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inflation-and-unemployment

8. Inflation and unemployment are not inversely related

Over half a century ago William Phillips argued that inflation and unemployment were inversely related. Put simply, the higher the rate of inflation, the lower the rate of unemployment would be. The ‘Phillips Curve,’ taken up by economic writers including Paul Samuelson and Robert Solow (both of whom later repudiated it), became the basis for government policy. Governments thought that they could reduce unemployment by allowing a higher rate of inflation.

In the 1970s this apparent relationship broke down, and very high rates of inflation coincided with very high rates of unemployment – a condition called ‘stagflation.’ The Phillips curve went vertical, with increased inflation having no effect on unemployment. Although some proponents of interventionism have tried to save the Phillips theory by introducing notions such as ‘rational expectations,’ many economists now recognize that the inverse relationship is only short term. In the longer term expectations change, and many economists suppose that only brief temporary changes can be made to the long-term non-accelerating inflation rate of unemployment (NAIRU). Some still try, however, to incorporate both short- and long-term effects into “expectations-augmented Phillips Curve” models.

When governments and their central banks inflate, the extra money and easy credit enter the economy at specific places, not spread evenly throughout it. The credit affects asset prices differentially. The money and credit send false signals which lead to over-investment in some types of producer goods. In the short term this does indeed mop up some of the unemployment, giving the illusion of an inverse relationship. People grow accustomed to expecting the inflation, however, and change their behaviour accordingly. When the extra spending stops, the long-term ‘natural’ rate of unemployment reasserts itself. The lesson is that governments cannot “spend their way out of a recession,” soaking up the unemployment it features by means of huge public sector programmes, or by huge monetary stimulus (the fallacy offers a false rationale to both). These only distorts the economy and builds in future unemployment when economic reality reasserts itself. Nor can governments ‘smooth’ the business cycle by using high public spending to cushion against (and if possible prevent) cyclical downturns. Governments might enjoy more success if they devoted their energies not to preventing economic downturns, but to mitigating their social consequences, and in helping people to deal with them.

This is part of Dr Pirie’s ongoing series: Philosophical Observations on Economics.