“The case for aggressive monetary and, when necessary, fiscal policies to sustain demand is much stronger than we used to think. Errors like the turn to austerity and the ECB’s 2011 rate hike were much bigger mistakes than the previous doctrine allowed for; premature Fed rate hikes would be a bigger sin than even the Fed seems to realize now. For given what we now seem to know, output lost to weak demand is lost forever; there is no chance to make up for it later.” (Paul Krugman, New York Times, May 7, 2018)

Economic austerity policies, which supporters argue can restore stability to an unbalanced economy, often generate real damages long after the austerity program has ended.

Moreover, the linkage between higher unemployment and lower inflation (the so-called Phillips curve relationship) which the austerity approach assumes simply cannot be relied on to work as it may have in the past.

 In the case of the Phillips curve relationship, this writer believes that the main difference resides in the importance of inflationary expectations which effect the actual course of wage and price inflation.

As Krugman points out in a recent NYT article, in the 1980s the acceleration hypothesis (the view that there is no long run trade off between inflation and unemployment) assumed that if government policy tried to maintain the unemployment rate continuously below its natural level, it would require a course of continuous accelerating inflation to achieve that result.

In theory, the reverse also holds. If the actual unemployment rate is above the natural level, in theory, inflation should be decelerating.

While this mechanism seemed to work in explaining the cyclical performance of the U.S. economy in the first-half of the 1980s, the Phillips curve argument and the accelerationist argument hasn’t worked as well following the financial meltdown of 2008-09.

As the following chart illustrates, there was a huge increase in unemployment in the first half of the 1980s, and the unemployment rate eventually came back to its earlier starting level.

Inflation at the end of the 1980s cycle was a lot lower than at the beginning, seeming to confirm the accelerationist hypothesis.

In the recent experience, however, unemployment also fell dramatically but the inflation rate could not fall far enough.

According to Krugman “after 2008 we once again had a huge rise in unemployment, which eventually came back down to roughly its starting point (actually lower at this point). If this cycle had produced an 80s-level disinflation, we’d be well into deflation by now. Instead, inflation is also pretty much back where we started.”

In the wake of the less than reliable Philips curve assumption, the significant shock to the real economy from the 2008-09 financial crisis left the recovery economy weaker than it should have been.

All of this implies, as Krugman correctly observes, that the case for erring on the side of economic stimulus policies, is much stronger than conventional economic wisdom has long held. 

In other words, beware of austerity programs and their unintended consequences.

U.S. Unemployment And Core Inflation Since 1980

(Click on image to enlarge)