I'm only about two thirds done with Piketty - it's been very busy this summer between events, getting the dissertation proposal off the ground, and starting work again at the Urban Institute. But I
just happened to get to one of the parts in Piketty that Acemoglu and
Robinson quote, and it turns out to be an extremely dishonest rendition.
They quote this to show that Piketty doesn't think institutions matter
(from page 365):
"The fundamental inequality r > g can explain the
very high level of capital inequality observed in the nineteenth
century, and thus in a sense the failure of the French revolution.... The formal nature of the regime was of little moment compared with the inequality r > g.".
So what is in that ellipses?
He explains that the revolution didn't change the course
of inequality (relative to monarchical Britain) because the new
institutions that were established were much closer to Britain than
popular perception in France at the time suggested! It was NOT a big
change in institutions, which was why the French revolution did not
shift the parameters of the model. Immediately after this he goes on to
discuss changes in institutions in the 20th century that WERE
substantial enough to impact inequality, and he even reviews how
inter-country differences in these institutions explain differences
between (for example) Germany and France.
In other words, the
real point of this section is that institutions matter a lot, regardless
of what the hype and propaganda around the Revolution really said. And
not only did A&R get that wrong - they deliberately removed the portion of the quote where he made the point.
I have always taken one of the central theses of Piketty's book to be that institutions are central in shaping wealth and income distributions. He says that over and over again. All of the explanations for the empirical changes in the distribution over time are either (1.) institutions, or (2.) shocks (which, given the nature of these shocks, inevitably also have institutional origin). Apparently it's not just Acemoglu and Robinson that missed this memo. I have since had conversations with people who suggest that discussion of institutional determinants of inequality is minimal and that Piketty is just "covering his butt" when he mentions it. But as far as I can tell that's the whole point - the analysis is grounded in inequality.
Piketty without institutions in the capital share of income section could probably survive. Piketty without institutions in the inequality section of the book simply wouldn't exist any more. I mean, you'd have the data I guess, but the analysis is entirely institutional until you get to the last third of the book where he brings some of the subsumed Solow model (all that r > g stuff) back in to talk about with institutions
"Cover your butt" for these people seems to mean "have as your main emphasis for several hundred pages". This is like saying Milton Friedman wasn't all that concerned with money!
Tuesday, August 26, 2014
Thursday, August 21, 2014
Am I the only one to find the Acemoglu and Robinson review of Piketty strange?
I have taken one of the central tenets of Piketty to be that institutions are central to the determination of wealth and income inequality. The "laws of capitalism" act on capital ratios and even the capital share of income, but given an institutional environment that determines r (in conjunction, of course, with technology itself). And certainly institutions determine wealth and income distributions more broadly.
That's like the one thing that he says over and over and over again: institutions, institutions, institutions.
But Acemoglu and Robinson have a review out that seems like it has a lot of interesting stuff on the focus on the top shares, etc., but that centrally claims that Piketty doesn't think institutions matter.
This seems really strange to me.
That's like the one thing that he says over and over and over again: institutions, institutions, institutions.
But Acemoglu and Robinson have a review out that seems like it has a lot of interesting stuff on the focus on the top shares, etc., but that centrally claims that Piketty doesn't think institutions matter.
This seems really strange to me.
Reswitching and the Minimum Wage: An Austrian doing Sraffian Economics that is not Bob Murphy
Don Boudreaux walks through an interesting exercise where the minimum wage leads to switching between two production techniques as a possible reason for increased employment as a result of the minimum wage. The logic from Don is as follows:
It's also interesting, though, because reswitching situations like this are typically highlighted by left-heterodox economists and Sraffians, most notably during the Cambridge capital controversy. For all Don complains about fairly standard models with turnover, fixed hiring costs, and monopsony power as explanations of the minimum wage, this invocation of reswitching is a much bigger departure from received neoclassical economics.
So what do we make of it? In practice I doubt it's a major contributor to the lack of a disemployment effect in the best empirical analyses. A lot of the studies have focused on low-skill service sector work where the opportunity for this sort of reswitching seems like it would be minimal. It seems like it would be much easier as a manager to make low-skill workers more productive than it would be to change a production process, particularly because the reswitching usually involves a capital-labor substitution of some sort. Add in the fixed costs of making the switch in the first place and it just doesn't seem likely. But if there are any good examples where something like this is going on that would be really interesting and I'd love to hear about it. The result is so anomalous I think it's likely that lots of things are going on to drive the result and this might be part of the puzzle.
"Suppose that the two lowest-cost options for Acme Co. to produce Q amount of output X are as follows (and reckoned on an hourly cost basis):First, I want to give kudos to Don for spelling this out when many people (myself included) were confused by a previous post where he said that increased supply from a minimum wage might increase overall employment. Actually that still confuses me and it's not at all what he has here (here it's a demand shock, not a supply shock that's occurring). This provides a sensible (likelihood is another question I'll get to in a moment) explanation of a result that empirical analyses seem to point to - and a result that is not one that is particularly amenable to Don's own views on the minimum wage as policy.
