I don’t know Betsy Stevenson, beyond the fact that her relatively young career has been impressive. She served as chief economist of Barack Obama’s Department of Labor, from which she was promoted to a member of the White House’s Council of Economic Advisors. She’s now a professor of public policy and economics at the University of Michigan and co-host of a podcast “Think Like an Economist.” Her role in this post is to illustrate the continued power, ambition, and wrong-headed Friction-Augmented General Market Equilibrium (FGME) instincts of second-generation NK macro theorists. That has become a central theme of this Blog.
The policy issue under consideration is inflation. Will it continue to rise? Is the current jump an aberration? Can the Fed properly continue its focus on economic growth that is driving down unemployment? In order to adequately answer those questions, an adequate evidence-consistent model of inflation is needed. Professor Stevenson, typical of second-generation New Keynesians, does not have such a model. Any macroeconomist who constructs her view of stabilization-relevant behavior on FGME theory lacks a useful grasp of aggregate price movement.
In a recent interview in the New York Times, Stevenson confidently makes the mainstream case:
“So I think what you’re describing is the difference between ongoing inflation that’s driven by expectations for ongoing inflation, right? That’s sort of that— we had to break the back of that. Because what was happening is everybody expected inflation, so they’re building that into contracts. People are saying, hey, if you’re going to be paying me in a year, you’ve got to be paying me 10% more, because I see 10% inflation on the horizon. Workers are demanding that they’re going to get raises that keep them up with inflation, and it just becomes this self-sustaining prophecy. That because people expect it, they build it in, and they make it come to fruition.”
In a nutshell, Stevenson’s well-worn stabilization-policy argument is: You Just Need to Believe Inflation Is (or Is Not) Coming and It Will (or Won’t) Come. That maxim has long been a mantra of NK theorists. It, perhaps surprisingly, has no grounding in macroeconomics governed by the neoclassical tenets of optimization and equilibrium. It also has little support from the huge pile of relevant evidence. Most consequential, its related policy theorems are fatally flawed. The profession has senselessly constructed a wellspring of really bad advice. Those facts, perhaps excluding problems with the evidence, will surprise Stevenson. Maybe she will be most surprised that she has never thought very hard about a key innovation of NK macro theory, the use of rational expectations rooted in the cost-effective use of available information to motivate periodic wage adjustments for product-price inflation.
Stevenson has been especially inattentive to two crucial facts that have been particularly damaging. First, the use of rational expectations of inflation as a determinant in wage adjustments has been shown to be irrational, violating the mandate of the New Neoclassical Synthesis. Catch-up to inflation that has already occurred has easily been shown to be the efficient choice. That analysis is consistent with an important fact about which Stevenson – given her NK training – has probably never been curious. Periodic wage determination in highly specialized firms always uses catch-up to adjust labor pricing for inflation; expectations are never used. What do economists know that practitioners, after a vast accumulation of trial-and-experience has resulted in the consensus use of catch-up, do not?
The good news is that the GEM Project’s revised rational-behavior Phillips curve uses catch-up rather than Lucasian expectations. The better news is that it no longer damages useful Early Keynesian stabilization-policy theorems. We can finally move beyond that silliness. The bad news is that Stevenson and most of her NK colleagues do not know that there is a new (GEM) sheriff in town.
The persisting myth that FGME (aka DSGE) macroeconomics is finished theory continues to stifle the propagation of truly rational GEM inflation mechanics, uniquely capable of explaining what’s happening today as well as during the stagflation decade. In neither case, believing inflation is or not coming means does not mean it will or won’t come. The actual story describes both a more nuanced beginning of a typical inflationary episode and the more difficult process of excess productive capacity grinding it down.
Blog Type: New Keynesians Chicago, Illinois