The rapid economic recovery has brought back interest in old ideas. To paraphrase a famous quote by Max Planck, funerals move science forward. The Nobel Prize-winning physicist claimed that new ideas in his field would take root only after the supporters of old ideas left. So the economy is driven forward by crises.
The Great Depression became fertile ground for the germination of John Keynes' theories, the Great Inflation of the 1970s spread Milton Friedman's monetarist ideas, the global financial crisis of 2007-2009 stimulated interest in loans and banking, The Economist recalls.
The recovery from the COVID-19 pandemic has allowed economists to once again learn from their mistakes. Reports at a recent conference of the American Economic Association (AEA) suggest theories that may eventually become generally accepted for the next generation.
One of them examines the Phillips curve, which describes the relationship between unemployment and inflation. According to the theory, with low unemployment, inflation increases because competition for workers puts upward pressure on wages. In turn, consumer prices are also rising. However, in the 2010s, this curve seems to have disappeared. Unemployment continued to decline, but inflation remained at the same level. Then, after the pandemic, this connection seemed to suddenly reappear: inflation was skyrocketing while unemployment was falling.
At the AEA conference, Gauti Eggertsson from Brown University suggested that adding a kink to the previously smooth Phillips curve could save this concept. The idea is that at a certain point - when the last available worker is employed - the relationship between inflation and unemployment suddenly becomes non-linear.
Eggertsson's kink can explain both the lack of inflation in the 2010s and its sudden resurgence in 2021. To understand why inflation has subsided recently without an increase in unemployment, he suggests studying how a limited labor market is associated with supply disruptions. The shortage of materials and components exacerbates the shortage of labor. Without additional labor, companies will not be able to increase production or use workers as a substitute for other resources. When the supply shortage decreased, this process went into reverse. Thus, the inflationary effect of a tight labor market has decreased, without leading to an increase in unemployment.
Part of the confusion around the Phillips curve, as suggested by an article presented by Stephanie Schmitt-Grohe of Columbia University, arose from the fact that the Great Inflation was too deeply embedded in the minds of economists. Friedman's work emphasized the role of inflationary expectations in that period. Workers and businesses have lost faith in the willingness of central banks to deal with rising prices. Then there was a vicious circle in which rising inflation fueled expectations of future price increases, which were self-fulfilling.
However, according to Schmitt-Grohe, the experience of the 1970s was far from typical. Analyzing the past, she points to frequent cases of a sudden increase in inflation in the United States, and then an equally sudden drop in it. One such episode occurred during the Spanish flu pandemic that began in 1918. That year, annual inflation soared to 17%. But by 1921, the situation had turned into deflation, and prices had fallen by 11%. If we take into account the data of the entire 20th century, and not just its second half, then the attenuation of the last burst of inflation will be much less surprising. Schmitt-Grohe suggests that the shocks the economy is currently facing, such as climate change, conflict, and the pandemic, mean a return to the greater volatility of previous eras.
Meanwhile, other experts are trying to improve economic models in general. Traditionally, manufacturing was considered to be in one sector (hiring workers, renting capital, and manufacturing), which is subject to supply and demand shocks. Ivan Werning of the Massachusetts Institute of Technology suggests instead looking at a number of different sectors, each of which has suffered from shocks in its own way. Thus, the task of monetary policy is to control inflation without hindering the necessary redistribution of labor between sectors.
The Werning model is well suited for a post-pandemic economy. It is adapting not only to the shift in demand from services to goods, but also to supply chain disruption, energy shocks and the fact that employees in some sectors work from home. Inflation spread through the economy in waves, starting with individual goods. According to Werning, this does not mean that monetary and budgetary incentives did not contribute to price growth. Rather, the restructuring of the economy acted as a supply shock, raising inflation at any given level of aggregate demand.
New ideas in old books
Many of these ideas are not entirely new. Eggertsson, for example, noted that the experience of the last few years has forced him to return to the "old Keynesian theory", and that his version of the Phillips curve is similar to the original. Werning refers to a speech by James Tobin, a Keynesian economist, delivered in 1972. Like Werning, Tobin suggested that inflationary pressures could result from the growth and contraction of sectors at different rates. Combining them with the nonlinear Phillips curve, Tobin believes, it is possible to predict a rise in inflation even without an overheated labor market.
Searching for answers in the archives is also not new. To understand the Great Depression, Keynes turned to Thomas Malthus, a 19th-century economist. Friedman explained the causes of the Great Inflation according to the quantitative theory of money, which was first mentioned in ancient Chinese texts and popularized in Europe by Nicolaus Copernicus, an astronomer of the XVI century. Science holds one funeral at a time. However, there are resurrections in the economy.
