Phillips Curve Fail

In the late 1970s the impossible happened.  Inflation and unemployment simultaneously went vertical.  The leading economists of the day were flummoxed.

 

summersLarry Summers favors us with his “eternal stagnation” shrug. The man is a sheer inexhaustible fount of truly atrocious ideas. As we have previously pointed out, when he’s around, the economy can only be deemed safe under certain circumstances.

Photo credit: Reuters

 

The Phillips curve said there’s an inverse relationship between inflation and unemployment.  When unemployment goes down, inflation goes up.  Conversely, when unemployment goes up, inflation goes down.

 

Phillips_curveThese are the data economist William Phillips originally studied – wage rates vs. unemployment in the UK in the years 1913 to 1948. Phillips’ study will forever stand as a monument as to why economic theory cannot possibly be derived from empirical data. In the wake of the 1970s experience, at least seven Nobel prizes in economics were awarded for work that debunked the Phillips curve-based assumptions of the Keynesians in some shape or form. Recently its long dead cousin NAIRU has risen from the grave again, like a zombie – click to enlarge.

 

How could it be that both were going up at once?  Weren’t they mutually exclusive?  Indeed, it took years of heavy handed government intervention to pull off such a feat.

When unemployment began creeping up in the 1970’s the U.S. Treasury, with backing from the Federal Reserve, did what Keynes had told them to do.  They spent money to stimulate the economy and spur jobs creation.

According to the Phillips curve, with rising unemployment the planners could have their cake and eat it too.  They could run large deficits without inflation.

Unfortunately, something unexpected happened.  Instead of jobs they got inflation.  Then, when they tried it again, they still didn’t get jobs.  Astonishingly, they got more inflation.

 

Phillips Curve - evidence, shmevidence65 years of “adventures with the Phillips curve” – it works or it doesn’t, best flip a coin. See what we mean? Such data cannot possibly provide us with universally valid economic laws. Phillips’ work on this topic was ultimately for naught – click to enlarge.

 

Almost Predictable

This little episode illustrates the point that the economy is hardly predictable. One decade people borrow money and spend it.  The next they save and pay down debt.  No graphical curve can predict what way people’s behavior will swing from one period to the next.

Obviously, when the unemployment rate goes up the economy sinks.  But then when the unemployment rate goes down shouldn’t the economy go back up.  One would think so?

 

basketball-4-forcesIf human beings were inanimate objects, we could calculate their flight path, so to speak…but they aren’t. They have volition, act with purpose and frequently change their mind. There is nothing to calculate.

 

But the experience of the last five years of declining unemployment has not been an economic boom.  It has been economic lethargy.  Perhaps this has something to do with the fact that the unemployment rate and the labor participation rate have declined in tandem.

That may be a good theory.  It would be entirely correct…until the very instance that the economy boomed in the face of a declining labor participation rate.  Then it would be incorrect.

The fascinating thing about the economy is not that it’s predictable.  Or, for that matter, that it’s not predictable.  It’s that it is almost predictable…or at least it seems it should be. Even more fascinating are the abundance of academic quacks and hucksters that explain the economy like they’re explaining how to calculate the area of a circle.

Some even win the Nobel Prize for their ventures into nonsense.  Armed with line graphs, curves, and dot plot charts, they attempt to elucidate how the great big economic machine works.  What’s more, they espouse ways to improve it.

 

how-our-economic-machine-works-hedge-fund-billionaire-ray-dalio-explains-our-current-deleveraging-phase-32-minutes-2013-700x500Fund manager Ray Dalio once released a paper (plus a video) attempting to explain how the “economic machine” works, based on another historical data study. But this is actually a monumental error, because contrary to superficial impressions, the economy is not a “machine” – and it cannot be “explained” with empirical data. Nevertheless, economic laws do of course exist.

 

Lost in Extrapolation

One of the more tedious drivellers of popular economic thought is former Treasury Secretary Larry Summers.  He’s smarter than you and he’ll make sure you know it.  There’s hardly a questions he doesn’t know the answer to.  So, too, there’s hardly an answer he doesn’t know the question to.

Larry Summers, if you recall, is the man Janet Yellen beat out for the top job at the Fed.  Perhaps he felt slighted or underappreciated because of this.  Who knows?

But now, with regular frequency, he publicly tells Yellen how to do her job.  On Wednesday, for example, he took to the press to enlighten Yellen on what Fed interest rate policy should be…

“You should kick up interest rates, as has been true forever, when you have an inflation problem,” explained Summers to CNBC, after confirming that inflation wouldn’t go much over 1 percent for the next 10 years.  “In the face of a ‘low-flation problem,’ [there’s] no reason to raise rates.”

Obviously, Summers has it all figured out.  He even knows what the inflation rate will be 10 years from now.  For he can predict the future because he has charts that extrapolate the past and project it into the future.  Naturally, Summers proposes his solution.

“The key is you got to have demand if you want companies to invest.  Otherwise, they’re investing in capacity they don’t need.”

 

stimulusHe brings stimulus with him wherever he goes …

 

Apparently, Summers hasn’t considered what happens when artificial demand is created by people borrowing money with cheap financing stimulated by years of low interest rates.

In short, the economy becomes so larded over with debt it becomes impossible to stimulate demand by pushing more cheap credit.  That’s why, after seven years of ZIRP, the economy’s prone as a dead man.

Summers solution has failed to compel the economy back to life. No doubt, Larry could use a new chart.

 

M N. Gordon is the editor and publisher of the Economic Prism.

 

Image captions by PT

 

Charts by: Wikipedia, St. Louis Federal Reserve Research

 

 

 

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One Response to “Lost in Extrapolation”

  • VB:

    Ahem, the Phillips curve has been deduced from economic data taken during a time when the UK was on a gold standard. You don’t suppose sumthin’ has changed since?

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