THE CONTROVERSIAL CORRELATION

THE CONTROVERSIAL CORRELATION

The Keynesian notion that a country’s aggregate demand determines
the level of economic activity was supported by the empirical findings
of Professor A. W. Phillips in 1958 which seemed to show
beyond contention that, for almost a century, the UK’s rate of inflation
had varied inversely with unemployment in a remarkably stable,
almost predictable way. As unemployment went down, inflation went
up, and vice versa. It thus supported the Keynesian theoretical model
that said you either get unemployment if aggregate demand is too
low or inflation if aggregate demand is too high. It also supported
political advisors who suggested you could get less unemployment,
and thus more votes, by increasing government spending.
The Phillips correlation dominated policy thinking of the time. It
was an incontrovertible piece of analysis that seemed to prove you
had to live with either one extreme or the other or find some notentirely-
happy medium. The compromise that most developed
countries chose to live with in the immediate post war years was a
degree of creeping inflation. It was thought to be the necessary
price for reducing unemployment.
Friedman’s voice (also that of another US economist Edmund
Phelps) arguing to the contrary was not heeded outside the field of
theoretical economics. Notwithstanding the irrefutable evidence of
an inflation/unemployment trade-off stretching way back into the
nineteenth century, these two economists separately argued that if
governments began spending money to try and reduce unemployment,
in effect opting for a bit more inflation, then the supposedly
reliable correlation would break down.
Friedman, in a famous address to the American Economics
Association in 1967, said that the Phillips’ curve illustrated in
Figure 4.7 offered a reasonable prediction of policy alternatives in a
world where zero inflation was the norm; that is, where years in
which there was inflation were counterbalanced by years of deflation.
© 2004 Tony Cleaver
But as soon as people expected governments to fuel inflation over a
continuing period then they would build that into their wage
demands. And as soon as that happened, if governments still
persisted in their spending plans to reduce unemployment, there
was the potential for inflation to accelerate (Box 4.5).
Box 4.5 The trade-off that shifted
The PHILLIPS CURVE PP (Figure 4.7) illustrates data for UK wage
inflation against unemployment over the entire period
1862–1958. It shows a remarkably stable trade-off. Friedman
predicted, however, that if governments deliberately attempted
to peg unemployment to some level B below what he called the
natural level A then this original trade-off would inevitably break
down as the Phillips curve shifted up and out.
Assume government spending reduces unemployment below
A (1) but leads to an increase in inflation (2). Next round wage
claims would build in this increase – which would then lead to a
fall in demand for labour (3). If government increases spending
yet again, inflation now rises to (4). This leads to even greater
wage demands – returning unemployment to (5). If the cycle
keeps repeating, the end result will be that inflation/unemployment
locii explode off the curve: 6, 7, etc.
Inflation
P
4 5
6 7
2 3
1 Unemployment
0 B A P
Figure 4.7 The Phillips curve and movements off.
© 2004 Tony Cleaver
In the 1970s it was more than economists who took note of what
Friedman said. Most of the western world, in reaction to the OPEC
oil shocks of 1973 and 1979 (see Box 4.6), experienced accelerating
inflation almost precisely as predicted. A shift in inflationary expectations
provoked a wage–price spiral and many democratic
governments – unwilling to take the political risk of allowing
unemployment to rise – opted to spend money instead with the
exact consequences as illustrated earlier.
The world seemed to have adjusted to living with inflation –
only to find that once started, it was a notoriously difficult process
to hold in check. For economists and advisors of the Keynesian
school, the events of the late 1970s condemned them to the margins
of policy-making whereas Friedmanite analysis and recommendations
now captured the centre-ground. The macroeconomic
paradigm shifted once more.
Box 4.6 OPEC and the oil price shocks
The Organisation of Petroleum Exporting Countries was formed in
1960 in an accord between original members Iran, Iraq, Kuwait,
Saudi Arabia and Venezuela. But it was not until the USA in particular,
in 1973, began to import increasing amounts of oil as its own
supplies fell short of demand that OPEC could act as a successful
cartel. The spark that lit the oil crisis was the 1973 October War
between Arabs and Israelis when OPEC shut off oil supplies in
retaliation to Western support of Israel. The price of world oil
soared 400 per cent between October 1973 and January 1974.
