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Did Phelps Really Explain Stagflation?
Tags The FedFinancial MarketsMonetary Theory
This year, the Nobel Prize in Economics was awarded to American economist Edmund S. Phelps, whose book on labor was favorably reviewed by David Gordon and who has engaged the Austrian theory of the business cycle on the pages of the Wall Street Journal. While rejecting the Austrian view, Phelps has nonetheless written that "we must honor the Austrian theorists as the first to see capitalist ventures as voyages to the unknown, driven by visions of entrepreneurs and hunches of lenders and investors and fraught with unanticipated consequences."
The Nobel committee credits Phelps for clarifying the relationship between inflation and unemployment. Indeed, he did make a contribution in this respect. What he did not do is what most economists credit him for doing: identifying the true causes behind the phenomenon of stagflation.
The phenomenon of stagflation is characterized by the simultaneous occurance of a strengthening in the growth momentum of prices and a decline in real economic activity. A famous case of stagflation occurred during the 1974 — 75 period. In March 1975, industrial production fell by nearly 13% while the yearly rate of growth of the consumer price index (CPI) jumped to around 12%. Likewise a large fall in economic activity and galloping price inflation was observed during 1979. By December of that year, the yearly rate of growth of industrial production stood close to nil while the rate of growth of the CPI stood at over 13%.
The stagflation of 1970s was a big surprise to most mainstream economists who held that a fall in real economic growth and a rise in the unemployment rate should be accompanied by a fall in the rate of inflation and not an increase.
According to the then accepted view, the central bank influences the real rate of economic expansion by means of monetary policies. This influence however, carries a price, which manifests in terms of inflation. For instance, if the goal is to reach a faster rate of economic growth and a lower unemployment rate, citizens should be ready to pay a price for this in terms of a higher rate of inflation. Thus was it believed that there is a trade-off between inflation and unemployment (the Phillips curve). The lower the unemployment rate the higher is the rate of inflation. Conversely, the higher the unemployment rate the lower the rate of inflation is going to be.
The events of the 1970s therefore came as a shock for most economists. Their theories based on the supposed existing trade-off suddenly became useless. In the late 1960s Edmund Phelps and Milton Friedman (PF) challenged the popular view that there can be a sustainable trade-off between inflation and unemployment. PF had been arguing that, contrary to the popular way of thinking, there is no long-term trade-off between inflation and unemployment. In fact, over time, according to PF, loose central bank policies set the platform for lower real economic growth and a higher rate of inflation, i.e., stagflation.1,2
PF Explanation of Stagflation
Below we provide a simplified framework of the thought of Phelps and Friedman (PF) regarding the inflation-unemployment trade-off and its link to stagflation.
Starting from a situation of equality between the current and the expected rate of inflation, the central bank decides to lift the rate of economic growth by lifting the rate of growth of the money supply.
As a result, a greater supply of money enters the economy and each individual now has more money at his disposal. On account of this increase, every individual is of the view that he has become wealthier. This increases the demand for goods and services, which in turn sets in motion an increase in the production of goods and services. All this in turn lifts producers demand for workers and subsequently the unemployment rate falls to below the equilibrium rate, which both Phelps and Friedman labelled as the natural rate.3
According to PF, the increase in people's overall demand for goods and services and the ensuing increase in the production of goods and services is of a temporary nature. To begin with, once the unemployment rate falls below the equilibrium rate, this puts upward pressure on the rate of price inflation. (According to Phelps, the natural-rate theory says that when unemployment is below the natural level, the tightness in the labor market will cause prices and wages to be reset above expectations.)4
Individuals then begin to realize that there has been a general loosening in the monetary policy. In response to this realization, they start forming higher inflation expectations. Individuals realize that their previous increase in the purchasing power is actually dwindling. Consequently, the overall demand for goods and services weakens. A weakening in overall demand in turn slows down the production of goods and services while the rate of unemployment goes up — an economic slowdown emerges.
In short, the realization that there was a general loosening in monetary policy weakens the demand for goods and services. Observe that we are now back where we were prior to the central bank's decision to loosen its monetary stance, but with a much higher rate of inflation. Consequently, what we have here is a fall in the production of goods and services — a rise in the unemployment rate — and an increase in price inflation. That is to say, we have stagflation.
As long as the increase in the money supply rate of growth is unexpected, this theory implies, the central bank can engineer an increase in the rate of economic growth. However, once people learn about the increase in the money supply and assess the implications of this increase, they adjust their conduct accordingly. Subsequently, the boost to the real economy from the increase in the money supply rate of growth disappears.
In order to overcome this hurdle and strengthen the rate of economic growth the central bank would have to surprise individuals through a much higher pace of monetary pumping. However, after some time lag people will learn about this increase and adjust their conduct accordingly. Consequently, the effect of the higher rate of growth of money supply on the real economy is likely to vanish again and all that will remain is a much higher rate of inflation.
