Consequences of the Computer Revolution
for the Business Cycle
- Remember the Phillips Curve--the relationship
between unemployment and inflation?
- For more than 25 years mainstream economists'
forecasts have rested on the idea that should unemployment fall
below an unknown (but very real) level called the natural rate
of unemployment, then inflation will start to rise.
- Today, however, the Phillips Curve is missing.
- No one at the end of the 1980's knew exactly
what the natural rate of unemployment was. But even the most
optimistic did not think it could be lower than 5.5 percent and
even the most pessimistic knew it could be no higher than 6.5
percent.
- Today, however, the unemployment rate is
between 4.0 and 4.5 percent--and any acceleration in inflation
is very slow to show itself.
- Is the favorable inward shift of the Phillips
Curve the result of the "new economy"?
- Perhaps--if workers have not woken up to
the greater bargaining power faster real productivity growth
gives them...
- If real wage aspirations are a function not
of productivity growth but of the unemployment rate, then an
acceleration of productivity growth produces a more favorable
inflation-unemployment tradeoff.
- In the context of the 1960s, 1970s, 1980s,
and 1990s, the current natural rate of unemployment does seem
to be profoundly affected by current productivity growth.
- But the chief reason to pin the more favorable
inflation-unemployment tradeoff on the "new economy"
is a weak, negative one--the absence of alternative theories.
- With a floating exchange rate it is hard
to see how "globalization" can have a big effect on
wage and price setting...
- Demographic shifts have not been large enough...
That's why officials in the Clinton Administration
and the Federal
Reserve, as well as independent analysts, bit their fingernails
throughout the 1990's as they awaited the return of rising inflation.
By 1994 unemployment - at 6.1% - was in the range where inflation
had started to accelerate in the late 1980's, so the Fed spoke
of undertaking "preemptive strikes" against inflation.
Yet no inflation followed. By 1996 the unemployment
rate was as low as it had ever gotten in the 1980's. Yet inflation
fell to less than two percent a year. By 1999 unemployment was
4.2%--well below anyone's previous estimate of the natural rate--yet
inflation was an even-lower 1.5%.
Where was the Phillips Curve? Until the end
of 1997 there was confidence that the Phillips Curve would soon
return. Temporary special factors--health care costs, rapid falls
in computer prices, and so on--were momentarily retarding the
tendency of inflation to rise when unemployment was lower than
its natural rate. Such factors couldn't last forever, could they?
Of course not. So when their influence came to an end, inflation
would begin its rise. But years passed, and inflation did not
rise.
So mainstream economists' opinion shifted
to the belief that the natural rate of unemployment had fallen,
though how far no one really knew. Economists began spinning
theories of what had caused the natural rate to fall. Harvard's
Jim Medoff began arguing in the early 1990's that technological
and organizational changes had led the labor market to do a better
job of matching workers needing jobs to vacancies, thus substantially
lowering the natural rate. Others pointed to faster productivity
growth that allowed higher wage increases to be consistent with
relative price stability. Still others pointed to workers' fears
for their jobs generated by the memory of the deep recession
and high
unemployment of 1981-1983.
At some primal level, all economists still
believe in something like a Phillips Curve. All believe that
unemployment will fall if demand expands faster than the economy's
long-run productive capacity. And all believe that if demand
keeps on expanding faster than the economy's long-run productive
capacity then, in the long run, inflation will rise.
It was just that the natural rate of unemployment--the
signal that
this long run had arrived--had fallen mysteriously far and mysteriously
fast.
But, truth be told, the Phillips Curve has
not worked well outside
America. Economists Doug Staiger, Mark Watson, and Jim Stock
pointed out in the _Journal of Economic Perspectives_ that even
in the United States the Phillips Curve relationship was never
as strong or as good at forecasting inflation as was taught in
intermediate macroeconomics. And only in the United States has
there been a relatively stable natural rate of unemployment to
serve as a reliable indicator of when demand pressure is about
to raise inflation. Elsewhere the causes of rising inflation
have
always been too complex to be summarized by simply comparing
unemployment to even a semi-stable "natural rate."
Thus perhaps the surprising thing is not that
Phillips Curve-based
forecasts of inflation have gone awry in the past half decade.
Perhaps the surprising thing is that the complicated economic
processes determining changes in inflation could be summarized
for so long by such a simple relationship as the standard Phillips
Curve. In any event one thing is very clear: the simple theory
of the relation between inflation and unemployment that economists
have peddled for a quarter century no longer works; if economists
are to be of any use, they need to come up with a better - and
in all likelihood more sophisticated - approach to understanding
why inflation rises.
Professor
of Economics J. Bradford DeLong, 601 Evans Hall, #3880