Would Bundesbank have helped US escape Great Inflation of 1970s?

Keeping Jurgen Stark’s criticism aside that Americans always call economic events great, let us look at this interesting paper

The Great Inflation of 1970s led to the monetary policy revolution and we saw much lower inflation rates from thereon. There were papers which asked if we brought Greenspan back to 1970s would America escape the great inflation? The papers largely said no Greenspan would not have helped and blamed the extraordinary economic situation which led to the inflation then. 

This paper looks at the problem from the other angle. Bundesbank’s track record in Great Inflation was admirable. Its track record overall was exemplary. So what if Bundesbank was made incharge of America’s monetary policy. Would it have helped? Ideally, it should lead to lower inflation. 

However, the author finds this is not the case which is a big surprise. We never know what Greenspan would have done in 1970s as America only learnt its monetary policy lessons after Volcker showed how Fed could lower inflation. But we surely know what Bundesbank would have done as we know its strategy. So to see Bundesbank not being effective is a surprise. 

The conclusions the author draws are more interesting. These kinds of studies use a technique called Structural VAR (SVAR) to evaluate these situations. The author says instead of thinking that Bundesbank would not have helped; we should instead see the results from SVAR with some suspicion. 

Since the structural VAR methodology came to essentially dominate applied macroeconomic research, around mid-1980s, policy counterfactuals have been one of its
main applications. As we have discussed, the outcome of such counterfactuals is seldom questioned, and the results they produce are usually taken at face value. In this
paper we have shown that standard structural VAR methodology, when applied to a specific policy counterfactual–‘bringing the Bundesbank to the post-WWII United
States’–produces a result which the vast majority of macroeconomists would likely find extremely hard to believe: the very same central bank which burnished its ‘hardmoney’,
anti-inflation reputation by successfully countering the 1970s’ inflationary impulses in West Germany would not have been able to deliver a comparable performance
had it been put in charge of U.S. monetary policy. The fact that (i) such counterfactual is a ‘standard’ one–in the specific sense that, instead of being performed
within a single country and across time, it is performed across countries–and (ii) it has been produced based on ‘off-the-shelf’ methods (in terms of both estimation
 and identification), sounds a cautionary note on taking the outcome of SVAR-based policy counterfactuals at face value, and raises questions on their very reliability.  

So the key issue here, in our view, is the mapping between the underlying true model of the economy and its structural VAR representation, and in particular the ability of counterfactuals based on the latter to correctly capture the true counterfactuals based on the former. Both issues are currently being investigated in our work in progress.

Exciting stuff. What amazing research these guys end up doing.


To read how Bundesbank avoided Great Inflation see this Otmar Issing piece



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