The Conquest of American Inflation

"This book offers a very nice idea about the conquest of American inflation. It’s a narrative and, if you’re an economist and you’re really interested in his out-of-the-box reasoning, then you’ll enjoy it. But you cannot read this book just with a coffee. It requires a lot of understanding, it’s a difficult read. The main story is that we abandoned the gold standard and then central banks had to learn how to control inflation and why it was important to do so. At a certain point in the 1960s, Paul Samuelson and Robert Solow convincingly argued that there was a trade-off between unemployment and inflation. Thus, whenever you allow an increase in inflation, you will bring about a decrease in unemployment. This trade-off is the idea behind the Phillips Curve. Then Robert Lucas pointed out that although there was this correlation, if you were to try to exploit it for policy purposes, the correlation would disappear because people will internalize the idea and you wouldn’t be able to exploit it anymore. Moreover, scholars tend to accept the idea that there is a rate of unemployment towards which the economy converges that does not depend on inflation. This level of unemployment depends on the fundamentals underlying the economy. Thus, inflation can have transitory effects, but not permanent effects on unemployment. In the end, if you’re going to implement expansionary policies many times over, you will end up with the same level of unemployment, but higher inflation and that is undesirable. “It is important to look at Latin America if we want to understand inflation” The conventional wisdom is that in the ’70s, people began to accept this Lucas critique. Then, in the ’80s, Paul Volker, as chairman of the Fed, took very strong action against inflation. So the Fed started to implement this disinflationary policy and the Fed understood that using the Phillips Curve was bad. Again, a conventional idea among scholars is that the Fed understood that there is this natural rate of unemployment. Thus the Fed realized that the tradeoff between inflation and unemployment cannot be exploited anymore. Most of the scholars agreed that after Volcker the economy was in a new regime. This is ‘the conquest of American inflation’. The US managed to keep inflation stable because policymakers understood that they could not game inflation much and that the Phillips Curve is a nice relationship, but we shouldn’t move inflation like crazy because we cannot move unemployment. That is a positive story. We understood how it all happened. Policymakers learned that they were doing something wrong, now they’re not doing that anymore. Sargent comes with a second story. This is the difficult one. He argues that the same observation for inflation may have occurred in the absence of the change in regime. In the alternative story proposed by Sargent, there has been no change in policymaking. Policymakers operate, as they were before, according to their beliefs. Crucially, however, we must assume a small departure from rationality in the sense that the policymaker should learn about the functioning of the economy, and they learn over time. How does this process of learning work? Policymakers have some priors about the functioning of the economy. They play their policy and they update their priors according to the empirical observations. This is not what would happen under rational expectations, where the policymakers would know exactly how the economy responds to policy. In the second narrative, policymakers did not change their ideas about the Phillips curve from the 1970s onwards. And Sargent argues the main reason for believing that is that, if you look at their forecasts, and the way they take decisions, you’ll see that policymakers are still estimating the Phillips curve. Why are they doing that if they don’t care about it? It is important to understand that unemployment and inflation move for two reasons: as a result of policy and as a result of shocks. Assume that we are in a system of belief where policymakers think that it is very costly to decrease inflation. Thus, they never play any disinflationary policy. Now, there was a lucky combination of shocks that brought both unemployment and inflation down. Then these shocks trigger a change in belief among policymakers about the past. They observe a dropoff in inflation and a drop of unemployment. So they think that maybe their beliefs were wrong. They no longer believe that if they lower inflation, they will cause a huge increase in unemployment. Thus, they change their beliefs about the Phillips Curve. They give it weight, but they don’t think that the Phillips Curve is exactly like the one that was used before. They learn from this new process. After these shocks, policymakers start to implement policies that they were not prepared to implement before because they were very scared about increasing unemployment and they observe that these policies bring inflation down, without harming unemployment. Support Five Books Five Books interviews are expensive to produce. If you're enjoying this interview, please support us by donating a small amount . In this second narrative, Sargent argues that it was a lucky sequence of shocks that changed policymakers’ beliefs. However, we are exactly in the same regime as before. It may happen that an unlucky sequence of shocks may change policymakers’ beliefs again. He compares the two narratives and he argues the USA did not conquer inflation because of a shift in policymaking. He is inclined to think that what happened was just a change of beliefs. And it could be that we are going to go back to a regime in which we are going to have high inflation again because the policymaker does still care about the Phillips Curve and still puts a lot of weight on that. It’s a nice book, but it has a lot of critics. Many scholars think that the conventional narrative is not wrong. However, I think it’s an interesting exercise. It’s out-of-the-box thinking because most people think that the reason why, from the 1980s to 2008, we had this big period in which there was inflation stabilisation is due to the fact that monetary policy was very successful. He claims that, no, it’s just a coincidence. It’s interesting, but it is difficult to read."