The committee members who choose Nobel laureates worry that history will judge their insights. Sometimes, they hedge their bets by honoring leaders from opposing sects within the discipline. That happened this year in awarding the economics prize to Edmund Phelps, a professor at Columbia University.
In his prize-winning work from 1968, Phelps recognized a gaping hole in the Keynesian theory that dominated in the 1960s. Phelps’ response was to patch the hole, not discard the theory. Ten years later, a younger set of economists looked at the same defects in the foundations of Keynesian theory and chose to implode the whole structure.
A quick review of the history of economic thought helps put things in perspective. The 1776 publication of Adam Smith’s “The Wealth of Nations” marked the birth of modern economics. When it came to the role of government, Smith’s advice was clear: Government should play a minimal role in economies. Private markets, left alone, might not bring utopia, but would have better results than any other system.
This doctrine of minimal government intervention dominated “the economic thought, both practical and theoretical, of the governing and academic classes” for 160 years, wrote English economist John Maynard Keynes in his “General Theory of Employment, Interest and Money.” Keynes argued in his book that the minimal government prescription was wrong.
Though Keynes had been brought up on the ideas of Smith and his followers, in 1936 he rejected what he long had assumed in reaction to the Great Depression. Keynes argued that governments could and should actively intervene to manage national economies.
When economies fall into recession and unemployment rises, Keynes said, government should cut taxes, increase spending and increase the money supply so as to lower interest rates. If, instead, an overheated economy produced inflation, government could control it by raising taxes, cutting spending and decreasing the money supply to raise interest rates.
Economists have argued about Keynes’ ideas ever since. He died in 1946, just as governments in Europe began to use his policies. With John Kennedy’s election in 1960, the U.S. government overtly adopted Keynesian policies.
Keynes’ early death kept him from fleshing out his theory, but his ideas came to dominate economics by the 1960s. Not everyone was convinced, however. Monetarists, often identified with Milton Friedman and the University of Chicago, rejected Keynesian tromping on economic gas and brake pedals.
Keynes implicitly assumed that the problem would be inflation or unemployment, but not both. In 1958, a New Zealand-born economist, A.W. Phillips, argued that there was an explicit trade-off between inflation and unemployment. If you wanted to lower inflation, unemployment would increase and vice versa. This trade-off became the accepted wisdom, especially among practical policymakers.
One theoretical weakness in Keynes was an implicit assumption that people would keep on responding by rote to government’s revving and braking. This obviously was not true. What people expected government would do affected economic decisions they made. These reactions by millions of people in turn limited the effectiveness of government policy.
Edmund Phelps recognized this flaw. He reworked Keynesian theory to incorporate the fact that people adapted their behavior to what government did and that their expectations influenced how policies worked.
One result of Phelps’ work was to discredit Phillips and others who saw a neat trade-off between inflation and unemployment. Phelps “expectations-augmented Phillips curve” demonstrated that, in the long run, government fiscal and monetary policy had no effect on the number of jobs.
His work came several years before simultaneous high inflation and high unemployment prevailed in the United States and Europe in the 1970s. Such “stagflation” vindicated Phelps’ argument that you could not buy more long-term jobs by accepting a shot of inflation.
Just as the Depression changed Keynes’ mind, so did the 1970s convert a cohort of younger economists trained as Keynesians. Robert Lucas, Thomas Sargent, Neil Wallace and others ran with the idea that people’s rational reactions to government policies were important.
Their “Rational Expectations” revolution argued that Adam Smith had been right all along. Government attempts to manage the economy were not just ineffective but also harmful. The economic pain of the 1970s did not occur despite Keynesian policies, it occurred because of these policies.
Lucas got the Nobel Prize in 1995 for work done in 1978. Now, Phelps gets the prize for work from the late 1960s. It’s a case of the Nobel committee not putting all its bets on one theoretical horse.
This is not new. Paul Samuelson, the most prominent U.S. Keynesian, received the prize in 1970. Friedman, the most-prominent anti-Keynesian, won in 1976.
Rational Expectations destroyed the hegemony of Keynesian ideas within economics, but Keynesianism has not disappeared. There are still many Keynesian economists and implicit Keynesianism still dominates government policy. But it is Keynesianism as revitalized by the insightful work of Edmund Phelps. He deserves the prize.
© 2006 Edward Lotterman
Chanarambie Consulting, Inc.