An Austrian Reconstruction of the Phillips Curve
The Phillips Curve has one of the most colorful and storied pasts of any economic model. Once embraced as a powerful tool for economic theory and monetary policy, it has fallen out of favor in recent decades. In the present day, it is almost exclusively referred to in the past tense — as a model that was useful at one point, but no longer (Gordon 2010). It remains famous (or perhaps, infamous) even today, but is no longer a relevant aspect of macro-economic analysis.
Ever since the inception of the Phillips Curve, economists within and adjacent to the Austrian School tradition have remained skeptical of its explanatory power (Shostak 2018, Oliver 1999). However, the core framework of the Phillips Curve is highly compatible with an Austrian macroeconomic analysis — specifically in the area of Austrian Business Cycle Theory. By simply recontextualizing elements of the standard Phillips Curve model, it can be used to richen and strengthen Austrian analysis of the business cycle.
To demonstrate this compatibility, I will first recount a brief history of the Phillips Curve, after which, I will describe the mechanics of Austrian Business Cycle Theory as understood in the Misesian/Hayekian tradition. Once these are both established, I will elaborate how the Phillips Curve can be reconfigured to align with Austrian Business Cycle Theory. Lastly, I will discuss the conclusions and applications of this new view of the Phillips Curve.
A Brief History of the Phillips Curve
The origins of the Phillips Curve are found in the New Zealand economist, A.W. Phillips, after whom the curve is named. In 1958, Phillips published “The Relation Between Unemployment and the Rate of Change of Money Wages in the United Kingdom, 1861–1957”. In this paper, Phillips finds an empirical relationship between the increases in the nominal wage rate and unemployment. When unemployment is low, nominal wages rise more quickly. When unemployment is high, nominal wages rise more slowly. Phillip’s work was noticed by Paul Samuelson and Robot Solow, who later applied Phillip’s findings to the problems on inflation in the United States in their famous “Analytical Aspects of Anti-Inflation Policy”. Whereas Phillips was focused just on nominal wages in his paper, it would be Samuelson and Solow that would take his work and apply it more broadly to the problems of general price increases as a whole (Hoover 2015). The idea of a general trade-off between inflation and unemployment quickly gained popularity, and soon became ingrained as a tool of macroeconomic policy.
The Phillips Curve remained a reputable and oft-referenced model until the turbulent economic environment of the 1970s. Throughout the decade, the United States suffered from persistent high inflation and high unemployment. Within the logic of the Phillips Curve, this shouldn’t have been possible, especially over an extended period of time. This development — combined with the seeming inability of current economic policies to improve the situation — forced many economists back to the drawing board to re-examine their macroeconomic assumptions. The result was multiple revisions of the Phillips Curve by different schools of thought (Gordon 2010). The mainstream revision followed along the lines of the famous “Lucas Critique” and Friedman Natural Rate Hypothesis by implementing inflationary expectations into the classic Phillips Curve model. Rather than the trade off between inflation and unemployment being true both in the short and long run, it only held in the short-run. If a certain level of inflation is expected, then it will already be “baked into the cake” of future prices, and therefore, will not have any demand effects.
Since the 1970s, the Phillips Curve has gradually declined in popularity and usage. This is partly due to its more limited short-run application, but also a result of mounting empirical data that does not fit into the model. This is especially true in the post-2008 era, where central banks all over the world maintained historically low interest rates while also keeping inflation low. In such a policy landscape, the Phillips Curve has increasingly less explanatory power. Illustrative of this point are recent comments from Fed Chairman Jerome Powell, stating that the Phillips Curve relationship is just a “faint heartbeat” at this point (Kiernan 2019). As a result, alternative models for understanding inflation have gained traction in recent years as the luster of the Phillips Curve has faded.
Austrian Critiques of the Phillips Curve
Since its inception by Phillips in 1958, Austrian School economists have remained skeptical of the Phillips Curve’s trade-off of inflation and unemployment. As Murray Rothbard writes,
“Originally, the Keynesians promised us that by manipulating and fine-tuning deficits and government spending, they could and would bring us permanent prosperity and full employment without inflation. Then, when inflation became chronic and ever-greater, they changed their tune to warn of the alleged tradeoff, so as to weaken any possible pressure upon the government to stop its inflationary creation of new money.
