Thursday, August 24, 2006

Dangerous Curve

Arthur Laffer, on the opinion page of today’s Wall Street Journal (hat tip to Dave Altig), writes:

You'd have to dig pretty far down in the duffle bag of economists to find one who actually believes in the Philips Curve-- the idea that rapid growth causes inflation.

It appears that, all these years that I’ve been studying the Phillips curve, I’ve been under a wrong impression about what the Phillips curve was. You see, naïve as I was, I thought that demand was the causal factor. I thought that excess demand caused both faster growth and rising inflation rates. I had this crazy idea that maybe, faced with excess demand, firms would both raise prices and increase production, thus increasing the inflation rate and increasing the growth of output at the same time. And I also thought that this excess demand would give firms a reason to hire more workers, even if they had to pay higher wages to do so, so the unemployment rate would fall and wages would rise. Seems like a pretty reasonable theory to me; I doubt you would have to dig very far down in the duffle bag to find an economist who believes it. But apparently, this is not what the Phillips curve is about.

No, according to Laffer, the Phillips curve is the idea that growth itself causes inflation. That is a really dumb theory. No wonder so few of us actually believe it. All this time I thought I believed in the Phillips curve, when actually what I believed was something quite different.

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18 Comments:

Anonymous Anonymous said...

Laffer's of course talking about growth in potential output, which would be disinflationary. Actually, in an RBC model, Laffer would be correct.
You're talking about demand growth, which, admittedly, is that more conventional way of interpreting the Phillips curve. But Laffers interpretation is also consistent with the Phillips curve (via supply shocks, or a widening in the output gap, via potential rising)

Thu Aug 24, 12:55:00 PM EDT  
Blogger knzn said...

Another way to put it is that Laffer is concerned with shifts in the Phillips curve, whereas I’m concerned with movements along the Phillips curve. But rhetorically, Laffer is starting from the premise that the Phillips curve is fixed by definition. And since (as everyone agrees) we often experience movements that are not consistent with a fixed Phillips curve, therefore the whole Phillips curve idea must be wrong, and only a few low-in-the-duffle-bag kooks believe it.

A more intellectually honest thing for him to say would have been that he thinks shifts in the Phillips curve are much more important than movements along, to the point where the concept loses it usefulness. But if he said that, he wouldn’t be able to sustain the claim that most economists agree with him.

Thu Aug 24, 01:17:00 PM EDT  
Anonymous Anonymous said...

The Conspiracy to Keep You Poor and Stupid also blasts Laffer here, although that post goes broader into Laffer than knzn does.

I don't buy the dollar foreign exchange theory of the post, but I disagree with most formal theories by economists and pundits on foreign exchange anyway. The reason the dollar started going up in 1980 is pretty much common sense (in hindsite anyway) and I won't delve into that. The reason it kept going up as high as it did can be explained in one word: bubble. It popped in Feb 1985 without any apparent trigger, but so what...bubbles pop, that is what they all eventually do. The decline of the dollar to a more moderate fluctuation range then became inevitable.

Thu Aug 24, 01:58:00 PM EDT  
Blogger Gabriel M said...

Excuse my undergraduate-ish question but are we talking about the original, '60s, groovey Phillips curse; or are we talking about the expectations-auggmented version that won't allow for long-run trade-offs but only for "surprises"? (And is it a relevant distinction here?)

On the other hand, inflation is most likely monetary. The weakest point in your theory is postulating the sudden appearance of excess demand... *poof*. Weird.

Excess demand in one sector means lower demand in another, higher prices in some mean lower prices in others, and it should all wash out in the aggregate. (For fixed income and purchasing power: this is why in a previous topic the issue came down on the Fed "accomodating" the expansion by reducing the purchasing power.)

So if you're saying that there's a long-run, exploitable, Phillips curve, because of excess demand + Okun's Law... yes, people who believe that are hard to find. (You won't find anyone supporting this in the RBC crowd, obviously; Mankiw, Romer and even Tobin would agree with Friedman. Who else is left?)

A more plausible scenario, at least for me, is the one in every intermediate textbook. Someone "smart" gets the idea of applying expansionary policy by loosening the monetary policy (via deficits or directly via monetary instruments), inflation ensues, excess demand appears because of it, unemployment reduces but then the "money illusion" goes away and we return to the previous steady state but with higher inflation.

By starting the story with excess demand, I think Keynesians put the cart before the horse and maybe that's why much of their dynamics end up in wage-inflation spirals which don't match the data.

Just my 2 cents/not so humble opinion.

Thu Aug 24, 02:02:00 PM EDT  
Blogger Gabriel M said...

P.S. It says "the idea that rapid growth causes inflation"... and I read "rapid growth" to mean growth faster than trend, i.e. growing gap.

So I guess he's blasting those that use a gaps-version of the Phillips curve: output gap vs. inflation gap (core inflation as trend).

