Nobel laureate deserves the prize

This year’s Sveriges Riksbank Prize in Economics, the award given by the central bank of Sweden in memory of Alfred Nobel, honored American economist Edmund Phelps. Sometimes things do get put right in this world.

The prize was awarded to him, at last, “for his analysis of intertemporal tradeoffs in macroeconomic policy.” As all public speakers know (some from experience) the mere mention of the word “intertemporal” makes audiences drowsy. The prize committee in this case, though, was trying to emphasize that Phelps was really on to something important in economic policy decisions – the tradeoffs and conflicts between short-run and long-run effects.

In the 1960s, when Phelps began his work on this subject, economic policy still bore the imprint of the 1930s Great Depression and economists still bore the imprint of John Maynard Keynes’ explanation of how it happened – when it was theoretically impossible.

What economic theorists couldn’t figure out was the relationship between unemployment and inflation – both of which were obviously real but didn’t fit very well into the chalkboard equations. Then, in 1958, along came A.W.H. Phillips and his “Phillips Curve,” which described a direct relationship between the employment level and the rate of inflation.

Phelps realized, though, that because in real markets wages and prices are adjusted infrequently and irregularly, the key to the Phillips Curve had to be expectations – workers’ expectations about wage increases and consumers’ and producers’ expectations about prices. Essentially, what he found was that inflation and unemployment were not in a fixed, permanent relationship but one that could and would change substantially when expectations about future price increases changed.

This led to his development of what the prize committee called an “expectations-augmented Phillips curve,” which not only launched his life work but also turned out to be a key factor in developing Federal Reserve policy to this day. (It also launched decades of confusion, for in our diction-impaired, “close enough” world Phelps and Phillips sounded pretty much the same to students.)

The implications of Phelps’ work for economic policy makers took a while to be absorbed, but when they were, they turned out to be even greater than first imagined. The first thing that emerged was the “expanded whammy” effect of inflation. Because rising prices lead to expectations of higher inflation, price stabilization policies become less effective over time. The worse it is, the worse it gets.

This effect meant that there was a big payoff for early action in suppressing inflation, and severe punishment for delay or timidity. And if there were any doubts about Phelps’s work, they evaporated after the uncontrolled run-up in inflation in the late 1970s – where the Fed was chasing futilely after the economy yelling, “slow down.”

Phelps also helped us to understand the differences between the short-term and long-term implications of economic policy. What makes good economic sense for one generation may end up leaving an unpaid bill for the next.

By their very nature, expectations involve time – now vs. later – and Phelps’s work made it clear that expectations, and time, had to be integrated into economic policy in order to make it work effectively. In doing this he changed things forever and for the better.

The changes were not easily made. Anyone who has suffered even an accidental exposure to economic models can tell you that the complexity of dynamic and comparative static models can quickly spin out of control. But in the end Phelps’s insight into analyzing short-run and long-run effects became the new standard way of approaching monetary policy issues.

In some ways, Phelps’s insights were so spot-on that his reputation may have been obscured by the “of course” factor. So much of his theoretical work seems, after he did it, to be part of the natural order of things. Of course inflation expectations are important. Of course there are tradeoffs between the short and long term. In a sense, his brilliant insights were often met with the reaction perhaps best expressed in the words of young Dr. Frankenstein, “That goes without saying.”

The “of course” factor meant that Phelps’s work was under-recognized, at least in the public sense, but the work that Phelps did to complete the mechanics of integrating these concepts into solid economic theory made a crucial difference. His ideas about unemployment, inflation, economic growth, and expectations weren’t going away; in fact, over time they became more and more integral to our economic thinking.

In recent decades, through successive, yet very different, administrations, we have enjoyed an economic prosperity that was achieved without destructive inflation or excessive unemployment. A good bit of the credit belongs to Edmond Phelps. And this time, it doesn’t go without saying. The Nobel Prize committee has finally seen to that.

James McCusker is a Bothell economist, educator and consultant. He also writes “Business 101” monthly for the Snohomish County Business Journal.