From this we can conclude that by means of loose monetary policies, the central bank can only temporarily create real economic growth. Over time however, such policies will only result in higher price inflation. In short, according to PF there is no long-term trade-off between inflation and unemployment.
Can money grow the economy?
We have seen that according to PF, loose monetary policy can only grow the economy in the short term but not in the long term. In this sense, PF have accepted mainstream ideas that for a given level of prices, an increase in money supply increases the purchasing power of money, which in turn lifts the overall demand for goods and services. (To be more precise, PF are saying that the rate of increase in the money supply must be unexpected.) The increase in overall demand in turn triggers an increase in the production of goods and services — demand creates supply. In this sense money is an agent of economic growth.
However, there are some serious difficulties with all this.
In PF's story, as a result of the increase in the money supply rate of growth, a greater supply of money enters the economy and each individual now has more money at his disposal. This is, however, not a tenable proposition. When money is injected, there must always be somebody who gets the new money first and somebody who gets the new money last. In short, money moves from one individual to another individual and from one market to another market.
The beneficiaries of this increase are the first recipients of money. With more money in their possession (assuming that demand for money stays unchanged) and for a given amount of goods available, they can now divert to themselves a bigger portion of the pool of available goods than before the increase in money supply took place. This means that fewer goods are now available to those individuals who have not received the new money as yet (i.e., the late recipients of money).
This of course means that the effective demand of the late recipients of money must fall since fewer goods are now available to them. The fact that their effective demand must fall is made manifest through the increase in prices (more money per unit of a good) and to the consequent fall in the last recipients' purchasing power. People are not identical, even if their respective money holdings have risen by the same percentage. Their response to this will not be identical. This in turn means that those individuals who spent the new money first benefit at the expense of those who spend the new money later on.5
Hence an increase in money supply cannot cause a general increase in overall effective demand for goods. Only through an increase in the production of goods can this be achieved. The more goods an individual produces the more of other goods he can secure for himself. This means that an individual's effective demand is constrained by his production of goods, all other things being equal. Demand, therefore, cannot stand by itself and be independent. It is limited by production, which serves as the mean of securing various goods and services.
According to James Mill,
When goods are carried to market what is wanted is somebody to buy. But to buy, one must have the wherewithal to pay. It is obviously therefore the collective means of payment which exist in the whole nation constitute the entire market of the nation. But wherein consist the collective means of payment of the whole nation? Do they not consist in its annual produce, in the annual revenue of the general mass of inhabitants? But if a nation's power of purchasing is exactly measured by its annual produce, as it undoubtedly is; the more you increase the annual produce, the more by that very act you extend the national market, the power of purchasing and the actual purchases of the nation…. Thus it appears that the demand of a nation is always equal to the produce of a nation. This indeed must be so; for what is the demand of a nation? The demand of a nation is exactly its power of purchasing. But what is its power of purchasing? The extent undoubtedly of its annual produce. The extent of its demand therefore and the extent of its supply are always exactly commensurate.6
We can also infer that the dependence of demand on the production of goods cannot be removed by means of loose monetary policy. On the contrary, loose monetary policy will only undermine the rate of growth of real goods and services. Here is why.
Increases in Money Supply Actually Weaken Economic Growth
In a market economy, money has just one role — to provide the services of a medium of exchange. According to Rothbard,
Consumer goods are used up by consumers; capital goods and natural resources are used up in the process of producing consumer goods. But money is not used up; its function is to act as a medium of exchanges — to enable goods and services to travel more expeditiously from one person to another.7
Money permits the product of one specialist to be exchanged for the product of another specialist. Or we can say that an exchange of something for something takes place by means of money. Things are, however, not quite the same once money is generated out of "thin air" as a result of loose central bank policies and fractional reserve banking.
Once money is created out of "thin air" and employed in the economy, it sets in motion an exchange of nothing for something. This amounts to a diversion of real wealth from wealth generators to the holders of newly created money. In the process genuine wealth generators are left with fewer resources at their disposal, which in turn weakens the wealth generators' ability to grow the economy.
So contrary to PF's theories, money cannot grow the economy even in the short run. On the contrary, an increase in money only undermines real economic growth. Notice that this conclusion is reached regardless of whether the money rate of growth is expected or unexpected.
To clarify this point let us assume that the central bank makes it known to everyone that the rate of growth of the money supply is going to increase from 5% to 10%. According to PF this shouldn't have any effect on real economic growth.
If the earlier and the later receivers of money now anticipate higher inflation in the future they may lower their present demand for money. Once they lower the demand for money and increase the amount of goods bought, only then, all other things being equal, will the prices of goods start rising in line with the expected increase in price inflation.
This however, does not alter the fact that once early receivers spend the newly printed money it results in an exchange of nothing for something and to a weakening in the process of real wealth formation. (Again, the increase in money supply is never instantly spread across the board but always starts with earlier receivers.) In short, contrary to PF, irrespective of the fact that the increase in money is anticipated it will undermine real economic growth.