For oil-consumer countries in the rich and poor world alike,
the 1970s was a time of painful adjustment to high oil prices and
the inflation this fuelled. Just as they thought they were coming
out of it, in 1979 oil prices surged again. This time it was the
Iranian revolution when the pro-Western Shah of Iran was
deposed by Muslim fundamentalists who again shut down sales
of Iranian oil. By the 1980s, however, governments in the West
had changed and economic policies had changed with them (see
section ‘The supply-side consensus’).
© 2004 Tony Cleaver
THE SUPPLY-SIDE CONSENSUS
Economics is not an exact science. Things never turn out quite the
way theory predicts since – unlike the ‘hard’ sciences such as
Physics – there are so many variables beyond the economists’
control. But for evidence to confirm theoretical predictions as
comprehensively as was demonstrated in the inflationary 1970s was
really remarkable. Friedman, famous already, became even more
renowned and his influence now extended to policies advocated by
decision-takers all round the world, just as had been the case with
Keynes, earlier.
Any attempt by governments to spend their way out of recessions
was now condemned. By extension, almost any initiative for
governments to intervene in the economy was heavily criticised.
Right-wing, free-market conservatism – with the ascent to power of
Margaret Thatcher in the UK and Ronald Reagan in the USA – now
dominated the political agenda.
In the short term, it was alleged that a country’s productive
resources were more or less fixed and their allocation between
competing uses was best decided by unrestricted market forces.
Trying to reduce unemployment below its ‘natural’ level by increasing
aggregate demand could not increase national income/
output/aggregate supplies one iota – it could only stimulate increasing
inflation as already described.
This implies that the original Phillips curve PP becomes superseded
by the new version: an EXPECTATIONS-AUGMENTED PHILLIPS
CURVE, which is a vertical line at point A (Figure 4.8).
What are the policy recommendations that flow from this?
Ignore inflationary meddling with aggregate demand – focus
instead on the microeconomic features of the SUPPLY-SIDE of the
economy.
Only policies that are aimed at making resources more flexible
and responsive to market forces could hope to reduce unemployment
and improve a nation’s fortunes.
LIBERALISATION, deregulation, privatisation, removing the
allegedly dead hand of government, were all the new buzz words
of the 1980s supply-side revolution. Markets had to be set free so
that they would restore flexibility and dynamism to Western
economies.
© 2004 Tony Cleaver
The tenets of this latest orthodoxy in macroeconomics were now
as follows:
Central authorities varying money supplies cause most of the
instability in an economy. Money growth should be fixed at
a rate commensurate with that of long-run trend growth of the
economy and then left alone.
There is no long-run trade-off between inflation and unemployment.
The economy is inherently stable such that if disturbed by
misplaced government meddling then it will return eventually to
the long-run equilibrium at the NATURAL RATE OF UNEMPLOYMENT.
The natural rate of unemployment is increased by the provision
of welfare payments which allegedly give people an incentive
not to work, and by minimum wage laws and protective labour
legislation that inhibit hiring and firing workers.
Future expectations, the actions of unions and the flexibility of
prices and wages all impact on inflation and misguided government
intervention can exaggerate these influences.
Such an economic philosophy dictates a detailed restructuring of
the relationship between the government and the economy as
a whole.
Inflation
P
0 A P
Unemployment
Figure 4.8 The expectations-augmented Phillips curve.
© 2004 Tony Cleaver
Fiscal Discipline
First, supply-side economics requires governments to balance their
budgets, live within their means and thereby stop inflationary
spending. Loss-making industry should not be bailed out in the
mistaken pursuit of trying to protect jobs. Similarly, it also means
reducing welfare payments and handouts to workers. This saves
government money, lets failing industry fail and prompts workers
to move to new, growing firms. On the side of taxation, high
MARGINAL INCOME TAX RATES should be cut and the tax base broadened.
Such discipline also addresses the problem of incentives (Why
should industry strive to be efficient if government bails out
failure? And why should the individual work if earned income is
highly taxed and unemployment brings you benefits?).
Privatisation
State-owned or NATIONALISED INDUSTRIES should be sold off to
whichever private investors might be interested (e.g. telephones and
telecommunications) and closed down where industries have no
buyers (e.g. coal). One-off sales of public industry will net large
revenues for the government which can be used to pay off the
NATIONAL DEBT and balance budgets over the longer term and simultaneously
they remove altogether the permanent drain on the
public purse of otherwise loss-making dinosaurs.