This week, the Royal Swedish Academy of Sciences announced the winner of the 2005 Nobel Prize in economic science: Edmund S. Phelps, of Columbia University. He earned the prize "for his analysis of intertemporal tradeoffs in macroeconomic policy." That's fancy language for two main contributions.
The more important of the two was Mr. Phelps's work on the tradeoff between unemployment and inflation. In the early 1960s, most economists believed that the tradeoff was stable. Government policy makers, according to this view, could pick a combination of inflation and unemployment as if they were ordering from a menu.
But in the late 1960s, Mr. Phelps challenged this view by going back to basics -- that is, by considering how individual employees and employers act. He assumed that employees would act based on their expectations of future inflation. If they expected, say, 3% inflation, they would build this into their wage bargains. But what if the Federal Reserve printed money at a rate that caused a 5% inflation rate?
Then with this higher inflation rate, wages offered would be higher than expected also. Unemployed workers looking for work would see wages that they would mistakenly think were higher in real terms and would, therefore, accept jobs at these wages sooner than otherwise. Millions of unemployed workers taking jobs just a few weeks earlier would result in a lower unemployment rate. But then workers' expectations would adapt to reality. They would realize that the wages weren't as high in real terms as they had thought, and some would quit and look for more lucrative work, thus slowly raising the unemployment rate. In other words, policy makers could temporarily reduce the unemployment rate by making inflation higher than people expected, but could not achieve a long-run reduction in unemployment with an increase in inflation. In the long-run, then, there is no tradeoff between inflation and unemployment. This striking finding is now mainstream economic wisdom.
Mr. Phelps was not the first to point this out. Nobel Laureate Milton Friedman (1976) had done so in 1967, as Mr. Phelps himself noted. And Mr. Phelps also credited Austrian economist Ludwig von Mises's book, "The Theory of Money and Credit," first published in 1911. But Mr. Phelps gets the credit because -- this is not his fault -- academic economists now insist on formal models. Nor was Mr. Phelps the last to point out the "no tradeoff" result. Nobel Laureate Robert Lucas (1995) introduced "rational expectations" rather than "adaptive expectations" and found even stronger results. Mr. Lucas's model implied that the only way policy makers could use monetary policy to affect the unemployment rate was by being unpredictable.
Mr. Phelps's other major work acknowledged by the Swedish Academy was on capital accumulation and economic growth. In the early 1960s, he derived the "Golden Rule" of capital formation. The rule is that if one's goal is to attain the maximum consumption per capita that is sustainable in the long run, annual saving as a percent of national income should equal capital's income as a percent of national income. In the late 1960s, Mr. Phelps did further work on this with Robert Pollak, now of Washington University in St. Louis. They argued that the government should force people to save more than they wish, on the grounds that people put too little weight on their children's well-being...
| • | Commentary: Laureate Phelps
The Wall Street Journal, Thursday, Oct. 12, 2006 Byline: David R. Henderson, research fellow, Hoover Institution at Stanford |
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