Stable prices and fast growth: just say no 

INDEX TERMS  Krugman, Paul|signed article on monetary policy; Monetary policy|signed article by Paul Krugman; Economists|Krugman, Paul signed article; Economic policy|Krugman, Paul signed article; 
DATE 31-Aug-96 
WORDS 3139 
In this article Paul Krugman questions current orthodoxies about monetary policy in rich countries 

MANY years ago Paul Samuelson who is widely regarded as the father of modern economics memorably cautioned against basing economic policy on 'shibboleths' by which he meant slogans that take the place of hard thinking. Strictly speaking his was an incorrect use of the word: the 'Oxford English Dictionary' 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 Mr 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 truth. 

Public discussion of monetary policy is increasingly dominated by two such sects. The shibboleth of one sect is 'growth'; that of the other 'stable prices'. Those who belong to neither sect find it hard to get a hearing: it seems that you must believe either that central banks should aim for zero inflation to the exclusion of all else (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. 

The case against growth 

Bob Dole the Republican Party's presidential candidate is running on an economic plan which depends crucially on the assumption that over the next seven years the American economy can grow at an annual average rate of at least 3.5%-more than half as much again as the recent sum of labour-force and productivity growth. While his more conventional advisers have offered some unconvincing claims that his tax-cutting and tax-reforming plan will produce huge gains in economic efficiency the main argument underlying this kind of 'growthism' is the insistence of a vocal group of pundits that the only current obstacle to faster growth is mean-spiritedness at the Federal Reserve Board. 

This pro-growth critique of America's central bankers cuts right across the usual left-right divide. On one side stands Robert Bartley the ultra-conservative editor of the Wall Street Journal declaring that the central bank is responsible for America's disappointing growth even in the long term: 'if the Fed stamps out any growth in excess of 2.5% the long-run growth rate of the economy will be less than 2.5%.' On the other stands the liberal financier Felix Rohatyn whom President Clinton unsuccessfully proposed as the Fed's vice chairman. Mr Rohatyn has claimed that monetary policy can safely aim for 3.5% or even 4% growth in each of the next five or ten years. 

Some simple arithmetic suggests why he is surely wrong. Over the past four years the American economy has achieved an average annual growth rate of less than 3%; nonetheless this modest growth has been enough to reduce the unemployment rate by more than two percentage points. If the economy were to grow substantially faster over the next four years than it did over the past four it seems hard to avoid the conclusion that the accompanying fall in unemployment would also be substantially larger. And since the current unemployment rate is only 5.3% to believe that the Fed can safely target the kind of growth Mr Rohatyn advocates (or that Mr Dole is counting on) you must believe that unemployment can be driven below 3%-which is not only much lower than the current rate but well below even the rates that prevailed at the height of the Vietnam war-without creating inflationary pressures. How many people would be prepared to defend that proposition? 

Some growth proponents like to point out that the American economy grew at slightly more than 3.5% during the seven years from 1982 to 1989. But that was mainly a matter of recovery from a deep recession; over the course of that recovery the unemployment rate fell by more than five percentage points. To manage a comparable performance over the next seven years America would have to achieve a negative unemployment rate by 2003. 

While they are rarely willing to confront this arithmetic directly members of the growth sect do offer some arguments about why they think high growth targets are now feasible. Here is what one of the many influential publications supporting the sect said recently: 

For some time Business Week has taken a strong pro-growth position. We believe that US productivity is higher than government statistics indicate and inflation is significantly lower. We see the global economy as severely restraining the pricing power of companies which recognise that in the current competitive reality they must generate profit by boosting efficiencies not prices. In other words we believe the US can achieve growth rates higher than 2% without renewed inflation. 

Many people find these arguments convincing. You have to think about them a bit to realise that they make no sense at all. 

Consider first the proposition that higher growth is now possible because true productivity growth is much higher than the disappointing official numbers. There are good reasons to doubt this claim-the rhetoric of business productivity seems to have outpaced the accomplishment-but suppose that it were true. It would still offer no justification for a more expansionary monetary policy or a higher growth target. Why? Because estimates of growth and estimates of productivity are based on the same data. Suppose the official numbers say that the American economy is growing by 2% annually while productivity is rising only 1%. And suppose you think that the true rate of productivity growth is actually much higher say 2.5%. Then you must correspondingly believe that true GDP growth is higher by exactly the same amount-that it is 3.5%. So you should not fault Alan Greenspan for failing to deliver a high growth rate; you ought to believe that he has already done so. 

What about the argument that global competition prevents inflation? One might point out that the American economy is not actually that globalised: imports are only 13% of GDP and at least 70% of employment and value-added is in 'non-tradable' sectors that do not compete on world markets. One might also point out that if the economy really were as globalised as Business Week imagines increased domestic demand would do little for American growth and employment-most of the extra spending would be on goods produced elsewhere. But the crucial point is that if you believe that prices throughout the American economy are closely constrained by foreign competition you ought to conclude that changes in the dollar's exchange rate-which immediately change the costs of those foreign competitors measured in dollars-must have a powerful effect on the inflation rate. An episode like the 1993-95 rise in the value of the yen which at a stroke increased the dollar costs of American industry's most formidable competitors by 50% must surely have led to a sharp acceleration in American inflation. 

