Inflation and Unemployment

Standing in line marking time
Waiting for the welfare dime
'Cause they can't buy a job
--Bruce Hornsby & The Range

Frank Hollenbeck suggests various flawed rationales for the Fed's current monetary policy, including the proposition that greater inflation reduces unemployment. This claim seems so preposterous that most would dismiss it out of hand.

But economists, it seems, have no general claim on straight thinking. The rationale traces back to a paper by Phillips (1958) where he reported a negative relationship between unemployment and change in wages in the UK:

It should be noted that the 100 years of data used by Phillips corresponded to a period when Britain was on the gold standard and general price inflation was low. Therefore, the original 'Phillips Curve' can be seen as reflecting the relationship between higher real wages--the result of higher productivity--and unemployment.

Stated differently, the higher the productivity (which raises real wages), the lower the unemployment.

Over the years, however, economists have bastardized the relationship. Today's Phillips Curve removes the original gold standard/higher productivity context and merely posits a negative relationship between inflation and unemployment:

The prescription is straightforward. Simply print more money and unemployment should fall. Of course, money is a unit of exchange--not an economic resource. Printing money only changes who gets claims on economic resources--not the total amount of economic resources in the system.

The prescription is problematic on several other fronts as well. There is no guarantee that money printing gets into the hands of producers--newly printed cash might find its way into other channels. Even if the cash does make its way into worker's hands, nominal rather than real wages would be increased. Nominal wage increases are likely to push up the general price level, leading to upward price spirals that can be difficult to control (see Revolutionary France and Weimar Germany).

This has led some economists to rationalize a possible short term benefit of inflation with respect to unemployment. In the short term, inflation lowers a worker's real wages and these lower real wages make hiring cheaper workers more attractive to employers. However, once workers figure out that they have been duped and are working for less, then they will demand reparation either from employers or from the government. All of which makes any reduction in unemployment temporary at best.

John Hussman has studied the empirical evidence and finds a positive, not negative, relationship between CPI inflation and the unemployment rate one year later:

However, when current unemployment is related to subsequent wage changes then the negative relationship revealed by Phillip's (1958) original study comes back into focus:

Hussman summarizes the resulting relationship simply. Wages rise, relative to other prices, when unemployment is low and labor is scarce. Wages fall, relative to other prices, when unemployment is high and labor is abundant.

This is simple ECON 101 supply and demand stuff. It is not a relationship that can be manipulated to create jobs or lower the unemployment rate.

Unless/until central bankers and other policymakers figure this out, the economy will sputter until the money printing causes interest rates and prices shoot higher.

Then real economic malaise commences.

position in gold

Reference

Phillips, A.W. 1958. The relationship between unemployment and the rate of change of money wage rates in the United Kingdom, 1861-1957. Economica, 25: 283-299.