Politics & Policy

Memo to Krugman

Wow, were you wrong when you served on the Reagan CEA in 1982.

Paul Krugman says whistle-blowers “deserve to be celebrated” for their “shocking revelations about how American institutions, from corporations to government agencies, really operate.” Let’s see how America’s most dangerous liberal pundit celebrates me — because I’m going to blow the whistle big-time on how Krugman “really operated” when he briefly served as an economist on the staff of the Council of Economic Advisors for the Reagan administration starting in 1982.

My colleague Bruce Bartlett has liberated a copy of the first page of a smoking-gun memo that Krugman wrote in 1982 with Larry Summers (who would 15 years later be Treasury secretary under Bill Clinton). I’ve already mentioned this memo — titled “The Inflation Time Bomb?” — in my column rebutting Krugman’s most recent attack on Ronald Reagan’s economic record. But now I’ve got the actual memo. And it’s a doozy.

I’ve seen Paul Krugman make lousy predictions about the economy before — lots of times (actually, every time). But until I read this memo, I had no idea that he could be so thoroughly, spectacularly, awesomely, shockingly wrong. And this is no mere Krugman jeremiad on the op-ed pages of the New York Times. This is a document on United States Government letterhead, written in order to guide national economic policy. Thank God Ronald Reagan was smart enough not to believe one word of it.

Here’s the memo. (You can click here to download it as a full-size printable Adobe PDF file.)

This September 9, 1982, memo addressed to CEA chair Martin Feldstein and member William Poole must have been among the first Krugman wrote upon arriving at the CEA. In it, Krugman warns that the dramatic drop in consumer price inflation from its double-digit levels in 1979, 1980, and 1981 was a temporary aberration, and that inflation would soon come back with a vengeance. He wrote,

We believe that it is reasonable to expect a significant reacceleration of inflation in the near future. Much of the apparent progress against inflation has resulted from the temporary side effects of tight money and high real interest rates. These side effects must be expected to reverse themselves as real interest rates decline and the economy expands. … Our very rough guess is that correction of … distorted relative prices will add at least 5 percentage points to future increases in consumer prices … This estimate is conservative …

Before we drill down to understand exactly how and why Krugman was wrong, let’s look at the sheer magnitude of his wrongness. In the top panel of the chart below, you can see the history of consumer price inflation in the years before Krugman wrote his memo, and for the rest of the Reagan presidency. When Krugman wrote his memo, inflation was running at an annual rate of 5.97 percent — “at least 5 percentage points” higher would be a minimum of 10.97 percent. Krugman wasn’t even close. In fact, if anything, the right number was closer to 5 percent in the other direction.

The bottom panel of the chart below shows, month by month, just how wrong Krugman was. In the very next month after the memo appeared, inflation dropped by more than one full percentage point, and for the rest of the Reagan presidency it was never even close to the same level as when the message was written — never mind being “at least 5 percentage points” higher than that. Krugman was never less wrong than about 6 percentage points of inflation. At his worst, he was almost 10 percentage points wrong.

These days, however, Krugman flat out lies about his inflation-forecasting record. Instead of admitting he got it wrong, in his New York Times column last Friday, he bragged that the collapse of inflation in the 1980s “played out just as ‘left-wing Keynesian economics’ predicted.”

Today he explains the collapse of inflation as being solely due to Federal Reserve chair Paul Volcker and his “tight money policy.” Is that because he recognizes the reality that inflation is strictly a monetary phenomenon? Or does he credit the Fed with inflation’s collapse in the 1980s just so Ronald Reagan gets no share of the glory? Either way, it’s a stark contradiction to his position in the 1982 memo that the Fed’s policies produce only “temporary side effects.”

In 1982 Krugman thought inflation was caused by the exchange rate of the U.S. dollar, the price of commodities, and the price of oil. But as anybody with a lick of common sense could tell him, he had it completely backward — these things are the effect of inflation, not the cause.

Krugman noted that in 1982 the real foreign-exchange rate of the U.S. dollar was sharply higher — and real commodity prices were sharply lower — than they had been over the last decade. He concluded from this that as “the economy recovers, we can expect the real exchange rate and real commodity prices to return to approximately their historical levels.” He couldn’t have been more wrong in both cases.

The chart below shows the real exchange rate of the U.S. dollar for a decade before the 1982 memo, and then through the end of the Reagan presidency. It did drift slightly lower in the first couple of years after the memo. But then it took off to new highs — resembling nothing like a “return to approximately their historical levels.”

Same thing for commodities — but here Krugman spent an even shorter time being slightly and temporarily right. By early 1985 commodity prices had broken to new lows. Again, nothing that could even charitably be called a “return to approximately their historical levels.”

How about oil? Wrong again. In the 1982 memo, Krugman had said that his “at least 5 percentage points” was “conservative in that it assumes stable oil prices.” Of course, what Krugman meant was that it assumes oil prices don’t go up — after all, downward instability would present no problem. As the chart below shows, downward instability is exactly what we got. Other than for a month or two, oil never traded higher during Reagan’s presidency than its price when the 1982 memo was written. At the end of the Reagan presidency, its price had been cut in half.

So let’s review. In September 1982, Krugman forecasted that inflation would rise by “at least” 5 percent, that the real exchange rate of the dollar would fall, and that real commodity prices would rise. And he also worried that oil prices would rise. Inflation didn’t rise at all — it fell by close to 5 percent. The real exchange rate of the dollar rose. Commodity prices fell. The price of oil was cut in half.

In fact, about the only good piece of advice in the whole Krugman-Summers memo was the little slogan that was printed on the bottom of the page — “Buy U.S. Savings Bonds Regularly on the Payroll Savings Plan.”

– Donald Luskin is chief investment officer of Trend Macrolytics LLC, an independent economics and investment-research firm. He welcomes your comments at don@trendmacro.com.


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