Phillips lived an incredible life. Besides traveling the world, working an amazing variety of jobs, and performing heroic feats of bravery (and coming within days of perishing before the end of World War II, when he literally dug what was to be his own grave in a Japanese prisoner of war camp), Phillips studied economics at the London School of Economics (LSE) and wowed his mentors. He secured himself an academic post at the school after graduation based largely on his invention of a plumbing contraption, the “hydraulic computer” or “Phillips machine,” that ingeniously captured the interconnection between the various macroeconomic markets.
A few years after joining the LSE faculty, he happened to observe that if we plotted the annual data for wage inflation and unemployment on a graph, the data exhibited a stable, inverse relationship: in years where inflation is high, unemployment tends to be low, and vice-versa.
As Harford recounts, Phillips wasn’t sure what to make of the statistical artifact and for that reason he was not terribly enthusiastic about publishing his discovery. His colleagues, on the other hand, urged him to get the results out, and he eventually relented.
With his paper, Phillips managed to return a raison d’etre to Keynesian economics that it had been lacking in the postwar years. Keynes’s General Theory laid out his arguments for using fiscal stimulus in a moribund economy, but it was primarily focused on addressing the Great Depression. In the busy years that followed, which he devoted to crafting a postwar financial system to help jumpstart the reconstruction of Europe and provide some semblance of global monetary stability, Keynes never got around to articulating his thoughts on the proper role of government managing the economy across a normal business cycle environment.
With Phillips’ graph, Keynes’ adherents had an organizing principle: in order to keep the economy at full employment, a central banker only needed to fiddle with the money supply to inflate away any excess labor.
The exploitation of the inflation–unemployment tradeoff soon became the central tenet of Keynesian economics. We remember the 1960s as a halcyon economic decade with low unemployment and steady economic growth that Keynesians largely attributed to the sagacity of the central bank and its exploitation of the Phillips Curve. At one point, the government journal Business Cycle Developments changed its name to Business Conditions because it appeared as if the business cycle had been defeated and steadily growing prosperity was all but inevitable.
Soon afterward, of course, the economic gods punished that hubris. By the early 1970s, the price of lower unemployment was higher and higher inflation, until we saw higher inflation occurring concomitantly with higher unemployment (which came to be called “stagflation”) during the 1973–74 recession. That directly contradicted the precepts of the Phillips Curve. Suddenly, macroeconomics (specifically Keynesian macroeconomics; the two were one and the same at the time) was in crisis and economists were looking for a way out.
Rational expectations / Harford crucially notes that Phillips never did offer a rationale for why a tradeoff between inflation and unemployment would exist. Much later, Keynesians came to posit that people had trouble distinguishing between nominal and real wages. As a result, people would see their wages go up, presume that it was a real wage increase, and agree to work more hours, or some people on the margin between working and not working would forgo school or leisure and take a job at the higher wage.
The rub is that while nominal wages are rising, the actual amount of goods and services they can obtain with an hour’s wage are falling, as wages don’t initially keep pace with inflation in this model. Workers essentially are being fooled by the government into working more than they would otherwise do if they knew what was happening.
While Keynesians spent the 1960s congratulating each other, not everyone had jumped onto the Phillips Curve bandwagon. Soon after Phillips published his original paper, an economist at Carnegie Tech named John Muth took issue with the concept, suggesting in a series of papers that the idea that the government could systematically fool people by manipulating inflation prices was nonsense. (See “Remembering the Man behind Rational Expectations,” Spring 2006.) Instead, Muth suggested that people form their expectations rationally, based on all available data, and offered some data on hog markets that belied the adaptive-price expectations framework the Keynesians had come to rely on. While people might make mistakes from time to time, on average their best guess of inflation in the next year will be the right one. Just as hog farmers cannot afford to make systematic mistakes about prices, it is costly for the rest of us to do so as well.
Muth’s paper went virtually unnoticed its first few years, until his colleague Robert Lucas began chatting with him about it in Lucas’s quest to improve the treatment of labor markets in macroeconomics. Their conversations led to Lucas publishing a paper with Leonard Rapping on rational expectations in macroeconomics just as the Phillips Curve consensus was collapsing and economists were casting about for an explanation.