1) 10 hours of low-skilled labor combined with 50 dollars of capital expenses;
2) 11 hours of skilled labor combined with 30 dollars of capital expenses.
If the prevailing hourly wage for low-skilled workers is $7.25, then Acme Co.’s hourly production costs will be $122.50 if it goes with option 1. ($72.50 for ten hours of low-skilled labor plus $50 of capital expenses.) If the prevailing hourly wage for skilled workers is $8.41 or higher, then Acme will use option 1; it will produce X using low-skilled rather than skilled labor. (If Acme employs 11 skilled workers at $8.41 per hour, and uses with these workers $30 of capital every hour, Acme’s hourly production costs are $122.51 – higher than the total costs of hiring ten low-skilled workers at $7.25 per hour along with $50 worth of capital each hour.)
Now let the minimum wage be raised to (say) $8.41 per hour. If Acme continues to produce Q amount of X each hour by employing ten low-skilled workers, along with $50 worth of capital, Acme’s hourly production costs would rise from $122.50 to $134.10. (Ten low-skilled workers at $8.41 per hour = $84.10; adding $50 of hourly capital expenses sums to $134.10 per hour.) But by instead employing 11 skilled workers at $8.41 per hour, along with $30 worth of capital, Acme’s hourly production costs will rise only by one cent, to $122.51."
It's also interesting, though, because reswitching situations like this are typically highlighted by left-heterodox economists and Sraffians, most notably during the Cambridge capital controversy. For all Don complains about fairly standard models with turnover, fixed hiring costs, and monopsony power as explanations of the minimum wage, this invocation of reswitching is a much bigger departure from received neoclassical economics.
So what do we make of it? In practice I doubt it's a major contributor to the lack of a disemployment effect in the best empirical analyses. A lot of the studies have focused on low-skill service sector work where the opportunity for this sort of reswitching seems like it would be minimal. It seems like it would be much easier as a manager to make low-skill workers more productive than it would be to change a production process, particularly because the reswitching usually involves a capital-labor substitution of some sort. Add in the fixed costs of making the switch in the first place and it just doesn't seem likely. But if there are any good examples where something like this is going on that would be really interesting and I'd love to hear about it. The result is so anomalous I think it's likely that lots of things are going on to drive the result and this might be part of the puzzle.
My review of Peter Boettke's book "Living Economics"
Is here.
Some outtakes:
And:
Some outtakes:
"Peter Boettke’s Living Economics gets off to an inauspicious start. Although the book’s principal plea is for people to “live” economics passionately, it begins with a rhetorical assault on one of the greatest and most passionate practitioners of economics in the history of the science, John Maynard Keynes. To the average economist or economics student, Boettke seems to be sending mixed signals from the outset. Are we supposed to be “living economics” or policing ourselves for any traces of Keynesianism—or “mainstream economics”, or “market failure”, etc.?"
And:
"Credulous readers of Boettke are likely to walk away with the impression that a “Smithian Keynesian” is an oxymoron. Such credulous readers will find themselves woefully unprepared for real world interactions with economists outside the George Mason University orbit. Rather than engage those who see things differently as scientists, Boettke unfortunately chooses to brands their views as “dogma” (p. 304) or a “disease on the body politic” (p. 12). This is not just my interpretation. A more sympathetic David Gordon, in his review of the book, describes Boettke as waging “a battle” against “false doctrine”, a doctrine that is promoted in a “quest” for a “false god”.
It’s little wonder that Boettke occasionally feels that his perspective on economics is marginalized! Who would want to talk economics with someone that’s going to call them a dogmatist or wage a battle against them, and then present said battle to students as good economics?"
Krugman's other forays into public choice
David Henderson rightly praises a recent post by Paul Krugman on the motivations to go to war, and notes the use of public choice logic in the post. Really it's just good old fashioned political economy. "Public choice" is more a name for a particular group of political economists and the literature they produce, but the approach of explaining the incentives of "the sovereign" is long-standing. I agree with David it was a great piece on war, but I have a different favorite Krugman foray into public choice - one that I think is in woeful need of elaboration by other economists: his discussion of public choice explanations of austerity.
Public choice dealings with fiscal policy I think have had a lot more success as micro explanations - explaining why certain spending decisions get made or not - than as macro explanations of the broader fiscal stance. My favorite illustration of this is Democracy in Deficit, published by Buchanan and Wagner in 1977 to explain oh how awful Keynes was for fiscal responsibility. Publication of the book came after several decades of declining federal debt as a share of GDP, right before debt as a share of GDP would reach its lowest point in the post-war period in 1981 (and right after a very-close-to-lowest-point in 1974). After the late 1970s when Keynes was tossed as a guide for fiscal policy, monetary policy ruled the macro-stabilization roost, and tax and spending decisions were made on a non-Keynesian basis of course the debt began to climb rapidly. I'm not claiming the debt burden will never climb under Keynesian principles. It ought to sometimes! But the entire public choice framework for thinking about fiscal policy from a macro perspective was completely out of sync with what was going on in the real world, outside their office windows.
