Wednesday, November 4, 2015

INCREDIBLE The Phillips Curve is a Joke as a Model, But Janet Yellen Takes It Seriously



By Caroline Baum

In most circumstances, when a model breaks down and ceases to provide valuable information, it gets tossed out the window. Not so with the Phillips Curve, which still informs the way today's central bankers think about the relationship between unemployment and inflation.

The unemployment rate has fallen from a peak of 10 percent in October 2009 to 5.1 percent in September. Yet wage growth has been flat-lining at 2 percent, year over year, while inflation remains non-existent, undershooting the Federal Reserve's 2 percent target for the last 3 1/2 years.

Alas, hope springs eternal.

"Some tentative hints of a pickup in the pace of wage gains may indicate that the objective of full employment is coming closer into view," Fed chief Janet Yellen said in July.

Closer, perhaps, but still over the horizon.

Yellen is perhaps the Fed official most closely associated with the Phillips Curve, the idea that there exists a trade-off between unemployment and inflation. Some history is in order.

The Phillips Curve originated with New Zealand economist A.W. Phillips, who plotted U.K. data on unemployment and wages from 1861 to 1957 and observed a consistent inverse relationship between the two. He published his findings in 1958.

"It was an ex-post relationship observed by Bill Phillips," said Michael Bordo, an economic historian at Rutgers University. "He didn't talk much about a trade-off."

That was left to those who followed. In 1960, Canadian economist Richard Lipsey provided the theoretical justification for the Phillips Curve based on the idea that wages adjust to an excess demand for labor. In the same year, Paul Samuelson and Robert Solow looked at the U.S. data and found periods when wage and unemployment rates moved inversely, as they did in the U.K., along with some gaping inconsistencies (1933-1941), which they explained in terms of New Deal policies.

The Samuelson and Solow paper was the first to suggest a possible role for government policy in influencing the perceived trade-off, with inflation now substituting for wages. And the timing was perfect: The 1960s witnessed the rise of Keynesian economists, who were only too happy to use government policy to reduce unemployment. Pretty soon, the Phillips Curve had made its way into academia (Samuelson's textbook, Economics) and was influencing policy makers in Washington (Economic Report of the President, 1962).

In the late 1960s, Edmund Phelps and Milton Friedman challenged the notion of any long-term trade-off between unemployment and inflation. In the long run, expansionary monetary and fiscal policies could only produce lower unemployment at the expense of permanently higher inflation because workers would realize their money wages weren't keeping up with inflation. Try as they might, policy makers could not influence some unobservable natural rate of unemployment.

The stagflation of the 1970s - high unemployment and high inflation - proved Friedman and Phelps correct. The misery index, or the sum of the two variables, peaked at 21.8 percent in 1980. Both unemployment and inflation declined through most of the 1990s. The current decade has seen low unemployment, at least as measured by the official rate, accompanied by minimal inflation.

Still, the idea of a trade-off between unemployment and inflation - and the Fed's role in facilitating it - persists to this day.

"I don't recall tracking the Phillips Curve any time at an FOMC meeting," said Al Broaddus, who was president of the Richmond Fed from 1993 to 2004. But "it's in the woodwork, in the infrastructure."

It's also in the Fed's econometric model, known as FRB/US. Former Fed chief Paul Volcker didn't subscribe to the Phillips Curve, according to Bordo. Alan Greenspan was a skeptic. Ben Bernanke had his hands full with a potential collapse of the financial system. Any trade-off between unemployment and inflation was supplanted by the one between life and death.

Read the rest here.

Then be sure to read Murray Rothbard on The Phillips Curve Myth

4 comments:

  1. Last week (28 Oct), Fortune Magazine published an article titled: "No one (not even Janet Yellen) understands inflation." The article made reference the Ben Bernanke referring to the Phillips Curve as "really the only model economists have" for predicting inflation. I would suspect that the Fortune article is what led Caroline Baum to write her current piece, but I could be wrong.

    The Fortune article itself is an absolute mess. The author either believes that prices are determined by costs (or made it appear as though he does). And while he referred to the Phillips Curve as being on shaky ground (thus making him better then either Janet Yellen or the Ben Bernanke), he still didn't point out that it's been completely discredited.

    If these mainstream economists and economic journalists aren't even aware that prices determine costs (through imputation), then how could they be expected to understand more complex economic ideas?

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  2. I read Rothbard's excerpt and I'm very confused. He states that the premise of the curve, that higher wage rates lead to higher employment, is illogical. He uses an example of going to your boss and asking for triple the wage rate that you'd find yourself unemployed.

    But consider a scenario in which there is full employment, a state of equilibrium. Obviously equilibrium isn't permanent and an entrepreneur anticipates this change. How can this entrepreneur hire new workers if they already employed? Would he not be forced to increase the wage rate?

    I'm not saying the Phillips Curve is correct, I'm just suggesting that it is not theoretically impossible. I think Rothbard confuses the demand for higher wages with the actual wage rate.

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  3. Phillips Curve debunked from 1970s / 1980s stagflation. I don't know how much more you need. Obviously unemployment and inflation can rise / fall together.

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