Walking with Keynes

As an alternative to the NAIRU (see these earlier posts and links and explanation), James K. Galbraith argues for an “Old Keynesian” paradigm, in which

full employment was not inherently inflationary; in fact, we saw the greater inflation risk in stagnation itself. In a slowdown, we believe, monopolistic enterprises raise prices in order to try to recover their fixed costs. While on the other hand, full employment production foments ample competition in product markets, high rates of technical change, and declining costs, as businesses seek ways to save on scarce and expensive labor. In other words, productivity growth accelerates because of full employment itself.

I see various difficulties with this point of view. For one thing, slowdowns historically have typically been associated with declining inflation rates, not rising inflation rates. There has been “stagflation,” but generally the “flation” part began before the “stag” part. I don’t doubt that stagnation can cause some firms to raise prices, and that rising interest rates can produce some inflationary feedback, but on balance, tight money (by means, specifically, of the slowdowns it induces) seems to have been a very effective way of reducing the inflation rate. If tight money weren’t the way to do it, one would have to wonder how inflation could possibly be eliminated once it appears.

There is a stronger empirical case to be made, perhaps, for the proposition that booms are not necessarily inflationary. At least there is the salient example of the late 1990s, but even in that case the inflation rate crept upward as the boom moved toward its acme. The rise in inflation rates was more dramatic (though by no means catastrophic) in the more powerful boom of the late 1960s. Generally booms have been associated with moderate but not severe inflation, except in the early (and arguably, again in the late) 1970s when OPEC took advantage of boom conditions by raising oil prices dramatically.

Robert Eisner, whom Galbraith cites as a fellow “Old Keynesian,” argued that booms are in fact not inflationary but slowdowns do have disinflationary effects. In other words, the Phillips curve – the relation between inflation (vertical) and unemployment (horizontal) – is concave, bending downward as it moves to the right. The policy implications are interesting: this view would seem to imply no disadvantage in maintaining a zero interest rate policy during normal conditions. Nonzero interest rates (which would probably end up far from zero) could be reserved for those occasions when inflation (presumably sui generis and unavoidable) needs to be throttled from the system. It’s an intriguing possibility, but one has to be a tad worried about whether the political will to tame such inflations would be forthcoming.

My reading of Keynes’ General Theory, however, suggests an interpretation that is, in some ways, just the opposite. While my Keynes would agree with Eisner’s Keynes that there is a region in which the Phillips curve is fairly flat, my Keynes would say that region is on the right, not on the left. That is, the curve is convex, bending to the right as it moves downward, instead of the other way around.

The policy implications of this view are also interesting: a stimulus policy to raise employment continues to work extremely well up to a point, but then it starts to turn more and more rapidly into an inflationary disaster. This does tend to argue for a “Don’t shoot until you see the whites of their eyes” policy toward inflation, but it also suggests that (1) you want to be cautious about approaching that point and (2) once you get there, you want to make an all-out attack. It also implies that it’s worth devoting a very large amount of resources to finding out just where that inflection point lies. The cost of being wrong in either direction is quite high in terms of either foregone employment or unnecessary inflation.


UPDATE: I should point out that the shape of the Phillips curve (concave, convex, or linear) is a separate issue from whether it has the “accelerationist” property that gives rise to the NAIRU concept. With Eisner's concave Phillips curve, there might still be a NAIRU, but the inflationary cost of going below it would be small, and it would be advantageous to keep unemployment below the NAIRU most of the time and allow a very slow rise in the inflation rate, which could then be brought down again fairly quickly when it started to reach an unacceptable range. The NAIRU idea would not have pleased “my” Keynes, but it is gospel to many contemporary proponents of the convex Phillips curve that I associate with him.

UPDATE2: Added parenthetical links at top.