There are few economic models with a more interesting past than the Phillips Curve. Originally conceived by A.W. Phillips, the model purports to show that there exists a tradeoff between inflation and unemployment. Whenever inflation goes up, unemployment will decrease, and vise versa. The resulting curve looks much like a traditional demand curve, starting off very high in on the left side, and moving downward as you look farther and farther to the right.
Phillips created this model through examining data on both inflation and unemployment in Great Britain from the mid-19th to mid-20th centuries, and found that there is a tendency towards an inverse relationship between the two. He published a paper detailing his findings and the resulting curve that would come to be named after him. This model quickly became popularized and made into a tool for monetary and fiscal policy in the economics field in the late 1950s.
However, it didn’t take long for the Philips Curve to bend and break. The 1970s brought about a phenomenon that, according to the Phillips Curve, should be impossible. This phenomenon was stagflation, the advent of high unemployment rates and high inflation. Many economists, convinced of the validity of the Philips Curve, found this perplexing. After all, it shouldn’t be possible to experience both high inflation and high unemployment! If you have less of one, it should result in more of the other.
It was back to the drawing board for the economics profession. The majority were still convinced of the base validity of the concepts behind the Philips Curve. However, something about it must be changed to account for the stagflation of the 1970s. Some kind of adjustment was necessary. The result was that most economists now view the Phillips Curve as being applicable only in the short run. If we are dealing with a small period of time, we can expect a tradeoff between inflation and unemployment that the Phillips Curve predicts. If we shift to a longer period of time, then this relationship no longer exists.
One of the strongest arguments for the Phillips Curve, and one of the main reason’s that economists felt to need to rehabilitate the model as opposed to throwing it out altogether, has always been the purported empirical evidence supporting the tradeoff the model presents. It was empirical data that inspired Phillips to create the model in the first place. Throughout various countries and time periods, this relationship does appear to exist. Even if the data does not show that the model does not hold up in the long-run, we still must recognize that the data does appear to show that it does in the short run.
Austrian Economists have generally been skeptical of the Phillips Curve. The stagflation of the 1970s appears to justify that skepticism. Austrian theory rejects the idea that inflation and unemployment must be inversely related. However, if Austrians are to refute the Phillips Curve, the empirical data must be explained. If the tradeoff in the Phillips Curve does not exist, as Austrians would claim, why does it appear to be present in the short-run?
To argue against the Phillips Curve, Austrians have two options. We could argue against the underlying logic and then attempt to show how the data is misleading. The alternative option is to not reject the Phillips Curve per se, but rather, to take the model and interpret it through an Austrian lens to show how the data supporting the model can be integrated into an Austrian framework. To do this, we must employ the use of an Austrian model: Austrian Business Cycle Theory (often shorted to ABCT).
ABCT involves three main components: inflation, interest rates, and capital structure. First, the Austrian understanding of inflation. Austrian analysis emphasizes that the location at which new money enters the economy is of great importance. For example, if we were to hand over a large sum of newly minted money to the citizens of New York City, we would expect prices for goods and services to rise in New York City before they would start to rise anywhere else. If we inflate the money supply and give it to accountants, goods and services that accountants generally buy will increase before we will see price increases anywhere else in the economy. In economics terms, Austrians understand that money is not neutral.
The second component is the interest rate in the economy. Austrian analysis emphasizes that interest rates are not just the cost of borrowing money. Interest rates serve a much greater purpose. Interest rates reflect the time preference of society. Time preference is simply how much you are willing to sacrifice in the present to reap greater rewards in the future. If one decides to save 99% of their income, they have a very low time preference. You are willing to consume very little in the present to consume more in the future. If one decides to save only 1% of their income, that would be a relatively high time preference. You are not willing to give up very much consumption in the present to consume more in the future. Likewise, if society as a whole decides to save a large portion of their income, then we say that society has a low time preference. That time preference is reflected in the interest rate. If there are move savings in the economy, there are more savings to be lent out the potential borrowers. A higher supply decreases price, which in this case is the interest rate, the price of borrow money.
The third component is the capital structure of the economy. The Austrian view of capital sees capital as being heterogeneous. Contra Neoclassical views on capital, Austrians recognize that not all capital is the same. A truck, a hammer, and a sheet or iron are all capital, and all serve different purposes. Capital is not just Because of the heterogeneity of capital, the organize of capital in an economy forms into a structure. Goods progress along this structure until they reach the end, where they are sold as consumers goods.
The capital structure is affected by time preference as well. If time preferences in society are lower, there will be less demand for consumers goods at the end of the capital structure. However, interest rates will be lower. With lower interest rates, investment projects into new capital goods will become profitable when they were not so before. At the same, resources that were employed in the production of consumers goods are now available to be shifted to capital goods industries to meet the growing demand. If time preferences increase, then the opposite shift occurs and interest rates go up and more resources are shifted to consumers goods industries.
