Five Macroeconomic Myths

Nobel Prizer Edward Prescott looks at Five Macroeconomic Myths in today’s Wall Street Journal. Here’s #1, “Monetary policy causes booms and busts.”

Greg Mankiw, former chairman of the Council of Economic Advisers, wrote the following in a 2002 paper: “No aspect of U.S. policy in the 1990s is more widely hailed as a success than monetary policy. Fed Chairman Alan Greenspan is often viewed as a miracle worker.” Or, as Mr. Mankiw later asks, was Mr. Greenspan just lucky?
One of the mysteries of the 1990s is how to explain the economic boom when the increase in capital investments — as measured by the national accounts — grew at a subdued pace. The numbers simply don’t add up. However, it turns out that something special happened in the 1990s, and it wasn’t monetary policy. In a recent paper, Minneapolis Fed senior economist Ellen McGrattan and I show that intangible capital investment — including R&D, developing new markets, building new business organizations and clientele — was above normal by 4% of GDP in the late 1990s.
This difference is key to understanding growth rates in the 1990s: Output, correctly measured, increased 8% relative to trend between 1991 and 1999, which is much bigger than the U.S. national accounts number of 4%. Associated with this boom in unmeasured investment is the huge amount of unmeasured savings that showed up in the wealth statistics as capital gains. This was the people’s boom, the risk-takers’ boom. We should hang gold medals around these entrepreneurs’ necks. So indeed, it does seem that Mr. Greenspan was lucky in that a boom happened under his watch; but we can at least say that he did a pretty good job of keeping inflation in check. Here’s hoping for the same performance from our current chairman.
What about busts? Let’s begin with the assumption that tight monetary policy caused the recession of 1978-1982. This myth is so firmly entrenched that I could have called this downturn the “Volcker recession” and readers would have understood my reference. To accept the myth, you have to accept a consistent relationship between monetary policy and economic activity — and as we’ve just seen, this relationship is simply not evident in the data.
Between 1975 and 1980, the inflation-corrected federal funds rate was low; at the same time, output trended upward until late 1978. So far, things look somewhat promising for the mythmakers. But looking closer at the data we see that output began its downward trend in late 1979 while monetary policy was still easy through most of 1980. Also, output continued its decline through 1982, when it began to climb at a time when monetary policy remained tight.
These facts do not square with conventional wisdom. Our obsession with monetary policy in the conduct of the real economy is misplaced.
One caveat: I am not saying that there are no real costs to inflation — there certainly are. And if we get too much inflation we can exact high costs on an economy (witness Argentina as an example). However, I am talking here of the vast majority of industrialized countries who live in a low-inflation regime and who are in no danger of slipping into hyperinflation. It is simply impossible to make a grave mistake when we’re talking about movements of 25 basis points.

It’s true, the Fed doesn’t run the world. Please don’t tell the gold bugs.

Posted by on December 11th, 2006 at 7:03 am


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