Neil Irwin, a veteran economics reporter for The New York Times, has long been skeptical about what macroeconomists do. In a recent article (“ Nobody Really Knows How the Economy Works”, October 15, 2021) he wrote: “It has long been a central tenet of mainstream economic theory that public fears of inflation tend to be self-fulfilling. Now though, a cheeky and even gleeful takedown of this idea has emerged from an unlikely source, a senior adviser at the Federal Reserve named Jeremy B. Rudd. His 27-page paper, published as part of the Fed’s Finance and Economics Discussion Series, has become what passes for a viral sensation among economists. The paper disputes the idea that people’s expectations for future inflation matter much for the level of inflation experienced today. That is especially important right now, in trying to figure out whether the current inflation surge is temporary or not.
“But the Rudd paper is part of something bigger still. It reflects a broader rethinking of core ideas about how the economy works and how policymakers, especially at central banks, try to manage things. This shift has also included debates about the relationship between unemployment and inflation, how deficit spending affects the economy, and much more. In effect, many of the key ideas underlying economic policy during the Great Moderation – the period of relatively steady growth and low inflation from the mid-1980s to 2007 that also seems to be a high-water mark for economists’ overconfidence — increasingly look to be at best incomplete, and at worst wrong.
“It is vivid evidence that macroeconomics, despite the thousands of highly intelligent people over centuries who have tried to figure it out, remains, to an uncomfortable degree, a black box. The ways that millions of people bounce off one another — buying and selling, lending and borrowing, intersecting with governments and central banks and businesses and everything else around us — amount to a system so complex that no human fully comprehends it.”
Four weeks ago, this blog used macro theory developed by the GEM Project to dismantle the mainstream canard that expectations usefully explain inflation. That conclusion will not be relitigated here. Instead, I want to look at Irwin’s more dangerous indictment, i.e., that the macroeconomy is a black box that is too complex to be understood by macro theorists. By beating the drum that experts are inherently unable to explain economic behavior, Irwin recklessly opens the door to crackpot analyses of a crucially important policy problem.
The know-nothing approach has long been one of Irwin’s hobby horses. In an earlier NYT piece (“The 57-Year-Old Chart That Is Dividing the Fed”, October 24, 2015), he made the same point about the same problem and, in so doing, provided analytic context for this post: “[The 57-year-old chart displays] the Phillips curve, one of the most important concepts in macroeconomics. It shows how inflation changes when unemployment changes and vice versa. The intuition is simple: When joblessness is low, employers have to pay ever higher wages to attract workers, which feeds through into higher prices more broadly. And inflation is particularly prone to rise when the unemployment rate falls below the “natural rate” at which pretty much everybody who wants a job either has one or can find one quickly…. [As] Janet L. Yellen put it in a 2007 speech the Phillips curve ‘is a core component of every realistic macroeconomic model.’ Except it doesn’t work. Or at least, it hasn’t worked very well in the last few decades in the United States. And it has proved particularly problematic to try to use that historical relationship to predict where inflation is going.”
This chapter uses the Project’s generalized-exchange theory to work through the proper specification and use of the famous Phillips curve. It makes clear that the critical processes it describes, including inflation and the role of expectations, are not incomprehensible. Even more, it becomes clear that an adequately constructed Phillips Curve usefully informs stabilization policymakers. The analysis is divided into four parts. Next week briefly summarizes the relevant economic literature. The second post investigates the most contentious aspect of the Phillips debate – the adjustment of nominal wages for price inflation. The third melds the GEM Project’s rational LEV and SEV labor pricing, producing a powerful single-equation (Phillips-class) model. The fourth summarizes lessons learned about labor and product pricing after the Second Industrial Revolution and the advent of workplaces restricted by asymmetric, costly information and routinized jobs.
Blog Type: Policy/Topical Chicago, Illinois