Enter Paul Krugman.
A year ago (almost exactly a year ago, as it happens), Paul Krugman was blogging about an issue that has bugged me for a while now - what is a good economic explanation for why politicians are embracing austerity? Why has federal spending flat-lined in the midst of a depression? Why have we been flirting with and actually imposing shut-downs. Why the sequestration? And why have comparable policies been put in place in Europe? It is perhaps the most important public choice/political economy problems of our time but we aren't making nearly as much progress on the answer as we are on more standard macro questions (like how monetary and fiscal policy work in a liquidity trap). Krugman decided to reach back to Kalecki (1943) for insights, following Mike Konczal's lead (as well as Naomi Klein, but I think Kalecki is the more fertile route for academics). A sampling:
I think this explanation has potential merit in particular cases. A simpler, general explanation is of course that voters have an antipathy to deficits and often analogize governments to households and perhaps the political system is responding to those demands accordingly. It's a little unsatisfying for an economist because the argument is based on preferences and ignorance, but "unsatisfying for economists" is not always the same thing as "wrong". In that case, the answer is perhaps stronger economics education.
I am not sure we have a great answer yet - it needs more work (perhaps Econlib can spearhead something, David?). But I do believe that getting a grip on the political economy of austerity is one of the more important questions that economists are going to have to grapple with. I can muse but my day to day work is in empirical labor stuff and I am getting less scope to be creative lately (hopefully once a few obligations have passed that might change a little). What we need is someone with expertise in public choice and political economy to tackle it. Any takers?
Public choice dealings with fiscal policy I think have had a lot more success as micro explanations - explaining why certain spending decisions get made or not - than as macro explanations of the broader fiscal stance. My favorite illustration of this is Democracy in Deficit, published by Buchanan and Wagner in 1977 to explain oh how awful Keynes was for fiscal responsibility. Publication of the book came after several decades of declining federal debt as a share of GDP, right before debt as a share of GDP would reach its lowest point in the post-war period in 1981 (and right after a very-close-to-lowest-point in 1974). After the late 1970s when Keynes was tossed as a guide for fiscal policy, monetary policy ruled the macro-stabilization roost, and tax and spending decisions were made on a non-Keynesian basis of course the debt began to climb rapidly. I'm not claiming the debt burden will never climb under Keynesian principles. It ought to sometimes! But the entire public choice framework for thinking about fiscal policy from a macro perspective was completely out of sync with what was going on in the real world, outside their office windows.
Enter Paul Krugman.
A year ago (almost exactly a year ago, as it happens), Paul Krugman was blogging about an issue that has bugged me for a while now - what is a good economic explanation for why politicians are embracing austerity? Why has federal spending flat-lined in the midst of a depression? Why have we been flirting with and actually imposing shut-downs. Why the sequestration? And why have comparable policies been put in place in Europe? It is perhaps the most important public choice/political economy problems of our time but we aren't making nearly as much progress on the answer as we are on more standard macro questions (like how monetary and fiscal policy work in a liquidity trap). Krugman decided to reach back to Kalecki (1943) for insights, following Mike Konczal's lead (as well as Naomi Klein, but I think Kalecki is the more fertile route for academics). A sampling:
"Noah Smith recently offered an interesting take on the real reasons austerity garners so much support from elites, no matter hw badly it fails in practice. Elites, he argues, see economic distress as an opportunity to push through “reforms” — which basically means changes they want, which may or may not actually serve the interest of promoting economic growth — and oppose any policies that might mitigate crisis without the need for these changes... And the lineage goes back even further. Two and a half years ago Mike Konczal reminded us of a classic 1943 (!) essay by Michal Kalecki, who suggested that business interests hate Keynesian economics because they fear that it might work — and in so doing mean that politicians would no longer have to abase themselves before businessmen in the name of preserving confidence."
I think this explanation has potential merit in particular cases. A simpler, general explanation is of course that voters have an antipathy to deficits and often analogize governments to households and perhaps the political system is responding to those demands accordingly. It's a little unsatisfying for an economist because the argument is based on preferences and ignorance, but "unsatisfying for economists" is not always the same thing as "wrong". In that case, the answer is perhaps stronger economics education.
I am not sure we have a great answer yet - it needs more work (perhaps Econlib can spearhead something, David?). But I do believe that getting a grip on the political economy of austerity is one of the more important questions that economists are going to have to grapple with. I can muse but my day to day work is in empirical labor stuff and I am getting less scope to be creative lately (hopefully once a few obligations have passed that might change a little). What we need is someone with expertise in public choice and political economy to tackle it. Any takers?
