Krugman’s blog, 11/28/15

There was one post on Saturday, none yesterday.  Saturday’s post was “Demand, Supply, and Macroeconomic Models:”

I’m supposed to do a presentation next week about “shifts in economic models,” which has me trying to systematize my thought about what the crisis and aftermath have and haven’t changed my understanding of macroeconomics. And it seems to me that there is an important theme here: it’s the supply side, stupid.

What I mean by that is that if you came into the crisis with a broadly Hicksian view of aggregate demand you did quite well. You made predictions that Very Serious People scoffed at — that as long as we were at the zero lower bound massive increases in the monetary base wouldn’t be inflationary, that budget deficits would not drive up interest rates — and also predicted large multipliers from fiscal policy, in particular nasty consequences of austerity. And you would not have found anything in what happened from 2008 on that contradicted your views.

I worded the above carefully. There’s a whole industry of people trying to show that Keynesian predictions about austerity didn’t pan out; it’s an industry that relies mainly on crude misrepresentations of what those predictions really amount to, and especially on confusions between levels and rates of change. (Britain imposed a lot of austerity from 2010 to 2012, but it grew in 2013. Ha! Keynes disproved!) But I won’t claim that the data prove Hicks/Keynes models right; the point is just that when you do the obvious comparisons, say between austerity and growth, they’re pretty much what a Keynesian would have said:

What hasn’t worked nearly as well is our understanding of aggregate supply — which was, if truth be told, always based on much less solid reasoning.

One big problem has been the absence of deflation. The “accelerationist” Phillips curve that used to be standard — inflation depends on unemployment and lagged inflation — seemed consistent with the experience from previous big slumps, which were associated with large declines in the rate of inflation. Specifically, we used to cite the “clockwise spirals” one saw in unemployment-inflation space as evidence for something like the Friedman-Phelps theory of the natural rate.

But what worked in the 70s and 80s doesn’t look so good for recent experience:

Why didn’t the sustained high unemployment after 2008 push us into deflation? There are some popular stories — downward nominal wage rigidity that makes the long-run Phillips curve non-vertical at low inflation rates, “anchored” inflation expectations — and I cite those stories myself. But standard discourse on macroeconomics has not fully taken the non-deflation surprise into account.

The other big problem is the dramatic drop in estimates of potential output, which is clearly correlated with the depth of cyclical slumps — and with austerity policies. Fatas and Summers have made a splash recently making this point, but Larry Ball has been on the case for a while — and I made the link to austerity. Here’s what it looks like using Ball’s estimates of the fall in potential output:

Is there a policy moral from these supply-side failures of the pre-crisis doctrine? Yes: I think they both suggest the great danger of excessively contractionary policies. On one side, central banks focused on stable inflation may think they’re doing a good job — because where’s the deflation? — when they are actually falling very far short of providing enough support. And fiscal contraction in a liquidity trap seems to be absolutely terrible for the long run as well as the short run, and quite possibly counterproductive even in purely fiscal terms.

Again, I don’t think even Hicksian-inclined economists have taken all of this sufficiently into account.


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