Wealth of Nations October 2006

Prizing Independent Thinking

Edmund S. Phelps, the latest Nobel laureate in economics, has never commanded the attention outside the economics profession that his brillance warrants.

Last week the Royal Swedish Academy of Sciences finally addressed the biggest and longest-standing anomaly in its roll of Nobel laureates in economics: the fact that the name of Edmund S. Phelps was not on it. Phelps, a Columbia University professor, co-invented modern macroeconomics—the study of aggregate output, inflation, and unemployment, and the policies that affect them. The ideas that all mainstream economists now carry around in their heads about how economies respond to interest rates or taxes or public spending spring from a theory developed independently by Phelps and Milton Friedman at the end of the 1960s. Friedman got his Nobel 30 years ago, for this and other work. It is a travesty that Phelps had to wait so long to be recognized, especially when you look at some of the names honored in the intervening years—but, still, better late than never.

Phelps's ascension to Nobel immortality is especially welcome for another reason. He has never commanded the attention outside the economics profession that his brilliance, interests, and practical turn of mind ought to have brought him. Why was that? The likely answer, I think, is worth pondering because it reflects badly on America's political culture. It is that Phelps is an independent thinker. He has followed no particular school, has run with no duly constituted political tribe.

This is not true of the figures who have overshadowed him in popular acclaim. Friedman's influence—though founded, without question, on his stature as a thinker and a scholar—also owed something to the fact that he supplied the brainpower for a whole political movement. And some lesser economists, or pseudo-economists, such as John Kenneth Galbraith, were equally lauded in their time even though (as I argued of Galbraith in a previous column) they brought little more to the table than an affectation of intellectual profundity. The conservative Friedman and the liberal Galbraith disagreed about everything. That, and the attention they commanded outside their professional circles, were mainly what they had in common:

People knew whose side they were on.

Phelps has always been difficult to place. This is not because he ventures no politically charged opinions. He has taken stands, based on careful economic reasoning, on some controversial issues—but the thing is, he is inconsistent, politically speaking. He does not appear to be on anybody's side. Sometimes he sounds like an unyielding conservative, sometimes like a raging liberal. The man is downright unpredictable. America cannot tolerate that in its public intellectuals, any more than in its politicians.

The implications of the Phelps-Friedman breakthrough of the late 1960s were "conservative," to be sure. At that time orthodox thinking in economics held that governments had to grapple with a long-term trade-off between inflation and unemployment. You could run an economy at a high level of demand and create jobs for all who want to work, but that would push inflation up; or you could keep inflation low by curbing demand, but that would raise unemployment. In the early postwar years, most governments believed that they were ruled by this dilemma. They could steer for low unemployment and high inflation or low inflation and high unemployment, but not for both low inflation and low unemployment.

In this once-prevailing view, good economic policy was a matter of striking a balance between the two objectives and avoiding the instability that veering from one to the other would cause. This mandate had a political dimension. The Left cared more about keeping unemployment low than about avoiding inflation and promoting stability. The Right tended to prefer the opposite.

While disagreeing about priorities, both sides thought about ways to defeat the underlying trade-off. For many years, most left-leaning economists advocated central control of wages and prices. That way, they thought, you could run the economy at a level of demand sufficient to suppress unemployment while avoiding the inflation that would otherwise result. Right-leaning economists warned of the unintended consequences of regulation and the hidden costs of price and wage distortions.

Nonetheless, the notion that price and wage controls could resolve the dilemma was so appealing that, at one time or another, most governments gave them a try. The results were always disappointing, especially in the United Kingdom and Western Europe, which persisted more than most in the effort. (America's flirtation with this approach, incidentally, was the origin of today's wasteful and inequitable employer-based health insurance system, which firms first adopted as a way to evade wage controls. Talk about unintended consequences.)

Phelps and Friedman overthrew this whole way of thinking. If there was ever such a thing as a paradigm shift in modern economics, this was it.

In the old model, high inflation kept unemployment low by cutting wages. In the first instance, the theory went, prices rise faster than wages, so employers hire more workers. As far as they are concerned, the cost of labor is falling. Workers, meanwhile, are as willing to work as before because (so the theory insisted) they do not understand that inflation is cutting their pay.

Phelps and Friedman would have none of that. Workers would not only notice that inflation was cutting their wages but also look ahead and anticipate it. Wages would rise in line with prices. And if that happened, inflation could not boost employment. Except in the short run, unemployment would be determined by structural features of the labor market—that is, by factors that had nothing to do with the level of demand in the economy. If the government added to demand to drive unemployment lower than this "natural" rate, the result would be higher (indeed accelerating) inflation. The long-term trade-off between inflation and unemployment, the premise for decades of debate about macroeconomic policy, was an illusion.

To begin with, Phelps and Friedman were advancing a competing theory. Straight away, however, the 1970s—a decade of both high inflation and high unemployment—proved this basic theory correct, to the satisfaction of almost all mainstream economists.

It is, as I say, a conservative-leaning theory, insofar as it tells governments that demand-side policies cannot keep unemployment lower than the rate dictated by supply-side factors. That was something that the Left did not want to hear. And the sudden validation of this theory, together with its seeping into popular thinking about economic policy, surely had a lot to do with the subsequent resurgence of economic conservatism in America and Europe. Although Phelps (unlike Friedman) achieved little fame, he was, therefore, extraordinarily influential. He was present at the conception of what you might call the conservative consensus of modern economics—and he deserves his share of credit, or blame, for the far-reaching implications of that new view for everything that has happened since in Western politics.

Yet, despite all that, Phelps is not a conservative—not, at any rate, the kind that other conservatives would want on their team. Like an outright liberal, for heaven's sake, he has long been preoccupied with the need to make work pay all across the income scale. Enforced or encouraged idleness corrodes society, he believes. A healthy economy needs to keep all its people employed, and that means paying a decent income in return for work, even to those with few or no skills.

In 1997, he set out a stunningly ambitious proposal to that end in his book Rewarding Work. He called for a massive program of low-wage subsidies (costing well over $100 billion a year in 1997 dollars, or not much less than 2 percent of national income). A plan on this scale, he argued, would transform the prospects of the low-paid and, just as important, the prospects of those who opt out of the labor force altogether, either to be idle or to make a career out of crime. It would be very expensive but worth every cent.

The book attracted some attention (in this column, I may say, and elsewhere), but not nearly as much as it deserved. Maybe liberals were reluctant to applaud a contribution from the father of conservative macroeconomics. And conservatives just scratched their heads at the idea of this weirdo Phelps ("I thought he was a friend of Friedman's") distantly outflanking liberals on the left with the scale of his ambition to assist and empower the low-paid. In The Wall Street Journal last week, in a column celebrating Phelps's achievements and his Nobel Prize, David Henderson of the Hoover Institution dismissed Rewarding Work in a single sentence, as though it were a puzzling aberration, an unaccountable lapse in standards. Actually the book was as carefully argued as anything else Phelps has written—and, by the way, entirely consistent, so far as the economic reasoning goes, with his other work.

In America's politics and in its public intellectual life, people like Phelps don't fit. Gang loyalty trumps curiosity, open-mindedness, and intellectual honesty every time. It's depressing. But Phelps has finally got his Nobel, and that is something.

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