Fed Ache

It takes real talent to turn Meyer’s experience, which lacks not only sex and scandal but even drama, into a good read. But Meyer achieves it with a clear professor’s tone combined with jaunty self-effacement and a willingness to honestly appraise when he was right and when he was wrong. And considering that he was wrong on the central issue most of the time, this was a wise and disarming choice of style.

Meyer’s terrible idea is known as the Non-Accelerating Inflation Rate of Unemployment (NAIRU): the notion that there exists a threshold unemployment rate below which inflation increases without limit. The NAIRU was invented, mainly by Milton Friedman in 1968, in dissent from the prior doctrine of the Phillips Curve, the idea that full employment would entail only a modest rise in the permanent rate of inflation. Then, in the early 1970s, high inflation combined with unemployment to shatter the Phillips Curve. The NAIRU doctrine taught that even trying to push the unemployment rate down with monetary policy was futile; and, worse, that if unemployment were to fall for a substantial time below the NAIRU threshold, inflation would not only rise but also accelerate. This would lead over time to hyperinflation–to financial and social disaster.

Economists, therefore, came to see full employment as a poisoned chalice, something to be avoided by the most aggressive and, if necessary, painful measures. This assumption dominated macroeconomics for about 30 years, causing enormous damage. In particular, it prompted the Federal Reserve to raise interest rates and provoke repeated recessions. Millions were left unemployed, their families in stress, and their human potential wasted. It was all entirely unnecessary as we eventually learned.

Forecasters built the NAIRU into their models. In the 1980s, the usual estimate held that inflation would begin to accelerate if unemployment fell below 6 percent (which it rarely did). In his career as a consultant, Meyer had come to rely on such an estimate for predicting the inflation rate. Success at this modest task convinced him that the concept itself would bear the test of time and changing circumstances.

By the late 1990s, circumstances had changed. Unemployment was falling below established estimates of the NAIRU–and eventually to levels rarely observed in peacetime. Yet prices remained strikingly stable. Meyer was on the Federal Reserve Board. What to think? What to do?

Meyer chose to adhere to the NAIRU concept, while conceding ground, bit by bit, on his estimate of where the threshold of hyperinflation might be: a rationale which unfortunately always made him fear the worst. As unemployment fell, he would argue that inflation was just around the corner. Therefore (although in appointing him President Clinton had clearly hoped for better), he found himself generally favoring increases in interest rates–not because inflation was rising, but only because his model told him that it soon had to.

Eventually Alan Greenspan came to a different view. Though he had warned in 1997 (prematurely, but nevertheless with prescience) about “irrational exuberance” in the stock market, as the millennium approached, he convinced himself that the information-technology boom constituted a “new paradigm,” raising productivity growth so substantially as to keep inflation perhaps indefinitely at bay.

Greenspan’s vision of a productivity explosion was mystical. There was no evidence for it at the time, and even now the case is far from solidly established. Yet inflation did not rise. And in that context Greenspan’s transcendent intuition had practical merit, giving him grounds steadily to delay increases in interest rates.

But then again, it had the side effect of turning Greenspan into the nation’s second foremost cheerleader (after Clinton) for the NASDAQ bubble, and thereby precluded serious consideration of policies that might have slowed the bubble without raising interest rates, and thus helped to prolong the period of full-employment prosperity that came into being at that time. In particular, the Fed has the power to order increases in the margin requirement on broker loans, dampening stock market speculation. But such a step would have contradicted the new paradigm view.

In the end, despite two consecutive years of full employment, inflation never accelerated. Instead, the info-tech bubble popped and the technology sector collapsed, precipitating both a slump and the massive job losses of 2001, from which we have not yet recovered. Bye-bye NAIRU. Bye-bye new paradigm.

