Monday, October 09, 2006


Nobel Prize in Economics

Edmund Phelps is the 2006 winner of the Nobel Prize in Economics. The Nobel press release describes his contribution:

Low unemployment and low inflation are central goals of stabilization policy. During the 1950s and 1960s the view of a stable tradeoff between inflation and unemployment was established, the so-called Phillips curve. According to this, the price for reduced unemployment was a one-time increase of the inflation rate. Phelps challenged this view through a more fundamental analysis of the determination of wages and prices, taking into account problems of information in the economy. Individual agents have incomplete knowledge about the actions of others and must base their decisions on expectations. Phelps formulated the hypothesis of the expectations-augmented Phillips curve, according to which inflation depends on both unemployment and inflation expectations.

Essentially, Phelps said there is no long-run trade-off between unemployment and inflation. (Milton Friedman, the 1976 Nobel laureate, developed a similar argument. Their ideas are often combined as the Friedman-Phelps hypothesis.) This has had a great impact on macroeconomic policy, since most policy tools exploit the short-run trade-off between inflation and unemployment. Stimulative fiscal or monetary policies tend to increase inflation in order to reduce unemployment. Phelps argues these policies are only effective when people don't expect inflation. As people experience high inflation rates, they anticipate continuing high inflation rates. Policy-makers are then in a worse position-- spiraling inflation even with high rates of unemployment.

This a situation that many South American countries faced during the 1970s and 1980s. Ben Bernanke, now the Chair of the US Federal Reserve, wrote:
For those of us here in the United States, acclimated as we have become to price stability, the severity of inflation in many Latin American countries in recent decades may be difficult to comprehend. A measure of price changes in nine of the most populous Latin American countries shows that inflation in the region averaged nearly 160 percent per year in the 1980s and 235 percent per year in the first half of the 1990s. Indeed, high inflation morphed into hyperinflation--conventionally defined as inflation exceeding 50 percent per month (Cagan, 1956)--in a number of Latin countries during the latter part of the 1980s and in the early 1990s. Brazil's inflation rate, for example, exceeded 1,000 percent per year in four of the five years between 1989 and 1993. Other Latin American countries suffering hyperinflations at about that time included Argentina, Bolivia, Nicaragua, and Peru. A particularly striking aspect of this poor inflation performance is that it occurred while most of the rest of the world was reducing inflation to low levels.
[See Inflation in Latin America: A New Era?]

This level of inflation is unsustainable and usually leads to some kind of economic crisis. Policies designed to control this inflation can also cause tremendous economic hardship. Uruguay, like many of its neighbors, has suffered from both.

According to Phelp's work, low-inflation policies, while painful, may be a worthwhile long term investment. Whether populist governments are willing to make that investment remains to be seen.

update: The Wall Street Journal has a new opinion piece by Phelps on Dynamic Capitalism

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