Thomas I. Palley: Time is up for Milton Friedman
[Thomas I. Palley is the founder of the Economics for Democratic and Open Societies Project. ]
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. ...
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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. ...