This is from the Minneapolis Fed:
Interview with Christina and David Romer, Douglas Clement - Editor, The Region, September 2008: In times of financial turmoil, it is comforting—or at a minimum, illuminating—to receive counsel from those with long-term perspective. Tempered with the lessons of history, their views extract true trend from distracting noise. Guided by precedent, shaped by narrative, checked against data, the conclusions of economic historians are formed slowly and carefully.
In the realm of U.S. monetary history, few economists are as qualified to provide such counsel as Christina Romer and David Romer of the University of California, Berkeley. ...
The following conversation with the Romers covers this research as well as their work as co-directors of the monetary economics program of the National Bureau of Economic Research, their thoughts on asset prices as a focus of monetary policy, the benefits of research collaboration with one's spouse and, indeed, their perspective on current U.S. economic turmoil.
Taxes and Spending
Region: You recently wrote a very intriguing paper about the interplay between tax changes and government spending. Would you give us a brief description?
David Romer: Well, a major motivation that people have put forward for cutting taxes is their concern that government is too large. They think that the direct approach of going through the political process to cut spending is very difficult, and so the best strategy is to cut taxes. The idea is that this will reduce the revenues that Congress has available, and over time that will force spending down.
This is something that Ronald Reagan was very explicit about. It was one of the motivations for his tax cuts, and it goes under the name of the “starve-the-beast” hypothesis. The “beast” is government and its “food” is the revenues. Despite its importance, there's been very little empirical work on this, and most of that work boils down to looking at correlations: When revenues go up or down, do we later see spending move in the same direction? But a theme that runs through a lot of our work is that simply looking at correlation is often very misleading for getting at causation.
In the context of the starve-the-beast theory, my favorite example of the issue of correlation versus causation is the fiscal history of the Korean War. The North invaded the South at the end of June 1950. A month later Truman took a few minutes out from planning the military response and wrote to Congress to say that we needed a massive tax increase because we were going to have to ramp up military spending. A big tax increase was passed and put into effect three months after the invasion. We really hadn't succeeded in increasing military spending at all at that point.
So if you look just at the data, you see that taxes went up and spending went up afterwards. If you look at correlation, it looks like a great example of tax changes causing spending to change in the same direction. But if you listen to the history I just described, it's clear that, in fact, causation went from the decision to raise spending to the decision to raise taxes.
What we try to do in a lot of our work is bring in additional information from history to try to get at causation. In the paper on the starve-the-beast hypothesis, we go through the history of tax changes and take out the ones that are motivated by decisions that had already been made to increase spending, take out ones that are coming not from policy at all but from developments in the economy, and the like. We try to isolate changes in taxes that seem truly legitimate for testing the starve-the-beast hypothesis.
And what we find is no evidence for starve-the-beast. There's no systematic tendency for spending to fall after tax cuts relative to what it otherwise would have been. ...
Region: But you did find that tax cuts were followed by something else.
CR: Right. Tax cuts led, eventually, to tax increases. Basically, something has to give; there is a government budget constraint. ... A substantial fraction of a tax cut is typically undone in the subsequent five years.
Forecasting and the FOMC ...
Private Information ...
Evolution of Understanding
Region: ...You identified three distinct phases in that evolution, ending in the 1990s with a sophisticated model that seemed sensible. And you said this suggests "both a note of optimism and a note of caution about the future of stabilization policy." Would you describe those phases and elaborate on those notes?
CR: I'll start with the phases. There's a desire to think that we gradually learn things over time, and so we get gradually better and better policy. But, what we found was a more complicated evolution. We found that in the 1950s, policymakers didn't have a sophisticated model of the economy, but in its basics, it was actually pretty good. They had a sense that inflation was bad. They had a sense that there was a kind of capacity constraint to the economy, and that if you tried to push the economy too far, eventually you wouldn't get any benefits in terms of lower unemployment; all you'd get is inflation. It was a sort of proto-natural-rate kind of view. As a result, policy was also pretty good. It wasn't perfect—they were certainly doing the sort of "stepping on the gas, stepping on the brakes" that Milton Friedman always criticized—but overall, the basics were pretty good. Inflation was kept in check and recessions were brief.
Then what we see is deterioration in the 1960s and '70s. In the process of trying to add better analytics, policymakers in fact took a giant wrong turn in understanding how the economy operates. They first had the idea that there was a permanent trade-off between inflation and unemployment, so if we were just willing to have more inflation, then we could permanently lower unemployment.
