How Milton Friedman and Edmund Phelps changed macroeconomics

Last month marked the half-century of one of the most important academic articles written in macroeconomics in the post-war period. Economist Milton Friedman’s The Role Of Monetary Policy, published in March 1968, threw a stick of dynamite under the edifice of naive Keynesian economics. An article written the same year by economist Edmund Phelps constituted an additional surgical strike, and, taken together, the Friedman-Phelps fusillade would leave macroeconomics forever changed. Both economists would win well-deserved Nobel prizes, in part for their seminal 1968 work. Indeed, along with Robert Mundell, also a Nobel prize-winning economist, this trio comprises probably the greatest macroeconomists of the second half of the last century.

To understand their contribution, we need to turn the clock back to 1958. That was the year that a New Zealand-born statistician, A.W. Phillips, published a data-based paper showing a negative correlation between inflation in money wages and the unemployment rate for the UK. Soon after, other economists, including the Canadian-born Richard Lipsey, reconfirmed Phillips’ findings, and extended them to other countries. By this time, it was more usual to present the relationship as price inflation on the vertical axis and unemployment on the horizontal axis.

Finally, in 1960, economists Paul Samuelson and Robert Solow, themselves future Nobel laureates, named the relationship the “Phillips curve”, and, more importantly, provided a causal relationship in terms of the then prevailing Keynesian orthodoxy. To Samuelson and Solow, and a whole generation of Keynesian economists, the Phillips curve presented an apparent trade-off that policymakers could exploit: They had a menu of choices, with low inflation and high unemployment on one end and high inflation and low unemployment on the other, with all the points in between also available.

This was the high watermark of the Keynesian conceit, the West’s counterpart to Soviet-style central planning: that the economy was a machine that could be fine-tuned by a wise, omniscient, and omnipotent government. Long jettisoned was the classical, Austrian view of the economy as an organism—or, better yet, a force of nature, which could be understood and adapted to, but never mastered.

The full dismantling of the dirigiste edifice was to take several decades more, into the period of deregulation and privatization in the UK, US, and elsewhere. But, meanwhile, in 1968, Friedman and Phelps debunked the notion of a stable Phillips curve that policymakers could exploit, by arguing that if they attempted to do so, the curve would shift under their feet and negate their efforts. The key to their argument was inflationary expectations, which had been altogether absent from the earlier Keynesian system.

The two economists argued further that in the long run, when nominal prices and wages were able to adjust fully, the Phillips curve would become vertical, with no exploitable trade-off: No matter the inflation rate, unemployment would invariably settle at its “natural” or long run level, a level decided by structural, supply-side factors, and not amenable to short-run aggregate demand management. In other words, a trade-off existed only to the extent that the public was fooled when forming inflation expectations, but that this would, at best, be transitory, never permanent.

The extraordinary thing about the Friedman-Phelps argument was that it was made in the face of the data available at the time, which seemed to support the idea of a trade-off, and was based on theoretical reasoning—to wit, a return to the classical theory of the neutrality of money and the “classical dichotomy” between real and nominal variables. Their boldness and courage are breathtaking to this day: defying a near-universal consensus in the academic and policy world, based on theory, not data.

As it happens, their timing was perfect, for a year after their prophesy, the Phillips curve indeed did begin to break down, and the experience of “stagflation” in the 1970s—the dreaded combination of high inflation and high unemployment—put a nail in the coffin of naive Keynesianism. More nails were driven by the “new classical” or “rational expectations” revolution of the 1980s, which found fault with the absence of microeconomic foundations for conventional macroeconomic theory.

Yet, the excessive zeal of the new classicals—who argued, for instance, that a credible disinflation programme could be costless, an idea that was thoroughly debunked during the painful disinflations of the late 1980s and early 1990s in Canada and elsewhere—opened the door to a revived Keynesianism, via the “new Keynesians”, who rose from the ashes of the earlier avatar. This, indeed, was behind the orthodoxy of inflation targeting and reigned unchallenged until the eve of the global financial crisis, and has shown remarkable resilience since then.

Even the Phillips curve has risen, Phoenix-like, from the pyre. Indeed, contemporary debates in macroeconomics focus on why the Phillips curve has apparently flattened, especially near the horizontal axis, suggesting that disinflation at already low rates of inflation is potentially extremely costly and, therefore, inadvisable.

Recall, though, none of this contemporary debate would have been possible without the googly that two foresighted economists threw at the economics profession, half a century ago.

Vivek Dehejia is a Mint columnist and resident senior fellow at the IDFC Institute, Mumbai. Read Vivek’s Mint columns at www.livemint.com/vivekdehejia

Comments are welcome at views@livemint.com