Tag: stagflation

Is There an Inflation-Unemployment Trade-off?

Much of what drives the policy choices of Ben Bernanke and the Federal Reserve is a belief in the ability to trade higher inflation for lower unemployment, known within the economics profession as the “Phillips curve.”   But does this trade-off actually exist? 

While its true that many have found a negative correlation between inflation and unemployment prior to 1960, looking at U.S. data, this relationship appears to have broken down in the mid-1960s, just about the time policy-makers thought they could exploit it (Lucas critique anyone?).

It is hard, looking at the graph, which displays the annual change in consumer prices over the previous year and unemployment, to see much of a relationship.  In fact, since 1960, the correlation between changes in CPI and unemployment has been positive.  We have generally seen rising unemployment along with rising inflation.  Of course, one might be concerned that the stagflation of the 1970s is driving this result. But looking at the data since 1980, there still remains a positive correlation between inflation and unemployment.  While I am not arguing that inflation causes unemployment (after all, correlation is not causation), it should be clear from the data that there is not some exploitable trade-off that policymakers get to choose.

The Richmond Fed also has a great history of the Phillips curve that is well worth the read.  Perhaps Fed President Jeff Lacker should bring copies to the next FOMC meeting.

Hayek after 35 Years

Today I reread F. A. Hayek’s Nobel Lecture, “The Pretence of Knowledge.” Hayek was awarded the Nobel Memorial Prize in 1974 and delivered his lecture on December 11, 1974. I was amazed at how modern it was, and appropriate once again for the times.

The 1970s were terrible times: stop-go demand management policies had produced stagflation that would continue for the rest of the decade.  Hayek said that “we have indeed at the moment little cause for pride: as a profession we have made a mess of things.” He charged that the mess had been produced by policies the majority of economists “recommended and even urged governments to pursue.”

The focus of his lecture was on scientism and how its errors had led economists and the Western economies to where they found themselves at that moment.  What was the chief theoretical error? It was “the belief that we can permanently assure full employment by maintaining total money expenditure at an appropriate level.” The “Pretence of Knowledge” was that economists had or could ever have the knowledge required to do that.

What was the correct theory of the cause of widespread unemployment? It is “the existence of discrepancies between the distribution of demand among the different goods and services and the allocation of labour and other resources among the production of those outputs.” We call such discrepancies a coordination failure.

The coordination failure cannot be resolved by stimulating demand because spending is always on particular goods and services.  There is no aggregate out put on which to spend money. Aggregate demand and supply are categories of a model with no empirical counterparts.

Unless economists can solve the knowledge problem, they have no way of aligning spending with actual preferences.  Stimulus policies are more likely to aggravate as alleviate the problem.

Indeed, it was stimulus that caused the coordination failure.  Hayek outlined his theory succinctly in one paragraph.

  • Monetary injections into particular markets stimulate demand only temporarily.
  • Labor and other resources are drawn into the stimulated activities [think housing, 2002-07].
  • Once the monetary stimulus ceases or merely slows, the production and employment cannot be maintained.
  • Only if monetary stimulus or accelerated (once expectations come into play) can the new pattern of production and employment be maintained.

The consequence of monetary stimulus is “a distribution of employment which can be maintained only by a rate of inflation which would rapidly lead to a disorganization of all economic activity.”

The lecture is worth reading by those who have not done so, and rereading by those who have.

[Cross-posted at Thinkmarkets.]