The Postwar Business Cycle and the Quest for Stability

1. The Postwar Business Cycleand theQuest for Stability

2. The Bretton Woods Monetary System Post-World War II---all major economic powers except U.S. are devastated. What kind of international monetary system. Gold Standard----ensures long-term price stability and growth, but not short-term price stability and it is vulnerable if prices and wages are not fully flexible and factors mobile. Conference at Bretton Woods (1944) decides on a modified gold standard. �The Bretton Woods System� U.S. has much of world�s monetary gold---so U.S. $ will be used as reserves in addition to gold. Dollars are to be freely convertible at one ounce = $35. Dollars are widely in circulation as U.S. is largest economy and supports the revival of world�s economies. U.S. Balance of payments deficits leads to accumulation of dollar claims by foreign treasuries.

3. After the Treasury-Federal Reserve Accord, 1951 The Federal Reserve regained its control over monetary policy�may alter interest rates After Korean War, budget roughly in balance and no fiscal shocks. The Fed targets nominal interest rates�raises them to counter inflation and lowers them to induce growth.

4. Price Stability & Growth in 1950s and early 1960s U.S. Budget is largely balanced. No external or internal shocks.

5. The International Monetary System lacks automatic adjustment Asymmetric adjustment---if UK, France etc. runs a deficit they must pay out $ or gold, but U.S. can just pay in $ which are reserves. U.S. Budget deficits in 1960s, partly funded by money creation, inflation rises and inflation is exported to rest of the work. Balance of payments deficits leads to accumulation of dollar claims by foreign treasuries. These claims exceed U.S. gold holdings, thus casts doubt on ability of U.S. to freely convert dollars freely into gold at $35 an ounce.

6. Fiscal and monetary expansion and the Legacy of the Great Depression �Great Society� and Vietnamese War produce large budget deficits---some of which are monetized. Fear of unemployment. Keep it low. Economists find a trade-off between inflation and unemployment. Samuelson and Solow (1960) identify 3% unemployment as goal but may have 6% inflation. Arthur Okun (1969) suggests 4% unemployment compatible with 2% inflation.

7. The Phillips Curve circa 1960

8. Inflationary Pressures Build in the 1960s

9. Collapse of Bretton Woods and Restraint on Inflation In 1966, foreign central banks and governments held over 14 billion U.S. dollars. The United States had $13.2 billion in gold reserves. If governments and foreign central banks tried to convert their holdings at one time, the United States would not be able to honor its obligations to freely convert dollars freely into gold at $35 an ounce. Result is a slow run on the dollar. But U.S. does not respond by tight monetary policy---expansionary---continued loss. Convertibility is suspended in August 1971---era of flexible exchange rates begins.

10. Increased Inflationary pressures President Nixon attributed his defeat in 1960 to unwillingness of Eisenhower administration to stimulate economy even at risk of increasing inflation. Eager for 1972 election to have good economy. Pressure on Arthur Burns�new Chairman of the Fed Result is a monetary stimulus from the Fed----but inflation looms so price and wage controls are imposed Correct Remedy? Effective? Expectations after Lifted? Oil price hikes 1973 & 1979---huge relative increase in commodity prices�the Fed is accommodative---severe political pressure.

11. October 6, 1979 High unemployment and high inflation---over 10%, no Phillips-Curve trade off. New chairman of the Federal Reserve�Paul Volcker. On Saturday October 6, 1979, the Fed announces new operating procedures where the volume of bank reserves would be targeted to control monetary aggregates and federal funds rate would be allowed to fluctuate. Bond prices collapse and interest rates jump. Economy moves into deep recession 1981-1982 but drives inflation down to 4%. Once inflation under control Fed changes to a policy of targeting the federal funds rate.

13. Fed has a clear goal�price stability: Inflation Tamedbut not Financial Crises

14. �Is Stabilization of the Postwar Economy a Figment of the Data?�C. Romer (AER, 1986) What is the key �Stylized Fact� about macroeconomic fluctuations pre-1914 compared to post-1945? What does Romer find about this stylized fact? What are the policy conclusions of her finding?

15. Edwin Frickey Who was Edwin Frickey? Why is he influential?

16. Frickey? Frickey�s index of industrial production is substantial more volatile than the modern Federal Reserve Board index of industrial production. Are these series comparable? Why? Why not? What is the data exercise that Romer performs in her paper?

17. �Romerizing Data� She constructed an exact replication of Frickey�s prewar index for the post-1947 period to obtain a consistent series. She constructed an updated replication of Frickey�s series, employing the FRB materials index which is qualitatively like Frickey�s but less anachronistic (out-of-date) sample of commodities. Why does she exclude 1915-1946?

