Taking issue with Janet Yellen's economic theory

Janet Yellen
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Janet Yellen

Unlike bell-bottoms and AstroTurf, the Phillips Curve is a fad from the 1970s that never really went away. The nomination of Janet Yellen to lead the Federal Reserve has brought it out from the shadows, much to the chagrin of a generation of economists who learned in the '80s and '90s that low inflation is a condition for robust economic growth.

The idea of a tradeoff between inflation and unemployment was first raised at length in a 1958 paper by the New Zealand economist A.W. Phillips, in which he tracked a century's worth of wage and jobless-rate changes in the United Kingdom. Phillips understood the dynamics of the commodity market — if the demand for a product rises then so does its price — to apply to the long-term labor market.

Revisions of this model by other economists in the modern paper money world, namely Milton Friedman, found that this theory does not apply in the long run after all. Higher prices only give the appearance of an increase in real demand. Workers will ask for higher nominal wages to keep up with the inflation. Companies recognize that demand hasn't increased after all, and refrain from hiring more workers. The temporary confusion of inflation is resolved. Inflation does not create jobs after all; it just raises the nominal price of goods and labor.

The main harm done by the Phillips Curve, as former Federal Reserve Bank of Cleveland President Jerry Jordan describes in his 2012 paper "Friedman and the Phillips Curve," is that it quickly became a method for economists to attempt to "fine tune" levels of inflation and unemployment they believed reflected socially desirable outcomes. Allow a little more inflation to get a little less unemployment, or vice versa depending on the direction chosen. The central bank serves as the state's economic planner.

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Through Friedman, and later the stagflation triggered by the end of the gold-exchange standard in 1971, we learned that inflation is a monetary phenomenon. It can't boost economic output for very long, nor does output cause inflation. High inflation coincided with slow growth in the 1970s, then the economy expanded rapidly under low inflation in the 1980s. From this vista, the Phillips Curve was an artifact of history. Then, Janet Yellen and like-minded economists stormed the Fed in the mid-1990s.

Though the no-nonsense Alan Greenspan chaired the institution during these years, Yellen and her colleagues frequently invoked the Phillips Curve during her tenure on the board of governors from 1994 to 1997. Greenspan's focus on the goal of price stability, combined with proposed congressional legislation to affirm that in statute, prompted Phillips Curve devotees on the Federal Open Market Committee to warn about the dangers of low inflation for output and employment.Yellen, for one, was willing in the FOMC's first meeting of 1995 to stipulate how much exactly: "Each percentage point reduction in inflation costs on the order of 4.4 percent of gross domestic product, which is about $300 billion, and entails about 2.2 percentage-point-years of unemployment in excess of the natural rate," she claimed.

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Howdoes Yellen arrive at these projections? She did not say in the meeting. Her husband, the economist George Akerlof, has done work on this topic and in a paper the following year for the Brookings Institution, estimated that permanent GDP growth would be 1-3 percentage points lower and unemployment 2 percentage points higher under a policy of zero inflation. Akerlof has written that he andhis wife have "always been in all but perfect agreement about macroeconomics."

If you believe that lower inflation causes economic harm, there's not much constraint to opening the door to a little more inflation. In the same Federal Open Market Committee meeting, Yellen said, "To me, a wise and humane policy is occasionally to let inflation rise — even when inflation is running above target." Then why have a price target at all? She believes that the central bank should maintain enough inflation to prop up business activity, because "uncertainty about sales impedes business planning and could harm capital formation just as much as uncertainty about inflation can create uncertainty about relative prices and harm business planning."

This approach extends the Fed's mission beyond even the dual mandate of Humphrey-Hawkins and into the sphere of American corporate activity, a place that the business economist Greenspan was reluctant to go. Yellen, a discipleof predictive modeling, dismisses the notion that the Fed could go too far. To her, the record shows that "tuning works even if it is not 'fine.'"

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Those words express the Phillips curve in a nutshell. It's the belief that economic policymaking is the practice of top-down management of the economy, informed by the assumed tradeoff between inflation and unemployment.

It isn't just the 1970s, but the last few years, that show how money creation does not produce permanent employment gains. As the Fed has increased bank reserves, much of the job growth that exists has been part-time work in sectors like construction, retail, hospitality, and bars and restaurants. These are the industries that seem to respond to the short-term effect of the Phillips curve where perceived rising demand triggers hiring. Yet they evaporate when the economy shakes off the monetary stimulus. Do we want the Fed to double-down on that folly with Janet Yellen at the helm?

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— By Rich Danker

Rich Danker is economics director for American Principles Project, a conservative policy organization.