Why Has the Price Level Been So Slow To Recover?

John Cochrane offers a detailed critique of some leading efforts to model the current state of the economy in New Keynesian terms. The basic question he’s looking at is what accounts for the fact that consumption, after tumbling off a cliff during the crisis, appears to have simply resumed its old trend from a lower level rather than “catching up.” He’s correct, I think, that the New Keynesian models don’t actually explain this very well—they seem to predict that we should be seeing deflation. So by Cochrane’s lights, if New Keynesian models fail, then more real business cycle-ish models more or less win by default. Thus his alternative explanation is that we should see depressed consumption as a result of a depressed outlook for “permanent income.” Essentially we had a collective realization during early 2008 that the adoption of public policies that John Cochrane doesn’t approve of have depressed the economy’s long-term growth potential, so the only way to revive the economy in the short term is to adopt public policies that John Cochrane views as conducive to long-term growth.

This is a view that I think has serious problems that can’t be fixed simply by pointing to the flaws in New Keynesian accounts. Specifically, look at the inflation rate:

The personal consumption expenditures deflator shows the exact same “notch” effect as real consumption. You fall off a cliff during the recession proper and then grow at a new trend instead of “catching up” to the old trend.

Just as many New Keynesian models have a problem with the fact that the inflation rate isn’t negative or falling, I think RBC models have a problem with the fact that the inflation rate isn’t accelerating. The world gives us, after all, lots of microeconomic examples of adverse supply shocks. In the case of chicken wings, for example, output is down, but prices are up because a combination of drought and ethanol mandates have made it harder for chicken producers to feed their chickens. If a war disrupts the supply of Persian Gulf oil, we’ll see gasoline output fall and gasoline prices rise. When quantities produced fall but prices don’t rise, we’re seeing a drop in demand.

The fact is that neither of the macroeconomic modeling approaches that are most popular in the academic literature explain the observed facts very clearly, which is why there’s increased interest in approaches—be they “market monetarist” or “post-Keynesian” or what have you—to macro policy that aren’t popular in the literature. Those schools, the “Old Keynesian” approach of John Hicks that Paul Krugman likes to use on his blog, and Robert Gordon’s “1978 Macro” (PDF) all seem to me to do a much better job of accounting for what we’re actually seeing. But none of them have been worked out in the level of detail by oodles of dissertation-writers that you see with the models that are academically popular. This post has gone on long enough already, but suffice it to say that people should read their Kuhn.