Can Macroeconomics Be Saved-Or Understood?

By Brannon, Ike | Regulation, Summer 2014 | Go to article overview

Can Macroeconomics Be Saved-Or Understood?


Brannon, Ike, Regulation


The Undercover Economist Strikes Back: How to Run--or Ruin--an Economy

By Tim Harford

272 pp.; Riverhead Hardcover, 2014

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Macroeconomics is currently in crisis, and not for the first time. And Bill Phillips is largely to blame. Phillips' life story--and his contributions to macroeconomics--are front and center in Tim Harford's excellent new book, and for good reason. Besides the outsized role Phillips' research played in the creation of a Keynesian economic model that survived John Maynard Keynes' death, the man's biography is a whale of a story, which Harford succinctly captures.

Phillips lived an incredible life. Besides traveling the world, working an amazing variety of jobs, and performing heroic feats of bravery (and coming within days of perishing before the end of World War II, when he literally dug what was to be his own grave in a Japanese prisoner of war camp), Phillips studied economics at the London School of Economics (LSE) and wowed his mentors. He secured himself an academic post at the school after graduation based largely on his invention of a plumbing contraption, the "hydraulic computer" or "Phillips machine," that ingeniously captured the interconnection between the various macroeconomic markets.

A few years after joining the LSE faculty, he happened to observe that if we plotted the annual data for wage inflation and unemployment on a graph, the data exhibited a stable, inverse relationship: in years where inflation is high, unemployment tends to be low, and vice-versa.

As Harford recounts, Phillips wasn't sure what to make of the statistical artifact and for that reason he was not terribly enthusiastic about publishing his discovery. His colleagues, on the other hand, urged him to get the results out, and he eventually relented.

With his paper, Phillips managed to return a raison d'etre to Keynesian economics that it had been lacking in the postwar years. Keynes's General Theory laid out his arguments for using fiscal stimulus in a moribund economy, but it was primarily focused on addressing the Great Depression. In the busy years that followed, which he devoted to crafting a postwar financial system to help jumpstart the reconstruction of Europe and provide some semblance of global monetary stability, Keynes never got around to articulating his thoughts on the proper role of government managing the economy across a normal business cycle environment.

With Phillips' graph, Keynes' adherents had an organizing principle: in order to keep the economy at full employment, a central banker only needed to fiddle with the money supply to inflate away any excess labor.

The exploitation of the inflation-unemployment tradeoff soon became the central tenet of Keynesian economics. We remember the 1960s as a halcyon economic decade with low unemployment and steady economic growth that Keynesians largely attributed to the sagacity of the central bank and its exploitation of the Phillips Curve. At one point, the government journal Business Cycle Developments changed its name to Business Conditions because it appeared as if the business cycle had been defeated and steadily growing prosperity was all but inevitable.

Soon afterward, of course, the economic gods punished that hubris. By the early 1970s, the price of lower unemployment was higher and higher inflation, until we saw higher inflation occurring concomitantly with higher unemployment (which came to be called "stagflation") during the 1973-74 recession. That directly contradicted the precepts of the Phillips Curve. Suddenly, macroeconomics (specifically Keynesian macroeconomics; the two were one and the same at the time) was in crisis and economists were looking for a way out.

Rational expectations / Harford crucially notes that Phillips never did offer a rationale for why a tradeoff between inflation and unemployment would exist. …

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