Back in the early 1980s, the Fed tried to gradually squeeze high inflation out of the economy, so as to avoid a bout of high unemployment. They failed. But it was not a failure to control inflation; it was a failure to bring inflation down gradually. Inflation fell much faster than almost anyone anticipated, and as a side effect the unemployment rate soared to a peak of 10.8% in late 1982.   This convinced many that reducing inflation was costly, and that it was best not to allow the inflation genie out of the bottle in the first place.

[To be sure, there is more evidence for this claim that just the 1982 recession.  Anti-inflation programs also led to recessions in 1921, 1957, 1970 and 1991, to name just a few examples.  But 1982 was a particularly dramatic case.]

So what did we learn from the 1982 experience?  Did this show that gradualism doesn’t work?  Not exactly, as a necessary precursor for gradualism never occurred.  The 1982 recession showed that gradualism is not easy to implement, but it provided no evidence on whether it would work if implemented.

So what is the necessary precondition for gradualism to work?  The central bank must engineer a gradual slowdown in the growth rate of NGDP. That’s the only reliable method for achieving a “soft landing”.  

A few weeks back, Tyler Cowen wrote a Bloomberg piece criticizing the economics profession for its failure to explain the economy’s surprising strength in 2023.  And  some of those who correctly saw that we might avoid recession had previously advocated models where inflation could not be brought down without high unemployment.  

It’s a very good article, but Tyler fails to mention the fact that 2023 is a strong piece of evidence in favor of one particular approach—gradualism.  For instance, look at the modest slowdown in 12-month NGDP growth from late 2022 to 5.8% late 2023:

When presented with this argument, many people complain that I’m engaged in a tautology.  “Growth slowed gradually because growth slowed gradually.”  Those making that complaint are confusing nominal GDP with real GDP, a completely unrelated concept. The fear has always been that sharply slowing inflation would be costly in terms of falling real GDP and high unemployment.  When economists use the term ‘growth’, they are referring to real GDP, not nominal GDP.

Thus there is nothing tautological in a claim that a recession might be often be associated with slow growth NGDP.  For instance, in 2008, Zimbabwe’s real GDP fell even as its NGDP rose more than a million-fold.  The two are radically different concepts, which do not always move in the same direction.

On the other hand, because of wage/price stickiness, short run movements in NGDP and RGDP are often highly correlated in the US.  Thus in late 1982, NGDP growth plunged from a peak of 14% to less than 4%, triggering a significant fall in RGDP and high unemployment.  While it’s much too soon to declare victory, there’s a real possibility that Jay Powell’s Fed will successfully implement the gradualism program that Volcker’s Fed tried and failed to implement. 

[In fairness, Powell was dealt a far easier hand, as by the early 1980s inflation expectations were stuck at double-digit levels and the Fed had lost credibility with the public.  This time around, long-term inflation expectations remained fairly low.] 

In his Bloomberg piece, Tyler made the following observation:

Krugman has lately further explained his position — complete with unironic headline — suggesting that the untangling of broken supply chains had helped lower the rate of inflation. That point, too, is correct. He didn’t mention that there also has been a massive negative shock to aggregate demand: High rates of M2 growth became slightly negative rates of M2 growth. Fiscal policy peaked and then retreated. The Fed raised interest rates from near-zero levels to the range of 5%, and fairly rapidly. It also sent every possible signal that it was going to be tight with monetary conditions.

I did an Econlog post criticizing his claim that there was a massive negative shock to aggregate demand:

[I]f you’d told economists in late 2022 that we’d have 6% to 7% NGDP growth in 2023, I doubt that very many would have predicted a recession.  So the events of 2023 in no way refute the assumption that a sharp slowdown in AD will generally trigger a recession—we failed to have a sharp slowdown in AD.

Notice that I’m equating “aggregate demand” and NGDP growth.  Not everyone defines AD in that way, indeed some people derisively call it a “tautological” definition.  Well, definitions are tautological, but that doesn’t mean they are not useful.  

A few days after I did this post, Tyler posted the following:

Any “very heavy” reliance on real shocks to explain the macro of the last two years has to account for why 2021 had high growth rates, in spite of supply chains then being quite tangled.  And why prices haven’t gone back down to their original levels?  And what happened to aggregate demand, once the Fed turned its attention to the problem?  There simply was a huge, negative AD shock in recent times, at least under any non-tautological definition of aggregate demand.  Why didn’t that crush us?  Any account needs to address these issues.

