The Federal Reserve has recently received much criticism from economic conservatives who claim it has ignored inflation, thereby risking a rerun of the 1970’s inflation show. In response, renowned Princeton economist Paul Krugman has come to the Fed’s defense arguing today’s inflation is fundamentally different from that of the 1970s.
Krugman is right, but his arguments do more than defend the Fed. They also unintentionally demolish the foundations on which central banks have based monetary policy the past twenty-five years. In effect, re-thinking the inflation of the 1970s also compels re-thinking economic policy.
The essence of Krugman’s argument is that we are not watching a rerun of the ‘70’s show because this time round there is no mechanism for creating a price – wage spiral. That is because unions are now dead so that workers are unable to ask for wage increases that match prices. As an example, Krugman contrasts the United Mine Workers contract of 1981 which bargained a three year eleven percent annual average wage increase with current conditions. Where now are the unions demanding 11-percent-a-year increases? Indeed, where are the unions, period?
Today’s reality is indeed characterized by absence of a price – wage spiral mechanism, and it is the reason why the Fed’s easy monetary policy is unlikely to cause general inflation. However, that raises a critical additional point.
Recognizing that the inflation of the 1970’s was the result of a price – wage spiral triggered by conflict with unions over income distribution, compels rejection of the theory of the natural rate of unemployment. This theory has dominated economists’ thinking about inflation for over a generation and has twisted public thinking.
The late Milton Friedman was the originator of the theory of the natural rate of unemployment, yet according to Friedman unions have absolutely nothing to do with inflation. Instead, inflation is everywhere and always an exclusively monetary phenomenon. For Friedman, the only role of unions is to increase unemployment, which fundamentally contradicts the union wage – price spiral story of inflation
That means if the union price – wage spiral story of inflation is correct (which it is), Friedman’s natural rate theory is wrong and policymakers should abandon it. Instead, the focus of policy can formally return to probing the boundaries of full employment.
Moreover, since inflation involves conflict over income distribution, there remains an unsolved policy challenge of how to fairly distribute income at full employment without triggering inflation.
Seen in this light, it becomes clear that Friedman’s natural rate theory has been used to justify running policy in a business friendly way. Thus, in the 1980’s high interest rates were used to tamp down inflation, thereby causing unemployment and weakening unions by weakening manufacturing. In effect, fighting a price – wage spiral with high interest rates is a form of class based policy that breaks the spiral by undercutting the bargaining power of workers.
A final implication concerns the economics profession and its teaching of economics. In the 1980s Friedman’s natural rate of unemployment theory became the mainstay of economics textbooks. However, if the union wage – price spiral story of inflation is correct, it is time to re-write those textbooks. Today’s students deserve a theory that explains both the inflation of the 1970s and why the Fed is right in downplaying current inflation fears.
Natural rate theory asserts the economy self-organizes with full employment, and that inflation is the result of monetary policy trying to push the economy beyond the natural unemployment rate. The theory is fundamentally ideological and it flooded into the academy as part of the conservative capture of economics in the 1970s. It has always struggled to fit the facts, and now may finally be the time to discard it.
Originally published at Thomas Palley and reproduced here with the author’s permission.