Economists may die, but their ideas can live on for decades or centuries. Sometimes a theory may seem dead, only to come back, like Lazarus. New Zealand economist A.W. "Bill" Phillips passed away in 1975, but his ideas endure at the core of Federal Reserve policymaking, 55 years after he expressed them.
Phillips' idea is that there is a trade-off between inflation and unemployment. As with many economic models, it can be expressed graphically, in this case in the Phillips Curve that millions of intro econ students have learned. However, unlike the supply-and-demand curves accepted as useful for 130 years or so, opinions on the Phillips Curve have changed.
In the first 20 years after its 1958 introduction, the downward-sloping curve was taught as gospel: If government acted to lower unemployment (through lower taxes, higher government spending and lower interest rates resulting from a greater money supply) it ran the risk of higher inflation. The more aggressively it did so, the greater the inflation. If it tried to curb inflation through government austerity - higher taxes and lower spending - coupled with crimping the money supply to raise interest rates, it was doomed to increase unemployment.
The terms of the tradeoff varied. Very high rates of employment initially could be brought down without much inflation. Ditto for very high rates of inflation that could be reduced for a while with little increase in unemployment. But in the middle of the curve there was a significant tradeoff. Some saw it as having to choose one's poison, others as always having a way of fleeing the more painful alternative.
Phillips did not arrive at this via abstract theorizing. Rather, he looked at rates of unemployment and changes in wage rates for the United Kingdom from 1861 to 1957. Other scholars found similar relationships in other countries. In 1960, MIT economists Paul Samuelson and Robert Solow, both later Nobel laureates, generalized Phillips' work incorporating consumer prices rather than wages and expressing it in a formal mathematical model. Along the way, others noted that U.S. economist Irving Fisher had pointed to the same relationship back in the 1920.
It rapidly became accepted wisdom because it meshed with the Keynesian theory that dominated academia and was coming to the fore in applied government policy. British economist John Maynard Keynes had argued that governments could moderate the business cycle with stimulus spending and easy money in recessions mirrored by fiscal austerity and tight money when booms threatened to boost inflation.
Keynes' followers, including Samuelson, Solow and Yale economist James Tobin (Janet Yellen's mentor) took this all much further than Keynes had himself.
There never was universal agreement, however. The "monetarists" led by Milton Friedman and the Austrians, typified by Friedrich Hayek, never accepted it. At first, they were voices crying in the wilderness, but as Keynesian "countercyclical policies" first applied in the 1950s and 1960s were accentuated in the 1970s, especially in the wake of the 1973 OPEC oil embargo, more and more problems appeared.
Continued application of such policies seemed to push the whole curve out, resulting in higher combinations of both inflation and unemployment than before. Keynes and the Phillips curve implicitly assumed you could have either rising inflation or rising unemployment, but not both.
But by the late 1970s many industrialized countries, including the United States and most of Europe, inexplicably (by Phillips' model) suffered from "stagflation," with high unemployment, low growth of output and rapidly rising prices.
The cohort of young theorists, who led the "rational expectations revolution," explicitly rejected Keynes and argued that, in the long run at least, there was no trade-off at all between inflation and unemployment. The "long-run Phillips curve" was a vertical line with the same rate of unemployment at every possible rate of inflation.Most economists accept that now.
For the first 25 years or so, econ texts stressed the validity of the curve. But after the mid-1980s, they instead warned of its limitations.
Nevertheless, a third of a century after the rational expectations group thought they had thoroughly refuted Keynes, the Federal Reserve's policy-making Open Market Committee apparently follows a Phillips Curve model. Starting in late 2012, it adopted criteria first suggested by Chicago Fed President Charles Evans to keep short-term interest rates near zero until unemployment drops to 6.5 percent or inflation rises above 2.5 percent. Minneapolis Fed President Narayana Kocherlakota, once thought part of the rational expectations camp, suggested slightly different triggers of 5.5 percent unemployment and 2.25 percent inflation.
Despite its rejection by some of the best and brightest academic economists, and being viewed as dangerous heresy by most Republicans in power, Keynesian ideas live on in the FOMC, as well as at the Bank of Japan and the International Monetary Fund.
The thought is low interest rates stimulate increased output and hence employment. But to keep interest rates low, one has to increase the money supply.
If money grows too fast, inflation results. So we need to find the best tradeoff between lowering unemployment and controlling inflation.
That is Keynes and Phillips in a nutshell. It is just another example of what Todd Buchholz, author of a very readable history of economic thought called "new ideas from dead economists."
Economist Edward Lotterman teaches and writes in St. Paul, Minn. Write him at email@example.com.