And Now For Something Completely Different …

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.

 

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