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 ¹ 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.

1. neocons?[↩]