The tradeoff doctrine is based on the alleged “Phillips curve,” a curve invented many years ago by the British economist A. W. Phillips. Phillips correlated wage rate increases with unemployment, and claimed that the two move inversely: the higher the increases in wage rates, the lower the unemployment. On its face, this is a peculiar doctrine, since it flies in the face of logical, commonsense theory. Theory tells us that the higher the wage rates, the greater the unemployment, and vice versa. If everyone went to their employer tomorrow and insisted on double or triple the wage rate, many of us would be promptly out of a job. Yet this bizarre finding was accepted as gospel by the Keynesian economic establishment.
By now, it should be clear that this statistical finding violates the facts as well as logical theory. For during the 1950s, inflation was only about one to two percent per year, and unemployment hovered around three or four percent, whereas nowadays unemployment ranges between eight and 11 percent, and inflation between five and 13 percent. In the last two or three decades, in short, both inflation and unemployment have increased sharply and severely. If anything, we have had a reverse Phillips curve. There has been anything but an inflation-unemployment tradeoff.
But ideologues seldom give way to the facts, even as they continually claim to “test” their theories by facts. To save the concept, they have simply concluded that the Phillips curve still remains as an inflation-unemployment tradeoff, except that the curve has unaccountably “shifted” to a new set of alleged tradeoffs. On this sort of mind-set, of course, no one could ever refute any theory.
In fact, inflation now, even if it reduces unemployment in the short-run by inducing prices to spurt ahead of wage rates (thereby reducing real wage rates), will only create more unemployment in the long run. Eventually, wage rates catch up with inflation, and inflation brings recession and unemployment inevitably in its wake. After more than two decades of inflation, we are all now living in that “long run.” (Rothbard 1984)
As Rothbard points out, the embrace of the Phillips Curve by economists and policy makers was not based on any economic theory demonstrating an inflation/unemployment tradeoff. Rather, it was the result of ad-hoc grafting an empirical relationship into economic theory. As Rothbard also points out, because of this unsound theoretical footing, they were unable to explain the stagflation of the 1970s. The necessary result was a shifting of the doctrine, in addition to feelings of vindication by many Austrian scholars.
Criticisms aside, the fundamental idea of a trade-off between inflation and unemployment should not be hastily rejected by Austrians. This trade-off expresses similarly macroeconomic dynamics to a core piece of Austrian theory: the Austrian Business Cycle Theory (ABCT). To illustrate this, I will describe the main tenets of ABCT, and then examine those tenets through the lens of inflation/unemployment.
Austrian Business Cycle Theory
Austrian Business Cycle Theory takes place in several steps:
- Credit Expansion
- Malinvestment
- Boom
- Credit Relaxation
- Realization
- Bust
The business cycle begins through an initial burst of credit expansion. This occurs when (either through a central bank or fractional reserve banking system) new money is created and injected into credit markets. This influx of these funds results in a lower interest rate — a rate lower than would have prevailed on markets absent any money creation. These artificially-lowered interest rates spur entrepreneurs to engage in a different set of investment projects than they otherwise would have pursued. However, these investments are fundamentally unsound because they are only undertaken through artificially low interest rates. However, their deleterious nature will not be revealed until later.
This increased investment accelerates economic activity and leads to the economic boom of the boom/bust cycle. Business is good, and the economy appears to be doing well. However, interest rates cannot remain low indefinitely. The same process that brings about credit expansion — increases in the money supply — also brings about inflation. The longer credit expansion continues, the greater the pressure will be from the public to reduce inflation. When they are raised back up to their natural level, the investments made by entrepreneurs are revealed to be mistakes. As the cost of continuing to finance their investments increases, while the projected revenue of these investments decreases, they are eventually forced to realize their losses and liquidate their investments. These losses all throughout the economy result in the economic crash that infamously follows the bust, and the economy goes into a period of readjustment and reallocation of resources before growth can begin again.