There is another viewpoint. One might call it the Old Keynesian view, held by just a handful of economists in the late 20th century, including Nicholas Kaldor of Cambridge, Robert Eisner of Northwestern, and the present reviewer. We never accepted either the Phillips Curve or the NAIRU. Instead, we believed that full employment was not inherently inflationary; in fact, we saw the greater inflation risk in stagnation itself. In a slowdown, we believe, monopolistic enterprises raise prices in order to try to recover their fixed costs. While on the other hand, full employment production foments ample competition in product markets, high rates of technical change, and declining costs, as businesses seek ways to save on scarce and expensive labor. In other words, productivity growth accelerates because of full employment itself.

My teachers Kaldor and Eisner didn’t live to see a full test of this proposition, but I did. They were right. In the late 1990s, full employment proved not to raise the inflation level, indeed sometimes to contract it. Tight, and rationally competitive, labor markets raised living standards and general prosperity, without adverse economic consequences of any kind.

Meyer entertained no wicked motives or bad faith. His virtues include a disinterested concern with economic outcomes and a willingness to accept the pragmatic goals of “full employment” and “reasonable price stability”–written into the Federal Reserve Act in 1978 when Old Keynesians could get away with such things. (Regrettably, when Meyer refers to this mandate, he always drops the adjective “reasonable,” and one wonders whether he knows that it is there.) His flaw was adherence to theoretical error and to the idea that interest rates are the first (and only) defense against inflation. This put him, the scientific Democratic liberal, on the hawkish side of monetary policy debates, while Greenspan, the mystical Republican conservative, often came down on the side of the doves. And–fortunately for the economy in those years–Greenspan always prevailed.

The pity was that the good times could not be sustained. As the slump-cum-jobless recovery has lengthened, the Old Keynesian view has been vindicated, grimly, on another score. Slowly we now see signs of rising inflation–not inflamed by recovery, which has at best only started but despite the fact that today we have five million fewer jobs, in proportion to our growing population, than we had four years ago. The rising inflation is the consequence of monopoly action in pharmaceuticals, health care, media, and other sectors, and of the rise of energy prices incident to the uncertainties of the oil market and the Iraq war. A rise in interest rates certainly lies ahead–to “fight inflation” as we are already being told.

But this only reveals the incoherence of thought at the Federal Reserve. Today, not even advocates of the NAIRU can favor raising interest rates to fight inflation, for no plausible estimate of the NAIRU could come close to today’s 5.6 percent unemployment. One wonders where Larry Meyer stands on this, and it’s too bad that he doesn’t tell us here. But that is not surprising. His framework, since it precludes predicting rising inflation in advance of improving labor-market conditions, has betrayed him once again.

Meyer convincingly portrays the Fed as a place of thoughtful discussion among intelligent and committed people. Among them, the examples of Janet Yellen, Alice Rivlin, and Donald Kohn–as well as Meyer himself–especially stand out. He is also gracious toward congressional oversight, which did not always treat him kindly. In 1996, this reviewer assisted Sen. Tom Harkin (D-Iowa), who held up Meyer’s nomination in order to secure a Senate debate over monetary policy, so that those who disagreed with the NAIRU doctrine might be heard–a debate the Senate could usefully renew today. It is impressive to read Meyer’s friendly acknowledgment of Harkin’s serious intent and good faith in this matter.

All in all, A Term at the Fed makes a term at the Fed seem fun. At least the small circle of monetary policy illuminati, however their policy views may differ, will say the same upon reading this book.

James K. Galbraith holds the Lloyd M. Bentsen Jr. Chair in Government/Business Relations at the LBJ School of Public Affairs, the University of Texas at Austin, and is Senior Scholar with the Levy Economics Institute.

James K. Galbraith holds the Lloyd M. Bentsen Jr. Chair in Government/Business Relations at the LBJ School of Public Affairs, the University of Texas at Austin, and is Senior Scholar with the Levy Economics Institute.

James K. Galbraith

James K. Galbraith is the author of Welcome to the Poisoned Chalice: The Destruction of Greece and and Future of Europe, forthcoming from Yale University Press.