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The Phelps Factor
Joseph E. Stiglitz
On December 10, Edmund Phelps, my colleague at Columbia University, received the Nobel Prize in
economics for 2006. The award was long overdue. While the Nobel Prize committee cited his
contributions to macroeconomics, Phelps has made contributions in many areas, including the theory
of growth and technological change, optimal taxation, and social justice.
Phelps’ key observation in macroeconomics was that the relationship between inflation and
unemployment is affected by expectations, and since expectations themselves are endogenous – they
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 from
Phelps’ analysis 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 (as Phelps’ work insists that we do), the relationship
between unemployment and inflation is highly unstable. It is virtually impossible to discern the
relationship from the data except in a few isolated periods.
Changes in education levels, unionization, and productivity are part of the explanation for this
instability. But, whatever the reason, 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, which in turn depends on other
properties of the inflation-unemployment relationship that Phelps’ analysis did not address. 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, where the relationship has been carefully
studied. 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 that have prevailed
in recent decades, 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 – comparable to the benefits of additional employment and growth
enjoyed in the excessive expansion of the economy that led to the increase in inflation.
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In the early 1990’s, the Fed, and many others, thought that the NAIRU was around 6%-6.2%. Based
on changes in the economy, I and the staff that worked with me on President Bill Clinton’s Council
of Economic Advisers argued that the NAIRU was considerably lower. We were right.
Unemployment fell to 3.8% without any surge in inflation.
This matters because, as the great economist 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 in that relationship. 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. But, while government policies, according to this school, are
ineffective, that matters little. 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.
Joseph Stiglitz is a Nobel laureate in economics. His latest book is Making Globalization Work.
Copyright: Project Syndicate, 2006.
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18.10.2007