(2021-02-05) Krugman Stagflation Revisited

Paul Krugman: Stagflation revisited. Nakamura, together with Jon Steinsson, has been at the cutting edge of empirical macroeconomics. For example, N/S made a big impact during the stimulus/austerity wars with a paper using the differential impact of military spending across states to estimate multipliers. The new paper uses a similar approach to estimate how much impact unemployment has on the inflation rate.

What they find is that the Phillips curve is very flat. That is, low unemployment does lead to higher inflation, but even a very hot economy only leads to modest inflationary overheating.

chill out about Biden’s big spending plans

in a hugely influential speech Milton Friedman made an argument also independently made by Columbia’s Edmund Phelps: the unemployment-inflation tradeoff wasn’t real, because any sustained effort to keep unemployment low would lead not just to high inflation but to ever-accelerating inflation

So their analysis predicted “clockwise spirals” in unemployment and inflation. Then came the 1970s:

Almost everyone in the economics profession took the Friedman-Phelps analysis as confirmed

This in turn had big practical and intellectual consequences.

But what if we’ve been telling the wrong story all along?

When the Great Recession struck, many people, myself included, worried about deflation

But while there was some decline in inflation, it wasn’t very big. Nor did inflation rise by much as the economy reflated, even when unemployment dropped below 4 percent.

This led many observers to conclude that the Phillips curve is now quite flat. What the Nakamura et al analysis suggests, however, is that it was always very flat

There is, however, a problem. The estimated slope of the Phillips curve is so flat that it says that the unemployment bulge of the early 1980s, big as it was, isn’t enough to explain the Volcker disinflation.

So what does explain the disinflation? A big fall in expectations of future inflation

They suggest that there was a regime shift: When people realized that Volcker was really willing to put the economy through the wringer, they marked down their expectations of future inflation in a way that went beyond the mechanical link via unemployment. Maybe, although they don’t offer direct evidence.

After listening to Nakamura, I found myself looking for other examples of regime shift

Spain, which has had huge swings in unemployment since it joined the euro in 1999... what if you extend the sample back? Joining the euro was definitely a regime change that might well have shifted expectations; and sure enough...

But if we’re telling a different story about why inflation came down, what about our story about why it went up in the first place?

I’ve always been a bit uneasy about the standard story of inflation in the 1970s

the economy never seemed to run hot enough to explain such a big rise in inflation.

The natural explanation would emphasize supply shocks — oil and other commodity prices — amplified by the widespread existence of cost-of-living adjustments in wage contracts. Maybe these supply shocks led to a rise in headline inflation which caused expectations to become untethered. We don’t know if that’s true.