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Reality trumps theory

GB Geo-Blog

Reality trumps theory

About six weeks ago, Ed Phelps, a professor at Columbia and the winner of the 2006 Nobel Prize in Economics, wrote an op-ed piece in the New York Times. He claimed: “The steps being taken by government officials to help the economy are based on a faulty premise. The diagnosis is that the economy is “constrained” by a deficiency of aggregate demand…The officials’ prescription is to stimulate that demand, for as long as it takes, to facilitate the recovery of an otherwise undamaged economy…The prescription will fail because the diagnosis is wrong. There are no symptoms of deficient demand, like deflation”.

According to Phelps, there is no cyclical problem in the US at this time.

To understand his comments, it is important to note that he was awarded the Nobel Prize primarily for his theoretical work on the natural rate of unemployment. After all these years, it seems as if he still believes his theory.

The natural rate theory postulates that when the actual unemployment rate is below the natural rate, the rate of inflation will accelerate, eventually pushing the unemployment rate back to its natural rate but with a much higher inflation rate. When the unemployment rate is above the natural rate, the rate of inflation decelerates, eventually pushing the unemployment rate to the natural rate and a much lower inflation rate. In this world, Keynesian counter-cyclical spending and tax policies serve no purpose since they cannot permanently change the unemployment rate.

At the present time, Phelps does not see the rate of inflation rate declining in the US, so obviously (at least for him), the unemployment rate of 9.5% cannot be above the natural rate. Indeed, 9.5% may be the new natural rate of unemployment in the US.

There always were several flaws in the theory. There is no specific value for the natural rate. It is the rate where the inflation rate, whether it is 2% or 10% or more, is constant. Thus, the natural rate itself could be 10%, or 5% or any other level.

As well, the theory provided no insights into how long any adjustment process taking the unemployment rate back to the natural rate might take, and what might happen to both the rate of inflation and the unemployment rate along the way. It makes a serious difference if the adjustment process takes a very short period of time, or many years. Further, the theory could not assure that the adjustment process would be relatively stable.

Finally, the theory never anticipated, and thus never allowed a role for China. The entry of China into the global trading system and the growth of its manufacturing industries greatly altered the relationship between inflation rates and aggregate demand (with the unemployment rate serving as a proxy) in the US.

The theory had its heyday in the early 1980s when Paul Volcker pushed short-term interest rates in the US above 20% in order to bring down the inflation rate from above 10% to closer to 2%. The policy worked, but the unemployment rate did rise to almost 13%, and the US economy experienced its worst recession in the post-War period.

One did not have to be an economic theorist to know that if the Federal Reserve slammed on the brakes, the economy would come to a rapid and painful stop, and the employed would fly through the window.

In 1993, when Bill Clinton entered the White House, economists believed that the natural rate of unemployment was somewhere in the 6% to 8% range. As the unemployment rate declined, neo-Conservative economists warned that the inflation rate would soon start rising. Yet the unemployment rate dropped below 6%, then 5% and even 4%, and surprisingly, the rate of inflation continued to hover around 2%. Phelps’ model broke down. Actually, supporters of his theory just kept scaling down their estimates of the natural rate – something they could easily do since no one really knew what this rate was.

The experience during the Clinton presidency, and even during the Bush presidency, pushed the natural rate theory far into the background. The theory lost credibility.

But the neo-Conservatives and Phelps have crawled out of the woodwork, Their shrill cries are becoming louder: Fiscal policy is a failure and governments must drastically cut their budget deficits, but not through higher tax rates. The economy will not suffer. Indeed, some even claim that the euphoria and greater confidence resulting from a credible commitment to restore fiscal discipline will lead to economic growth.

Many European countries bought into this argument earlier this year. These same countries are now surprised that their economies continue to shrink and their economic prospects are even more dismal after they initiated sharp cuts in spending. No s…!

I guess it is a shame when reality makes a mockery out of theory.

The opinions expressed in this blog are personal and do not reflect the views of either Global Brief or the Glendon School of Public and International Affairs.


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