Home > Uncategorized > And now for something completely different …

And now for something completely different …

from Peter Radford

My summer of research is almost over.  The season here in Vermont is changing and the view from our window will soon be dominated by the brilliant autumnal colors our region is famous for.  All is both regular and well.

Sort of.

Perhaps there’s something in the water down there in New York.  There are rumblings of life in economics.  The long sclerosis inhibiting the emergence of theories that explain rather than re-invent reality might just be close to loosening its grip.

I hope so.

In case you are unaware, there has been a paper published that has emerged as something of a viral hit.  We all need to add to its fame.  It begins thus:

“Mainstream economics is replete with ideas that “everyone knows” to be true, but that are actu- ally arrant nonsense. For example, “everyone knows” that:

  • Aggregate production functions (and aggregate measures of the capital stock) provide a good way to characterize the economy’s supply side;
  • Over a sufficiently long span—specifically, one that allows necessary price adjustments to be made—the economy will return to a state of full market clearing; and,
  • The theory of household choice provides a solid justification for downward-sloping market demand curves.

    None of these propositions has any sort of empirical foundation; moreover, each one turns out to be seriously deficient on theoretical grounds.  Nevertheless, economists continue to rely on these and similar ideas to organize their thinking about real-world economic phenomena. No doubt, one reason why this situation arises is because the economy is a complicated system that is inherently difficult to understand, so propositions like these—even though wrong—are all that saves us from intellectual nihilism. Another, more prosaic reason is Stigler’s (1982) equally nihilistic observation that “it takes a theory to beat a theory.”

    Is this state of affairs ever harmful or dangerous? One natural source of concern is if dubious but widely held ideas serve as the basis for consequential policy decisions.  In this note, I examine one such idea, namely, that expected inflation is a key determinant of actual inflation. Many economists view expectations as central to the inflation process; similarly, many central banks consider “anchoring” or “managing” the public’s inflation expectations to be an important policy goal or instrument.  Here, I argue that using inflation expectations to explain observed inflation dynamics is unnecessary and unsound: unnecessary because an alternative explanation exists that is equally if not more plausible, and unsound because invoking an expectations channel has no compelling theoretical or empirical basis and could potentially result in serious policy errors.”

So starts Jeremy Rudd an economist at the Federal Reserve Board in his discussion of inflationary expectations and their role in determining inflation.  He seems to think they aren’t as important as some theorists might imagine.  Oh dear.

The entire paper is designed to puncture the delusions that surround central bank policy making.  Which is, of course, an excellent and worthy goal.  The problem is that, at the end of the day, central bankers need to be able to attach their policy decisions to some theory or another in order to provide themselves with intellectual rigor.  Otherwise they would be reduced to telling the public that the recession they just induced in order to eliminate expectations of inflation was simply based on guesswork or reading the tea leaves.

Which is, perhaps, what they’ve been doing anyway given that most of the edifice of economics is simply jargon infested language describing just that.  Well, maybe not guesswork.  More like ideology.

I can’t resist.  Here’s the final few paragraphs:

“Say you had never heard of Phelps or Friedman, and only knew that the stochastic trend for in- flation (and labor costs) last shifted noticeably following a recession that occurred after a period when actual inflation had been running at four percent. You then came across some survey mea- sures of long-run expected inflation that roughly showed the same one-time level shift. Would you be convinced enough by this evidence to conclude that long-run inflation expectations were an important factor driving inflation dynamics? Or would you be skeptical of this conclusion because it is basically derived from a single observation (with later observations providing no evidence at all), and because one could just as easily explain these facts with an appeal to the notion that agents were simply making forecasts of inflation that were roughly correct on aver- age? How would you also explain that a recession permanently reduced trend inflation when actual inflation was four percent, but never did so thereafter?

Or would you justify the view that expectations “matter” by pointing to the inflation experience of the 1960s and 1970s, even though that period provides no actual evidence that workers or firms tried to boost their wages or raise their prices in anticipation of future price or cost changes? After all, history really only tells us that lags of actual inflation seem to enter inflation equations to a greater or lesser degree over time, not that expectations do or did; thinking that these lags of inflation are present because they are a proxy for some kind of forecast is more a habit of mind than anything solidly grounded in fact.

Alternatively, if you view the theoretical arguments as dispositive, exactly how would you explain to a fellow economist why it is that you see an important role for expected inflation in inflation dynamics? Would you make a halfhearted appeal to Phelps and Friedman? Would you feel a little guilty doing so, knowing that these authors either assumed such a role for expectations (Phelps) or motivated it with a theoretical mechanism whose basic predictions are clearly wrong (Friedman)? If not, then how would you explain that, in reality, only long-run inflation expectations seem even vaguely related to actual inflation? And if you tied your explanation to some sort of “wage bargaining” mechanism, what existing institutional feature of the economy would you point to in order to justify it? Would you instead try to fall back on the new-Keynesian Phillips curve, whose theoretical derivation is even harder to take seriously and whose empirical justification is close to nonexistent?

