Winner of the New Statesman SPERI Prize in Political Economy 2016

Sunday 26 July 2015

The F story about the Great Inflation

Here F could stand for folk. The story that is often told by economists to their students goes as follows. After Phillips discovered his curve, which relates inflation to unemployment, Samuelson and Solow in 1960 suggested this implied a trade-off that policymakers could use. They could permanently have a bit less unemployment at the cost of a bit more inflation. Policymakers took up that option, but then could not understand why inflation didn’t just go up a bit, but kept on going up and up. Along came Milton Friedman to the rescue, who in a 1968 presidential address argued that inflation also depended on inflation expectations, which meant the long run Phillips curve was vertical and there was no permanent inflation unemployment trade-off. Policymakers then saw the light, and the steady rise in inflation seen in the 1960s and 1970s came to an end.

This is a neat little story, particularly if you like the idea that all great macroeconomic disasters stem from errors in mainstream macroeconomics. However even a half awake student should spot one small difficulty with this tale. Why did it take over 10 years for Friedman’s wisdom to be adopted by policymakers, while Samuelson and Solow’s alleged mistake seems to have been adopted quickly? Even if you think that the inflation problem only really started in the 1970s that imparts a 10 year lag into the knowledge transmission mechanism, which is a little strange.

However none of that matters, because this folk story is simply untrue. There has been some discussion of this in blogs (by Robert Waldmann in particular - see Mark Thoma here), and the best source on this is another F: James Forder. There are papers (e.g. here), but the most comprehensive source is now his book, which presents an exhaustive study of this folk story. It is, he argues, untrue in every respect. Not only did Samuelson and Solow not argue that there was a permanent inflation unemployment trade-off that policymakers could exploit, policymakers never believed there was such a trade-off. So how did this folk story arise? Quite simply from another F: Friedman himself, in his Nobel Prize lecture in 1977.

Forder discusses much else in his book, including the extent to which Friedman’s 1968 emphasis on the importance of expectations was particularly original (it wasn’t). He also describes how and why he thinks Friedman’s story became so embedded that it became folklore. The reason I write about this now is that I’m in the process of finishing a paper on the knowledge transmission mechanism and the 2010 switch to austerity, and I wanted to look back at previous macroeconomic crises.

If it wasn’t a belief in a long run inflation unemployment trade-off, what was it that allowed inflation to gradually rise during those two decades? Forder has a lot to say on this, but the following is my own take. I think two things were critical: the idea that demand management was primarily designed to achieve full employment, and that full employment had primacy over the objective of price stability. Although more and more economists over that period began to see the policy problem within a Phillips curve framework, many still hoped that other measures like prices and incomes policies (in the UK in particular but also in the US) could override the Phillips curve logic. The primacy of the full employment objective meant the problem was often described as ‘cost-push inflation’ rather than a rise in the natural rate of unemployment.

If you find this hard to imagine, think about historians discussing the current period in a possible future in 2050. By then nonlinearities in the Phillips curve and the power the inflation target had in anchoring inflation expectations were firmly entrenched in mainstream thinking. Imagine that partly as a result in 2050 the inflation target has been replaced by a level of nominal income target. With the benefit of hindsight these historians were amazed to calculate the extent to which resources were lost decades earlier because policy had become fixated by a 2% inflation target and budget deficits. They will recount with amusement at the number of economists and policymakers who thought that the way to deal with deficient demand was by ‘structural reform’. Rather than construct folk tales, they will observe that even when most economists realised what was required to avoid being misled again policymakers were extremely reluctant to change the inflation target.


  1. What inflation problem? I can not find inflation problem of the real world in '70s. What problem is inflation of under 20% to an economy?

    Yes, there was inflation problem in the east europe and in '80s. Who is conflating those two areas and eges?

    1. Ask someone on a low / fixed income what the problem is.

    2. The "inflation problem" is that inflation reduces the wealth of people who hold dollars or are owed dollars. Those people are also the most influential when it comes to determining policy.

    3. There was no "inflation problem" until the oil shocks hit.

      The oil shocks caused unemployment for various reasons, mostly because oil was a vital cofactor of production. Attempting to address that by lowering interest rates makes no sense -- there's a quota on oil, lowering the cost to borrow money doesn't get you any more oil -- but that's what the government did anyway. Hence stagflation.

    4. "There was no "inflation problem" until the oil shocks hit."

      That depends on whether or not you think that unstable inflation in the 6-10% range is "problematic".

      The "oil shock" explanation really doesn't fit almost any of the facts of the 1970s inflation. For a starter, you need a story about how a shock to the level of prices can be affecting the rate of inflation several years after the shock, or why comparable oil shocks in other years without monetary excess didn't see inflation rates go much beyond 5%.

  2. Of folk-volk thinking, I keep seeing English-language economists being dismissed by German policy-makers as 'Anglo-Saxon' economists.

    Given that the English language is the most etymologically open of all languages and that the English language has far more economists speaking it, the oddity that Germans still use nationality-as-language thinking as reflecting some folk culture of their own that splits them off from the English speakers is embarrassingly trite.

