Chris House writes,

If the 1 percent reduction in core inflation is sufficient for the Keynesian model to generate the huge recession we just went through then where was the huge recession in the late 1990s? Where was the enormous recession in 1986?

I think I made this point somewhere along the way, also.

When the Phillips Curve was trumpeted by Samuelson and Solow, the thinking was that causality ran from unemployment to (wage) inflation. In the 1970s, the idea was that causality ran from inflation to unemployment. This latter view is what is now impossible to defend. To the extent that New Keynesians accept the inflation-to-unemployment causality story (which they seemed to do), they are in trouble as I see it.

However, even for older Keynesians, who look at the causality as unemployment-to-inflation, recent experience is somewhat puzzling. I wrote this in 2010:

Looking ahead, the next 12 to 18 months should be interesting. The unemployment rate has been so far above 6 percent for so long that if the Fuhrer equation holds up, we should be seeing some pretty strong downward pressure on inflation. Instead, if inflation remains between 0 and 2 percent, this will look to me like another anomaly for the Phillips Curve.

But, you know, the beauty of 1970s undergraduate textbook macro is that you can use it to tell a story for anything. What we seem to be getting is a story that suggests a zero lower bound for inflation. You cannot cut nominal wages, so there.

Mark Thoma has more links, and his conclusion is worth quoting:

this is an empirical question that will be difficult to resolve empirically (because there are so many different ways to estimate a Phillips curve, and different specifications give different answers, e.g. which measure of prices to use, which measure of aggregate activity to use, what time period to use and how to handle structural and policy breaks during the period that is chosen, how should natural rates be extracted from the data, how to handle non-stationarities, if we measure aggregate activity with the unemployment rate, do we exclude the long-term unemployed as recent research suggests, how many lags should be included, etc., etc.?).

Also, read the follow-up. The phrase “an empirical question that will be difficult to resolve empirically” pretty much sums up macroeconomics, as far as I am concerned.

Robert Waldmann writes,

There is a blog discussion among Keynesian to New Keynesian economists on the cause of the new Classical & Rational expectations revolutions. I have been typing my usual comments. I will now try a post. The question is: how important was stagflation in causing the abandonement of old Keynesian models ? I basically agree with Simon Wren-Lewis this time.

On the other hand, Noah Smith writes,

Sure, the old paradigm could explain the 70s, but it didn’t predict it. You can always add some wrinkles after the fact to fit the last Big Thing that happened. When people saw the “Keynsian” economists (a label I’m using for the pre-Lucas aggregate-only modelers) adding what looked like epicycles, they probably did the sensible thing, and narrowed their eyes, and said “Wait sec, you guys are just tacking stuff on to cover up your mistake!” The 70s probably made aggregate-only macro seem like a degenerate research program.

Pointers from Mark Thoma.

Let me try to clear some things up. In some sense, Milton Friedman predicted stagflation in his 1967 Presidential address, but he did not use a New Classical Model. By introducing rational expectations, Lucas produced the New Classical Model.

I want to talk about two stages of “conversion” of mainstream macro. Stage one was the conversion to Milton Friedman’s Presidential Address, delivered in 1967 and published in 1968. Stage two was the conversion from Friedman’s non-rational-expectations version to the New Classical model, which had rational expectations.

Stage one:

–By the mid-1970s, mainstream macro featured a natural rate of unemployment. Before the Great Stagflation, it didn’t.

–By the mid-1970s, mainstream macro featured an equation in which the price level was determined by the money supply. Before the Great Stagflation, it didn’t.

Stage two took over graduate macro without really penetrating freshman macro. It changed from Friedman’s story, which implicitly used backward-looking expectations, to Lucas’ model, which used forward-looking expectations.

In my view, there was no empirical event that drove the stage two conversion. That is, there was nothing that took place in the 1970s that required a rational-expectations explanation. You could predict stagflation just using Friedman’s model with backward-looking expectations. So maybe I am agreeing here with Wren-Lewis rather than with Smith, or maybe I am disagreeing a tad with both.

In my view, what drove stage two was (a) the inconsistency between believing in the paradigm of rational agents and believing in backward-looking expectations and (b) the aura of mathematical superiority that was associated with rational expectations modeling. Honestly, I think that (b) had a lot to do with it.

My macro memoir blames Stan Fischer at MIT for a lot of (b).

Tim Harford writes,

There were 77 countries under consideration, and 49 of them were in recession in 2009. Economists – as reflected in the averages published in a report called Consensus Forecasts – had not called a single one of these recessions by April 2008.

… Making up for lost time and satisfying the premise of an old joke, by September of 2009, the year in which the recessions actually occurred, the consensus predicted 54 out of 49 of them – that is, five more than there were. And, as an encore, there were 15 recessions in 2012. None were foreseen in the spring of 2011 and only two were predicted by September 2011.

He cites research from Prakash Loungani and Hites Amir. Some comments:

1. This underlines the fact that macroeconomists are using equations that are not verified empirically.

2. Perhaps the “target the forecast” mantra of market monetarists would not work as robustly as they might hope.

3. According to the NBER, the U.S. was already well into a recession by April 2008 and already out of recession by September of 2009.

John Cochrane writes,

Philadelphia Fed President Charles Plosser made this nice graph, showing how reduced views of potential GDP are closing the gap, not rises in actual GDP.

Obviously, it would help to go to his post and look at the graph. But potential GDP is perhaps my least favorite economic statistic. Keep in mind that potential GDP refers to real GDP, not nominal GDP.

How to define potential GDP? I think then when you come down to it, the definition is “what GDP would be if there were no shortfall of aggregate demand.” So I think that in order to buy into potential GDP, you have to be really committed to the AS-AD paradigm.

How is potential GDP arrived at? I think that the process involves taking a graph of the history of GDP and fitting trend lines in between the peaks, perhaps with some smoothing thrown in. Since we never know what the next peak of GDP will be, we pretty much never have a good idea of potential GDP in real time, only in retrospect.

When I think in terms of PSST, there is no analogue to potential GDP. Patterns of specialization and trade are always breaking and re-forming. When patterns break, unless the break is caused by war, disaster, or government policy, it is probably the economy’s way of freeing up resources that otherwise would remain misallocated. When new patterns form, it is only a good thing if the patterns are sustainable for a decent interval of time.