Wednesday, March 6, 2013

Side Door

Two examples from Sumner, on lies told in the teaching of economics:

1. We argue that the Keynesian model superseded a “classical model” that had a vertical AS curve, and assumed flexible wages and prices. In fact, no such classical model existed prior to 1975. Instead, the old Keynesian model replaced something closer to the modern new Keynesian model. The model of Fisher/Hawtrey/Cassel and many other interwar economists featured sticky prices, short-run non-neutrality of money, and a self-correcting mechanism that brought us back to the natural rate on the long run. In Fisher’s case there was even a Phillips Curve.

The textbook story is a good pedagogical device. But it’s not true. It’s not even close to being true.

In fact, no such classical model existed prior to 1975. The whole thing is made up. No wonder the financial crisis caught economists with their pants down.

Sumner's second example is a very big deal:

2. We explain that inflation can be produced by fiscal stimulus, supply shocks, and/or monetary stimulus. Then we talk about the Great Inflation mostly by referring to two shocks. The first was the huge fiscal stimulus of the 1960s, when LBJ ran up huge deficits to finance the Vietnam War and the Great Society without raising taxes. Except that this never happened. Then in the 1970s OPEC jacked up oil prices twice, and this caused the high inflation of the 1970s and early 1980s as the SRAS curve shifted to the left. Another lie, as SRAS was shifting to the right during the 1970s.

That, and inflation took off well before OPEC’s price hike.

In an endnote to his post, Sumner adds:

PS. If you are wondering why the LBJ story is a lie, recall that the huge budget deficits began under Reagan, and were associated with a big fall in inflation.

I don't "recall" things. I always have to check things.

The first graph shows deficits relative to GDP. The second shows deficits relative to Federal spending.

Similar patterns.

It would be easy to say there was a long-term uptrend -- higher in the 1960s than the '50s, higher again in the early 1970s, higher yet in the late 1970s, and highest in the 1980s.

That's not at all what Sumner says. Sumner says "huge budget deficits began under Reagan" (in the 1980s). I think Sumner oversimplifies.

Clearly, however, there is much less blue in the first half of these graphs than in the second half. Deficits were a lot smaller before 1975 than after. So I am willing to accept Sumner's denial that a huge fiscal stimulus began in the 1960s with LBJ and the Great Society and the Vietnam War.

This is a very big deal. The two shocks that are taught to us as being the cause of the Great Inflation are lies, Sumner says.

So let me pry open a side door here, make my own way out of Sumner's box, and ask: So then, what caused the Great Inflation? It wasn't the liberal spending, and it wasn't OPEC, so what was it?

Brother, it was the cost of finance.

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