Explorer of new vistas

The Nobel Prize in Economic Sciences in 2006 was awarded to Edmund S Phelps, then at Columbia University, "for his analysis of intertemporal trade-offs in macroeconomic policy".

Phelps did his BA in economics from Amherst in 1955 and went to Yale University for his PhD in the same subject, which he finished in 1959. At Yale, among his teachers were future Nobel laureates — James Tobin and Thomas Schelling. After completing his PhD, he worked at RAND Corporation for a short period of time, following which, he took up a research position at Cowles Foundation while teaching at Yale simultaneously. In 1966, he moved as a professor to the University of Pennsylvania where he stayed till 1971. He thereafter moved to Columbia University where he continued till retirement. Phelps worked on a range of issues such as growth, unemployment and inflation, but is best known for his work on providing microeconomic foundation to macroeconomic theories of unemployment and inflation. As the website of Columbia University puts it: His work can be seen as a lifelong project to put "people as we know them" into economic theory. In this article, we will review the main works of Phelps and see how they impact public policy even today.

Main works

In the early 1960s, while at Cowles Foundation, Phelps worked on the neoclassical growth model, which was based on Solow's research. His work led to the famous article, 'The Golden Rule of Accumulation: A Fable for Growthmen', in the 'American Economic Review' in 1961. The golden rule is simply that the savings rate should equal capital's share in national income in order to achieve sustainable economic growth. Taking this argument further, Phelps argued (with Robert Pollak) that the government should force people to save more than they wish, on the grounds that people put too little weight on their children's well-being.

After Phelps moved to Pennsylvania in 1966, he began working on the link between inflation, employment and wages. More specifically, he challenged the Phillips curve trade-off between unemployment and inflation, and thereby challenged the Keynesian view. His research included the role of adaptive expectations (expectations of individual economic agents) and imperfect information. He argued that labour market equilibrium is independent of the rate of inflation and so there is no long-run trade-off between unemployment and inflation. As a result, this questioned the Keynesian view that expansion of aggregate demand would lead to a fall in unemployment in the long run. In this work, Phelps gave a microeconomic foundation to the macroeconomic theories of unemployment and inflation.

He assumed that employees would act on the basis of their expectation of future inflation. If they expected, say, three per cent inflation, they would build this into their wage bargains. In Phelps models — also known as 'micro-macro' models — wages adapt to the higher inflation. This research was captured in his 1968 paper, 'Money-Wage Dynamics and Labour Market Equilibriium'. He also published a book, 'Phelps Volume', which was a result of a conference he organized on the microfoundations of inflation and unemployment in Pennsylvania. Continuing with his research, in a 1969 paper, Phelps sketched an economy of widely separated 'islands' where workers had to decide whether to accept the local market wage or to move on. Even in an equilibrium scenario, workers on an island with an appreciably inferior wage would get on the boat to try another island, suffering voluntary unemployment during their search.

Another concept credited to Phelps (along with Friedman) was the natural rate of employment. As pointed out above, Phelps and Friedman had suggested that there was no long-run trade-off between unemployment and inflation and hence the Phillips curve was vertical. However, in the short run, the trade-off existed because there was money illusion among workers — when the government increased money supply, which increased prices, workers were fooled into accepting wages that appeared higher than they were and hence accepted jobs, thus, reducing unemployment. However, with time, workers realise that their real income has fallen since prices have risen more than they expected. Consequently, as prices rise, they supply lesser labour and insist on wages in keeping with inflation. This raises the real wage to the earlier level and the unemployment rate returns to the natural rate.

The experiences in the 1970s proved Friedman's and Phelps's theory. Contrary to the original Phillips curve, when the average inflation rate rose from about 2.5 per cent in the 1960s to about seven per cent in the 1970s in the USA, the unemployment rate not only did not fall, it actually rose from about four per cent to above six per cent.

The point made by Friedman's and Phelps's analyses is well established and accepted in economics today viz there is some rate of unemployment that, if maintained, would be compatible with a stable rate of inflation. This is also referred to as 'nonaccelerating inflation rate of unemployment' (NAIRU) by some because, unlike the term 'natural rate', NAIRU does not suggest that an unemployment rate is socially optimal or constant.

