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Monday, December 04, 2006

Stiglitz on Phelps

Joseph Stiglitz with a very nice description of Edmund Phelps' contributions to macroeconomics, and how some have misinterpreted his work to mean we are powerless to affect the unemployment rate through government policy:

The Phelps factor, by  Joseph Stiglitz, Project Syndicate: On December 10, Edmund Phelps, my colleague at Columbia University, will receive the Nobel Prize in economics for 2006. The award was long overdue. ...

Phelps' key observation in macroeconomics was that the relationship between inflation and unemployment is affected by expectations, and since expectations ... change over time - so, too, will the relationship between unemployment and inflation. If a government attempts to push the unemployment rate too low, inflation will increase, and so, too, will inflationary expectations.

This insight holds two possible policy implications. Some policymakers have concluded ... that the unemployment rate cannot be lowered permanently without ever-increasing levels of inflation. Thus, monetary authorities should simply focus on price stability by targeting the rate of unemployment at which inflation does not increase, referred to as the "non-accelerating inflation rate of unemployment" (NAIRU).

But the NAIRU is not immutable. The correct implication, which Phelps repeatedly emphasized, is that governments can implement a variety of policies, particularly structural policies, to allow the economy to operate at a lower level of unemployment.

Policies that focus exclusively on inflation are misguided for several other reasons. As a practical matter, even controlling for expectations ..., policymakers face considerable uncertainty about the level of NAIRU. Thus, they still face a trade-off between pushing unemployment too low, and setting off an episode of inflation, and not pushing hard enough, resulting in an unnecessary waste of economic resources.

How one views these risks depends on the costs of undoing mistakes... The weight of evidence indicates that the cost of undoing the mistake of pushing unemployment down too far is itself very low, at least for countries like the US... In this view, the Federal Reserve should aggressively pursue low unemployment, until it is shown that inflation is rising.

By contrast, inflation "hawks" argue that inflation must be attacked preemptively. While most central banks are inflation hawks, this stance is a matter of religion, not economic science. There is simply little or no empirical evidence that inflation, at the low to moderate rates ..., has any significant harmful real effects on output, employment, growth, or the distribution of income. Nor is there evidence that inflation, should it increase slightly, cannot be reversed at a relatively minor cost...

This matters because, as ... Arthur Okun argued, reducing unemployment by two percentage points would increase output by 2%-6%, or $0.5-1.5 trillion dollars in the case of America. Even for a rich country, that is a lot of money. It could be used to put America's social security system on a stable footing for the next 75-100 years. It could even pay for a substantial share of the cost for a war like that in Iraq!

Phelps' work helped us to understand the complexity of the relationship between inflation and unemployment, and the important role that expectations can play... But it is a misuse of that analysis to conclude that nothing can be done about unemployment, or that monetary authorities should focus exclusively on inflation.

That view belongs to a school of modern macroeconomics that assumes rational expectations and perfectly functioning markets. In other words, individuals - usually assumed to be identical - fully use all available information to forecast the future in an environment of perfect competition, no capital market shortcomings, and full insurance of all risks. Not only are these assumptions absurd, but so are the conclusions: there is no involuntary unemployment, markets are fully efficient, and redistribution has no real consequence. ... Because markets are always efficient, there is no need for government intervention. More perniciously, many supporters of this view, when confronted with the reality of unemployment, argue that it arises only because of government-imposed rigidities and trade unions. In their "ideal" world without either, there would, they claim, be no unemployment.

For more than three decades, Phelps has shown that there is an alternative approach. He has tried to understand what we can do to lower unemployment and increase the well-being of those at the bottom. But he has also striven to understand what makes capitalist economies dynamic, what lies behind the entrepreneurial spirit, and what we can do to promote it further. Phelps' economics remains one of action, not resignation.

There are two facets to structural policies. First, increasing the average growth rate of real GDP increases labor demand and lowers the average unemployment rate. These are well-known supply-side policies. Second, and this is where there is the least focus, workers who become unemployed through the process of "creative destruction" need to be reemployed as fast and as productively as possible with as little disruption to their lives as possible. The faster we can put displaced workers back to work, hopefully at an equivalent or better paying job, the lower the unemployment rate. If retraining and reeducation doesn't work in its present format, if we are having structural difficulties matching people and jobs due to information, geographic, or other problems, then we need to find a way to overcome these problems and do better. Stiglitz is right - Phelps' work is a call to action and we can do more to help those who, through no fault of their own, lose their jobs to the ongoing process of technological change and globalization.

    Posted by on Monday, December 4, 2006 at 05:00 PM in Economics, Macroeconomics | Permalink  TrackBack (1)  Comments (6)

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