Phelps versus Friedman

Edmund Phelps is a good choice for this year’s Sviriges Riksbank Prize in Economic Sciences.

He’s best known as the joint inventor, with Milton Friedman, of the concept of the natural rate of unemployment, in the late 1960s. The NRU essentially means full employment – or labour market equilibrium at the macro level –  and it seems an obvious enough idea. What was new was their theory about the consequences of being out of equilibrium, and the implications for economic policy. The consensus for the previous decade (named for convenience Keynesian) had been that governments, by managing the level of overall spending in the economy, could keep the unemployment very low, as long as they were prepared to accept some price inflation. The lower the unemployment rate, the higher the inflation rate.

This trade-off was named the Phillips Curve, after A.W. Phillips, who had found that the data over a century seemed to indicate a stable inverse relationship. The theory behind it wasn’t developed much beyond the pretty obvious idea that once you pass some threshhold ‘level of ecoonomic activity’ (measured say by GDP) – that is, you go below some critical unemployment rate – labour shortages appear, wages rise as firms compete for scarce labour, and the higher wages are passed on to consumers as higher prices. The lower the unemployment rate below the critical level, the more inflation you get. Phelps and Friedman pointed out that offering the sought-after workers higher wages would only succeed if the said workers were confident that other firms weren’t doing likewise, and indeed in their efforts to poach labour, firms would need to offer wage rises above and beyond the economy-wide wage increases workers expected anyway. So unemployment can only stay below the natural rate if the rate of inflation itself is constantly rising. And such a situation is obviously not sustainable – ultimately it must lead to hyperinflation.

I don’t think it’s an exaggeration to say that the NRU turned out to be the key idea in post-war macroeconomics. Just about every mainstream macroeconomist accepts it in some form or another. This is not say that disagreements between Keynesians and anti-Keynesians dissolved. Rather, the battle lines were redrawn around the question of how high the NRU is and what determines it. Anti-Keynesians tended to argue that the measured rate is generally around the natural rate, and that it’s a point of gravitation from above as well as below. If unemployment happens to be high, it’s either due to voluntary choices that we shouldn’t wory too much about, or because of institutional distortions like trade unions, minimum wages, or excessive unemployment benefits. Keynesians acknowledged the latter, but also identified various kinds of market failure that could prevent the price mechanism from doing its job and clearing labour markets. This lack of faith in the market was reflected in a Keynesian preference for the term NAIRU (non-accelerating inflation rate of unemployment) to ‘natural rate’. Keynesians were also more prone to argue that just as inflation is self-fueling, this NAIRU can rise if long-term unemployment is allowed to fester. Notwithstanding these differences, the whole spectrum of mainstream macroeconomists accept the basic idea of a threshold rate of unemployment, and this is now more or less explicitly the target of monetary policy in most countries.

If this is a Nobel-worthy acheivement, Phelps deserves the prize at least as much as Friedman. Indeed, Phelps’ formulation of the natural rate idea, for which he in fact gave credit to William Fellner and Abba Lerner (a Keynes devotee), was more fully developed than Friedman’s; Phelps has also continued to develop the theory, advancing creative suggestions about why the NRU has fluctuated over the years, largely due to technological changes. Obviously Friedman made other contributions, but within macroeconomics the NRU was the most important of them, with his theory of consumption coming in second. His attempt to revive the quantity theory of money was if anything a backward step, sending many central banks down the blind alley of money supply targetting, where some of them are still stuck.

I don’t know to what extent Friedman’s popular writings contributed to his getting the prize thirty years earlier, but certainly Phelps hasn’t produced a work like Free to Choose. He did not have the snake charmer’s vocation, and in any case his faith was never quite that pure. This is not to say he isn’t a lion of free enterprise. He spent the early 1990s studying European unemployment, and blamed excessive regulation, and at the same time worked on ways to make private enterprise flourish in ex-communist Central Europe. Nonetheless, in the late 1990s Phelps emerged as the US’s strongest advocate of wage subsidies. The message of his 1997 book Rewarding Work is summarised here, and passionately argued in his testimony to the National Commission on Economic Growth and Tax Reform. His basic attitude to government intervention is stated in the same article where he attacks European policies that stifle enterprise, where he writes:

Of course Smith was known for his point that markets, if kept open to competition, would be good for efficiency. But the Enlightenment theorists were Philosophers [neocons?] as well as economists, and viewed markets accordingly. For them it was a moral axiom that running the economy on the principle of free enterprise would lack legitimacy if the system left people out. The Scots saw the moral imperative of extending free enterprise to the largest number possible, stamping out privilege and democratizing opportunity… This market – call it competitive capitalism – is not the free market of recent decades. Free market advocates view any intervention in the market as a step on a slippery slope to stifling state control. They want markets not just open – no breaks for vested interests. They want markets free of all subsidies, all regulations, most taxes.

He sees obstacles being thrown in the way of job subsidy programs by both the left and the right.

But the right ought to be able to see the defects of its virtues. My hope is that it will be possible to persuade the right that subsidies are one of the few things that government ought to be limnted to. The sprit of competitive capitalism is not threatened by a constructive market intervention where there is clear and present need.

He’s speaking to his own constituency here. Maybe they’ll pay attention now.

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Ken Parish
Admin
15 years ago

James

Many thanks for this excellent post. It’s very helpful to economically semi-literate readers like me, and I especially love the link back to Adam Smith, morality and society.

Fred Argy
Fred Argy
15 years ago

I agree. Great post. In Cut and Paste (The Australian 11/10/06) Edmund Phelps is quoted as saying ” well-functioning capitalism must be grounded in all its consequences, not just those called freedoms”

Rafe
15 years ago

This is an alternative view on the Phelps achievement.