ABCT differs from other business cycle theories in several major ways. First, the goal of policy-makers should not be to sustain the boom, but to end it as soon as possible. As Austrians uniquely understand, the boom is where unsustainable mistakes are made. The economy is in a euphoric state precisely because it cannot last forever. Secondly, the bust is a painful, but necessary adjustment. Resources need to be diverted away from unprofitable to profitable ventures. This causes a great deal of pain in the economy (especially if the boom was prolonged), but once the mistakes are made in the boom, then the bust has to happen.
Austrianizing the Phillips Curve
In the economic story of ABCT, there is a subtle inflation/unemployment dynamic at work — the same dynamic displayed in the Phillips Curve. The boom period is fueled by money creation, which inevitably leads to inflation. But the increased economic activity of the boom also leads to a higher demand for labor, and therefore, decreased unemployment. In other words, the boom period is marked by high inflation and low unemployment. This relationship is flipped in the bust period. When interest rates are raised back to their natural level and credit expansion halts, inflation decreases as well. The bust also results in economic losses being incurred and firms going bankrupt, which inevitably leads to layoffs and an increase in unemployment. Thus, the bust is marked by low inflation and high unemployment.
Nevertheless, the macroeconomic dynamics of ABCT don’t align perfectly with the Phillips Curve. On the Phillips Curve, the relationship between unemployment and inflation can — in theory — move both ways at any given time. We can always “trade” more inflation for less unemployment and vice versa. However, the events of ABCT follow along a given path: first a period of high inflation and low unemployment and a subsequent period of low inflation and high unemployment. This narrative structure can be illustrated through the graph below, which I dub the “Credit Expansion Curve”:
Figure 1
Tracing along this curve above in Figure 1, we can illustrate each phase of the business cycle in terms of inflation and unemployment:
Figure 2
At Point 1 in Figure 2, the economy in a pre-credit expansion state, where both inflation and unemployment are at moderate levels. When credit expansion begins, the economy is “pushed” up the credit expansion curve up to Point 2. At this point, the economy is experiencing the high inflation and low unemployment characteristic of the boom. Once credit expansion ceases, the economy is plunged into the bust, dropping down the curve to Point 3. At this point, the economy is suffering through the recovery process, bringing with it high unemployment and low inflation. As this recovery continues, the economy slowly returns back to Point 1 until another cycle of credit expansion begins.
This graph only represents the economy during a one-time (or at least, very short) injection of artificial credit. In reality, credit expansions almost always take the form of constant, repeated rounds of money creation. This results in increased inflation, and a continuation of the boom period. The inevitable consequence of this heightened boom period is increased inflation, and an even more painful bust. These repeated rounds of credit expansion can be represented by a gradual climbing up the credit expansion curve. The higher up the economy is “pushed” up the left side of credit expansion curve, the harder it will fall along the curve in the crash in the right side:
Figure 3
In Figure 4, the economy starts at Point 1, in a pre-boom state, but moves up to Points 2, 3, 4, and 5 consecutively as each round of credit expansion both fuels the boom and generates higher inflation. When the bust arrives, however, the economy slides far down the right side of the CE Curve, illustrating the painful liquidation of the mistakes made during the exuberance of the boom. As history would tell us, credit expansions are rarely composed of one-time “injections”. Especially in the age of central banking, credit expansions can be continued for years on end, which leads to an ever-expanding boom and ever-expanding piles of malinvestments to be revealed. Consequently, this scenario of rising, sustained boom is much more applicable to the business cycles we see in practice today.
The scenario of stagflation can be illustrated through the Credit Expansion Curve as well. Stagflation occurs once the bust has arrived, but a new round credit expansion is begun to try and combat the consequences of the bust and restore the illusory economic growth of the boom. The result is that the economy suffers from both the inflation of credit expansion and the unemployment of the bust simultaneously — the worst of the both worlds:
Figure 4
In Figure 4 above, the economy moves from Points 1, 2, and 3, as outlined above, but the onset of stagflation moves the credit expansion curve outwards, landing the economy at Point 4 on CE 2. This is because the particular environment of stagflation alters the relationship between inflation and unemployment.
