March 22, 2016

The 15th March Financial Times article that I rubbished in a blog post last week contained the comment: “the 1970s ‘Phillips Curve’ trade-off between unemployment and inflation is alive and well“. Unbeknownst to me at the time, since I never tune in to Federal Reserve press events, Fed chief Janet Yellen said almost exactly the same thing at the 17th March post-FOMC press conference. Specifically, she said: “The Phillips Curve is alive“, by which she meant the purported trade-off between general price inflation and unemployment (the idea that lower unemployment generally comes at the cost of higher inflation and lower inflation generally comes at the cost of higher unemployment) was becoming an important consideration. This statement reveals cluelessness in three different ways.

First, the Phillips Curve and the theory behind it does NOT suggest that there is a trade-off between unemployment and general price inflation. In fact, it says nothing whatsoever about the relationship between general price inflation and unemployment. The Phillips Curve is about the relationship between changes in REAL wages and changes in employment. It is basic supply-demand stuff. As explained by John Hussman back in 2011:

Phillips demonstrated a principle that is well-known to every economist: very simply, when a useful resource becomes scarce, its price tends to increase relative to the prices of other goods and services. That finding doesn’t need all sorts of intellectual contortions or modeling tricks to make it “work,” because it is one of the most basic laws of economics.

The true Phillips Curve, then, is a relationship between unemployment and real wages. When workers are scarce, wages tend to rise faster than the general price level. When workers are plentiful, wages tend to rise slower than the general price level.

Second, the empirical data clearly show that there is no consistent relationship between general price inflation and unemployment. The above-linked Hussman article includes the relevant evidence in chart form. That is, even if the misrepresentation and misuse of the Phillips Curve is put aside, no economist who has bothered to check the historical data could believe in the inflation-unemployment trade-off.

Third, any half-decent economist would realise that there is no basis under sound economic theory for there to be a trade-off between unemployment and “price inflation”. The simple reason is that economic progress, which usually leads to more opportunities for employment, results from increasing productivity and, all else being equal, would therefore tend to be associated with a falling, not a rising, general price level. That is, all else being equal there should be a positive correlation rather than a trade-off between unemployment and “price inflation”. Of course, in the real world all is not equal, first and foremost because the central bank is constantly manipulating prices. Based on the fatally flawed models to which they are committed, central banks try to curtail the decline in the general price level that would naturally stem from economic progress. In doing so they falsify the price signals upon which the market economy relies, thus creating greater inefficiency.

The nicest thing I can say about Janet Yellen is that she doesn’t appear to be as stupid and dangerous as Mario Draghi, although I’ll change my mind about that if she ends up taking the Fed down the negative-interest-rate path.

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