Uneasy Money

Publication of Lipsey’s article nicely coincides with Roger Farmer’s new book Prosperity for All which I discussed in my previous post. A key point that Roger makes is that the assumption of a unique equilibrium which underlies modern macroeconomics and the vertical long-run Phillips Curve is neither theoretically compelling nor consistent with the empirical evidence. Lipsey’s article powerfully reinforces those arguments. Access to Lipsey’s article is gated on the JHET website, so in addition to the abstract, I will quote the introduction and a couple of paragraphs from the conclusion.

One important early post-WWII debate, which took place particularly in the UK, concerned the demand and inflationary pressures at which it was best to run the economy. The context for this debate was provided by early Keynesian theory with its absence of a unique full-employment equilibrium and its mainly forgotten, but still relevant, microeconomic underpinnings. The original Phillips Curve was highly relevant to this debate. All this changed, however, with the introduction of the expectations-augmented version of the curve with its natural rate of unemployment, and associated unique equilibrium GDP, as the only values consistent with a stable inflation rate. This new view of the economy found easy acceptance partly because most economists seem to feel deeply in their guts — and their training predisposes them to do so — that the economy must have a unique equilibrium to which market forces inevitably propel it, even if the approach is sometimes, as some believe, painfully slow.

The current behavior of economies with successful inflation targeting is inconsistent with the existence of a unique non-accelerating-inflation rate of unemployment (NAIRU) but is consistent with evolutionary theory in which the economy is constantly evolving in the face of path-dependent, endogenously generated, technological change, and has a wide range of unemployment and GDP over which the inflation rate is stable. This view explains what otherwise seems mysterious in the recent experience of many economies and makes the early post-WWII debates not seem as silly as they appeared to be when economists came to accept the assumption of a perfectly inelastic, long-run Phillips curve located at the unique equilibrium level of unemployment. One thing that stands in the way of accepting this view, however, the tyranny of the generally accepted assumption of a unique, self-sustaining macroeconomic equilibrium.

This paper covers some of the key events in the theory concerning, and the experience of, the economy’s behavior with respect to inflation and unemployment over the post-WWII period. The stage is set by the pressure-of-demand debate in the 1950s and the place that the simple Phillips curve came to play in it. The action begins with the introduction of the expectations-augmented Phillips curve and the acceptance by most Keynesians of its implication of a unique, self-sustaining macro equilibrium. This view seemed not inconsistent with the facts of inflation and unemployment until the mid-1990s, when the successful adoption of inflation targeting made it inconsistent with the facts. An alternative view is proposed, on that is capable of explaining current macro behavior and reinstates the relevance of the early pressure-of-demand debate. (pp. 415-16).

In reviewing the evidence that stable inflation is consistent with a range of unemployment rates, Lipsey generalizes the concept of a unique NAIRU to a non-accelerating-inflation band of unemployment (NAIBU) within which multiple rates of unemployment are consistent with a basically stable expected rate of inflation. In an interesting footnote, Lipsey addresses a possible argument against the relevance of the empirical evidence for policy makers based on the Lucas critique.

Some might raise the Lucas critique here, arguing that one finds the NAIBU in the data because policymakers are credibly concerned only with inflation. As soon as policymakers made use of the NAIBU, the whole unemployment-inflation relation that has been seen since the mid-1990s might change or break. For example, unions, particularly in the European Union, where they are typically more powerful than in North America, might alter their behavior once they became aware that the central bank was actually targeting employment levels directly and appeared to have the power to do so. If so, the Bank would have to establish that its priorities were lexicographically ordered with control of inflation paramount so that any level-of-activity target would be quickly dropped whenever inflation threatened to go outside of the target bands. (pp. 426-27)

I would just mention in this context that in this 2013 post about the Lucas critique, I pointed out that in the paper in which Lucas articulated his critique, he assumed that the only possible source of disequilibrium was a mistake in expected inflation. If everything else is working well, causing inflation expectations to be incorrect will make things worse. But if there are other sources of disequilibrium, it is not clear that incorrect inflation expectations will make things worse; they could make things better. That is a point that Lipsey and Kelvin Lancaster taught the profession in a classic article “The General Theory of Second Best,” 20 years before Lucas published his critique of econometric policy evaluation.

I conclude by quoting Lipsey’s penultimate paragraph (the final paragraph being a quote from Lipsey’s paper on the Phillips Curve from the Blaug and Lloyd volume Famous Figures and Diagrams in Economics which I quoted in full in my 2013 post.

So we seem to have gone full circle from the early Keynesian view in which there was no unique level of GDP to which the economy was inevitably drawn, through a simple Phillips curve with its implied trade-0ff, to an expectations-augmented Phillips curve (or any of its more modern equivalents) with its associated unique level of GDP, and finally back to the early Keynesian view in which policymakers had an option as to the average pressure of aggregate demand at which economic activity could be sustained. However, the modern debated about whether to aim for [the high or low range of stable unemployment rates] is not a debate about inflation versus growth, as it was in the 1950s, but between those who would risk an occasional rise of inflation above the target band as the price of getting unemployment as low as possible and those who would risk letting unemployment fall below that indicated by the lower boundary of the NAIBU  as the price of never risking an acceleration of inflation above the target rate. (p. 427)