Monday, August 4, 2014
Two more points on the Phillips Curve discussion
I know this Magness guy is really not worth the time investment, but before I leave this behind I wanted to share this great passage from Samuelson-Solow on the difficulty of pinning down microfoundations (which, as you'll recall from the last post, is the point of the paper - to discuss competing microfoundational explanations of the Phillips Curve floating around in the 50s). From page 191:
"We have concluded that it is not possible on the basis of a priori reasoning to reject either the demand-pull or cost-push hypothesis, or the variants of the latter such as demand-shift. We have also argued that the empirical identifications needed to distinguish between these hypotheses may be quite impossible from the experience of macrodata that is available to us; and that, while use of microdata might throw additional light on the problem, even here identification is fraught with difficulties and ambiguities."
They go on to talk about a hypothetical natural experiment (they don't use that term obviously) and how it could potentially sort things out.
This is, of course, the Lucas critique. It just took Lucas to really make it stick.
The second point I want to make is that when you're talking about history of thought you really need to distinguish between what contribution (say) Friedman actually made to the discussion and what contribution Friedman said he made (or even what contribution the textbook or the Nobel prize committee said he made... because you don't do intellectual history by polling practitioners). It's trivial to find Friedman saying those crazy Keynesians didn't realize the Phillips Curve isn't stable. If the question is "how did Friedman describe his own research program" that has a different answer from the question of "how did Friedman fit into the history of the Phillips Curve".
"We have concluded that it is not possible on the basis of a priori reasoning to reject either the demand-pull or cost-push hypothesis, or the variants of the latter such as demand-shift. We have also argued that the empirical identifications needed to distinguish between these hypotheses may be quite impossible from the experience of macrodata that is available to us; and that, while use of microdata might throw additional light on the problem, even here identification is fraught with difficulties and ambiguities."
They go on to talk about a hypothetical natural experiment (they don't use that term obviously) and how it could potentially sort things out.
This is, of course, the Lucas critique. It just took Lucas to really make it stick.
The second point I want to make is that when you're talking about history of thought you really need to distinguish between what contribution (say) Friedman actually made to the discussion and what contribution Friedman said he made (or even what contribution the textbook or the Nobel prize committee said he made... because you don't do intellectual history by polling practitioners). It's trivial to find Friedman saying those crazy Keynesians didn't realize the Phillips Curve isn't stable. If the question is "how did Friedman describe his own research program" that has a different answer from the question of "how did Friedman fit into the history of the Phillips Curve".
The history of economic thought is not a food fight: Phillips Curve edition
One thing I hate and tried to teach my students to avoid in the History of
Economic Thought class is the tendency to view intellectual history as a food
fight - some kind of extended battle between the good guys and the bad guys. A
great example of this is the Keynesv. Hayek rap and the whole idea
that this is a fight stretching over the centuries. Of course there are
disagreements - and certainly there was a disagreement between Keynes and Hayek
- but nothing like these epic battles which dumb down the actual scientific
discussion. This weekend I got into an argument with Phil Magness, a program
director at the Institute for Humane Studies, about
the Phillips Curve. He sees the history of the Phillips Curve very much in
these terms: a Keynesian vs. non-Keynesian fight where Keynesians
opportunistically used relationships in the data to push a policy preference.
Friedman, Phelps, and Lucas came in to save the day and destroy the Phillips
Curve, and nobody makes use of the Phillips Curve now except for
"peripheral Keynesians" (his words).
Two notes: (1.) This will be long, but I’m going to divide it into sections to help focus on the main points. So if you’re not going to bother reading it all, please at least skim the section headings. (2.) None of this is hidden knowledge or original digging on my part – in fact I think it’s fairly widely known among people that care about this stuff. A lot of this is pulled from Leeson and Young's (2008) "Mythical Expectations", Robert Gordon's (2011) "The History of the Phillips Curve: Consensus and Bifurcation", several articles by James Forder, and some from the primary sources. I'm not going to cite them formally below because this is not a formal write-up.
This is written sort of on the fly. There are a lot of subtle differences between these perspectives (prices vs. wages, direction of causality, reasons for LR/SR differences, etc.) so if some of it is a bit off don’t get too upset with me and let me know so I can adjust.
1. Expectations augmentation did not start with Friedman and Phelps.
Expectations have been important to economists for a long time. Malthus, Ricardo, and Bastiat all extensively discussed how taking expectations about the future into account often changes results in static models or models that don't include expectations. When it comes to expectations in macroeconomics, this was not new in the 1960s either.