We can now put all three of these components into one unified theory of the business cycle. If there were to be new money created and put into the loan market, the effects of that new money would affect the loan market before it would affect the rest of the economy. Specifically, if new money was printed to be lent out to borrowers, we would expect a reduction in the interest rate. With a fall in the interest rate, capital investment projects that were not profitable before would now become profitable. As a result, there would be in an increase in investment relative to consumption. However, there is a problem. There has been no lowering of time preferences by society. Society as a whole has not decided to reduce its consumption and increase its savings. The only reason that these new investments seemed profitable is because of new money created and then lent out to borrowers. If it were not for this new money being printed and lent out, these new projects would have never been embarked upon. As such, the interest rate has been artificially lowered and resources have been shifted to meet the new demand in capital goods created by that artificial lowering.
Therefore, the economy is now on an unsustainable path. Investment is increasing while society never lowered consumption. If the inflation injected into lending markets is a one-time injection, then once the interest rates return to normal rates, it will become apparent that the choices made by entrepreneurs to start investment projects and decisions made to move into industries to have supply those investment projects were all mistakes. When this occurs, a readjustment process is necessary. Entrepreneurs will go bankrupt and have their resources distributed to others. Workers will be laid off and be hired by other companies.
If the money injection is not a one-time occurrence, then the economy is kept in this unsustainable state. This is done through repeated injections of new money into lending markets. This cannot be kept up forever, however, as each succeeding round of inflation must be larger than the last to account for the increase in prices that the previous inflations have caused. The end result of this practice is either hyperinflation or the printing presses are eventually halted. When the new money dries up, then the interest rate returns normal and the economy goes bust.
As a result, Austrians view the bust that results as being a necessary and good part of returning the economy to normal. The previous capital investments were unsustainable, and thus, must be liquidated in order to return the economy to its normal working order. The boom resulting from cheap money creates the unsustainable situation that the bust must fix. They are hand in hand. You cannot just have the boom without the bust, nor would we want to, according to the Austrian viewpoint.
This is the Austrian Theory of the Business Cycle, and it provides to us a useful framework to look at the Phillips Curve. A short-run relationship between inflation and unemployment makes sense within its context. The cause of the business cycle is the creation of new money that results in the artificial lowering of interest rates. Without new money being pumped into lending markets, the boom-bust cycle would never occur. Creation of new money will lead to inflation and the increase of prices everywhere in the economy.
Eventually, the inflation must come to an end. When it does, the unsustainable investment projects and resources used to create the will be liquidated. There will then be a great increase in bankruptcies and unemployment throughout the economy as resources are shifted to other sectors of the economy. This will lead to increased unemployment, especially among industries that were employed in the creation of capital goods.
The framework of Austrian Business Cycle Theory gives us a pattern where we have creation of new money, which then leads to a bust that causes unemployment. In other words, a cycle between inflation and unemployment. Once the inflation stops, and interest rates return to normal levels, then the bust comes, which brings unemployment. Once one stops, the other begins.
It is here that we see the Austrian tradeoff between inflation and unemployment. While not the direct relationship posited by the Philips Curve, it explains why the phenomena occurs in the data. The true nature of this relationship is not in the inflation and unemployment themselves, however. The relationship is one of economic boom leading to economic bust. The inflation and unemployment are just the outcomes of the boom-bust cycle. From the Austrian Perspective, the Phillips Curve is not a tool for economic policy, but rather, a picture of the consequences of inflation the money supply through banks and the loan market.
In this way, the Phillips Curve is not a graph where we can choose our path directionally. We cannot move from one part of the graph to the other at will. Once we start on inflation on the money supply, the graph only goes towards unemployment, and must necessarily do so. Once we artificially lower the interest rate, it will create malinvestments which must be liquidated. We cannot turn back. Unemployment will come. It is inevitable. It stands before us, and we are but a raft floating helplessly towards a giant waterfall. We can delay the drop with more and more rounds of increasing inflation, but it only delays the inevitable. Once our journey is started, it must finish.
Once the drop occurs, inflation will decrease (assuming that the government does not try and reinflate the boom like it did in the 70s), but unemployment will increase. It is here, in the doldrums of high unemployment, that we will remain until the economy returns to normal or a new boom is created through new rounds of cheap money. When this occurs, we start back up on the top of our Phillips Curve, with the next drop coming up. Who knows how many more drops there might be?
The mistakes that lead to the boom-bust cycle and the trade-off of the Phillips Curve are made time and time again. The Phillips Curve is depressing in this way. It tells a story that is repeated over and over again, with no end in sight. Identical errors made generation after generation. This does need to be so, however. If we can learn from the past and halt the artificially expansion of credit into the banking system, the business cycle can be halted in its tracks. With interest rates remaining at their natural levels, there can be no mass malinvestments to be liquidated. The constant up and down, inflation and unemployment, of the Phillips Curve can finally be put to an end. If the boom-bust cycle can be stopped for good, then the Phillips Curve can finally be laid to rest.
