The zombie economics of inflation and unemployment

Bad economic ideas can have a frustratingly long shelf life. Amid surging consumer and producer prices, the apparent tradeoff between inflation and unemployment has become a hot topic. There’s just one problem: the tradeoff doesn’t exist. Economists have known this for 40 years. Policymakers and commentators asserting otherwise should get with the program.

The illusion of a permanent and controllable tradeoff between a strong dollar and a strong labor market persists in various centers of elite opinion. Lisa Cook, one of President Biden’s nominees to the Federal Reserve’s Board of Governors, confidently asserted the importance of “the tradeoff between inflation and unemployment” for monetary policy. The New York Times recently promoted similar worries that the current focus on taming inflation could come at the cost of unemployment. In a separate Times column, Paul Krugman depicted a “huge surge in unemployment” as the hefty price-tag of reining in our last major inflationary crisis some 40 years ago. Other media outlets routinely depict “tight money” as a certain pathway to skyrocketing unemployment. When some of the most important forums in the world host some of the most elementary economic errors in the world, something has gone very wrong.

Alan Blinder, a former Fed vice chair, recently did the public a service when he reminded us about 1970’s stagflation: simultaneously high inflation and unemployment. This grim prospect should have put to rest forever the mirage of a tradeoff. Amid a supply-constrained economy, Fed-induced excessive demand growth fueled major price hikes. Sound familiar? Sadly, each new generation of economists seems fated to spend precious time and energy rediscovering the wheel.

Monetary policy has a big effect on total spending on goods and services, but not the amount of productive employment. Fed officials are tasked with keeping us as close to the jobs frontier as possible. If they’re too stingy, as in 1929 or 2008, spending collapses and the economy must painfully recalculate to new patterns of production and trade. If they’re too gung-ho, as in the 1970s or 2020, spending skyrockets and households and businesses are left scrambling for purchasing power. Keeping spending stable is the foundation for healthy markets, including labor markets. So long as monetary policy is predictable, full employment is compatible with many different inflation rates.

In the case of monetary policy, many of our problems trace to the zombie-like reemergence of the Phillips Curve — a mid-20th century chart that purported to show an inverse relationship between employment and inflation. Although it bears the name of its originator, A.W. Phillips, Nobel prize-winning economist Paul Samuelson and Robert Solow are the real culprits behind the myth that anti-inflationary policies imperil a healthy labor market. As Solow recounted, “I remember that Paul Samuelson asked me when we were looking at [Phillips’] diagrams for the first time, ‘Does that look like a reversible relation to you?’ What he meant was ‘Do you really think the economy can move back and forth along a curve like that?’” Solow answered in the affirmative, and the myth of a “menu” of choices for inflation and unemployment was born.

The pair presented their argument in an influential 1960 article, arguing that “In order to achieve the nonperfectionist’s goal of high enough output to give us no more than 3 percent unemployment, the price index might have to rise by as much as 4 to 5 percent per year.” By implication, intentionally allowing the price level to rise “would seem to be the necessary cost of high employment and production.”

The Phillips Curve reflected the Keynesian pieties of mid-20th century macroeconomics. It offered economists a monetary lever to accelerate or slow economic growth with supposedly technical precision. Just as usefully, it patched up a giant hole in John Maynard Keynes’s system, which famously enlisted fiscal stimuli and accompanying deficit spending as solutions for economic downturn. 

Within less than a decade, however, the Phillips Curve had fallen apart. Milton Friedman, Edmund Phelps and Robert Lucas, all Nobel laureates in economics, published devastating salvos against the inflation-unemployment tradeoff. The bottom line: Economic productivity doesn’t depend on the printing press. You can’t fool people with “money illusion” by eroding wages with inflation. Loose monetary policy causes a depreciated dollar, with no lasting gain in employment. You can’t exploit a contingent, historical correlation for the purposes of economic control.

These setbacks did not dampen the ardor of diehard Keynesians. Samuelson tried to rescue his toolbox, calling it “one of the most important concepts of our times” in a 1967 lecture. By then, it was clear the Phillips Curve wasn’t holding up. Samuelson attributed this to the instability of the relationship. The Phillips Curve moved around, you see. It was therefore the goal of policymakers to seize control of the shift and situate it in a more “ideal” position. To achieve this, he proposed a suite of vaguely elaborated measures to increase antitrust enforcement and establish government-financed jobs training programs. Sen. Elizabeth Warren (D-Mass.), Federal Trade Commission Chairperson Lina Khan and their fellow progressives are peddling the same snake oil today. These measures didn’t work for Samuelson in the 1960s and 70s, and they won’t work now.

The Phillips Curve was doomed from the beginning. It didn’t originate with a theoretical insight or rigorous empirical testing. Rather, it was a “god of the gaps” of the mid-century Keynesian system — an all-too-convenient discovery that appeared to justify monetary assistance for deficit finance and large government programs. Unable to grapple with the possibility that Phillips simply stumbled into a weak or spurious relationship, the heirs of the Samuelson-Solow approach have instead tried to salvage it through increasingly fanciful just-so stories, each crafted in response to a tangible failure of an earlier iteration of the curve.

The idea of an exploitable tradeoff between inflation and unemployment is dead. It’s time we buried it. This false concept paves the way for counterproductive government programs that hinder the economic dynamism on which labor markets depend. If we want full employment, we should simultaneously normalize monetary policy while easing regulatory constraints. Anything else is chasing a mirage.

Phillip Magness is the director of research and education at the American Institute for Economic Research. Alexander William Salter is an economics professor in the Rawls College of Business at Texas Tech University, a research fellow at TTU’s Free Market Institute and a senior fellow with AIER’s Sound Money Project.