More followup on the state of Keynesian economics. In the Brad DeLong post I cited, he mentions as one of the key planks of New Keynesian (as opposed to old Keynesian) macroeconomics the rejection of the old-fashioned notion of a stable relationship between unemployment and inflation.

Now, you can argue that the notion of a long-term usable unemployment-inflation tradeoff was never really part of Keynesian economics, that it’s a caricature of what 60s Keynesians actually believed. Nonetheless, the stagflation of the 70s was a decisive moment in economic ideology. Stagflation seemed to confirm the Friedman-Phelps notion — based loosely on “microfoundations”, i.e., notions of rational behavior — that sustained inflation would get built into wage and price setting, so that historical correlations between unemployment and inflation would disappear. And this in turn gave a huge push to the anti-Keynesian revolution.

Put it this way: when I was in grad school, I remember lunchtime conversations that went something like this; “I just don’t buy the Lucas stuff — it’s not remotely realistic.” “But these people have been right so far, how can you be sure they aren’t right now?”

But that was then. And here’s a question: How many economists realize that the data since around 1985 — that is, since the Reagan-Volcker disinflation — actually look a lot like an old-fashioned Phillips curve?

Start with the raw data. Here’s unemployment and increases in nonsupervisory wages since 1985:

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What you see is that wage growth was low when unemployment was high, and vice versa. Now take annual averages (to avoid overlapping data) and plot the unemployment rate against the wage change over the next year:

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There are a couple of possible explanations for the return of the good old-fashioned Phillips curve: anchored inflation expectations, downward sticky nominal wages. I’ll have more thoughts on that later (actually, downward rigidity and anchored expectations I think reinforce each other). But the point is that notions of how inflation works that were formed in the era of stagflation are very much at odds with the way the world has looked, not just since the Great Recession began, but since the mid-1980s. Yet stagflation still shapes both public perceptions and policy.

This matters, a lot. The belief that the economy fluctuates around potential output, that it can’t be persistently below potential, is based ultimately on the natural rate hypothesis, which in turn took over economic thinking during the era of stagflation. This belief, in turn, underlies official estimates of potential output, which as Simon Wren-Lewis notes, causes any sustained slump to get built into official estimates of potential. Hence the official EU view that Spain is near full employment, the notion that Britain in 2007 was a hugely overheated economy with a huge structural budget deficit, and so on. If stagflation-era macro is wrong, so are all of these conclusions.

It is, in short, time to go back to the future.