in 1980 to 4.3 percent by 1986 (Pg. 408).
Stockman and the Administration projected a decrease in the annual growth of M1-B from 6.4 percent to 3.4 percent by 1986, with inflation projected to fall from 9 percent to 4.9 percent over that period (Pg. 417).

Johnson uses a couple of Administration documents to create this chart, which is worth reproducing (sources: A Program For Economic Recovery, Feb 18, 1981 and Mid-Session Review of the 1982 Budget, OMB):
Reagan Administration's Forecast:
Note that the Reagan Administration wanted the Fed to achieve NGNP growth just over 9 percent by 1986. (Maybe Newt Gingrich is right to long for Reagan-era monetary policy. I'm really hoping a "quasi-monetarist" can comment on this post. *Update*- in the same book, Robert Hall has an essay calling on the Fed to follow a nominal GNP target. ) The Fed would constrain money supply growth and inflation while the Reagan tax cuts would boost productivity, velocity, and RGNP growth.

Keynesian Nobel Laureate James Tobin's essay "The Reagan Economic Plan: Supply-Side, Budget and Inflation" puts it thus: "Reagan is hitching a Volcker engine at one end and a Stockman-Kemp locomotive to the other and telling us the economic train will carry us to full employment and disinflation at the same time...Our President promises disinflation without tears, indeed with prosperity" (Pg. 337-338).

The Administration's monetarists vehemently disagreed with the official projections, arguing, like Tobin, that the tax cuts and Volcker Fed could not boost velocity in such a fashion. Basically, the Administration monetarists (Beryl Sprinkle) argued that velocity (V) was relatively stable. While it may fluctuate in the (very) short run, on a year-to-year basis it would be reliably stable (3.2 percent). Tobin remarks "these (projected) increases in velocity are beyond historical experience, even in the recent decade of unprecedented financial innovation...if the inflation and interest rate projections of the administration were realized, velocity would slow down" (Pg. 338, emphasis mine-- you'll see later that velocity did slow down).

Treasury Department supply-siders like Paul Craig Roberts and Norman Ture disagreed. They cited evidence that RGNP growth and velocity growth are correlated, and since the Reagan tax cuts were going to permanently boost productivity and RGNP growth to a new trend, velocity would permanently increase as well. They expressed skepticism at the Fed's ability to control monetary aggregates and were "willing to consider... the adoption of a price rule, " but seemed to believe the Fed could control inflation if it was committed (Pg. 408-409).

Where the supply-side camp split, however, was in its faith in the Fed. Art Laffer, Jude Wanniski, and Lewis Lehrman advocated an immediate return to the gold standard. Laffer's reasoning for this is just bizarre:
1) Tightening the money supply and raising the discount rate was "equivalent to imposing a tax on the activities of these banks."
2) Banks would raise the interest rates on the loans they were making, moving them up to an elastic point on the demand for loanable funds-- causing bank revenue and profits to decrease.
Then, in Laffer's own words (Pg. 409, emphasis mine):

"Both demanders and suppliers of credit will substitute out of dollars held...into Eurodollar accounts, foreign currency...indexed accounts, and gold. In short, the Fed's actions have reduced the viability and attractiveness of the dollar...As such, the Fed's actions per se have increased the prospects for inflation, in spite of the fact that their actions clearly will result in a slower growth in measured quantity of money."

Laffer's view was that reining in the growth of the money supply and raising interest rates would cause a decrease in demand for money (increase in velocity) and capital flight, and the only solution was a gold standard to "restore confidence in the dollar." (I'll come back to this later.) Johnson summarizes: "Gold standard supply-siders...assert that monetarism is destabilizing because the policy tools employed by monetarists cause prices to move in the opposite direction from the quantity of money. But this position falls outside the mainstream of economic thought and is not shared by supply-siders holding policy-making positions in the government." Laffer was basically scoffing at several hundred years of economic thought and the quantity theory of money. (Laffer's theories paint the Fed into a no-win debate: If it increases money growth, it's causing inflation. If it decreases it, it also causes inflation.)

Monetarists like Milton Friedman (who opposed the gold standard) saw a less-rosy scenario than the Administration. As stated in his interview in the book and PBS series The Commanding Heights (Google Video), the only way you could wring inflation out of the system was to have a temporary recession. In the same video, Paul Volcker agrees with this assessment, he just didn't realize at the time how high interest rates and unemployment would have to go to get the job done.

