Demand, Supply And What's New After 2008

An alternative title might be my usual comment reminding Krugman’s readers of the history of “hysterisis”.

Krugman wrote a very clear, even better than usual post summarizing how his views on macroeconomics have changed since 2008. It is best to click the link, but the one sentence summary is that he wasn’t surprised by the liquidity trap, but he was surprised that the Phillips curve seems to be flat at very low inflation rates so low inflation followed by a period of high unemployment doesn’t become deflation.

I wrote a semi-snarky comment in which I suggested that the reason he was surprised is that the examples he always has in mind are the USA (of course) and Japan in the 90’s, while he doesn’t constantly think about the European unemployment problem.

The natural unemployment rate hypothesis failed spectacularly in Europe in the 1980s. Extremely high unemployment did not lead to deflation — rather it coexisted with moderate inflation for a long time, then with low inflation.

Krugman posted a graph showing how the US graph of inflation and unemployment has changed (just click the link and look). In the past, high unemployment gradually lead to lower inflation and then to lower inflation and unemployment — this is the pattern predicted by Friedman, Phelps, Tobin (and discussed already by Samuelson and Solow in 1960). But in the recent past extremely high unemployment has come with low and stable core inflation.

Things used look very different here in Italy than in the USA. Here is a graph of data from before January 2008. Extremely high unemployment was consistent with moderate and then with low inflation. The only clear shift in inflation occurred in 1996 and 1997 (which may or may not be when Italians began to think they might actually earn the wonderful reward of being allowed to adopt the Euro).