But it didn't; and this is decisive evidence that global competition does not in fact constrain prices the way the growth tribe imagines. Oh and by the way: wouldn't a looser monetary policy lead to a weaker dollar? And if foreign competition constrains American prices doesn't that mean that monetary expansion would translate into inflation more not less surely and rapidly in a globalised economy than in a closed one? 

Perhaps one should not be too hard on Business Week. After all the editorial simply repeated the arguments made by Mr Rohatyn Lester Thurow and others of the growth sect; and the logic of its case was no more confused than usual. But that of course is the point. 

The case against stable prices 

While the growth sect has converted America's Republican Party and much of its business press central bankers remain notably unmoved. This is easily understood in the case of the Fed which can with some justification claim credit for an unemployment rate that is close to a 20-year low. But European central banks faced in many cases with unemployment at rates not seen since the 1930s have been equally unwilling to heed the sometimes desperate calls of political leaders for lower interest rates (Jacques Chirac of France for example declared recently that France needed lower interest rates to cut unemployment). Instead with hardly any exceptions central bankers insist that the best thing they can do for the economy is to pursue unrelentingly the goal of price stability. 

The ideology underlying this intransigence is nicely captured by the wording of 'The Economic Growth and Stability Act' proposed last year by Senator Connie Mack who was widely touted as Bob Dole's likely running mate before Jack Kemp entered the picture. Price stability the act declares 'is a key condition to maintaining the highest possible levels of productivity real incomes living standards employment and global competitiveness.' It's a confident declaration; you would never guess that there is hardly any reason to believe it is true. 

The fact is however that the costs of low inflation (ie at the low single-digit rates that now prevail in rich countries) have proved theoretically and empirically elusive. Very high inflation which leads people into costly efforts to avoid holding cash is one thing; but the West is not remotely in that situation. Moreover it is fairly certain that the costs of inflation such as they are are 'non-linear': ie 3% inflation does much less than one-third as much harm as 9%. 

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% to around 4% was achieved only through a prolonged period of high unemployment 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 three 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 trade-off between inflation and unemployment. But recent work by George Akerlof William Dickens and George Perry* makes a compelling case that this no-trade-off rule breaks down when inflation is very low. 

The NAIRU hypothesis is based on the reasonable proposition that people can figure out the effects of inflation-that both workers and employers realise that an 11% wage increase in the face of 10% inflation is the same thing as a 6% increase in the face of 5% 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% inflation does not buy a long-term unemployment rate significantly lower than that which can be sustained with 5% 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 in which real wages must decline to maintain full employment.) Is a 2% wage increase in the face of 5% inflation the same thing as a 3% wage cut in the face of stable prices? To hyper-rational 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. Messrs 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 declines but a large concentration at zero a clear indication that there are many 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 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%). 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%. Why? A Canadian economist Pierre Fortin points out that from 1992 to 1994 a startling 47% of his country's collective-bargaining agreements involved wage freezes. Most economists would agree that high-unemployment economies like Canada suffer from wage inflexibility; Mr Fortin's evidence suggests however that the cause of that inflexibility lies not only in structural microeconomic problems but also in the Bank of Canada's 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 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. 

A shibboleth-free policy 

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 a long-run target fairly low but not zero inflation say 3-4%. 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. Monetary policy however affects inflation only with a long lag so you also need some intermediate target. A reasonable strategy is to try to stabilise unemployment around your best estimate of the level consistent with stable inflation at the desired rate even while recognising that such estimates are imperfect. So you should be prepared to adjust the unemployment target if inflation is worse or better than expected. And of course if past misjudgments have caused inflation to move above-or below-the target policy must seek to bring it back into line. 

This proposal will presumably bring angry objections from both sides. The growth sect will denounce it as an acceptance of defeat insisting that the West needs higher growth to raise living standards and solve its 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 to be 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 big central banks. In particular what I have described is close to the behaviour predicted by the 'Taylor rule'. This rule which suggests setting interest rates automatically based on a comparison of the actual and potential output of an economy 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 behaviour of other central banks including the Bank of England and even-dare one 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 intelligibly realises why more experienced hands prefer to cloak their actions in obscurantism and hypocrisy. But while hypocrisy has uses it also has 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 central banks-the Banks of Canada and France are obvious examples-which really seem to believe what they say about stable prices; their sincerity is costing their nations hundreds of thousands of jobs. 

Beyond the slogans 

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 propagandise incessantly for the belief that Americans can grow their problems away; aside from raising the possibility that America will end up rediscovering the joys of stagflation this campaign seriously weakens the country's already faltering resolve to put its 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 Europe's economic and monetary union comes to pass? The new European Monetary Authority will operate under a constitution that honours price stability above all else; more important it will feel obliged to show 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 you feel good. They are an alternative to the pain of hard thinking and because so many people repeat them they offer a reassuring sense of community. But you must go beyond shibboleths however comfortable they make you feel: monetary policy is too serious to be conducted on the basis of slogans. 

* George Akerlof William Dickens and George Perry. 'The Macroeconomics of Low Inflation.' Brookings Papers on Economic Activity. 1 1996 

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