For whom the Nobel tolls

The 2006 Nobel Prize in Economics goes to Edmund Phelps. (Technically, this is the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, because Nobel did not actually endow a prize in economics back in 1901; the economics prize was added in 1968.) The essay accompanying the prize can be found here. Below I’ve pasted two differing econo-blog perspectives on Phelps’s legacy.

Quoth Tyler Cowen:

Today’s Nobel Prize in economics: Edmund Phelps…. He was born in Chicago in 1933 and now teaches at Columbia…. His main contribution is a better understanding of the Phillips curve and the dynamics of short-run unemployment and the concept of the natural rate of unemployment. He gave the Phillips curve microfoundations and developed the “expectations-augmented Phillips curve.” As the name suggests, the level of inflationary expectations matter for how money will influence output….

His most influential 1960s work suggested that economies possess a natural rate of unemployment, monetary policy can reduce unemployment only temporarily (NB: in his view this is a conclusion, and should not be an axiom in economic models), monetary policy can reduce unemployment temporarily, and Keynesian economics should not treat the rate of unemployment as arbitrarily at the whim of monetary and fiscal policy. He was also concerned with how the natural rate of employment can change over time…. The evolution of Phelps’s thought on how money can matter is complex. His later work stresses monetary non-neutrality, mostly through non-rational expectations and non-synchronized wage and price setting. His work in the 1980s focused on what the concept of rational expectations means in such complex environments.

Do not assume that early Phelps and late Phelps are saying the same things or arguing against the same opponents. Sometimes it is argued that he redefined macroeconomics twice. After criticizing Keynesianism, he later turned against the “rational expectations” point of view. He is a complex thinker, although it can be hard to divine his “bottom line.” He fails to fit inside the “macroeconomics boxes” that have developed since the early 1980s, namely real business cycle theory vs. neo-Keynesianism….

My take: It is hard to argue with this pick. It is a good selection. His 1960s macro work was true, important, and extremely influential. The capital theory work endures and provides a foundation for subsequent theory. The overall scope is impressive, and Phelps’s concerns never strayed far from the real world….

What this Prize means: The big questions still matter. Unemployment, economic growth, labor markets, capital accumulation, fairness, discrimination, and justice across the generations are indeed worthy of economic attention. Phelps contributed to all of those areas. Normative questions matter. Relevance and breadth triumph over narrow technical skill.

Quoth Dean Baker:

Edmund Phelps and the Natural Rate of Unemployment

The awarding of the non-Nobel prize (this prize was created by the Bank of Sweden in 1968, not Alfred Nobel) to Columbia University Professor Edmund Phelps, in part for his work on the theory of the natural rate of unemployment, provided the media with a good opportunity to talk about the current status of the natural rate theory. Unfortunately, they seem to have largely missed the opportunity.

The great innovation that Phelps, along with Milton Friedman, brought to the theory of the natural rate of unemployment is that workers would develop expectations of inflation, so that they could not be systematically fooled about the true value of the real wage. This fooling process was important for at least some strains of Keynesian economics at the time, because they held that inflation could be used to reduce unemployment by fooling workers. According to this Keynesian view, because workers fail to recognize inflation, they can effectively be tricked into working for a lower real wage. This allows us to get a lower rate of unemployment.

Phelps’ contribution was to make the reasonable point, that if workers are motivated by the real wage, then they will be smart enough to figure out the impact of inflation on the value of the real wage. Therefore, they could not be systematically fooled by inflation. The effort to fool workers would require ever higher rates of inflation, and would eventually lead to hyperinflation, if central banks tried to keep the rate of unemployment below the natural rate.

This story can run into several potential problems. First, it is not clear that workers’ decision to work or not work is very sensitive to small changes in the real wage (we’re typically talking about changes of around 1 percent or less). Keynes argued that workers were largely concerned about relative wages (within certain bounds). The advantage of moderate inflation in his view is that it allows for adjustments in real wages without workers having to accept nominal pay cuts, which would clearly lower their wages relative to other workers. If workers don’t have a rigid view of the real wage that they require, then Phelps view about inflation necessarily accelerating once the unemployment rate falls below a certain level, does not follow.

The second major flaw in the Phelps’ view is that if workers’ productivity is itself a function of their recent employment (e.g. unemployed workers pulled into the workforce by a strong economy quickly develop new skills and become more productive workers), then there would be no “natural” rate of unemployment. The lowest rate of unemployment consistent with a stable inflation rate would itself be a function of the actual unemployment rate.

The natural rate view took a real beating in the nineties. The overwhelming consensus within the economics profession was that the natural rate of unemployment was in the range of 5.8-6.4 percent. This meant that if the unemployment rate fell below this range, the inflation rate would increase. It turned out that the unemployment rate fell below this range in the summer of 1995 and stayed below this range until the recession hit in 2001. There was no increase in the inflation rate through most of this period, and only a modest increase in 2000, which was driven as much by rising energy prices as a tight labor market.

Proponents of the natural rate view, or more correctly the “non-accelerating inflation rate of unemployment” (NAIRU) view, have worked to rescue the theory with ideas about “time-varying” NAIRUs, but if it is really possible for an economic theory to be disproved by evidence, the nineties business cycle did the trick on the natural rate theory. The mainstream within the economics profession has done its best to sweep the recent history under the rug, and still claims that there is a consensus within the economics profession on macroeconomic policy.

But, they should not be allowed to get away with re-writing history. If policy had been directed by the mainstream of the profession (rather than an eclectic follower of Ayn Rand named Alan Greenspan), we never would have seen the late nineties boom. They would have raised interest rates in late 1995 and the unemployment rate never would have been allowed to get below the NAIRU, and the economy never would have been given the opportunity to disprove Mr. Phelps theory.

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