Steve Randy Waldman has a series of thoughtful posts on the role of demographics* in causing undesirably high rates of inflation in the 1970s. This post is something of a reply to Waldman.
In my understanding, and I will get to why I am rephrasing him in a moment, Waldman's thesis is that the 1970s saw a fast and sustained increase in the labor supply. That increase forced upon monetary policymakers a less desirable trade-off between short-run inflation and unemployment than they faced in the 1960s. In particular, the existing capital stock was unable to accommodate the surge in new workers, raising the non-accelerating inflation rate of unemployment (NAIRU), so the central bank could accept much higher unemployment for maintained inflation in the short run, or it could try to maintain unemployment at the old NAIRU for a short time while accepting accelerating inflation. The 70s Fed chose the latter option.
My revisions to Waldman's story:
(1) He talks about 70s inflation not being a "monetary phenomenon" in his second post. I don't like that because he still has the central bank making a choice. I think it would be much clearer to phrase this as: the worse trade-off was not a monetary phenomenon.
(2) It would be helpful, in my view, to think about not just a capital stock, but a training "pipeline" for workers that allows them to accumulate human capital through learning-by-doing. Waldman is saying that pipeline was maxed out in the 1970s. Faced with more liquid to put into the pipeline than ever before, the Fed responding by pushing harder.
(3) I'm wary of writing about inflation-unemployment trade-offs. Hence the "short run," "accelerating" and "trying."
Now comes the part of this post that Waldman isn't going to like. I really don't think I understand the theory, underlying model, or whatever phrase you'd like to use to describe the guts of causality here.
This is how I think I'm getting to problems. Consider a standard Cobb-Douglas production function: Y = zKαLβ. Consider a large and sustained shock to L, as Waldman shows. Consider, also, that the level of K has some rigidities, such that the level of K is not always optimal given the level of L, but that in a single shock to L, K will eventually approach the optimal level of K over some lag period. With this background, the marginal productivity of labor should drop and remain low over that lag period.
Now assume that real wages tend towards the marginal productivity of labor with a lag. What we should expect to see is that real wages should drop in the 1970s. Why? Surplus labor reduces the bargaining power of workers relative to that of employers. We don't see that; real wages begin to fall after monetary policy tightens in the 1980s. My Cobb-Douglas model is also a bit limiting, but if anything, we might expect to see downward pressures on the labor share of income β. We don't see that either -- as compared to later periods, the 1970s appears to be a time of slightly stronger labor-share performance.
Let's simplify. Waldman's thesis, stated uncharitably, is that a large increase in the labor supply acted as an inflationary pressure on the economy of the 1970s. I don't see how that works. Show me the model. Less uncharitably, it forced a worse trade-off on the Fed, specifically forcing higher unemployment or higher inflation. I don't see how that works, either. Unemployment might have been higher, but that would have put a deflationary pressure on the central bank, all else equal, given the exogenous surge in the labor supply.
Think about it this way: Whatever the Fed of the 1970s did in monetary policy, it faced an unstoppable surge in the labor supply. That should be a tremendous headwind against wage increases and broader inflation. You can argue that the capital stock wasn't ready for the higher labor supply, and I would grant that point, but that should translate into a downward pressure on wages, not an upward pressure on inflation. It's not an adverse supply shock.
* It might be worth pointing out that there were two distinct causes in the increase in the labor supply: the increase in the female labor-force participation rate due to social change and the increase in the 18-65 cohort as the lagged result of the "Baby Boom."