The two really obvious cases are Keynes (1936) and Hayek (1937). Expectations play an enormous role in the General Theory in determining policy effectiveness. Keynes's interest in expectations and belief formation generally go back to his Treatise on Probability, some common interests with Frank Ramsey, etc. This is all very well known, and it was at the time. Hicks said in his review of the General Theory that 'From the standpoint of pure theory, the use of the method of expectations is perhaps the most revolutionary thing about this book' (see Forder, "The Historical Place of the Friedman-Phelps Expectations Critique"). For Keynes expectations fed primarily into entrepreneur's investment decisions and the liquidity preference function. They played less of a role in his analysis of consumption, at least in the General Theory (he seems to get at some of these ideas as they relate to consumption in How to Pay for the War, but I have yet to look closely at that). In any case, as far as the science is concerned this would come in later with Modigliani and Friedman, etc.. Hayek initially did not make expectations as central as Keynes as far as I can tell, but he made up for that in his 1937 paper "Economics and Knowledge" which laid a lot of the groundwork for how to think about defining a dynamic equilibrium in terms of expectations.
Much of this was not formalized until later - a point I'll come back to. In the early formalizations of all of these ideas in the 1930s and before of course you start out simple, perhaps not formalizing the more complicated ideas, and then build up. But that is very different from saying that nobody understood or thought about the role of expectations.
This is getting far afield of the Phillips Curve (of course there was no Phillips Curve per se at this point). However, even at the very beginning of work on the Phillips Curve people understood the importance of expectations and appreciated each other’s insights. Most notably, Leeson and Young (2008) report that Friedman actually got the equation for adaptive expectations from Phillips in 1952. He was fascinated by Phillips’s work (at this point, principally the machine although the Phillips Curve grew out of that) but understood that the implicit assumption of the model was an expectation of stability. Friedman asked Phillips how he would model expectations that were potentially unstable, and he produced the adaptive expectations equation that Cagan would make so famous in his analysis of hyperinflation (which, if you think about it, is just Friedman/Phelps with half a Phillips Curve!). The Cagan analysis would of course be adapted by the rational expectations revolution as well. So Friedman certainly was not under the impression that the early thinking on the Phillips Curve was done in ignorance of expectation augmentation. Interestingly enough, Friedman twice offered Phillips a job at the University of Chicago (which he twice turned down).
So even in these early years expectations were an important part of economics, the germ of later developments came from Phillips himself, and there was no sense that the scientific questions these men were probing were “peripheral”. What about Samuelson and Solow?
2. The difference between Friedman/Phelps and Samuelson/Solow was a difference of (a.) formalism, and (b.) the natural rate hypothesis. It was not a disagreement about whether the Phillips Curve existed or whether it was stable. Everyone agreed that it did exist and it was not necessarily stable.
I really don’t need to overcomplicate this: If you think Samuelson and Solow (1960) said that the Phillips Curve offers a stable menu of trade-offs between inflation and unemployment there is an extraordinarily high probability that you simply have not read Samuelson and Solow (1960). Not reading them is OK in my opinion. I am not one of those people that think every single person should take history of economic thought. But by the same token if you’re going to make a claim about the article you should probably... I dunno… read the article?
Samuelson and Solow (1960) are actually principally concerned not with a menu of policy options (though that comes up) so much as with the fight going on at the time between cost-push, demand-pull and other lesser varieties of explanations of inflation. But they do come back to how to think about the Phillips Curve on page 193 where they (very famously) write:
What don’t Samuelson and Solow offer us? Well they don’t have a clear vertical long run Phillips Curve (i.e., they don’t have a natural rate). They have shifting curves in mind, which actually is what the data do end up looking like. If you read the rest of the article you’ll know that they also don’t have a model or any formal presentation of expectations. Part of the reason for this, of course, is that the whole point of their article is that the jury is still out on the theoretical underpinning of the Phillips Curve. We get both of these things from Phelps and Friedman, who set the ball rolling for modern macroeconomics: rational expectations, the Lucas critique, New Classical macro, New Keynesian macro, and what is sometimes called the “New Consensus” model.
The nature of adjustment depends of course on how expectations are formed, but the result of a NAIRU pops out as long as you assume that (1.) in the long run expectations have to conform to reality and (2.) full employment is determined by technical/exogenous factors. Phelps offers a more formalized picture than Friedman does and therefore has a more direct impact on later New Classical and New Keynesian Phillips Curves.
Some people, when discussing Samuelson and Solow on the stability of the Phillips Curve, like to point out that they thought that the curve shifted somewhat in the 1940s and 1950s or that differences in labor market institutions (principally unions) can explain some of the differences between the UK and the US. That’s all well and good but I think the passage above is what really drives the point home.
3. The contributions of Lucas were (a.) the introduction of much stronger assumptions about expectations and (b.) broader insights about the importance of using structural models.
Lucas comes at all this from a completely different angle because he’s interested in making a point about how we do modeling in macroeconomics. In the seminal Lucas island model, agents are assumed to be unaware of how much of the short run variation in their prices are due to general price level changes and how much is due to changes in the relative demand for their product. If they knew, they would not change their behavior in response to general price level changes but because they don’t know there is production (and therefore labor demand) response to price level changes: a Phillips Curve. The agents know the underlying probability distribution of all these components of the price and they have rational expectations, so in the long-run they can’t be fooled. There is, therefore, a slight difference in emphasis (though I wouldn’t say a fundamental difference) between Friedman’s argument and Lucas’s. In the island model the Phillips Curve comes from fooling people and you can’t fool people in the long run. In Friedman the Phillips Curve comes from more standard demand arguments and you can’t escape real factors in the long run. That’s a little stylized, but put in these terms it’s clear how Lucas is making much stronger assumptions about how agents interact with the world around them.
