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Volume XLIV, No.49

Meaning of Nobel Prize to Phelps

Tuesday 24 April 2007, by Girish Mishra


The phenomenon of open or involuntary unemployment came up with the rise of modern industrial capitalism. This was because labour power became a commodity, that is, a subject of sale and purchase. People uprooted from land had no other means of production except their capacity to work. They had, of course, freedom to go wherever they liked and to work or not to work. The freedom not to work meant the decision to starve. The owners of the means of production as well as people with only their labour power or capacity to work needed one another to complete the process of production. The former had only one aim —to earn maximum possible profit by selling the final product or commodity. To achieve this aim, they tried to give as little as possible to the workers but there were constraints that could not be overcome.

In course of time, while workers united and formed unions to increase their wages and better the conditions of work, capitalists brought in the instrument of “reserve army of labour” to keep the workers “disciplined”. The fear of unemployment, quite often, acted as a restraint for the workers. Then there were lumpen elements to help smash collective actions by workers and help the capitalists keep them under control. This strategy, more or less, worked well till the Great Depression.

Capitalists, however, realised, after the painful years of the Great Depression, that they too had insurmountable constraints because mounting unemployment would deplete the volume of effective demand and commodities would remain unsold. Say’s law that supply creates its own demand was proved fallacious and was consigned to the dustbin. It was Keynes’ prescription of the government action to generate employment opportunities in order to increase the volume of effective demand to clear the market that saved capitalism. He emphasised full employment and growth. To quote Joseph Stiglitz,

Keynes was vilified by conservatives, who saw his prescription as increasing the role of government. They seized on the budget deficits that accompany a downturn as an occasion to cut back on government programs. But Keynes actually did more to save the capitalist system than all the pro-market financiers put together.

It was the impact of Keynes that full employment was accepted as an important aim by the governments in the West. State intervention to achieve this became crucial. The New Deal in America and the Beveridge plan of 1944 in UK came to embody this thinking. The existence and the impact of the Soviet Union was also a factor in moving the capitalist world towards striving for full employment and a welfare state.

This was, however, not to the liking of conservatives. A number of theories were advanced to counter Keynesianism. One of them was Phillips curve, advanced in 1959 by Alban William Phillips (1914-1975), a British engineer turned economist. William Phillips, the son of a New Zealand dairy farmer, taught at the London School of Economics. Using the British data from 1861 to 1913, he demonstrated that a negative relationship existed between unemployment and the level of inflation. It means that when unemployment rose, the rate of increase of money wages fell, and vice versa. This relationship came to be known as the Phillips curve.

Two leading American economists, Paul Samuelson and Robert Solow (both of whom were awarded the Nobel Prize), had a look at the Phillips curve in 1960 and came out with a two-fold advice to the US policy-makers. First, to maintain zero inflation, they must ensure that unemployment rate remained between five and six per cent. Second, at the unemployment rate of three per cent, which was regarded by most Americans as the full employment level, inflation would be between four and five per cent. Clearly, maintaining zero level of unemployment was not desirable. Thus, the objective of full employment was given a burial. Maintaining a particular level of unemployment was declared to be in the interest of the economy and the people because the real worth of money would be stable as inflation would be under check.

As ill luck would have it, the credibility of the Phillips curve nosedived during the 1960s and 1970s when the phenomenon widely known as “stagflation” became dominant. Both unemployment and inflation rose simultaneously. According to an analyst:

Comparing the average rates of inflation and unemployment in the years 1968-73 with those of 1961-7, for example, in nine out of the eleven major countries… both unemployment and inflation were clearly higher on average in 1968-73 than they had been in 1961-7. An even clearer break took place around 1974, with both inflation and unemployment being distinctly higher in the1974-9 period than even the 1968-73 period in 10 out of 11 major countries.” (Paul Ormerod, The Death of Economics, New York, 1994, p. 121)

The Phillips curve implied that, for any particular economy, at any point of time, there was a unique level of unemployment at which the rate of inflation would neither increase nor decrease. This unique level of unemployment came to be known as NAIRU or non-accelerating inflation rate of unemployment. Later on, it came to be regarded as natural rate of unemployment. In other words, this level of unemployment was regarded as virtually God-ordained. Any argument against this came to be taken as an act questioning the will of God or defying the all powerful forces of nature.

After computing or determining this God-ordained rate of unemployment, it was the sacred duty of a government to maintain it, come what may. In America, during the start of the 1960s, this was determined to be six per cent with an inflation rate of one per cent. Bringing down the unemployment rate to four per cent meant pushing up the rate of inflation to three per cent or so.

For all practical purposes, the Phillips curve was dead and almost confined to garbage heap of history till Edmund S. Phelps came forward to rescue and rehabilitate it to the great joy of monopoly capitalism. Professor at America’s Columbia University, beginning with 1968, he wrote a series of papers to claim that he had solved the riddle of stagflation and reiterate the validity of the Phillips curve. Phelps claims:

Keynes’ great work… had left it unexplained why involuntary unemployment is observed even in the best of times and why a drop of aggregate “effective demand” causes a rise of unemployment-why not a prompt fall of money wages and prices by just enough to forestall a fall of employment? The challenge was to resolve these issues while continuing to posit the elementary rationality that economics traditionally ascribed to workers, consumers and firms.

If the labour market is tight because the rate of unemployment is low, companies may offer higher wages to attract workers, but these higher wages are bound to push up the prices by pushing up costs of production. Rising prices, in turn, pull down the real wages, which may, sooner or later, prompt workers to agitate for higher wages. Thus an unending race between higher wages and higher rates of inflation begins. The solution, according to Phelps, is establishing an equilibrium where workers’ expectations are fulfilled and prices stabilize. This equilibrium does not mean full employment. Phelps stresses that this equilibrium is achieved when unemployment rises to its natural rate, telling a certain number of workers that they are redundant or unwanted.

The following observation by The Economist (October 12) is very revealing, specially when the media all over the world are hailing Phelps as a new messiah:

Given economists’ almost theological commitment to the notion that markets clear, the presence of unemployment in the world requires a theodicy to explain. Mr Phelps is willing to entertain several. But in much of his work he contends that unemployment is necessary to cow workers, ensuring their loyalty to the company and their diligence on the job, at a wage the company can afford.

Assuming that a government tries to maintain the natural rate of unemployment as computed according to the formula of Phelps, it means a number of workers who possess the necessary qualifications and physical ability to participate in the process of production and contribute to the national wealth, are told that they are redundant. It is sure to hurt their self-respect and inculcate a feeling in them that the government and economy have no relevance for them. If they, in these circumstances, have no stake in the society, country and the economy, they may take to subversive activities and to some kind of nihilism or commit suicide. It is a sad commentary on the system that allows people to spend valuable resources in acquiring requisite capabilities and skills and when they acquire them and are ready to contribute, they are told that they are unwanted. How humiliating it is!

Notwithstanding all the sophistications of Phelps’ analysis and models, his pontifications violate human dignity. His kind of economics may earn a Nobel Prize and endear him to monopoly capital in the present era of globalisation, it cannot be accepted by people who care for human dignity and think that human beings must be at the centre of all economic policies.

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