The direction the economy takes in this stagflationary period depends on the duration and intensity of the renewed credit expansion, as well as how entrepreneurs react to that credit expansion. It may be that entrepreneurs are willing and eager to leap upon the cheap credit once again and another destructive boom has begun. However, the cheap credit may also fall on deaf ears, with the entrepreneur class discouraged by the bust and unwilling to expand their business activities. Regardless, the introduction of another round of credit expansion during the bust either prevents or delays the necessary redistribution of factors from taking place. Thus, the economy remains unprepared for sustainable economic growth until this readjustment process can take place.
Limitations
The business cycle — as is typical in the field of economics — is never quite as simple as a model might depict. Depending on the specific circumstances at hand, the inflation/unemployment tradeoff can be altered, or possibly even eliminated altogether.
First, it is possible that an increase in prices expected during the boom may be largely or entirely offset by productivity gains. If the economy is growing during the boom period, the real gains from increased productivity may counteract the inflation resulting from the inflation, with the net result being a moderate or negligible inflation rate. This isn’t just a theoretical concern either — it has precedent in history. During the 1920s leading up to the Great Depression, the Federal reserve was engaged in a lengthy credit expansion. However, the simultaneous reduction in prices due to the expanding American economy led to only moderate price increases. In this case of expanding productivity, a decrease in the inflation brought about by a credit expansion would flatten the left end of the CE Curve. The result is a curve that extends along the X-axis and climbs only very slowly up the Y-axis.
It is also possible that the unemployment resulting from the bust may also be abrogated through government intervention. The bust is characterized by the realization of malinvestments, and the subsequent failing of businesses. However, if the government — either directly or indirectly — helps to support these businesses and prevent their collapse, they may avoid some or most of the unemployment that should have resulted from the bust. To be clear, such a policy is far from harmless. The cost of delaying the economic readjustment within the bust is that resources that were employed in unprofitable investments cannot be reallocated. This cripples the economy’s ability to grow after recovery has taken place. Even so, these measures would alleviate the pain of high unemployment, even if that pain is ultimately beneficial. These interventions bend the right side of the CE Curve downward, increasing its slope into a curvature resembling an “L” shape.
Another potential factor that may serve to prolong the unemployment brought about by the bust is “entrepreneurial malaise”. As Ludwig von Mises pointed out in his seminal work, Human Action, the necessary losses and bankruptcies suffered during the bust cause entrepreneurs to lose confidence in themselves and their forecasting ability (pg. 576). The optimism of the boom period had convinced them that the economy was strong and they could continue to expect strong profits and returns for the foreseeable future. All of that changed when their malinvestments were revealed and they discovered they had been bamboozled. Consequently, they will be wary of any new business ventures after the bust strikes, being much less willing to risk capital on unproven lines of production. Depending on how long this “malaise” lasts, it may impede the recovery process, resulting in a slower readjustment along the CE Curve in Figure 2 from Point 3 back to Point 1.
Applications and Conclusions
The Credit Expansion curve helps Austrian theorists understand Austrian Business Cycle Theory through the dual lens of inflation/unemployment. Whereas the traditional Austrian narrative of the business cycle focuses on the capital structure, the Credit Expansion gives an alternative vector of understanding. Given that inflation and unemployment are the two most watched and discussed macroeconomic metrics, understanding ABCT in their terms is a useful theoretical tool. While there are many factors that can affect these variables over the course of a business cycle, modeling how they react to credit expansion allows us to better understand the symptoms of the business cycle and its phases.
This model can also serve as a valuable pedagogical tool, especially as outreach to those working in Neoclassical or Keynesian traditions. Traditional Austrian exposition of ABCT involves discussions of the time preference, capital theory, entrepreneurship theory, and more. While these are all important and necessary elements of ABCT, they may confuse those not already familiar with Austrian theory. In contrast, the Credit Expansion curve presents a more simplified way to understand the boom/bust cycle from an Austrian perspective.
Lastly, the Credit Expansion Curve can also be useful for empirical analysis and description of the business cycle. Because the boom is accompanied by high inflation and low unemployment, and the bust vice-versa, this allows us to pinpoint at what periods in the past a boom period ends, and a bust period begins. While not a fool-proof measure, it may serve as a valuable indicator for what phase of the business cycle the economy is experiencing.
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