I’m sure Lucas was interested in inflation and unemployment, but the island model is extremely unrealistic (and when you read the paper it’s clear he knows that). So his real point, I think, isn’t to offer a convincing model of what’s going on so much as it is to point out that you can get the same reduced form relationship from a lot of different microfoundations and if you don’t know what microfoundations are true you can make policy decisions that can come back to bite you in the long run. This was a bit under the surface in his 1972 paper on the island model but it is front and center in his 1976 paper “Econometric Policy Evaluation: A Critique”. That paper is one of the most important in economics in the twentieth century. When I taught history of economic thought it was the only selection that I made my students (undergrads) read from for our single lesson on post-war short run macroeconomics (I had another lesson on growth theory). With Lucas I think you really get the whole path of post-war short run macro, from the Phillips Curve discussion through microfoundations, rational expectations, the rise of New Classical macroeconomics, and the structure of New Keynesian macroeconomics when it emerged. All of this pivots on Lucas.
But what didn’t Lucas say? Lucas definitely didn’t say there was no Phillips Curve or that it was “peripheral” (Magness’s words). It was quite real and like basically everyone before him he said that the short run and the long run versions were not the same thing. Friedman and Phelps brought formal expectations to the table and a NAIRU, while Lucas brought broader points about microfoundations and rational expectations assumptions to the table.
4. The Phillips Curve is extremely important. Essentially everyone uses it; it is not peripheral. There are active areas of research and disagreement over the Phillips Curve.
The other, older discussion concerns “hysteresis” and whether the NAIRU is really stable. If the NAIRU is a function of past unemployment it could move around. Notice this is not just an observation that supply shocks could occur (which arguably is just a change in exogenous/technical factors and thus consistent with the original NAIRU idea). These are demand-side factors with a long-run impact on the NAIRU (albeit potentially through supply-side channels like skill degradation). This also has Post-Keynesian counterparts, and it is also of interest lately given the experience of persistent high unemployment.
None of this is “peripheral” stuff, I should add. Some of the biggest names in the field have wrestled with both of these questions, particularly the hysteresis issue.
Two notes: (1.) This will be long, but I’m going to divide it into sections to help focus on the main points. So if you’re not going to bother reading it all, please at least skim the section headings. (2.) None of this is hidden knowledge or original digging on my part – in fact I think it’s fairly widely known among people that care about this stuff. A lot of this is pulled from Leeson and Young's (2008) "Mythical Expectations", Robert Gordon's (2011) "The History of the Phillips Curve: Consensus and Bifurcation", several articles by James Forder, and some from the primary sources. I'm not going to cite them formally below because this is not a formal write-up.
This is written sort of on the fly. There are a lot of subtle differences between these perspectives (prices vs. wages, direction of causality, reasons for LR/SR differences, etc.) so if some of it is a bit off don’t get too upset with me and let me know so I can adjust.
+++++++++++++++++++++++++++++++++++++++++++++++
"No one
supposes that a good induction can be arrived at merely by counting cases. The
business of strengthening the argument chiefly consists in determining whether
the alleged association is stable, when accompanying conditions are varied"
- John Maynard Keynes, 1921
+++++++++++++++++++++++++++++++++++++++++++++++
1. Expectations augmentation did not start with Friedman and Phelps.
Expectations have been important to economists for a long time. Malthus, Ricardo, and Bastiat all extensively discussed how taking expectations about the future into account often changes results in static models or models that don't include expectations. When it comes to expectations in macroeconomics, this was not new in the 1960s either.
The two really obvious cases are Keynes (1936) and Hayek (1937). Expectations play an enormous role in the General Theory in determining policy effectiveness. Keynes's interest in expectations and belief formation generally go back to his Treatise on Probability, some common interests with Frank Ramsey, etc. This is all very well known, and it was at the time. Hicks said in his review of the General Theory that 'From the standpoint of pure theory, the use of the method of expectations is perhaps the most revolutionary thing about this book' (see Forder, "The Historical Place of the Friedman-Phelps Expectations Critique"). For Keynes expectations fed primarily into entrepreneur's investment decisions and the liquidity preference function. They played less of a role in his analysis of consumption, at least in the General Theory (he seems to get at some of these ideas as they relate to consumption in How to Pay for the War, but I have yet to look closely at that). In any case, as far as the science is concerned this would come in later with Modigliani and Friedman, etc.. Hayek initially did not make expectations as central as Keynes as far as I can tell, but he made up for that in his 1937 paper "Economics and Knowledge" which laid a lot of the groundwork for how to think about defining a dynamic equilibrium in terms of expectations.
