Friday, November 08, 2002

Phillips Curve, R.I.P.-In my Macro class, I’ve been going over the chapter on the Phillips curve (the basic idea that inflation goes up when unemployment goes down and visa versa) and wage theory and finding that what I learned when I first took Macro as a freshman back in 1979 (yes, it was that long ago) doesn’t hunt anymore. First, to the basic idea of the Phillips curve; it works just fine when inflation is due to an increased demand for goods (typical of the 40s-60s), or demand-pull inflation as it’s described in the textbooks-people want more goods (which drives up inflation) and more people are hired to make those goods (thus driving unemployment down). It doesn’t work as well when the inflation is due to increased factor costs (cost-push in the textbooks), such as the oil shocks of the 70s. OPEC threw the Phillips curve a wicked curve, for you got increased inflation and increased unemployment. The higher cost of doing business due to the higher oil prices will be passed on to the consumer, who will buy less of the products as a result. Fewer products being made translates to layoffs and higher unemployment. The 80s saw screwballs and knuckleballs added to the economy’s repertory, as technology and the Reagan tax cuts and investment incentives helped keep prices down while the stagflation of the 70s and early 80s subsided. We saw combinations of low inflation and low unemployment that had economists scratching their heads. Also, the addition of women to the workforce and the decreasing percentage of unionized workers helped mitigate wage inflation. The 90s continued the trend of a lack of relationship between inflation and unemployment. Two oil-price-related recessions didn’t help matters. Also, the technological adaptations of the 90s and the addition of more women, seniors and the disabled increased the workforce. Lileks has a nice Bleat today about “motorized” customer-service reps and mentally-challenged stock clerks at Target. He doesn’t even dwell upon the increasing number of seniors working in the service sector since we were kids. A lot of the thinking in the economics of the past revolved around the idea of “full employment,” that there was an unemployment rate (short of zero) that we couldn’t get past without having massive inflation. The problem with the full-employment concept is that there are a lot of people that aren’t in the workforce that can be brought into the workforce as wages increase. Stay at home moms might not stay at home if the jobs are out there. Would-be retirees might work a bit more if the pay’s right, and students might work on the side or quit school altogether if there are good paying jobs without getting the next degree. Immigration can be factored in to this mix, as bringing in tech workers has offset shortages in our high-tech sector; my next-door neighbor here in my office bay is a Computer Science professor from Armenia. Thus, the idea that we will max out the economy when we get to a given rate of unemployment isn’t as valid as it used to be. Also, automation has made switching to a more capital-intensive workplace possible; a tight labor market can lead to spending more money on machines to allow the most bang for the buck for each worker. We’ve also seen a change in how wages are set on a long-term basis. Until the 70s, unions were used to getting pay increase after pay increase. I remember the quote from early labor leader Samuel Gompers; when asked what Labor wanted, his response was “More.” That had been the bargaining orders for the first eight decades of the last century. The last quarter-century has seen the decrease in bargaining power of unions, as the value of technology has often seen the marginal value of capital far outpace the marginal value of labor. It’s been the increasing use of technology, including the lower cost of transportation making imports easier to bring in, that has diminished the value of factory labor, not some GOP plot to screw the little guy in order to help Big Business’s bottom line. One of the economic theories that gained popularity in the 70 was “adaptive expectations,” where workers myopically overreact to inflation, causing a wage-price spiral that helps create stagflation. It tended to be favored by the Keynesian crowd, but seemed to underestimate the economic intelligence of the shop rat. That might have been true of the 70s, but modern economics has changed; we’re getting closer to the shop-floor econometricians that the neoclassical “rational expectations” theory would come closer, where workers are willing to take pay cuts or increases that don’t quite match inflation if the alternative is to be laid off. So, a growing workforce, added technology, falling tax rates and more economically realistic workers have essential buried the Phillips curve.

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