And would you feel the slightest bit nervous (or chagrined) about any of it?”

Go on.  Read the whole paper.  I know you want to.

  1. October 5, 2021 at 12:13 am

    Did the rest of the Fed staff ride the guy out of town on a rail?

  2. Ken Zimmerman
    October 8, 2021 at 6:48 am

    As the folks on this blog like to say, let’s get into the ‘real world.’ I don’t care about production functions and similar actions because they are not real. They have no impact on events or actors. The reality of change is often complex. As illustrated below. Economists’ perspectives are so limited that they harm everyone and everything.

    Post-industrial societies have been for some time moving from industrialism to informationalism, the ‘informational mode’, which now operates together with the capitalist mode of production. Their societies are not based on services so much as information processing as the basis of production, distribution, consumption and management. Collective consumption organized by the state, and private consumption organized through the market, also involve the increasing use of information and information technology. The new technology must be produced somewhere, and in the United States the electronics and software industries are concentrated in a small number of regions located around San Francisco, Los Angeles, Phoenix, Portland, Dallas-Fort Worth, Austin, New York, Boston and Philadelphia. Their locations generally depend on the location of the top universities and exceptional engineers and scientists. Historically, Stanford was particularly important as the institution which gave rise to the development of Silicon Valley. Once these areas develop as high-tech centers, a number of other social processes happen. Land and house prices rise, the middle classes involved in these industries move in, and the working class moves out. They form what have been called ‘edge cities’ on the edges of the traditional large urban centers, and people with money prefer to move there because they are more convenient and safer than the larger American cities, with their problems of crime, violence and poor public education. High-class recreation and retail facilities to cater to these groups also move in, but these employ a completely different group of people: lower-skilled, lower-paid workers in service industries, with heavy concentrations of women and ethnic-minority workers. The result is the ‘dual city,’ with its increasing division between the rich and the poor, as the middle class of skilled workers and clerical workers increasingly disappears. There has also been a shift in state funding from the ‘urban welfare state’ to the ‘suburban warfare state.’ Much of the traditional state funding of education, health and welfare in large cities like New York has been cut back, while big defense contracts have led to an economic boom in the edge-city suburbs where the high-tech industries are located. Finally, of course, many of the traditional industrial jobs have moved or are moving overseas as the large companies look for cheaper labor outside the United States, Europe and Japan, in other words to the semi-periphery. And many semi-periphery nations have used and are using this new money to enhance and expand their nations, the welfare of their people, and their industrial and military capabilities. One nation, China was so successful that in less than 20 years it became a major world military power and the world’s second largest economy.

    The effects of information technology have been to speed up the processes of globalization in the world economy. After the Second World War, the costs of research and development very quickly led to the development of multinational corporations, and with the decreasing cost of transmitting information these have been able to organize their research and production on a global rather than a national or even a regional basis. Three interdependent core areas of the world economy have emerged: North America, Europe and East Asia. The rise of information technology is also linked to the development of a global currency market, based in the four world cities of London, New York, Tokyo, and Beijing, and the rise of financial services industries, which are based there as well.

    Deregulation of the currency values and attachments means that capital can be transferred anywhere in the world electronically, and there is a vast subsidiary industry of people making money through betting on future currency movements. The result has been to amplify instability in world markets, and of course to marginalize even further the areas and people outside the reach of this new technology. And it is the corporations that have flexibility and are able to adapt quickly that have been particularly successful in this kind of environment. Gaining great wealth and political influence. Along with monopoly control of many parts of economic life.

    The East Asian corporations were particularly well placed to take advantage of this new technology because of the nature of the links between them. The Japanese industries were organized around the keiretsu, networks of companies both big and small, with one or other of the large banks at the center. Along with the growth of the giant corporations has gone the ‘small is beautiful’ philosophy, and Japan combines the two ideas, with huge companies sitting at the top of a hierarchy of small family businesses. The Chinese businesses in East Asia are linked together in a similar way through family ties, which give flexibility in terms of flows of capital, loans, information and so on. With a strong communist party apparatus sitting atop the pyramid. These network enterprises are also marked by flexibility of employment, the collapse of traditional work patterns in many cases and the massive influx of women into work, often at lower rates of pay than their male counterparts. In the UK this took place during the Thatcher period of the 1980s, and in Japan it still seems to be taking place in the present. In the US such changes began with the election of Ronald Reagan as president and accelerated quickly beginning about the year 2000.

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