Milton Friedman and the rise and fall of the Phillips Curve
The ascendancy of the Phillips Curve and later monetarism showed that economists are no better at economic management than politicians
David Ricardo’s idea of the impossibility of general gluts, John Maynard Keynes wrote, “conquered England as completely as the Holy Inquisition conquered Spain.” The triumph of the Phillips Curve in post war economics was not quite so complete but its rise, fall, and fallout, is a fascinating intellectual episode. It shows how Keynesianism died the last time and its defenestration marked one of the most stunning achievements of Milton Friedman who was born a century ago this year.
In 1958 AW Phillips, a New Zealander working at the London School of Economics, published The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957. Based on data going back nearly a century, Phillips discovered a close inverse relationship between unemployment and percentage changes in the average nominal wage rate; as one rose, the other fell.
If the percentage change in money wages was taken as a proxy for inflation (a big assumption) then the curve which emerged from this inverse relationship, which Phillips gave his name to, offered a choice to policymakers: they could trade higher unemployment for lower inflation and, vice versa, they could trade higher inflation for lower unemployment. Economic policy was reduced to a simple choice between these two options.
In 1968, at the height of the Phillips Curve’s influence, Friedman gave the Presidential lecture to the American Economic Association titled The Role of Monetary Policy. The Curve was nonsense, he said, at least in anything but the very short term.
The Phillips Curve offered lower unemployment at the price of higher inflation. But, if economic agents became aware of this, that the new nominal wealth represented no increase in real wealth, they would adjust their expectations accordingly.
So, on this graph, you have an initial Phillips Curve Pe=0% with an unemployment rate of U. You decide, in Keynesian fashion, to juice the economy to reduce this rate. Unemployment falls to V and inflation rises to 5 percent.
But, Friedman argued, when it became apparent that only nominal values had changed real values would adjust to accommodate. This meant unemployment rising again to W. Friedman said that once economic agents – workers, bosses, trade unions etc – came to factor an inflation rate of 5 percent into wage bargains only by increasing the inflation rate above this could policymakers exert any traction over unemployment. Ever higher rates of inflation would be necessary to generate even short term falls in unemployment and that short term would get shorter all the time.
So, above, they could increase inflation to 8 percent and see unemployment fall from W to X. But, as before, once real values adjusted, unemployment would rise again to Y.
The values for unemployment U, W, and Y, form, in fact, a new vertical curve representing the ‘natural’ rate of unemployment. That this rate (technically called the Non-Accelerating Inflation Rate of Unemployment – NAIRU) was called ‘Natural’ did not mean it couldn’t be changed. But it was set by microeconomic factors such as wage flexibility and labour mobility and labour market reforms became a major policy theme of the 1980s.
Friedman’s prediction, made in 1968, was that the coming years would see inflation and unemployment rise together, something the dominant Keynesian paradigm, of which the Phillips Curve was part, said was impossible. Yet this is exactly what happened. Between 1969 and 1975 inflation in the United States rose from 5.9 percent to 9.1 percent while unemployment rose from 3.8 percent to 8.5 percent.
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