What then causes stagflation?
We have seen that an increase in money supply must lead to an exchange of nothing for something. As a result, the process of real wealth formation weakens and this in turn undermines the rate of economic growth.
The increase in the money supply rate of growth coupled with the slowdown in the rate of growth of goods produced is what the increase in the rate of price inflation is all about. (Note that a price is the amount of money paid for a unit of a good.) What we have here is a faster increase in price inflation and a decline in the rate of growth in the production of goods. But this is exactly what stagflation is all about, i.e., an increase in price inflation and a fall in real economic growth.
It seems therefore that the phenomenon of stagflation is the normal outcome of loose monetary policy. This is in agreement with PF. Contrary to PF, however, we maintain that stagflation is not caused by the fact that in the short run people are fooled by the central bank. Stagflation is the natural result of monetary pumping which weakens the pace of economic growth and at the same time raises the rate of increase of the prices of goods and services.
If we were to accept that increases in the rate of economic growth are inversely associated with the unemployment rate, then the unemployment rate and the rate of inflation should be positively associated — an increase in the rate of inflation is accompanied by the increase in the unemployment rate. Yet the historical data does not always support this conclusion.
For instance, during the 1948 — 1969 period, the rate of price inflation and the unemployment rate were negatively associated. (An increase in the rate of inflation was accompanied by a fall in the unemployment rate.) An inverse correlation between the rate of inflation and the unemployment rate can also be observed from 2000 to present.
A statistical correlation or lack of it between two variables shouldn't be the only or final determining factor regarding causality. If anything, it can be of some help in the beginning of the investigation. The data and its correlation are simply the raw material, which must be scrutinized. One must figure out by means of reasoning what the statistical display might mean.
We have seen that when money is created out of "thin air" and employed in an exchange it weakens real economic growth in relation to a situation wherein no monetary expansion took place. Likewise we can confidently say that on account of the increase in money out of "thin air" in comparison with a situation where no such money was created, the rate of growth of prices must increase. The fact that the strengthening in monetary growth may not always manifest visible stagflation doesn't refute what we have concluded with respect to the consequences of a stronger rate of monetary pumping on economic growth and prices.8
Consider the following situation. On account of past increases in the rate of growth of the money supply and the subsequent softening in the rate of growth of goods produced, the rate of growth of price inflation is going up. Now, because the underlying bottom line of the economy is still strong notwithstanding the damage inflicted by a stronger money supply rate of growth, the rate of growth of the production of goods only weakens slightly. Within such a situation the unemployment rate could still continue falling. (Remember that increases in the money supply undermine the wealth formation process and weaken the rate of production of goods and services.)
What we have here is a visible increase in price inflation and a fall in the unemployment rate. Any theory which concludes from this inverse correlation that there is a trade-off between inflation and unemployment will be false since it ignores the true consequences of loose monetary policy.
We suggest that any theory that relies solely on observed statistical correlations is nothing more than an exercise in curve fitting. For PF and most mainstream economists, the criteria for accepting a theory is a visible supporting statistical correlation. It is because of the visible stagflation of 1970s that PF's theory of stagflation gained wide support. One would have thought that in order to be consistent with their way of assessing a theory given the observed inverse correlation between inflation and unemployment since 2000, PF should acknowledge that their stagflation hypothesis is not valid.9
This year's Nobel Prize in Economics was awarded to Phelps for his work on the relationship between inflation and unemployment. 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. The profession's understanding of these issues still hasn't reached the heights of Mises's own understanding, as seen in his book The Causes of the Economic Crisis.
Contrary to the accepted way of thinking, we suggest that these amendments have done nothing to further our understanding of economic conditions such as stagflation. In this regard, both Phelps and another Nobel Laureate Milton Friedman have introduced more confusion rather than clarity regarding the explanation of the phenomenon of stagflation.
- 1. William PMilton Friedman, "The Role of Monetary Policy," American Economic Review 58 (March 1968): 1–7.
- 2. Edmund S. Phelps (1969), "The New Microeconomcs in Inflation and Employment Theory," American Economic Review 59.
- 3. Milton Friedman, "Inflation and Unemployment," Nobel Memorial Lecture, December 13, 1976.
- 4. Edmund S. Phelps, "Scapegoating the Natural Rate," The Wall Street Journal online August 6,1996.
- 5. Ludwig von Mises, Human Action, 3rd revised edition, pp.416 – 417.
- 6. James Mill, "On the Overproduction and Underconsumption Fallacies." Edited by George Reisman, a publication of The Jefferson School of Philosophy, Economics, and Psychology — 2000.
- 7. Murray N. Rothbard, What Has Government Done to Our Money?
- 8. Jörg Guido Hülsmann, "Facts and Counterfacts in Economic Law." Journal of Libertarian Studies 17, no. 1 (Winter): 57–102.
- 9. Milton Friedman, Essays in Positive Economics. Chicago: University of Chicago Press 1953.