Thu Aug 24, 02:09:00 PM EDT  
Anonymous Anonymous said...

Knzn,

I just want to give you props for having one of the most badass econ blogs on Web. All thinking and (mostly) no linking.

Great Stuff. Your readers appreciate it.

Thu Aug 24, 03:41:00 PM EDT  
Anonymous Anonymous said...

My understanding of the Laffer curve is that it is a poor man's version of Mirrlees' earlier work on revenue maximizing income tax rates based on elasticities of income and substitution effects. Laffer seems to have more or less assumed (without a lot of empirical evidence as best I can tell) that the revenue maximizing rate was 50%. I suspect the 50% figure had a certain cosmic elegance about it. Maybe Laffer was a closet ancient Greek. One consequence of the Laffer curve was that if tax rates were too high (i.e, > 50%) then substitution effects would dominate and the overall supply curve for the economy would shift to the left because productive entrepreneurs would withhold labor and take more leisure. That theory had some relevance back when the top marginal rate was 70%, but today it's a joke. No one, not even Laffer, believes that we are anywhere near the revenue maximizing marginal rate.

I think the general consensus is that the Phllips curve is the Fed's equivalent of a short run aggregate supply curve.

Thu Aug 24, 06:49:00 PM EDT  
Blogger knzn said...

Gabriel, I think Laffer is being deliberately vague about which Phillips curve he’s talking about. Obviously if he’s talking about a fixed, sloping, long-run Phillips curve, then indeed very few economists believe in it. But the idea that “rapid growth causes inflation” is a mischaracterization of either Phillips curve, and it could just as easily apply (equally inaccurately) to the modern, expectations-augmented version. A believer in the modern version would agree that “demand that causes growth to exceed potential will cause inflation to accelerate,” which Laffer might summarize as, “Rapid growth causes inflation.”

I don’t think the appearance of excess aggregate demand is such a mystery. Prices are sticky because of menu costs (if you like, though I’m willing to believe in money illusion, at least with respect to wages). If a lot of people decide they want to buy stuff (which might happen, for example, because of an investment bubble like the late 90s rather than because of a tricky monetary or fiscal policy), then more of the prices get un-stuck, and you get inflation. But because some prices are stickier than others, you also get more growth. That’s the New Keynesian Phillips curve.

Also, I don’t think the fact that you can’t exploit the Phillips curve in the long run implies that it’s something we don’t need to be concerned about. Granted, you can try (which Laffer and also Milton Friedman would like) a constant monetary base growth rule, and it will at least assure that you avoid hyperinflation or severe, prolonged deflation. But I think you can do a lot better if you “follow the money” through the economy and deliberately loosen or tighten when you notice (or anticipate) movements along the Phillips curve. I think there is a lot of variability, uncertainty, even chaos, in the monetary policy transmission mechanisms. The Phillips curve is one (not the only) tool that helps to get to the other side of that chaos.

Thu Aug 24, 07:52:00 PM EDT  
Anonymous Anonymous said...

"But because some prices are stickier than others, you also get more growth. That’s the New Keynesian Phillips curve."

Mankiw himself says that the NKPC doesnt fit the data. The best fit, I think, is a backward looking adaptive expectations model.

"The Phillips curve is one (not the only) tool that helps to get to the other side of that chaos."

But its a UFO, that is, an unidentified flying object. For operational reasons, Im very dubious about it, since its all over the place.

Thu Aug 24, 11:41:00 PM EDT  
Blogger Gabriel M said...

Right. I think that it's now a lot clearer as to who support what, overall.

You're saying that demand shifts in the private sector (from/to consumption to/from investment) will cause short-run fluctuations that will end up looking like a Phillips curve. That's plausible, at least at first view, but I don't understand where do price mechanism imperfections play a part?

If "inflation" = CPI then movements towards consumption and away from investment will cause inflation. So why mention sticky prices/wages?

I'm confused! I guess I need to read up on the "New Keynesian Phillips curve".

The worst thing is I think that neither your real demand fluctuation scenario nor that of monetary supply mismanagement, of Friedman, seem to be able to make sense of most of the post-WWII data, in the US, not to mention elsewhere.

Fri Aug 25, 07:06:00 AM EDT  
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Anonymous cheap electronics said...

output, which would be disinflationary. Actually, in an RBC model, Laffer would be correct.
You're talking about demand growth, which, admittedly, is that more conventional way of interpreting the Phillips curve.

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Another way to put it is that Laffer is concerned with shifts in the Phillips curve, whereas I’m concerned with movements along the Phillips curve. But rhetorically, Laffer is starting from the premise that the Phillips curve is fixed by definition. And since (as everyone agrees) we often experience movements that are not consistent with a fixed Phillips curve, therefore the whole Phillips curve idea must be wrong, and only a few low-in-the-duffle-bag kooks believe it.

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