That view disappeared pretty fast, but then policymakers replaced it with a natural rate of unemployment view where they thought the sustainable level of unemployment was, maybe, 3 percent. Then we see Arthur Burns in the early 1970s struggling with the fact that that didn't seem to be right. So he added the idea that maybe monetary policy just can't do anything—that inflation doesn't respond to slack. So another twist and turn, but a wrong turn. Policy in this period reflected these views-it was wildly overly expansionary most of the time, with a few half-hearted monetary contractions aimed at controlling inflation thrown in.
Not until the Volcker, Greenspan and now Bernanke era do you get a basically pretty sensible model—the view that inflation is bad, the sustainable rate of unemployment is moderate and inflation will respond to slack.
Region: You call it “sensible and sophisticated.”
CR: This is in contrast with the 1950s, which was sensible but clearly crude. The modern framework has a lot of sophisticated features that policymakers in the 1950s didn't have. The important thing is that these sensible views have led, by and large, to moderate, well-tempered policy. The result has been low inflation and remarkably steady growth over the past 25 years.
Region: And your notes of caution and optimism?
DR: The optimism is to say that we've now had monetary policy run on a very sound basis for 25 years. I think we're both pretty strongly of the view that the Great Moderation—the excellent performance of the U.S. macroeconomy over the last quarter century—is not just luck. A big part of it is improvements in the conduct of monetary policy related to improvements in economic understanding. That's the optimistic note, that maybe good ideas and good policy can continue.
The note of caution is that we haven't had a monolithic march toward better and better knowledge. So if people get complacent and start appointing people who have misguided ideas to the Federal Reserve, we can have a backsliding.
CR: Another wrong turn.
DR: Yes, another wrong turn in how policy is conducted. And so that's something we have to be vigilant about. We have to think about ways to ensure that monetary policy is consistently run on the basis of the best available ideas about how the economy works.
Region: From my reading of the symposium proceedings, it seemed there was a fair amount of criticism from the discussant [NYU economist Thomas Sargent] and others, saying among other things—and I'm from Minnesota so I have to bring this up—that your analysis left out major theoretical advances, such as rational expectations and the time inconsistency problem, among others.
Is it your view that these theoretical advances don't have much of a role in improved policy?
CR: I think our view is that to understand what went on in U.S. macro history, these things aren't crucial. Issues of credibility and rational expectations surely can matter and surely are something that any good monetary policymaker should be thinking about. But in terms of explaining why policy went so astray in the early 1970s, it wasn't time inconsistency, it wasn't failing to take credibility into account. It was Arthur Burns saying things like, "Monetary policy can't do anything." So in terms of the source of the big policy mistakes, we think that's not the best place to look.
The paper I'd cite that I think is very supportive of this comes very much from a rational expectations learning tradition. It's by [Northwestern University economist] Giorgio Primiceri in the 2006 Quarterly Journal of Economics. It uses a sophisticated "Sargent-esque" learning model, but finds that learning about just a few variables-the estimates of the natural rate and the sensitivity of inflation to deviations from the natural rate-can explain the evolution of policy and outcomes incredibly well. So again, I think it's an empirical issue, not a theoretical or methodological issue.
DR: The other example I would add besides the one of what went wrong in the 1970s is what finally went right when Volcker came in. The crucial thing was that Volcker had a much more sensible view of how the economy operated, and he took actions consistent with those views. He said, in effect, "Okay, look, we have to get inflation down. Monetary policy is capable of doing that. The natural rate of unemployment is pretty substantial, so to reduce inflation we're going to have very tight policy and the unemployment rate is going to have to go quite high."
As things turned out, it was actually less costly to bring inflation down than most economists had expected, and a likely reason is that at some point people started to realize that the Fed was really serious. The Fed gained some credibility, and so you didn't have purely mechanical backward-looking expectations. You got kind of a credibility or rational expectations kick.
So if you want to describe the very big picture of what happened, rational expectations isn't central. But if you want to get into a quantitative account and match the numbers, then that becomes something to consider. So, it's on the list, but it's not one of the top ones for the period we were looking at.
A Fourth Phase?
Region: It's too early to write our history about the current period, of course, but people are again talking about stagflation, and I guess it comes to a question of, What have we learned after all? Is the Great Moderation over? Have we entered a fourth phase?
