In the late 1970s the impossible happened. Inflation and unemployment simultaneously went vertical. The leading economists of the day were flummoxed.
The Phillips curve said there’s an inverse relationship between inflation and unemployment. When unemployment goes down, inflation goes up. Conversely, when unemployment goes up, inflation goes down.
How could it be that both were going up at once? Weren’t they mutually exclusive? Indeed, it took years of heavy handed government intervention to pull off such a feat.
When unemployment began creeping up in the 1970’s the U.S. Treasury, with backing from the Federal Reserve, did what Keynes had told them to do. They spent money to stimulate the economy and spur jobs creation. According to the Phillips curve, with rising unemployment the planners could have their cake and eat it too. They could run large deficits without inflation.
Unfortunately, something unexpected happened. Instead of jobs they got inflation. Then, when they tried it again, they still didn’t get jobs. Astonishingly, they got more inflation.
This little episode illustrates the point that the economy is hardly predictable. One decade people borrow money and spend it. The next they save and pay down debt. No graphical curve can predict what way people’s behavior will swing from one period to the next.
Obviously, when the unemployment rate goes up the economy sinks. But then when the unemployment rate goes down shouldn’t the economy go back up. One would think so?
But the experience of the last five years of declining unemployment has not been an economic boom. It has been economic lethargy. Perhaps this has something to do with the fact that the unemployment rate and the labor participation rate declined in tandem.
That may be a good theory. It would be entirely correct…until the very instance that the economy boomed in the face of a declining labor participation rate. Then it would be incorrect.
The fascinating thing about the economy is not that it’s predictable. Or, for that matter, that it’s not predictable. It’s that it is almost predictable…or at least it seems it should be.
Even more fascinating are the abundance of academic quacks and hucksters that explain the economy like they’re explaining how to calculate the area of a circle. Some even win the Nobel Prize for their adventures into nonsense. Armed with line graphs, curves, and dot plot charts, they attempt to elucidate how the great big economic machine works. What’s more, they espouse ways to improve it.
Lost in Extrapolation
One of the more tedious drivellers of popular economic thought is former Treasury Secretary Larry Summers. He’s smarter than you and he’ll make sure you know it. There’s hardly a questions he doesn’t know the answer to. So, too, there’s hardly an answer he doesn’t know the question to.
Larry Summers, if you recall, is the man Janet Yellen beat out for the top job at the Fed. Perhaps he felt slighted or underappreciated because of this. Who knows?
But now, with regular frequency, he publicly tells Yellen how to do her job. On Wednesday, for example, he took to the press to enlighten Yellen on what Fed interest rate policy should be…
“You should kick up interest rates, as has been true forever, when you have an inflation problem,” explained Summers to CNBC, after confirming that inflation wouldn’t go much over 1 percent for the next 10 years. “In the face of a ‘low-flation problem,’ [there’s] no reason to raise rates.”
Obviously, Summers has it all figured out. He even knows what the inflation rate will be 10 years from now. For he can predict the future because he has charts that extrapolate the past and project it into the future. Naturally, Summers proposes his solution.
“The key is you got to have demand if you want companies to invest. Otherwise, they’re investing in capacity they don’t need.”
Apparently, Summers hasn’t considered what happens when artificial demand is created by people borrowing money with cheap financing stimulated by years of low interest rates. In short, the economy becomes so larded over with debt it becomes impossible to stimulate demand by pushing more cheap credit. That’s why, after seven years of ZIRP, the economy’s prone as a dead man.
Summers solution has failed to compel the economy back to life. No doubt, Larry could use a new chart.
for Economic Prism