In a recent post, Bryan Caplan questioned my faith in markets as the best indicator of the impact of government economic policies:
Forbes provokes Sumner to don the robes of hanging judge for the hypocritical right:
“If Forbes is right, and the markets are made up by a bunch of fools, then why not go with socialism?”
. . .
His verdict rings true, but it reminds me of an earlier question that’s still bugging me: Why did financial markets like Nixon’s price controls so much? What gives, Scott? Was it just a random error, or what?
When you don’t have strong arguments, it is best to substitute quantity for quality, use some misdirection, and end up with an appeal to religious authority. I’ll do all three.
I was only 15 when Nixon made his famous August 15th price controls announcement, so I apologize if my memory fails me on a few points. But here is what I recall:
a. Nixon installed a ”temporary” wage/price freeze, which was to last for 90 days. It was widely (and correctly) anticipated that this freeze would be followed by a period of looser controls. It was also anticipated (correctly) that the weaker price controls would be easy for firms to evade. Wage controls were the real issue, price controls provided political cover.
b. Nixon pulled an FDR, and did an end run around the Fed by devaluing the dollar against gold by 10%. This had the effect of devaluing the dollar against many other major currencies. He also closed the gold window.
c. He cut taxes. I don’t recall exactly which ones, but I believe there were income tax cuts and a cut in excise taxes on cars.
1. My first argument is that it is not clear that the positive stock market response was in reaction to the wage/price controls announcement. The stimulus to AD was very impressive, and could explain at least part of the response. Nevertheless, for two reasons I do not want to rely on this excuse. First, because my hunch is that the stock market did welcome the wage/price controls, or at worst was neutral on them. Furthermore, the monetary stimulus was probably unwarranted, as NGDP growth was adequate. So what are some other possible reasons for the market reaction?
2. Wage/price controls combined with monetary and fiscal stimulus were a very potent mixture, almost sure to benefit the economy in the short run, and boost the odds of Nixon’s re-election. However the response of the markets was stronger than what one would expected from a mere increase in the probability of Nixon being re-elected. (The stock market rises about 2% on a 100% increase in the odds of a Republican winning.) And of course this argument would cut against my view that markets can tell us something about the wisdom of policy initiatives.
3. At the time, the controls were viewed as a sort of “incomes policy,” a way of shifting the Philips curve to the left and making it easier to reduce inflation. Some European countries were believed to have had success with this sort of policy, although the record was definitely mixed. If you believe that nominal wages were above the optimal level in 1971, perhaps due to the strength of unions, then wage controls can actually improve the performance of the economy. I recall reading that Hitler used wages controls to spur a rapid recovery in Germany after 1933, although I suppose Hitler is not someone I want on my side. So let’s move on.
4. Perhaps the wage controls combined with stimulus to AD were seen as a way of shifting income from labor to capital. I am pretty sure that corporate profits did well for the next two years, although someone should check-double that. In that case the market response might have been “rational” but again it would not support my argument that markets can tell us something about the wisdom of policy initiatives.
5. Ex post, the wage/price controls were a significant error, but recall that the markets had no idea what was coming next. They did not know that after 1973 productivity growth would slow sharply, causing monetary policy (which was excessively focused on real output and unemployment) to go off course and allow inflation to drift much higher. And of course they had no idea that OPEC would drive energy prices much higher in 1973. As far as I know, nothing like OPEC had ever been seen, at least at that scale of operation. I do think that even under the best of assumptions the markets misjudged the Phillips Curve relationship in 1971, as did the vast majority of economists. Which brings me to one of my strongest arguments.
6. As far as I can recall most economists supported the wage/price controls. This is important because this whole debate was motivated not by the question of whether markets are perfect, but rather whether they are better guides to policy effectiveness than the experts. And in this case the experts were wrong as well. So even in this 38 year old case, which admittedly looks very bad for EMH people like me, the experts seem to have done no better.
7. My claim is that one should look at the response of real stock prices. Usually the price level doesn’t change much from day to day, so a large rise in nominal stock prices translates into a large rise in real stock prices. And that was also true on August 16, 1971. But also note that US stock prices in terms of gold and foreign exchange fell sharply, as the 10% dollar devaluation was much bigger than the rise in the Dow (which I seem to recall was around 3% or 4%.) I really don’t have a good answer as to what to do in this sort of situation. Obviously if the Fed suddenly announced a policy of hyperinflation, the nominal value of stocks would soar. But that does not mean a policy of hyperinflation would be wise. Because many prices are sticky in the short run, you have to be careful in interpreting the response of markets to nominal shocks. Nevertheless, I stand by my previous discussion of market responses to policy in the Great Depression, and also in 2007-09. I think the markets did correctly point out which monetary policies would be helpful, and which were woefully inadequate.
I suppose I should be flattered that Bryan had to go back 38 years to find an example where the markets clearly seemed to have blown it. Especially since even in this example the experts did no better. And I can find many more examples where the “experts” failed us. I would also note that Bruce Bartlett made a similar comment (in my old blog), so apparently this example has become part of the folk wisdom that economists use when anyone cites market responses to policy to show that the “emperor has no clothes.” But since when is a single anecdote enough to discredit an economic argument that has the virtue of being consistent with economic theory, especially given that dozens of anecdotes can be found to discredit the counterargument that experts are smarter than markets?
In fairness to Bryan Caplan and Bruce Bartlett, there may be many other such counterexamples, perhaps they simply chose the most famous example. I admit that I was surprised by the seemingly positive market response to the Obama stimulus package, for instance. At this point I am tempted to trot out a religious argument. Recall how when someone mentions a particularly gruesome example of genocide committed by the “good guys” in the Old Testament, Christian fundamentalists will say something like; “The Lord moves in mysterious ways, we are not in position to second guess him.” Don’t the Catholics also see this sort of presumption as a sin? Perhaps the same is true of market responses to policy announcements. Maybe the markets thought the Obama stimulus package showed that the government was determined to avoid a depression, and that they would do whatever was necessary to boost AD. Or that it would indirectly make monetary policy more stimulative, by increasing the money multiplier. The stock market moves in mysterious ways, it is not for us free market believers to question its infinite wisdom.
Returning to reality (now that I have offended Protestants, Catholics and Jews), I suppose in the end my best defense of 1971 would be the following. The markets correctly saw that 1972 was going to be a very good year. I first heard of Arthur Laffer when he used the stock market to forecast NGDP growth in 1972; most other economists used econometric models. Laffer forecast higher nominal growth that the others, and was right. My hunch is that the stock market correctly understood that the stimulus would lead to higher NGDP over the next few years, which would justify higher nominal stock prices. In addition, the wage controls would weaken the power of unions and allow this higher nominal growth to show up in higher profits. They correctly understood that firms could evade the price controls and in any case most firms were monopolistic competitors and would like like nothing better than to have a slightly smaller price increase, but a much bigger market. Ex post the market was wrong. Nixon’s policy failed for all sorts of reasons; a misunderstanding of the Phillips Curve, a mistaken belief that the sort of incomes policies that were workable in small consensual societies like Austria could work in the US, bad luck with OPEC and crop failures, etc. But I don’t think the market reaction was quite as irrational as it might seem in retrospect. And again, most economists made similar mistakes at that time.
So how about the following: We will not use market responses to directly evaluate whether a particular policy is good or bad. Rather we will use markets to answer technical questions, such as how much inflation or NGDP growth we are likely to get next year and the year after. Right now the TIPS market says we can expect just over 1% inflation for the next few years. The political and economic right says inflation is a much bigger problem than unemployment. Let’s revisit this question in two years and see who was right.
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