CR: The key question is what happens from here. For the Great Moderation, we believe that good policy was a crucial part. But another thing that a lot of the studies have found is that during the Great Moderation, we didn't have big shocks. For example, we didn't have a lot of oil price shocks.
We're now in a nasty period. Ben Bernanke has been dealt just a rotten hand; there are awful shocks hitting the U.S. macroeconomy. The issue is going to be, What do we do from here? There's no way, confronted with some of these things, that you can have low inflation and 4 percent real growth every year.
What we don't have to do is what they did in the 1970s, which is to compound bad shocks with bad policy. The Fed ran massively expansionary monetary policy at a time when conditions didn't warrant it. The result was very high inflation, followed by massively high unemployment to get it down.
So I think the real question is going to be, What's the line we walk from here? Think about the action we saw just today [June 25], where the FOMC didn't keep lowering the federal funds rate. It said, "We're probably through the worst in the financial markets; we had to fight that fire, but now we're going to look at what's happening to inflation. There are benefits to low inflation, and so we're going to have to think about how much we stimulate the real economy and how much we're concerned about inflation." The fact that the FOMC is thinking this way suggests that even if they don't do everything exactly right, they're not going to make the sorts of huge mistakes policymakers made in the 1970s.
Region: It's long been Fed doctrine that we really don't have the ability to identify asset price bubbles with great accuracy, nor address them with alacrity. But given the housing market, the dot-com bust—given much of this past decade, I guess—some policymakers are reconsidering whether asset prices should be a focus of Fed policy. What is your view?
DR: I've always been of the view that it's very hard to identify an asset price bubble, and I don't think the Fed should be in the business of trying to determine what fundamental values are. A nice concrete example of this is that when Alan Greenspan gave his famous irrational exuberance speech, the Dow-Jones average was at something like 6,000; it eventually fell, but it had risen a great deal more before it fell. So in retrospect it looks like 6,000 was not too high for the Dow at that time.
I think the bigger issues are that rapid run-ups in asset prices, first of all, tend to stimulate the economy a lot, and secondly, can be followed by declines. So it might be best to think not in terms of trying to manage asset prices or identify fundamental values, but rather that rapid increases in asset prices are another indicator of potential overheating that the Fed might want to consider in how it conducts policy. To me that makes sense.
I think it's really framing the issue in a confusing way to try to focus on the question of the Fed directly managing asset prices or trying to have its own view of what fundamentals should be. I think that's not where the Fed should be. But I think they should still be thinking pretty hard about asset markets.
CR: I like David's point about big rises in asset prices as an indicator that maybe the economy is too hot, or that they're one of the things that you should look at. In thinking about the Greenspan era, there's a tendency for people like [former Fed Governor] Larry Meyer to say, "Oh, Alan Greenspan was so much smarter than I was because he realized that the unemployment rate could go down to an incredibly low level."
I'm not sure that's right. In some sense maybe we were taking things too far. Being aggressive in seeing just how good we can make things in the short run might be setting up these kinds of bubbles. I think we might want to take rapid asset price increases as one indication that we should be following a more moderate policy.
Choosing a Chair ...
NBER and Monetary Economics ...
...Region: ...your recent presentation to the Economic History Association on macro policy in the 1960s, ... I found it ... interesting. Would you tell us about it?
CR: That paper built on the work we did on the "Evolution of Economic Understanding," but added some of what we were learning from our new work on fiscal policy. ...
The question I focused on was, What went wrong? And the answer is, Basically, bad ideas. There was a revolution in ideas, but it was a misguided revolution. ...
The thing I added in this paper was the long-run fiscal side. We not only had a revolution in our views about how the macroeconomy works in the short run, but also a change in views about the importance of long-run budget balance. The paper looked at how that evolved.
What's very striking is that we had a pretty sensible long-run fiscal view in the 1950s—the budget should be balanced over the medium run, but not each and every year and not in exceptional circumstances. And, policy choices reflected that view-the budget was balanced on average, but not in recessions and not during wars.
But views took an unfortunate turn in the 1960s and '70s. Policymakers started to believe that budget balance was not important even over an extended horizon, and that tax cuts would pay for themselves. And views took another wrong turn in the 1980s, when policymakers added notions such as the starve-the-beast hypothesis that tax cuts would force spending cuts. I think these are wrong turns that we haven't corrected yet—as evidenced by our ever-worsening long-term fiscal outlook. That's the big picture that came out of this study.
Region: Thank you both very much.