William P. Orzechowski's essay "Monetary Aspects of Supply-Side Economics" claims that "Monetarists object to supply-side tax cuts...(because) supply-side economics does not portray budget deficits as inconsistent with economic growth and low inflation." (Pg. 428). Monetarists tended to recognize that the Reagan tax cuts would not produce the promised instant increase in productivity and would be inflationary in the short-term, and then the Fed would be under enormous pressure to monetize some of the debt.

Orzechowski, however, presents data from a cross-section of countries from 1977-1979 as evidence that there is no relationship between deficits and inflation, and that "budget deficits and slow monetary growth do not necessarily mean crowding out of private investment as the 'fiscal conservatives' allege."

So, what actually happened to monetary policy and the economy during the period from 1980-1986? As graphed out in the previous post, and pointed out in Paul Krugman's book Peddling Prosperity (1994) and Tyler Cowen's Kindle Single The Great Stagnation (2011), there was no permanent increase in productivity growth as a result of Reagan policies.

(If any of the below is amiss, just let me know. Thanks.) Here's a graph of M1 growth starting in 1976 (the first year of the series) and going to January, 1987. From 1976 to 1980, M1 growth averaged 7 percent. From 1980 through 1986, M1 growth averaged 9 percent. It was nowhere near the Administration's projections. It peaked at 13 percent from 1985-1986, a time when the Administration had projected in 1980 only 3.4 percent growth.

The growth rate of M1 velocity (the inverse of demand for money) also came nowhere close to Reagan Administration projections. You can see the stable trend in the 1970s that monetarists believed would continue, and then what actually happened:
Alan Blinder details the numbers and monetarists' and supply-siders' shock about velocity in his 1987 book Hard Heads, Soft Hearts.

Nominal GNP growth from 1980 through 1986 averaged 7.9 percent. Real GNP growth:The economy entered a nasty recession to kill inflationary expectations as standard economic theory had predicted. RGNP growth was about a percentage less than the Administration had projected in each of the last three years of its forecast (see chart above). But if you count that roaring back from the "greatest recession since the Great Depression," at least one year was way better than Reagan economists had initially dreamed.

What about Art Laffer's claim that Volcker's tight money/ higher interest rate policy would cause capital flight and decrease confidence in the dollar?

Effective federal funds rate:
Trade-weighted exchange rate value of the dollar (broad):

As you can see, as interest rates rose and the rate of inflation fell, the dollar appreciated. This is in line with hundreds of years of economic thought that Laffer ignored.

The Volcker Fed succeded in bringing inflation down to a lower rate faster than the Administration (or anyone else) had projected:

But contrary to the supply-side prognostication, the personal savings rate fell from 9.8 percent at the beginning of 1980 to 6.5 percent at the beginning of 1987:
Real private domestic investment increased, on average, 3 percent from 1/1/80 to 1/1/87. No great boon at all. The Reagan/supply-side promise was that reducing government investment in public infrastructure would spur private investment to take up the slack (Pg. 344). This promise was not achieved.

Tobin bemoans the monetarist bent on targeting a monetary aggregate "invariant to...other macroeconomic circumstances," such as when investment is lower than desired (Pg. 342-343). He believed that the Administration should have pursued policies that would have pulled investment decisions further into the present rather than waiting for them to materialize with the hypothetical increases in productivity and decreases in inflation.

Tobin was proven incorrect that no progress would be made on any front by the Reagan plan-- the dragon of inflation was slain (a worldwide phenomenon). Saudi Arabia pumped more oil, giving us the real supply-side boost of the 1980s. Economic and employment growth did resume extremely rapidly after the Fed relented, and the U.S. avoided another major recession until 2007. The "Great Moderation" was so influential that many seem to have forgotten 1982 ever happened, and the Reagan years are often remembered for many other mythical things.

Monetarist belief in very stable velocity would not survive the Reagan years. The Fed's inflation-fighting credibility was forever established. Real business cycle theory would replace most of the above in academic macro. Supply-side thinking would continue to live on forever in think tanks. The Great Stagnation of productivity growth since 1973 would continue.

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