Rational expectations didn’t say that people would never be fooled by price changes, only that they knew enough to know that the government had an incentive to boost inflation to induce them to work more and would accordingly be on the lookout for it to happen. Hence, for Phillips Curve policy to work, the government would have to hide the intentions of that policy—a trick that can’t work very often, at least not in the way the government would like. It’s for this reason that the Federal Reserve has long operated in an environment of near opacity; complete disclosure makes the Fed’s task more difficult.
Rational expectations won the war: Lucas (and later a key co-author of his, Thomas Sargent) won Nobel Prizes for their work, with Muth missing out mainly because of his eccentric persona and perch at a less-than-prestigious institution. A few economists tried to figure out how to reform Keynesian economics, but the bulk of the academy embraced rational expectations. Not only did Keynesian economics fail the profession, but its being predicated on some degree of irrationality was at odds with the very notion of a social science. If we can posit theories based on people making systematic mistakes, what on earth constrains the discipline? It’s a conundrum that behavioral economics has had to face as well.
By the 1980s the traditional Keynesian macroeconomic model had fallen out of favor. In most graduate programs in economics, it was discussed merely as an historical artifact, a way station on the road to a more complete and more intellectually coherent perspective on how the world works. This new perspective didn’t entirely eschew the notion that a monetary authority could use the money supply to provide a short-term jolt to the economy, but it suggested other reasons why this might work (rigid labor contracts, for example) and emphasized that this power is much more ephemeral than what the Keynesian model specified.
While the academy largely abandoned the Keynesian purview, it still has its adherents, most prominently among the politicians who treat it much the same as combat soldiers treat religion. In 2001 one of the Bush administration’s arguments for tax cuts was to provide a timely stimulus to an economy in recession—a classic Keynesian prescription. In 2003 Congress accelerated the remaining Bush tax cuts that had yet to take effect, again with a bevy of Republicans arguing that the economy needed a boost in demand to get it going.
And, of course, in 2008 the economy suffered its biggest decline since the Great Depression. The Federal Reserve responded with an unprecedented increase in the money supply. In early 2009 the Obama administration proposed its own $800 billion stimulus, which met Republican opposition motivated not by a distaste for stimulus but because this particular stimulus was neither targeted nor timely. It’s a notion I feel empathy with every time I walk by the shell of a building that used to house my favorite deli, a casualty of the stimulus funds given to pay for a remodeling of the building. The money allocated in 2009 led to the deli’s eviction in 2010, with construction beginning in earnest only in mid-2012. As of this summer, the retail space remained uninhabitable.
Collective confusion / Harford captures the intellectual angst facing macroeconomics: What is it that we are supposed to believe, precisely? Does unemployment remain high almost six years after the last recession began because stimulus wasn’t timely, or wasn’t big enough, or stopped too soon—or do we face more fundamental problems in the economy that stimulus can’t begin to solve?
The book is timely because, unlike during the Great Depression and the stagflation of the 1970s, the present uncertainty within the discipline in no way resembles an existential crisis for the discipline. It’s long been established that while economics and physics may share a common methodology, they are miles apart when it comes to their ability to explain the world, and it is unclear whether we economists have moved the ball forward all that much in recent years. The book is a series of pertinent questions about what happened during the last recession, whether stimulus worked, and what economists of all stripes think should be done, and it is written in a direct, chatty tone that doesn’t make the reader want to throw up his hands.
For hard-core economists who want more than a rehashing of the daily dispute between Paul Krugman and the Wall Street Journal editorial page, Harford delves deeply into growth economics in the latter portions of the book. Instead of worrying about stimulating aggregate demand, he examines how we can improve the productive capacity of the economy. It’s a topic that Congress has seemingly lost interest in, which is a real pity: the notion held by a growing number of the commentariat seems to be that economic growth accrues only to the wealthy and the methods by which we obtain it exploit the poor. It’s a destructive perspective that needs to be disposed of by whatever means necessary. Harford does a commendable job of doing precisely that.
These days, people actually defend policies that increase the cost of doing business (such as onerous regulations and, most egregiously, the minimum wage) as stimulating demand. When it has come to this, it is clear that the precepts of economics constrain no one in pretending economics supports whatever it is they want to say.
The irony of ironies in the current macroeconomic debate, of course, is that Keynes, the man who sagely observed that most politicians are in the thrall of some defunct economist, now happens to be that very entity. With this book, Harford has done yeoman’s work to beat those economic fallacies into submission.
