The Phillips Curve Debate

As I wade into the Phillips curve debate, a voice in the back of my brain is saying, no. It is reminding me of a great couplet in a fantastic Bengali dystopian fantasy movie, Hirok Rajar Deshe (in the land of the diamond king), "The quest for knowledge is endless, (hence) the pursuit of knowledge is futile." Still, I persist.

Let us take stock of the main questions:
1. Is there a stable relationship between inflation and unemployment, as the Phillips Curve has been defined in recent times?
2. Is there a stable relationship between unemployment and wages, the original Phillips Curve? 
3. Do wages cause inflation? 
4. Ultimately, does unemployment cause inflation?
I am a firm believer in Jon Elster's dictum that explanation in social sciences means the identification of causal mechanisms. Inflation is caused by an increase in money supply is NOT such an explanation. Derivative ones of the idea such as the following: an increase in monetary base leads price setters to expe…

Monetary Policy Feedback Loops and Instability

Inspired by this post by Edward Harrison, I sketched the diagram below to show the various feedback loops operating in the economy.  Red arrows are positive feedback loops (destabilizing) and blue arrows are negative feedback loops (stabilizing), By no means is this a comprehensive rendering of all interactions in the economy, but it is good enough to illustrate monetary policy dynamics, the inherent instability of a system, and that a single interest rate that stabilizes the system is unlikely to exist.

Start with the bottom loop, which we can call the conventional view of the real economy. Economic activity picks up, slack diminishes, inflation rises, and the Fed hikes rates, which, in turn, increases the cost of the capital and debt-service costs and slows the economy. In this Wicksellian world of New Keynesian economics, there exists a single rate, the natural rate, that delivers stable economy growth with steady inflation. 
Let us bring in credit. There is a positive feedback lo…

MMT at Work: The Case of India

In my mind, the best example of applying MMT, while juggling structural inflation and balance of payments constraints, is India since 1980. Before I delve into the main story, a 5-minute tour of modern Indian economic history.

Until 1980, India was stuck in what was pejoratively termed the "Hindu rate of growth" by economist Raj Krishna. It is now widely acknowledged that growth took off in 1980, although in popular commentaries 1991 is seen as the watershed year. The chart below and more sophisticated tests show that there was a trend break in growth around 1980.

However, there is considerable debate about the causes of the growth takeoff in the 1980s and whether it was sustainable. Many, perhaps most, economists believe that the 1980s growth was unsustainable, fueled by a rapid increase in government spending and deficits. The deficit-spending spree led to a steep rise in government debt, rising inflation, and a worsening current account deficit and foreign currency debt …

Data Analysis Ahead of Theory

Almost everybody agrees that we need to rethink macro. Of course, there is very little agreement about what that rethinking will involve. Predictably, there is a strong desire on part of the "mainstream" to cordon off the debate, to assert that it is all in there in the mainstream papers, we just need to rediscover them. I propose a different approach. A moratorium on macro theory, at least for now.

A little over 30 years ago, Ed Prescott, proclaimed that business cycle theory was ahead of measurement. Although he said it because the data kept rejecting his pet theories, he was probably right about macro data, which was uninformative. Yet, today we have reams of micro and disaggregated data that are being used to inform the macro debate. Mian and Sufi of House of Debt fame are pioneers in this regard and many others have since followed suit. Not just micro data, researchers are able to use macro and macrofinancial data more effectively. It is theory that is still in the dark…

Government Deficits: A Financial View

The Democratic attempts to invoke Ricardian equivalence to rail against the tax cuts and another brouhaha over MMT have prodded me to finally put down my thoughts on fiscal policy. I am not a card-carrying MMTer. I do not share the view of some MMTers that tax revenues do not matter. Fiscal capacity is a real constraint--just ask any emerging market government--and it is related to the productive capacity of the economy and the ability of the government to tax that productive capacity. To be sure, the fiscal capacity of the United States is probably far higher than most people imagine.

Most of the mainstream confusion about fiscal policy and government debt comes from trying to analyze the modern financial economy as a barter exchange economy and assuming that the ultimate purpose is increasing consumption. The modern economy is intrinsically a financial one and the goal of capitalists is to accumulate financial assets. It so happens that western capitalism has channelized the privat…

Are Foreigners Financing America?

Like the proverbial sky falling on the head fear, the financial community is perennially worried that foreigners will stop financing America's current account deficit--specifically, that they will stop buying Treasury debt and start selling it.

People think of 'our dependence on foreigner investors' as if America were perched on a high tree trunk and foreign investors were armed with saws, ready to cutoff the limb. The analogy is not bad, except that it has the actors switched. The question is not, "What will happen to us if foreigners stop buying our debt?" but, "What will happen to other countries if they can no longer sell us their goods?"

Two fallacies underlie the worry that we will be abandoned by foreign investors. The first is that foreigners somehow bring money to our markets that otherwise would not be there, and the second is that they can make money disappear from our economy. Last time I checked, Treasury debt was denominated in dollars, a…

The Decline in Productivity: It's the Demand, Stupid

Labor productivity in this expansion has been abysmal, with the last five years looking especially dreadful. Multifactor productivity has been slightly better, although it too has been anemic. Tyler Cowen thinks productivity is weak because Americans have become lazy and complacent. He has written a whole book about it. This would be not so egregious if productivity had also not dropped in the still-striving emerging markets. Maybe they too are becoming fat and happy. We all need to go back to the happy days of sweatshops perhaps to get our productivity juices flowing! leaving snark aside, most mainstream economists are puzzled. On the other hand, economists who think demand matters clearly recognize that the productivity slowdown has a lot to do with a persistently low-pressure economy. See, this EPI paper by Josh Bivens for an excellent exposition of the demand side view.

While I broadly agree with Josh Bivens, I have some disagreements about the causal factors. Bivens thinks that …