COMMENT
Time is up for Friedman
By Thomas I Palley
The US Federal Reserve has recently received much criticism from economic
conservatives who claim it has ignored inflation, thereby risking a rerun of
the inflation show of the 1970s. 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 over the past 25 years. In effect, rethinking the inflation of
the 1970s also compels rethinking economic policy.
The essence of Krugman's argument is that we are not watching a
rerun of the 1970s 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 11% annual average wage increase with current conditions. Where now
are the unions demanding 11%-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 1970s 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 price-wage 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
1980s, 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 price-wage spiral
story of inflation is correct, it is time to rewrite 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.
Thomas I Palley is the founder of the Economics for Democratic and Open
Societies Project.
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