Wednesday, June 2, 2010

Euro-Zone Defies Phillips Curve

Once upon a time, many economists ascribed to the notion that unemployment and inflation were trade-offs. 

The notion of an inverse relationship between inflation and unemployment was first put forth by William Phillips, a New Zealand born economist,  in a paper in 1958 entitled "The Relationship Between Unemployment and the Rate of Change of Money Wages in the United Kingdom 1861–1957".  Phillips describes how he observed an inverse relationship between wage changes and unemployment in the British economy over the subject period.

In 1960, Paul Samuelson and Robert Solow took Phillips' work and made explicit the link between inflation and unemployment using some statistical analysis.  When inflation was high, unemployment was low and vice-versa.

Milton Friedman concluded that there is a SHORT-term correlation between accelerating inflation and employment.  He observed that when an inflationary surprise occurs, workers are fooled into accepting lower pay because they don't see the drop in real wages right away.  Firms hire them because they see inflation as generating higher net income for a given level of wages.   Eventually, as workers discover that real wages have fallen, they push for higher pay.

Further studies of the Phillips Curve have demonstrated that any relationship is short-term at best.  In the long run, the relationship is likely direct rather than inverse.  Once inflation takes hold, the economic distortions that result are more likely to contribute to economic weakness and add to, as opposed to subtract from, unemployment.  History has shown that hyper-inflation can exist alongside high unemployment, so the theory's limitations have been accepted.

The situation today in the Euro-Zone demonstrates how fallacious this theory is.  Unemployment is now at a 12-year high of 10.1%, while inflation appears to be moving upward.  Even Germany, considered the strongest economy, has unemployment approaching 8% - a very high level in normal times.

Producer prices posted their sharpest gain for 21 months in April fueled by higher prices for energy and intermediate goods, data from the European Union's Eurostat statistics office showed this morning.

In March, factory level prices rose 0.6% on the month and 0.9% on the year.  The data showed producer prices for energy jumping 1.9% in April, while prices for intermediate goods gained 1.3%, the strongest monthly rise since January 1995.  On a year-to-year basis, intermediate goods prices gained 2.7% and energy prices jumped 7.7%, both the strongest annual increases since October 2008, Eurostat said.

Both unemployment and inflation are strongly influenced by the money supply.  In general, spurts in growth of money are typically followed by an "output effect", in which economic growth accelerates.  About a year later, the "price effect" takes over as upward pressure is put on inflation.  Initially, unemployment and economic growth get a boost which is then followed by prices increasing.  Thus, the appearance of an inverse relationship.

Of course, over time, price increases become worrisome.  With a background of a strong economy, financial authorities will act to cool inflation.  The result is the opposite.  The "output effect" is felt immediately, the economy slows and perhaps goes into a recession.  About a year later, price increases start to cool as people lose their jobs.

While the Phillips Curve itself is no longer advocated as a methodology for making economic adjustments, the Keynesian notion that government spending should be used as a policy tool remains in force.  Most of the top economic and financial advisers in the Obama Administration ascribe to Keynesian thinking which is at the heart of the notion of the Phillips Curve.

While Keynes and Phillips had plenty of data to support their ideas, neither are appropriate as a basis for making policy decisions today.  As long as these continue to get "air time", our economic and financial problems will remain most difficult to solve.

Marko's Take

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