18. Was pre-1914 more volatile than post-1947?

19. Statistically Significant?

20. Sample Autocorrelations?

21. Sources of Excess Volatility in Frickey? Reliance on Materials Cyclical movements in materials inventories are different than for consumption goods.

22. Romer�s Findings Pre-1914 seems more cyclically volatile than post-1947 for Industrial Production Unemployment Gross National Product Why---common source of error: all three the aggregate series is assumed to move one-for-one with series being used as a proxy rather than substantially less than one-for-one. Cycles before and after the Great Depression are equally severe. Decline of wage and price flexibility may explain why use of discretionary and automatic stabilizers has not yielded a more dramatic stabilization of the economy.

23. The Great Inflation Why did the inflation start? Why did it continue for nearly 20 years? Why did it end when it did rather than earlier or later?

24. Meltzer (2005) Did policy makers have the wrong models to interpret data and inform their actions? Did policy makers have the wrong information?

25. William McChesney Martin, Jr. Neither Martin nor his colleagues on FOMC had a valid theory of inflation or common sets of beliefs of how the economy worked. Duty to prevent inflation and protect value of $. Rejected Idea that policy could reduce unemployment now and respond to inflation later Wanted Fed to act with consensus�delays action Knew that President Johnson�s budgets were underestimates 1965 increase in interest rates? Attacked by Congress and the President.

26. Institutional Arrangments:Fed Independence 1951 Fed-Treasury Accord Fed gains independence to set interest rates, but� Martin: Fed was independent within the government not independent of the government. The Fed as an agent of Congress Retains responsibility for debt management and �Even-Keel� Policy: �Treasury had to price its issues in light of current market interest rates. The Fed�s role was to prevent the market from failing to accept a Treasury issue at an announced price.� No Auctions---but ensure that banks take up bonds. Federal Budget roughly balanced 1952-1961, deficit increases sharply 1965-1968�Vietnam and Great Society.

27. Absence of Common Model Meltzer�little evidence from the minutes that the FOMC distinguished between real and nominal interest rates.

28. Romer�s Critique of Metlzer Bad Models Early 1960s Samuelson-Solow permanent trade-off view of unemployment and inflation Early 1970s Natural rate framework with very low natural rate with high insensitivity of inflation to slack. Major Errors in Forecasting of Greenbook Excessive Optimism about the Natural Rate Miss the Productivity Slowdown Volcker Revolution---a triumph of better ideas over worse ones

29. Misinformation

31. So�how do you explain other countries?

32. Orphanides (AER, 2002) Use a Taylor Rule framework. Policy consistent with 2% inflation but using major errors from Greenbook, policy is too loose.

34. New World of 21st Century Price Stability Stable Low Inflation Rate Financial Stability Geography Restrictions Gone Product Line Restrictions Gone Line between banking and commerce? Why is Financial Stability Elusive? The Tech Bubble Crisis of 2000 The Subprime Crisis Bubbles & Asymmetric Information What is the Role for Regulation

35. What is the Kuznets� Curve? What did Kuznets propose How do Piketty and Saez find? What is their data source? Who do they focus on?

36. Top Incomes

37. Top Decile

38. Top Groups

39. Top 0.01

40. What�s the Source?

41. What�s the Source?

42. The Rest of the World?

43. Taxes?

44. And the Wealthy Pay?

45. Goldin and Katz The Race between Education and Technology: The Evolution of U.S. Educational Wage Differentials, 1890 to 2005 (NBER WP, 2008) U.S. educational and occupational wage differentials were exceptionally high at the dawn of the twentieth century and then decreased in several stages over the next eight decades. But starting in the early 1980s the labor market premium to skill rose sharply and by 2005 the college wage premium was back at its 1915 level. The twentieth century contains two inequality tales: one declining and one rising. We use a supply-demand-institutions framework to understand the factors that produced these changes from 1890 to 2005. We find that strong secular growth in the relative demand for more educated workers combined with fluctuations in the growth of relative skill supplies go far to explain the long-run evolution of U.S. educational wage differentials. An increase in the rate of growth of the relative supply of skills associated with the high school movement starting around 1910 played a key role in narrowing educational wage differentials from 1915 to 1980. The slowdown in the growth of the relative supply of college workers starting around 1980 was a major reason for the surge in the college wage premium from 1980 to 2005. Institutional factors were important at various junctures, especially during the 1940s and the late 1970s.