Much of this was not formalized until later - a point I'll come back to. In the early formalizations of all of these ideas in the 1930s and before of course you start out simple, perhaps not formalizing the more complicated ideas, and then build up. But that is very different from saying that nobody understood or thought about the role of expectations.
This is getting far afield of the Phillips Curve (of course there was no Phillips Curve per se at this point). However, even at the very beginning of work on the Phillips Curve people understood the importance of expectations and appreciated each other’s insights. Most notably, Leeson and Young (2008) report that Friedman actually got the equation for adaptive expectations from Phillips in 1952. He was fascinated by Phillips’s work (at this point, principally the machine although the Phillips Curve grew out of that) but understood that the implicit assumption of the model was an expectation of stability. Friedman asked Phillips how he would model expectations that were potentially unstable, and he produced the adaptive expectations equation that Cagan would make so famous in his analysis of hyperinflation (which, if you think about it, is just Friedman/Phelps with half a Phillips Curve!). The Cagan analysis would of course be adapted by the rational expectations revolution as well. So Friedman certainly was not under the impression that the early thinking on the Phillips Curve was done in ignorance of expectation augmentation. Interestingly enough, Friedman twice offered Phillips a job at the University of Chicago (which he twice turned down).
So even in these early years expectations were an important part of economics, the germ of later developments came from Phillips himself, and there was no sense that the scientific questions these men were probing were “peripheral”. What about Samuelson and Solow?
2. The difference between Friedman/Phelps and Samuelson/Solow was a difference of (a.) formalism, and (b.) the natural rate hypothesis. It was not a disagreement about whether the Phillips Curve existed or whether it was stable. Everyone agreed that it did exist and it was not necessarily stable.
I really don’t need to overcomplicate this: If you think Samuelson and Solow (1960) said that the Phillips Curve offers a stable menu of trade-offs between inflation and unemployment there is an extraordinarily high probability that you simply have not read Samuelson and Solow (1960). Not reading them is OK in my opinion. I am not one of those people that think every single person should take history of economic thought. But by the same token if you’re going to make a claim about the article you should probably... I dunno… read the article?
Samuelson and Solow (1960) are actually principally concerned not with a menu of policy options (though that comes up) so much as with the fight going on at the time between cost-push, demand-pull and other lesser varieties of explanations of inflation. But they do come back to how to think about the Phillips Curve on page 193 where they (very famously) write:
“Aside from the usual warning that these are simply our best guesses we must give another caution. All of our discussion has been phrased in short-run terms, dealing with what might happen in the next few years. It would be wrong, though, to think that our Figure 2 menu that relates obtainable price and unemployment behavior will maintain its same shape in the longer run. What we do in a policy way during the next few years might cause it to shift in a definite way.Let’s take a tally of what is here and what isn’t here to better understand what was so important about Friedman and Phelps. First, Samuelson and Solow definitely don’t think the Phillip’s Curve offers a stable menu of policy options. They definitely recognize that it is a short-run trade-off. They also definitely recognize that policy choices impact the long run state of the Phillips Curve and they definitely recognize that expectations determine the long run state of the Phillips Curve.
Thus, it is conceivable that after they had produced a low-pressure economy, the believers in demand-pull might be disappointed in the short run; i.e., prices might continue to rise even though unemployment was considerable. Nevertheless, it might be that the low-pressure demand would so act upon wage and other expectations as to shift the curve downward in the longer run-so that over a decade, the economy might enjoy higher employment with price stability than our present-day estimate would indicate.
But also the opposite is conceivable. A low-pressure economy might build up within itself over the years larger and larger amounts of structural unemployment (the reverse of what happened from 1941 to 1953 as a result of strong war and postwar demands). The result would be an upward shift of our menu of choice, with more and more unemployment being needed just to keep prices stable.
Since we have no conclusive or suggestive evidence on these conflicting issues, we shall not attempt to give judgment on them. Instead we venture the reminder that, in the years just ahead, the level of attained growth will be highly correlated with the degree of full employment and high-capacity output.”
What don’t Samuelson and Solow offer us? Well they don’t have a clear vertical long run Phillips Curve (i.e., they don’t have a natural rate). They have shifting curves in mind, which actually is what the data do end up looking like. If you read the rest of the article you’ll know that they also don’t have a model or any formal presentation of expectations. Part of the reason for this, of course, is that the whole point of their article is that the jury is still out on the theoretical underpinning of the Phillips Curve. We get both of these things from Phelps and Friedman, who set the ball rolling for modern macroeconomics: rational expectations, the Lucas critique, New Classical macro, New Keynesian macro, and what is sometimes called the “New Consensus” model.
The nature of adjustment depends of course on how expectations are formed, but the result of a NAIRU pops out as long as you assume that (1.) in the long run expectations have to conform to reality and (2.) full employment is determined by technical/exogenous factors. Phelps offers a more formalized picture than Friedman does and therefore has a more direct impact on later New Classical and New Keynesian Phillips Curves.
