Guessing games

In a post called Historical Fiction, John Cochrane writes:

Steve Williamson has a very nice post ... rebutting the claim ... that the late 1970s Keynesian macroeconomics with adaptive expectations was vindicated in describing the Reagan-Volker era disinflation.

The claims were startling, to say the least, as they sharply contradict received wisdom in just about every macro textbook: The Keynesian IS-LM model, whatever its other virtues or faults, failed to predict how quickly inflation would take off in the 1970, as the expectations-adjusted Phillips curve shifted up. It then failed to predict just how quickly inflation would be beaten in the 1980s.

In other words: The Keynesians failed to predict the fast pace of rising inflation, and then failed to predict the fast pace of disinflation.

So, the predictions were wrong. Ahh, but economics is best when it does not toy with prediction. Economics is best when it uses the past to understand the present and to make decisions about the future -- and not to play guessing games.

Whatever.

Cochrane and Williamson evaluate the predictions of Keynesians. Let us evaluate the predictions of people with money to lend.

I showed this graph on 20 August:

Five Interest Rates (red) and Four Measures of Inflation (blue)

See the fairly consistent gap between the red and blue lines around 1960-1965? As you should expect to see, interest rates fairly consistently ran two or three percentage points above inflation in those years. But then after 1965 inflation (blue) started climbing faster, and pretty soon closed the gap.

In other words, the people who set those interest rates did not expect inflation to rise as rapidly as it did in the 1965-1981 period. Those people were fooled by the fast pace of rising inflation, just as Cochrane's Keynesians were.

And then, around 1981, inflation (blue) started coming down. It came down faster than interest rates (red) so that a gap opened up again between red and blue. This gap stretches from the early 1980s to the year 2000. The gap is twice as wide as the gap of the 1960-1965 period -- because inflation fell quickly and interest rates fell slowly.

In other words, the people who set those interest rates did not expect inflation to fall as rapidly as it did in the 1981-2000 period. Those people were fooled by the rapid pace of falling inflation, just as Cochrane's Keynesians were.

Who are those people who were fooled? Well, the Fed sets the short term rates. People with money to lend set all the other rates.

Cochrane says the Keynesians did a terrible job predicting inflation. Okay. But guess what? The Fed and the people with money to lend did just as bad as Cochrane's Keynesians. Their inflation predictions were just as bad.

And you know what? The Keynesians were only making predictions. The people with money to lend were making predictions and betting on them.