JAMES TOBIN Yale University Stabilization Policy Ten Years After WHEN the Brookingspanel firstmet ten years ago, the U.S. governments managersof aggregatedemand were cooling an economy sufferingfrom an inflation4 pointshigher than ten yearsbefore. The unemploymentrate was 4.5 percent. Four years later, at the time of the panel's thirteenth meeting,the demandmanagers were cooling an economy sufferingfrom an inflation6 points higherstill. The unemploymentrate was 5 percent. As the panel meets today, the government'smanagers of aggregatede- mandare cooling an economysuffering from an inflation7 points higher thanten yearsbefore. The unemploymentrate is 7 percentand rising. Higher inflation, higher unemployment-the relentless combination frustratedpolicymakers, forecasters, and theoriststhroughout tLhe decade. The disarrayin diagnosingstagflation and prescribinga cure makes any appraisalof the theoryand practiceof macroeconomicstabilization as of 1980 a foolhardyventure. The patentbreakdown of consensusspares me the taskof seekingand describingcollective views. I will just give my own observationsand confessmy own puzzlements. In one respectdemand-management policies worked as intendedin the 1970s. On each of the occasions I describedat the beginning,the man- I am gratefulto my colleagues at Yale and to members of the Brookingspanel for comments on the original version, to Ray C. Fair also for the use of his model re- ported in the paper, and especially to members of the panel for many discussions of substance and for painstakingguidance of the revision. Bret Bertolin and Kathleen K. Donahoo provided efficient statistical and editorial assistance. Laura Harrison and other Cowles Foundation staff miraculously produced the typescripts under deadline pressuresof my own making. The work was in part supported by the Na- tional Science Foundationand the Cowles Foundation. 0007-2303180/0019-0071$01.0010 ? Brookings Institu-tion I ~~~~~~~~~~~~~0% P" % ~ I % 100 f*-q~ ~~~ 16. -CI t- 0 U r.~~~~ Nt 00 ci~~~~~~~~~ James Tobin 21 agerssucceeded in coolingthe economy.Thus the decadeis distinguished by its three recessions,all deliberatelyinduced by policy. Likewise the expansionarypolicies adoptedto reversethe first two recessions,begin- ning in 1971 and 1975 respectively,promoted recoveries, and in 1977 the new Carteradministration succeeded in sustainingand reinforcingthe expansion.Figure 1 shows the changesof nominaland real GNP during the decade. The major turns in directionconformed to the desires and intentionsof the managersof aggregatedemand. However,the expansionsof 1973 and 1978-79 and the recessionsof 1974-75 and 1980 weredoubtless more than the managersbargained for. One reasonwas that when the patientdid not respondpromptly to mod- eratemedication the impatientphysicians multiplied the dosage. In June 1974 and againin March1980 the FederalReserve, frustrated in waiting for evidenceof a downturnresponding to previous restrictivemeasures and alarmedby continuedbad news of inflation,sharply boosted nominal interestrates. On both occasionsthe cycle was alreadybeyond its peak, and the finalblows were overkill. The conformityof real to nominalGNP movementsdepicted in figure 1 and the greateramplitude of the nominalseries make a strikingprima facie case that nominal demandfluctuations were calling the tune. The exceptionsoccurred during the autonomouscommodity price shocks of 1974 and 1979. Whateverdifficulties there were in the managementof nominal de- mand,the majordisappointments came at the next stage.The inflationary componentsof the expansions,1971-73 and 1975-79, wereunexpectedly and distressinglylarge. The disinflationaryconsequence of the first con- traction,1969-71, was discouraginglysmall. Indeed, money wages "ex- ploded"while unemploymentwas rising. Price inflationfell sharply at and afterthe troughof the second contraction.OPEC-1, decontrol,and food shortageshad producedthe double-digitinflationary bulge, andonce the resultingprice increaseswere absorbedor reversedoverall inflation rates subsidedquickly. But wage inflationstayed on a somewhathigher plateau,spelling price troubleespecially when productivitygrowth later slowedto a halt.The disinflationaryrewards of the 1980 recessionremain to be seen. U.S. stabilizationpolicy in the 1970s was complicatedby important new developmentsin the world economy. Internationalconstraints became even more compellingthan they had 22 Brookings Papers on Economic Activity, 1:1980 been in the 1960s. Foreign trade was greaterrelative to GNP, and the growingsize and efficiencyof Eurocurrencyinstitutions linked U.S. finan- cial marketsmore tightlyto those in other jurisdictions.In August 1971 the UnitedStates abrogated the BrettonWoods agreement,made the dol- lar inconvertibleinto