Tyler doesn’t mention my name, but given that a few days earlier I had argued that he was wrong about the existence of a “massive negative shock to aggregate demand”, and used the assumption that AD equals NGDP to back up my claim, I felt like his remark might have been directed at my post.  After all, “non-tautological definition of aggregate demand” isn’t a phrase you hear every day.

(BTW, I’m inclined to equate “non-tautological definition” with “so vague as to be useless”.)

Over at Marginal Revolution University, Alex Tabarrok summarizes the definition of aggregate demand used in Cowen and Tabarrok’s superb textbook:

You can think about spending growth another way, too. It’s actually the equivalent of nominal GDP growth. If nominal GDP growth is 5%, an AD curve shows all of the possible combinations of inflation and real GDP growth that add up to 5% nominal GDP growth. Likewise, if nominal GDP growth is 7%, the AD curve will show all of the possible combinations of inflation and real GDP growth that add up to 7%, and so on. Increases in the growth rate of nominal GDP shift the aggregate demand curve outwards, whereas decreases shift it inwards.

That sounds pretty tautological to me.   And just to be clear, I don’t believe that 2023 saw a massive negative demand shock even using a non-tautological definition of AD.

More than a decade ago, Tyler started a blog post as follows:

Without meaning to take sides in the controversy, I got a kick out of this sentence, which describes the attitudes of contemporary macroeconomists:

Even something anodyne like “demand might also play a role” would come across like the guy in that comic who asks the engineers if they’ve “considered logarithms” to help with cooling.

The blog post, by JW Mason, is interesting throughout.

If you follow the link, JW Mason has a long post, which begins as follows:

People often talk about aggregate demand as if it were a quantity. But this is not exactly right. There’s no number or set of numbers in the national accounts labeled “aggregate demand”

Actually, there is—NGDP.

Mason continues:

Rather, aggregate demand is a way of interpreting the numbers in the national accounts. (Admittedly, it’s the way of interpreting them that guided their creation in the first place). It’s a statement about a relationship between economic quantities. Specifically, it’s a statement that we should think about current income and current expenditure as mutually determining each other.

Now we are back in the world of tautologies:

Gross domestic Income = Gross domestic Expenditure = Gross domestic product

Seriously, when people tell me something is inexpressible, a sort of way of thinking about the world, I’m likely to assume they are referring to some sort of eastern mystical religion, not a branch of economics that is supposed to explain prices, output and employment.  Aggregate demand is either total nominal spending, or it’s nothing at all, at least nothing of any use to economists.  Given that Mason thinks AD is not NGDP, I can’t criticize him for treating AD like a big joke.   

Economics is already full of hard to measure entities, such as the natural rate of interest or the natural rate of unemployment.  Let’s not make things needlessly obscure by acting as if AD is not a specific number that can be easily measured. 

In the long run, aggregate demand (NGDP) does not matter at all.  In the short run, it’s the most important macro variable—explaining almost everything we care about.  Why have we had a soft landing so far?  Because NGDP growth has slowed gradually.  Why has NGDP growth slowed gradually?  Because the Fed raised its interest rate target up close the the economy’s natural rate, without overshooting (as it had done so often in the past.). How were they able to do that?  I wish I knew.  Probably a mix of luck (30 years of Fed credibility plus some positive AS shocks such as a surge in immigration) and skill (more sophisticated reliance of financial market signals and a deeper understanding of the process based on learning from past mistakes.).

But that’s just a guess, and we are not even sure there won’t be a recession in 2024.  But there is one thing I can predict with confidence—the performance of the economy in 2024 will be largely determined by the NGDP growth rate.  If it’s around 4% by yearend, then we’ll have a soft landing.  If it’s around 2%, we’ll have a recession.  If it’s around 6%, we’ll have resurgence in inflation. 

Looking out over the next few decades, NGDP won’t matter much at all—the performance of the economy will depend on real factors such as the impact of AI. 

HT:  Commenter JP reminded me of the Cowen and Tabarrok textbook.