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Friday, June 18, 2004

Luskin: Distortions and Errors


Krugman-stalking Donald Luskin is still at it. Disturbingly, he's been able to find an economist (John Seater of North Carolina State University) to back up his criticisms of Paul Krugman's long forgotten 1982 memo. He's also attempting to goad Brad DeLong into arguing with him. I doubt DeLong will rise to the bait, since he's debated Luskin before. Presumably he knows that, as Paul Krugman has pointed out, arguing with Luskin is like fighting the Black Knight in Monty Python and the Holy Grail -- no matter how many limbs you hack off, he'll remain belligerent, insisting he's the better man, and crying, "it's only a flesh wound." Nonetheless, I'll rise to the Luskin's challenge.

Luskin has dug up a 1982 memo written by Paul Krugman and Larry Summers, forecasting a rise in inflation, or more specifically, he's found the first page of that memo. (It's unclear what happened to the rest it). In spite of not having read past the first page, Luskin ridicules Krugman's forecast.

In the September, 1982 memo, Krugman and Summers, then staffers on Ronald Reagan's Council of Economic Advisors, argue that "a significant portion of the slowing of consumer price inflation since 1980 does not represent a reduction in the underlying rate." To support this claim, they point out that the real exchange rate has risen by 35% since the beginning of 1980 (making imports cheaper) and that non-oil commodity prices have fallen 33% faster than inflation over the same period. Since these trends can't be expected to continue forever, they expect inflation to pick up in the future.

Seator, Luskin's economist backer, makes the same econ 101 point: "Commodity prices, an adjustment in the exchange rate, and so on cause once-and-for-all changes in the price level -- they do not permanently change the growth rate of prices (a.k.a. the inflation rate)." This is exactly right, and it's exactly what Krugman was saying: some of the 1980-1982 decline in inflation was due to temporary factors, that can't be expected to last. Oddly, Seator casts this as a criticism of Krugman. The charitable assumption here is the Seator has been taken in by Luskin's misrepresentation of Krugman's memo.

This is going to be a long post, but there's just so many problems with Luskin's critique. Not only does Luskin misunderstand Krugman's argument, but he also doesn't understand the inflation data he uses to try to rebut it, relying on a misleading inflation series rather than the one usually used by researchers.


Luskin's Distortion of Krugman's Argument.

According to Luskin, Krugman wrote the "the Fed's policies produce only 'temporary side effects.' In 1982 Krugman thought inflation was caused by the exchange rate of the US dollar, the price of commodities, and the price of oil." But the word "only" is Luskin's invention, Krugman & Summers say no such thing. They say that the Fed's policies produce temporary side effects such as high real interest rates. But they in no way argue that the Fed cannot also create permanent changes in inflation; in fact, they seem to assume this when the speak of the economy returning to its "underlying inflation rate." Krugman & Summers, on the first page of their memo anyway, don't discuss what drives the underlying inflation rate, but presumably it's related to the growth in the money supply.



Another way of making Krugman's point is that the core inflation rate (inflation excluding food and energy prices) in 1982 was higher than the overall inflation rate. Economists often focus on the core rate, because food and oil prices are notoriously volatile. If the overall inflation rate differs from the core rate, economists expect the overall rate to return to the core rate eventually. A striking example occurred in 1986, when overall inflation drops by several percentage points (due to a fall in oil prices). Following Krugman's logic (and the conventional wisdom), we'd expect the overall inflation rate to bounce back to the core rate, which it did. This kind of analysis is a staple of newspaper business sections, and it's surprising that Luskin would dispute it. Perhaps the problem is that he doesn't understand the intermediate macroeconomics jargon that Krugman and Summers couched their memo in.

During 1982, in the months before Krugman and Summers wrote their memo, core inflation had averaged 1.6 percentage points higher than overall inflation, hence it was reasonable to forecast that overall inflation would rise by 1.6 points in the future. Yet according to Luskin, they forecast a 5 percentage point increase in the inflation rate. What's going on here? One possibility is that Krugman was forecasting a small permanent increase in the inflation rate (after the import prices stop falling and return to a normal level) and a larger temporary increase (while import prices rise to their normal level). This was my initial interpretation, but Krugman's forecast is a little ambiguous (no doubt because we only have one page of his memo) and I've since changed my mind.


Luskin's Use of the Wrong Measure of Inflation.

After a little more reflection, I noticed that Krugman actually forecast a 5 point increase in consumer prices and a 2 point increase in the GDP deflator. Why would Krugman bring up the GDP deflator, which, while not exactly obscure, is a much less common measure of inflation than the CPI? I suspect the answer is because Krugman and Summers knew that in the late 1970s and early 1980s, the CPI was seriously biased, due to its treatment of housing prices. Hence, my guess is that Krugman's forecast of a 5 point increase in consumer price inflation referred to the CPI, as measured at the time. Was he right? There is no way to know, because the CPI time series underwent a major revision, bringing its treatment of housing prices into line with the GDP deflator, beginning just a few months after Krugman wrote his memo.

Luskin is apparently unaware of the change in the series, and so he uses the CPI-U as his measure of inflation. Although this is a common measure, it is not the one usually used by researchers, because revisions in the CPI-U are not incorporated retroactively, and so it is not consistent over time.

Hence, Luskin's chart showing that inflation fell after 1982, in contradiction to Krugman's forecast, is seriously misleading. Much of the fall in inflation in Luskin's chart is due to a change in how inflation was measured, not to anything substantive. In fact, a consistent series has since been published (called the CPI-U-RS). It shows inflation falling from a peak of about 11.5% to about 4% in mid-1983. In contrast, Luskin's inconsistent series shows inflation falling from a peak of about 14.5% to 2.5%. Krugman's forecast was probably wrong (he didn't foresee that oil prices would keep dropping) but not nearly so wrong as Luskin suggests.

Luskin's error is pretty egregious. Knowing the CPI underwent a major revision in 1983 sounds pretty arcane, but inflation is pretty fundamental to economics. If you flip through the inflation series in the back of the Economic Report of the President, for example, it's full of warnings about the 1983 revision: and someone who claims to be a macroeconomist ought to know how to find the standard inflation series used by researchers.


Conclusion

To sum up, Krugman and Summers presented a forecast of inflation based on widely accepted principles. The forecast was probably off, but so what? Inflation fell more than a smart economist would have predicted because oil prices kept dropping. Guessing wrong about the future path of oil prices is hardly a major error. Read today, Krugman's memo appears so incontrovertible as to be banal (though perhaps it was more cutting edge at the time).

Luskin totally misrepresents Krugman's argument, as does Seator (though perhaps he's relying on Luskin's distortion). Further, Luskin attempts to dispute Krugman's forecast of rising inflation using a measure that couldn't be more misleading if he had sought it out! It shows inflation falling sharply, right after Krugman's forecast. But Luskin's inflation measure falls much more sharply than inflation actually did, because of a major change in the measurement of housing prices that was implemented right after Krugman's forecast.

If you can't understand the theory, and you can't understand the numbers, you really shouldn't be criticizing Paul Krugman.

UPDATE: PGL at Angry Bear has an interesting post reminding us just how extreme and unusual the macro environment really was in the 1980s: tight money and big deficits caused high interest rates and an overvalued dollar: suppressing inflation at the cost of high unemployment. Not to mention wild swings in the price of oil. I bet Krugman was far from the only economist who failed to predict it!
 
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