gold, andforced other major countries to appreciate their currenciesagainst the dollar. These steps led in 1973 to abandon- ment of pegged exchangerates in favor of "dirty"floating. But the new regimedid not in the end fulfill the hope, long nurturedby economists, that floating would relax the internationalconstraints on domestic policies. The major economic events of the decade were the extraordinary changesin worldsupplies and pricesof specificcommodities. Their inter- actionwith macroeconomic indicators and eventsconfronted both policy- makersand analystswith problemsfor which they were unprepared.In the United States in particular,analyses of inflationhad habituallyfo- cused on the wage-pricepatterns of the "fixprice"sector. In the 1970s the "flexprice"sector, insteadof being a passive and innocuousappend- age, was a majorsource of macroeconomicshocks. Shortagesand price increases in foodstuffs, metals, and other primarymaterials were the salientfeature of the worldwide1973 inflationaryboom. Then, of course, OPEC and the energycrisis dominated the world economicscene for the rest of the decade, as they will likely continueto do for the foreseeable future.The cartel'sprice and supplyare obviouslynot "flex"in the sense of being determinedin competitivemarkets, but they are certainlyde- tached from the familiar wage-price-productionmilieu of domestic industry. These eventshave complicatedthe game and escalatedthe stakes,but the tormentingissues of strategy have remained essentially the same throughoutthe periodsince the SecondWorld War. Can the instruments of demandmanagement achieve both monetarystability and satisfactory real economic performance?If so, how? If not, what are the terms of feasible choices, and what criteria should guide them? If the macro- economicinstruments are inadequatefor the goals, is it useful to supple- mentthem with incomespolicies temporarily or permanently? I beginby describingwhat I call the consensusmacroeconomic model, vintage1970, of whichthe core was the augmentedPhillips curve. A loose consensuson the frameworkfor thinkingabout demand management left amplescope for differencesabout structural details and values of param- James Tobin 23 etersand for practicaldisagreements of diagnosisand prescription.I then review the failures of the consensus frameworkto prepare economists andour audiencesfor the macroeconomicsurprises of the 1970s;I discuss both the damageto the frameworkand its repair.Some of the new prob- lems arisefrom the revelationthat the supply and demandblades of the macroeconomicscissors are not as disjointed as the earlier consensus frameworkfound it convenientto assume.Consequently, this topic leads me naturally into a discussion of supply-side economics and policy recommendations. As I impliedat the beginning,an analysisof demandmanagement can be approachedin two stages. The first concerns the connectionsfrom policy instrumentsto dollar spendingon goods and services.The second concernsthe impactof nominalspending on prices and real output.I am not arguingfor any separationtheorem, only for some convenienceof exposition.In 1980 the issues concerningthe first stage seem secondary to those of the second stage.Nevertheless, I then take anotherlook at the old monetaristdebate, the conductof monetaryand fiscalpolicy, and the monetary-fiscalmix. Finally, I returnto the big analyticaland policy issues of the second stage,concluding with some thoughtson whereto go from here. The ConsensusMacroeconomic Framework, Vintage 1970 Ten years ago there was a broad consensus on the structureof the systemthat the managersof aggregatedemand were tryingto stabilize. The consensuspervaded the Brookingspanel and was graduallybecom- ing embodiedin most macroeconometricmodels used for forecastingand policy analysis.It left plenty of room for disagreementsabout policy. They concerned the empirical magnitudesof some crucial structural parameters,the relative importanceof nonpolicy demand shocks and policy variationsthemselves as sources of instability,the reliabilityand strengthof stabilizingresponses by private agents in decentralizedmar- kets, and the value weights attachedto variousdimensions of economic performance-inflation,unemployment, and output. The consensuson structure,within which these debatesoccurred, contained the following elements: 1. The nonagriculturalbusiness sector plays the centralrole in deter- 24 Brookings Papers on Economic Activity, 1:1980 miningthe economy'srate of inflation.In this sector,prices are marked- up labor costs, usually adjustedto normal operatingrates and produc- tivitytrends. According to the standard"augmented Phillips curve" view, rates of price and wage increasedepend partly on their recent trends, partlyon expectationsof theirfuture movements,