The zombie economy of inflation and unemployment

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Bad business ideas can have a frustrating lifespan. Amid soaring consumer and producer prices, the apparent trade-off between inflation and unemployment has become a hot topic. There is just one problem: the compromise does not exist. Economists have known this for 40 years. Policy makers and commentators claiming otherwise should follow the program.

The illusion of a permanent and controllable compromise between a strong dollar and a strong labor market persists in various centers of elite opinion. Lisa Cook, one of President Biden’s appointees to the Federal Reserve Board of Governors, confidently asserted the importance of “the trade-off between inflation and unemployment” for monetary policy. The New York Times recently raised similar concerns that the current focus on controlling inflation could come at the expense of unemployment. In a separate Times column, Paul Krugman described a “huge rise in unemployment” as the high price of bringing our last major inflationary crisis under control some 40 years ago. Other media regularly portray “tight money” as a certain route to skyrocketing unemployment. When some of the world’s most important forums host some of the world’s most basic economic mistakes, something has gone horribly wrong.

Alan Blinder, former Vice Chairman of the Fed, recently did the public a favor when he reminded us of the stagflation of the 1970s: both high inflation and high unemployment. This gloomy prospect should have put an end forever to the mirage of a compromise. In a tight supply economy, the Fed-induced excess demand growth fueled significant price increases. Sound familiar? Unfortunately, each new generation of economists seems doomed to devote valuable time and energy to rediscovering the wheel.

Monetary policy has a large effect on total spending on goods and services, but not on the amount of productive employment. Fed officials are tasked with keeping us as close to the employment frontier as possible. If they are too stingy, as in 1929 or 2008, spending plummets and the economy must painfully recalculate towards new patterns of production and trade. If they get too enthusiastic, as in the 1970s or 2020s, spending skyrockets and households and businesses find themselves scrambling for purchasing power. Maintaining spending stability is the foundation of healthy markets, including labor markets. As long as monetary policy is predictable, full employment is compatible with many different inflation rates.

In the case of monetary policy, many of our problems have their roots in the zombie-like re-emergence of the Phillips Curve – a mid-20th century chart that claimed to show an inverse relationship between employment and inflation. . Although named after its creator, AW Phillips, Nobel Prize-winning economists Paul Samuelson and Robert Solow are the real culprits behind the myth that anti-inflationary policies jeopardize a healthy labor market. As Solow recounted, “I remember Paul Samuelson asking me when we were reviewing [Phillips’] diagrams for the first time, ‘Does this look like a reversible relationship to you?’ What he meant was ‘Do you really think the economy can come and go along such a curve?’ Solow answered in the affirmative, and the myth of a “menu” of choices for inflation and unemployment was born.

The two men made their case in an influential 1960 paper, claiming that “in order to achieve the non-perfectionist’s goal of production high enough to give us no more than 3% unemployment, the index of price may need to increase by 4-5%. per year.” By implication, intentionally allowing the price level to rise “would seem to be the necessary cost of high employment and production”.

The Phillips curve reflected the Keynesian pieties of mid-20th century macroeconomics. It offered economists monetary leverage to speed up or slow down economic growth with so-called technical precision. Just as helpfully, it plugged a giant hole in the system of John Maynard Keynes, who enlisted fiscal stimuli and the deficit spending that came with them as solutions to the economic downturn.

Within a decade, however, the Phillips curve had collapsed. Milton Friedman, Edmund Phelps and Robert Lucas, all Nobel laureates in economics, issued devastating salvos against the inflation-unemployment trade-off. The bottom line: economic productivity does not depend on the printing press. You can’t fool people with the “money illusion” by eroding wages with inflation. An accommodating monetary policy leads to a depreciation of the dollar, without any lasting gain in jobs. You cannot exploit contingent historical correlation for economic control purposes.

These setbacks did not dampen the ardor of die-hard Keynesians. Samuelson attempted to salvage his toolbox, calling it “one of the most important concepts of our time” in a 1967 lecture. By then it was clear that the Phillips curve did not hold. Samuelson attributed this to the instability of the relationship. The Phillips curve has shifted, you see. It was therefore the objective of the political decision makers to take control of the change and place it in a more “ideal” position. To achieve this, he proposed a series of loosely-crafted measures to strengthen antitrust enforcement and establish government-funded job training programs. Sen. Elizabeth Warren (D-Mass.), Federal Trade Commission Chair Lina Khan and their progressive colleagues are peddling the same snake oil today. These measures didn’t work for Samuelson in the 1960s and 1970s, and they won’t work now.

The Phillips curve was doomed from the start. It was not born out of theoretical insight or rigorous empirical testing. Rather, it was a “gap god” of the mid-century Keynesian system – an all-too-convenient discovery that seemed to justify monetary aid for financing deficits and major government programs. Unable to cope with the possibility of Phillips simply falling into a weak or fake relationship, the heirs to the Samuelson-Solow approach instead attempted to save her through increasingly fanciful stories, each crafted in response to a failure. tangible from a previous relationship. curve iteration.

The idea of ​​a workable trade-off between inflation and unemployment is dead. It’s time to bury him. This false concept paves the way for counterproductive government programs that impede the economic dynamism on which labor markets depend. If we want full employment, we must simultaneously normalize monetary policy while loosening regulatory constraints. Everything else is chasing a mirage.

Phillip Magness is the director of research and education at the American Institute for Economic Research. Alexander William Salter is Professor of Economics at Texas Tech University’s Rawls College of Business, Research Fellow at TTU’s Free Market Institute, and Principal Investigator at AIER’s Sound Money Project.

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