Should-Read: Paul Krugman: Immaculate Inflation Strikes Again

Should-Read: Paul Krugman: Immaculate Inflation Strikes Again: “Oh, dear. We’ve been here before…. Economics is about what people… do…

…Your story… has to include an explanation of how peoples’ incentives change. That’s why the doctrine of immaculate transfer, which asserts that saving-investment balances translate into trade balances without any adjustment of the exchange rate, is silly…. Similarly, even if you think that inflation is fundamentally a monetary phenomenon (which you shouldn’t, as I’ll explain in a minute), wage- and price-setters don’t care about money demand; they care about their own ability or lack thereof to charge more, which has to–has to–involve the amount of slack in the economy….

The claim that there’s weak or no evidence of a link between unemployment and inflation is sustainable only if you insist on restricting yourself to recent U.S. data. Take a longer and broader view, and the evidence is obvious. Consider, for example, the case of Spain. Inflation in Spain is definitely not driven by monetary factors, since Spain hasn’t even had its own money since it joined the euro. Nonetheless, there have been big moves in both Spanish inflation and Spanish unemployment…. Low unemployment… the result of huge inflows of capital, fueling a real estate bubble. Then came the sudden stop after the Greek crisis, which sent unemployment soaring…. The pre-crisis era was marked by relatively high inflation, well above the euro-area average; the post-crisis era by near-zero inflation, below the rest of the euro area, allowing Spain to achieve (at immense cost) an “internal devaluation” that has driven an export-led recovery. So, do you really want to claim that the swings in inflation had nothing to do with the swings in unemployment? Really, really? But if you concede that unemployment had a lot to do with Spanish inflation and disinflation, you’ve already conceded the basic logic of the Phillips curve….

Economics is about what people do, and stories about macrobehavior should always include an explanation of the micromotives that make people change what they do. This isn’t the same thing as saying that we must have “microfoundations” in the sense that everyone is maximizing; often people don’t, and a lot of sensible economics involves just accepting some limits to maximization. But incentives and motives are still key. And it’s ironic that macroeconomists who are deeply committed to the microfoundations project–or, as Trump might say, the “failing microfoundations project”–also seem to be especially likely, perhaps due to their addiction to mathiness, to forget this essential rule.

March 27, 2018


Brad DeLong
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