AW Phillips with ‘the economy’
avid Ricardo’s idea of the impossibility of general gluts, John Maynard Keynes wrote, “conquered England as completely as the Holy Inquisition conquered Spain.” The triumph of the Phillips Curve in post war economics was not quite so complete but its rise, fall, and fallout, is a fascinating intellectual episode. It shows how Keynesianism died the last time and its defenestration marked one of the most stunning achievements of Milton Friedman who was born a century ago this year.
In 1958 AW Phillips, a New Zealander working at the London School of Economics, published The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957. Based on data going back nearly a century, Phillips discovered a close inverse relationship between unemployment and percentage changes in the average nominal wage rate; as one rose, the other fell.
If the percentage change in money wages was taken as a proxy for inflation (a big assumption) then the curve which emerged from this inverse relationship, which Phillips gave his name to, offered a choice to policymakers: they could trade higher unemployment for lower inflation and, vice versa, they could trade higher inflation for lower unemployment. Economic policy was reduced to a simple choice between these two options.
In 1968, at the height of the Phillips Curve’s influence, Friedman gave the Presidential lecture to the American Economic Association titled The Role of Monetary Policy. The Curve was nonsense, he said, at least in anything but the very short term.
The Phillips Curve offered lower unemployment at the price of higher inflation. But, if economic agents became aware of this, that the new nominal wealth represented no increase in real wealth, they would adjust their expectations accordingly.
So, on this graph, you have an initial Phillips Curve Pe=0% with an unemployment rate of U. You decide, in Keynesian fashion, to juice the economy to reduce this rate. Unemployment falls to V and inflation rises to 5 percent.
But, Friedman argued, when it became apparent that only nominal values had changed real values would adjust to accommodate. This meant unemployment rising again to W. Friedman said that once economic agents – workers, bosses, trade unions etc – came to factor an inflation rate of 5 percent into wage bargains only by increasing the inflation rate above this could policymakers exert any traction over unemployment. Ever higher rates of inflation would be necessary to generate even short term falls in unemployment and that short term would get shorter all the time.
So, above, they could increase inflation to 8 percent and see unemployment fall from W to X. But, as before, once real values adjusted, unemployment would rise again to Y.
The values for unemployment U, W, and Y, form, in fact, a new vertical curve representing the ‘natural’ rate of unemployment. That this rate (technically called the Non-Accelerating Inflation Rate of Unemployment – NAIRU) was called ‘Natural’ did not mean it couldn’t be changed. But it was set by microeconomic factors such as wage flexibility and labour mobility and labour market reforms became a major policy theme of the 1980s.
Friedman’s prediction, made in 1968, was that the coming years would see inflation and unemployment rise together, something the dominant Keynesian paradigm, of which the Phillips Curve was part, said was impossible. Yet this is exactly what happened. Between 1969 and 1975 inflation in the United States rose from 5.9 percent to 9.1 percent while unemployment rose from 3.8 percent to 8.5 percent.
Keynesians were at a loss to understand it. In 1971 Arthur Burns, Chairman of the Federal Reserve, complained that “The rules of economics are not working in quite the way they used to. Despite extensive unemployment in our country, wage rate increases have not moderated. Despite much idle industrial capacity, commodity prices continue to rise rapidly.”
By 1976 even Labour Prime Minister Jim Callaghan had recognised the truth of Friedman’s 1968 insight, saying
We used to think that you could spend your way out of a recession, and increase employment by cutting taxes and boosting Government spending. I tell you in all candour that that option no longer exists, and that in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment as the next step. Higher inflation followed by higher unemployment.
Curiously, despite the fact that trade unions are still blamed for the inflation of the 1970s, Friedman completely exonerated them. They were simply acting to restore their real wealth in the face of inflation (up to a point anyway). It was the Keynesians with their ‘cost push’ theory of inflation (that prices rise because prices rise) who pinned the blame on the trade unions.
The same applied to the other popular inflationary bogeyman, oil prices. Theoretically Friedman argued that an increase in the price of one good, if consumption was to remain constant, meant a reduction in spending on other goods and a fall in their prices. Only with an expanded money supply could a rise in the price of oil not cause offsetting price falls elsewhere.
Empirically he showed that countries like Germany and Japan, which imported more of their energy than Britain or the US but had tighter monetary policies, experienced lower inflation after the ‘oil shocks’. Inflation was, to Friedman, “always and everywhere a monetary phenomenon.”
The Phillips Curve lay dead amid the Stagflation of the 1970s just as Milton Friedman had predicted it would. Keynesian fiscal tools of demand management gave way to Supply Side policies aimed at reducing the NAIRU. Monetary tools were replaced by bastardised versions of another Friedman idea, monetarism.
An ironic post script to this story is Friedman’s own Phillips Curve moment. In his Monetary History of the United States, 1867 – 1960, he found that fluctuations in the money supply on the M2 measure were correlated with fluctuations in output. Thus he proposed his k-percent rule which proposed that expansion of the money supply should be fixed at some percentage figure corresponding to underlying productivity growth to give a stable price level.
Little of what was done in monetarism’s name followed this prescription. Even Margaret Thatcher’s supposedly monetarist government adopted a succession of varying, pre-announced targets for various money supply measures much as the Federal Reserve did under Paul Volcker. “If this is monetarism” Friedman said “I am not a monetarist”.
But even so, the statistical correlation between M2 and output upon which Friedman had based his theory collapsed as had the statistical correlation between unemployment and changes in money wage rates which Phillips had observed. A British monetarist, Charles Goodhart, coined Goodhart’s law which stated that “Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.”
Keynes wrote in 1931 that “If economists could manage to get themselves thought of as humble, competent people on a level with dentists, that would be splendid.”
By contrast, writing in 1988 Friedrich von Hayek reflected that “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.” But then Hayek had the benefit of 50 years experience of ‘economic management’. This 50 years covered the ascendancy of the Phillips Curve and then monetarism and it showed that economists are no better at economic management than politicians.
This article originally appeared at The Commentator