Phelps could have made great contribution to the economic profession by dismissing the entire framework of the supposed trade-off between inflation and unemployment (the Phillips Curve). Unfortunately he has chosen to stick to the bankrupt framework by making some amendments to it.

Provided by an “Austrian” “Austrian” in Australia!

Gaby
Gaby
15 years ago

Nice post as usual James. Until now Phelps was just the name in a few old eco texts.

I’ll certainly read the links to his stuff on subsidies. Sounds very interesting. I’m sure it won’t be “piffle”…as I’m sure Nicholas’s work on imputation and the company tax rate isn’t either.

Bring Back EP at LP
Bring Back EP at LP
15 years ago

Rafe, central banks around the world disagree with you and given this golden age thank God.

Mr Phelps of course got a recording which self destroyed in the original Mission Impossible

Chris Lloyd
Chris Lloyd
15 years ago

James: You said “His attempt to revive the quantity theory of money was if anything a backward step, sending many central banks down the blind alley of money supply targeting…”

Ken Parish
Admin
15 years ago

I think money supply targetting involves a central bank tightening or loosening the money supply by selling or buying government securities on the market, thereby leaving

derrida derider
derrida derider
15 years ago

As critics on both left (traditional Keynesians) and right (supplysiders) pointed out, there is nothing “natural” about the natural rate of unemployment. Both, for rather different reasons, asserted that in the real world the NRU does not provide an anchor for the unemployment rate, any perturbation from which tends to be self-correcting, and hence is not a particularly useful concept as it cannot be made operational.

The change from NRU to NAIRU was an attempt to meet these criticisms (unsuccessful in the view of the Real Business Cycle theorists, who are maybe best thought of as over-mathematicised Austrians). This change was responsible for the ‘neo-Keynesian synthesis’ of mainstream macro, which has led to inflation targeting rather than money supply targeting – to the disgust of the RBC crowd.

Phelps was always much less of a hardcore macroeconomist than Friedman – he actually paid lip service early on to the importance of the microeconomics of the labour market to stability, growth and distribution.

BTW Chris it’s now pretty apparent that, whatever the Nobel committee thought at the time, it is Friedman’s permanent income stuff (and maybe his portfolio theory) that will give him whatever immortality he gets. As a practical aid to running an economy that has a sophisticated financial sector (and thus is able to easily provide good substitutes for whatever concept of money you’re trying to target) monetarism is dead, outside perhaps parts of the ECB.

Bring Back EP at LP
Bring Back EP at LP
15 years ago

damned good summary DD

James Farrell
James Farrell
15 years ago

Chris

You’re right that monetary policy has become the main arm of macro policy, but it’s not the same thing as monetary targeting. Monetary targeting means targeting the money supply, that is, using whatever instruments the central bank has at its disposable to ensure that the aggregate quantity of money in circulation stays within certain precise bounds. Monetarists proposed that the money supply be restricted to a growth rate equal to the average growth rate of real GDP, leaving no room for price inflation. Most central banks tried this approach in the mid 1970s, but a decade later most had given up. Central banks can influence the money supply, but experience proved they can’t contol it, whether they target the money base, M1, or M3. In any case, the causation between money growth and price growth can work in both directions. Central banks these days simply monitor the inflation rate itself, and many, have an explicit inflation target. Do a search of the RBA web site and you won’t find any mention of the money supply, except in the more academic research papers. They still measure the various aggregates, though.

The ‘selling or buying government securities on the market’ that Ken referes to still happens, but this is the means by which the official interest rate (the ‘overnight cash rate’) is manipulated: it’s not done with a view to its effect on the money supply itself (although generally speaking if the interest rate is raised people will reduce their deposit holdings and the money supply will fall.)

Thanks to others for their comments.

Fred Argy
Fred Argy
15 years ago

Having now read the full article by Phelps in The Wall Street Journal, I find it very stimulating but it leaves me unhappy on several fronts.

First, he limits his empirical discussion of productivity and innovation to the last decade. A much longer historical perspective would have been appropriate.

More importantly I don’t know why he focuses on the “Continent’s Big Three”

Rafe
15 years ago

Interesting to see this thread running in parallel with the thread on morality, and to see how social justice and economic justice are invoked to justify interference with markets, without regard to the way that so many interventions and welfare programs reduce the incentive for poor people to help themsleves.

steve munn
steve munn
15 years ago

Let me just finish that sentence for you, Rafe:

“…without regard to the way that so many interventions and welfare programs reduce the incentive for poor people to help themsleves…. to their neighbour’s DVD Player, stereo and jewellery.”

America’s mean welfare system and prison population of over 2 million are not unrelated facts.

Ken Parish
Admin
15 years ago

Rafe’s assertion that commenters on this thread invoke social justice to justify interference with markets “without regard to the way that so many interventions and welfare programs reduce the incentive for poor people to help themsleves” is incorrect. Fred Argy is one of the main contributors to this thread, and one of his major themes on government intervention strategies pays very strong regard to self-help and similar incentives in welfare programs. Here’s a typical extract from one of Fred’s posts here at Troppo:

Model 4 is favoured by the Scandinavian countries and some of the smaller Europeans (such as the Netherlands and Austria). It involves high taxes and redistribution on an even larger scale than group 3 – but the income support provided, while generous, is more work-conditional and employment protection laws are less strict than group 3 – although stricter than in groups 1 and 2 (or Australia). Instead this model relies heavily on ‘active’ social programs to enhance the productivity and mobility of low income people throughout their life cycle. For example, in addition to spending much more on education, governments in Denmark, Norway, Sweden and the Netherlands invest about four times more (relative to GDP) on active labour market programs