Taking forward the work of Phelps and Friedman, Lucas claimed that the latter included irrational expectations about the way workers reacted to inflation. Accordingly, he introduced rational expectations into their model. This meant if, say, the government increased the growth rate of money supply to reduce unemployment, it would work only if the government increased money growth more than people expected, and the sure long-term effect would be higher inflation but not lower unemployment. In other words, the government would have to act unpredictably. In this context, we may also recall the 'Lucas critique', which was introduced in 1976, whereby Lucas criticised the macroeconometric models of the type used by Phelps and showed that the various empirical equations estimated in such models were from periods where people had particular expectations about government policy. Once those expectations changed, as his theory of rational expectations said they would, then the empirical equations would change, making the models useless for predicting the results of different fiscal and monetary policies. While Thomas Sargent confirmed this result of Lucas and suggested that government's policy has to be credible and that this credibility could be maintained by fiscal policy, later day Keynesians suggested that the Lucas critique was a mere syllogism and could not become the basis of macroeconomic theory. In this context, Phelps, with Calvo and John Taylor, started a programme to rebuild Keynesian economics with rational expectations by employing sticky wages and prices. They did so by introducing staggered wage setting which, in turn, gave monetary policy a role in stabilizing economic fluctuations. The use of staggered wage and price setting, further developed by Calvo in a 1983 paper, became a cornerstone of New Keynesian economics. During the 1970s, Phelps and Calvo also collaborated on research on optimal contracts under asymmetric information.

In 1971, Phelps moved to Columbia University, where he continued his research on inflation and unemployment. In 1972, he published a new book which popularized his 'expectations-augmented Phillips curve' and introduced the concept of hysteresis with regard to unemployment (prolonged unemployment is partially irreversible as workers lose skill and become demoralized). Later, Phelps also became critical of rational expectations and suggested that it was not the right way to model expectations.

Over the late 1980s and the early 1990s, Phelps created a new non-monetary theory of employment in which business asset values drove the natural rate. The theory, first fully set out in his book, 'Structural Slumps: The Modern Equilibrium Theory of Employment, Interest and Assets', explains the experience of Europe in the 1980s, when there was a fall in growth along with inflation. A similar theory of structural boom in the US was also dealt with in subsequent works by Phelps. His thesis in these papers was that the economic swings in the West in the past century not only did originate in non-monetary shocks but also operated fundamentally by non-monetary mechanisms. The following paragraph from the Columbia University website illustrates this work of Phelps:

At the level of historical understanding, this theoretical development served to underpin hypotheses linking the '80s slump to a worldwide rise of real interest rates, the sharp transition to more moderate productivity growth in the European economies, and the growth of the welfare state to huge proportions, especially on the European continent. At a more general level, this work pointed to the crucial role for employment determination played by the values (also known as shadow prices) that firms place on the various sorts of business assets with which they operate: the employee with the needed firm-specific preparation, the customer, and nonhuman tangibles such as industrial plant and office facilities. This feature of the theory suggested that the prices of shares traded on organized stock exchanges might be serviceable as observable proxies for the mostly unobservable asset values, which opened up new statistical tests of the theory. This equilibrium theory of endogenous structural unemployment turned out to supply an explanation of the inflationless booms in the late 90s. In their thinking about the long wave of business expansions in the late 19th century, the German School under Spliethof and Cassel suggested that prospects of new industries or new methods required further capital, and this interpretation can be translated into an unexpected jump in the values that firms, looking to the new opportunities, place on one or more business assets. (An April 2000 Wall Street Journal essay provides an introduction to this analysis.)

For the past two decades, Phelps has been concerned with issues of economic growth across the world: How structural factors determine growth and what makes countries grow? In 2001, he and Roman Frydman founded the Centre on Capitalism & Society at Columbia to promote and conduct research on capitalism. Apart from Edmund Phelps and Roman Frydman, the other founding members were Andrzej Rapaczynski, Amar Bhide, Richard Nelson, Glenn Hubbard, Joseph Stiglitz, Bruce Greenwald, Merritt Fox, and Pentti Kouri. As Phelps stated: the center's agenda was more in the tradition of the Austrian School and the 'Capitalism is Hayek territory'. The Centre is active even today and maintains a balanced approach — appreciating the self-regulating nature of market forces, while acknowledging the need of state intervention in many areas.

Conclusion

Phelps' ground-breaking works not only gave us an understanding of how real actors influenced various macroeconomic policies (He provided a microeconomic foundation to macroeconomic theories), but also taught us to distinguish between the short- and long-run trade-offs between unemployment and inflation. His theory of the natural rate and the hypothesis of the expectations-augmented Phillips curve have stood the test of time and still guide policymakers grappling with meeting targets of low unemployment and low inflation. His analysis led to the interesting result that the long-run rate of unemployment doesn't depend on inflation, as Keynes had hypothesised, but on the labour market and how wages adjusted to inflation expectations. The expectations-augmented Phillips curve is used extensively by most macroeconomic forecasting models.

The writer is an IAS officer, working as Principal Resident Commissioner, Government of West Bengal. Views expressed are personal