Some people, when discussing Samuelson and Solow on the stability of the Phillips Curve, like to point out that they thought that the curve shifted somewhat in the 1940s and 1950s or that differences in labor market institutions (principally unions) can explain some of the differences between the UK and the US. That’s all well and good but I think the passage above is what really drives the point home.
3. The contributions of Lucas were (a.) the introduction of much stronger assumptions about expectations and (b.) broader insights about the importance of using structural models.
Lucas comes at all this from a completely different angle because he’s interested in making a point about how we do modeling in macroeconomics. In the seminal Lucas island model, agents are assumed to be unaware of how much of the short run variation in their prices are due to general price level changes and how much is due to changes in the relative demand for their product. If they knew, they would not change their behavior in response to general price level changes but because they don’t know there is production (and therefore labor demand) response to price level changes: a Phillips Curve. The agents know the underlying probability distribution of all these components of the price and they have rational expectations, so in the long-run they can’t be fooled. There is, therefore, a slight difference in emphasis (though I wouldn’t say a fundamental difference) between Friedman’s argument and Lucas’s. In the island model the Phillips Curve comes from fooling people and you can’t fool people in the long run. In Friedman the Phillips Curve comes from more standard demand arguments and you can’t escape real factors in the long run. That’s a little stylized, but put in these terms it’s clear how Lucas is making much stronger assumptions about how agents interact with the world around them.
I’m sure Lucas was interested in inflation and unemployment, but the island model is extremely unrealistic (and when you read the paper it’s clear he knows that). So his real point, I think, isn’t to offer a convincing model of what’s going on so much as it is to point out that you can get the same reduced form relationship from a lot of different microfoundations and if you don’t know what microfoundations are true you can make policy decisions that can come back to bite you in the long run. This was a bit under the surface in his 1972 paper on the island model but it is front and center in his 1976 paper “Econometric Policy Evaluation: A Critique”. That paper is one of the most important in economics in the twentieth century. When I taught history of economic thought it was the only selection that I made my students (undergrads) read from for our single lesson on post-war short run macroeconomics (I had another lesson on growth theory). With Lucas I think you really get the whole path of post-war short run macro, from the Phillips Curve discussion through microfoundations, rational expectations, the rise of New Classical macroeconomics, and the structure of New Keynesian macroeconomics when it emerged. All of this pivots on Lucas.
But what didn’t Lucas say? Lucas definitely didn’t say there was no Phillips Curve or that it was “peripheral” (Magness’s words). It was quite real and like basically everyone before him he said that the short run and the long run versions were not the same thing. Friedman and Phelps brought formal expectations to the table and a NAIRU, while Lucas brought broader points about microfoundations and rational expectations assumptions to the table.
4. The Phillips Curve is extremely important. Essentially everyone uses it; it is not peripheral. There are active areas of research and disagreement over the Phillips Curve.
As with my Samuelson-Solow discussion, I’m not going
to overcomplicate this: if you think the Phillips Curve is unimportant or
peripheral to modern economics you’re simply wrong. Donald Kohn said that “A
model in the Phillips Curve tradition remains at the core of how most academic
researchers and policymakers – including me – think about fluctuations in
inflation”. Although it’s important to remember there are a few steps to get
from one to the other, the Phillips Curve is essentially just an aggregate
supply curve, and the business cycle doesn’t really make sense without the
aggregate supply curve. However, the fact that that’s settled doesn’t mean that
there’s nothing interesting happening in the literature. I’m no expert in this
area, but I think there are at least two important discussions going on.
First, it’s not entirely clear that the long run
Phillips Curve is vertical. There’s good empirical evidence indicating that the
long run Phillips Curve might be backward bending or otherwise downward sloping
at low inflation levels. There are a variety of reasons offered for why this
might be the case that are typically related to wage bargaining and rigidity or
cognitive limitations around very low inflation levels (inflation is most
costly to estimate and account for when it is high). This literature is
generally associated with Palley in the Post-Keynesian world and Akerlof,
Dickens, and Perry in the mainstream literature. Of course it has been of great
interest lately with better anchored inflation expectations and subdued
inflation during the Great Recession. This one is potentially huge because it
does actually claim a (limited) long run trade-off.The other, older discussion concerns “hysteresis” and whether the NAIRU is really stable. If the NAIRU is a function of past unemployment it could move around. Notice this is not just an observation that supply shocks could occur (which arguably is just a change in exogenous/technical factors and thus consistent with the original NAIRU idea). These are demand-side factors with a long-run impact on the NAIRU (albeit potentially through supply-side channels like skill degradation). This also has Post-Keynesian counterparts, and it is also of interest lately given the experience of persistent high unemployment.
None of this is “peripheral” stuff, I should add. Some of the biggest names in the field have wrestled with both of these questions, particularly the hysteresis issue.