    And it has pulled the Eurozone into a Folk play, a piece of economic mummery, which will also be looked on in 2050 with incredulity.

  3. The end of storytelling
    Comment on ‘The F story about the Great Inflation’

    “In order to tell the politicians and practitioners something about causes and best means, the economist needs the true theory or else he has not much more to offer than educated common sense or his personal opinion.” (Stigum, 1991, p. 30)

    Because economists have been aware at least since the 1930s that they lack the true theory they let a change of rules happen. The true/false criterion of science vanished and had been replaced by the first rule of communication: “A good principles of economics teacher is a good storyteller.” (Colander, 1995, p. 169)

    This is how economics eventually became a sitcom.

    This blog makes no exception. Already the third sentence of the intro is incorrect. You write: “After Phillips discovered his curve, which relates inflation to unemployment, ...” It has to be emphasized that Phillips ‘had not made an explicit link between inflation and unemployment’ (Ormerod, 1994, p. 120).

    The original curve was bastardized by Samuelson with the formula: rate of inflation = rate of wage growth -- rate of productivity growth (Samuelson and Nordhaus, 1998, p. 590). This ‘important piece of inflation arithmetic’ was fallacious but this did not prevent the acceptance of the Samuelson-Solow ‘Phillips’ curve. Phillips is said to have remarked ‘if I had known what they would do with the graph I would never have drawn it.’ (Quiggin, 2010, p. 91).

    The storytelling then continued with Friedman and the vacuous filibuster about expectations and the natural rate of unemployment.

    The correct Phillips curve is given with:

    This testable structural curve asserts inter alia (2012, Sec. 7):
    • An increase of the average wage rate leads to a lower unemployment rate. This is in accordance with the correlation of Phillips's original study, but clearly against conventional labor market wisdom (2015).
    • A price increase is conductive to lower employment. This is in accordance with the stagflation of the 1970s.

    The structural Phillips curve contains vastly more variables than the methodologically inferior bastard versions. All that has to be done is to stop storytelling and to check how data and formula fit together. Time to make economics a science.

    Egmont Kakarot-Handtke

    Colander, D. (1995). The Stories We Tell: A Reconstruction of AS/AD Analysis. Journal of Economic Perspectives, 9(3): 169–188. URL
    Kakarot-Handtke, E. (2012). Keynes’s Employment Function and the Gratuitous Phillips Curve Desaster. SSRN Working Paper Series, 2130421: 1–19. URL
    Kakarot-Handtke, E. (2015). Major Defects of the Market Economy. SSRN Working Paper Series, 2624350: 1–40. URL
    Ormerod, P. (1994). The Death of Economics. London: Faber and Faber.
    Quiggin, J. (2010). Zombie Economics. How Dead Ideas Still Walk Among Us. Princeton, NJ, Oxford: Princeton University Press.
    Samuelson, P. A., and Nordhaus, W. D. (1998). Economics. Boston, MA, Burr Ridge, IL, etc.: Irwin, McGraw-Hill, 16th edition.
    Stigum, B. P. (1991). Toward a Formal Science of Economics: The Axiomatic Method in Economics and Econometrics. Cambridge, MA: MIT Press.

    1. Thanks Egmont for this. With vacuous Krugman gadgets, rational expectations nonsense and what else you sometimes feel you are hitting your head against the wall, but many people appreciate your time and efforts in trying to get the facts sorted out - it's very important.

    2. «Phillips is said to have remarked ‘if I had known what they would do with the graph I would never have drawn it.’ (Quiggin, 2010, p. 91).»

      I have commented previously that the "Phillips curve" as it is commonly understood is by now quite discredited (because of the numerous counterexamples that have happened). It is nice to read that Phillips himself was quite horrified. His original graph was essentially a hunch based on a very small dataset that in some cases there is a tradeoffs between labour market pressure and accelerating inflation, a fairly plausible hunch; a very limited-scope empirical observation, backward looking, rather than a "law" to be used for forward-looking policy.

      And thanks from me too, but your fight against certain stories is not very lucky: there are large rewards to those who happen to do the "right" storytelling, in the "right" journals.

    3. «essentially a hunch based on a very small dataset that in some cases there is a tradeoffs between labour market pressure and accelerating inflation»

      Just read a very amusing analysis of the FOMC policy wrt inflation targeting with some interesting quotes about the Phillips curve/rule/...:
      «inflation declines in 2008 and 2009 were well described by a Phillips curve equation that included the unemployment rate as an explanatory variable. More generally, however, research has shown that over long periods spanning several decades, there is not a stable quantitative relationship between inflation and the size of production or employment gaps, where gaps are measured by the deviations from long-run trends. As such, there is much debate among economists regarding the usefulness of the Phillips curve as a tool for forecasting inflation»

      My translation of this, perhaps a misreading :-), is that the Phillips curve/rule/... can be found *ex-post* to hold in certain periods but not in others, but it is not possible to know *ex-ante* in which periods it will hold.

      Great :-).

    4. Excellent. Thanks for letting us know that Phillips was more empirically minded than the "Phillips curve" people.

    5. Comment on Blissex of 26th

      You write: “His [Phillips's] original graph was essentially a hunch based on a very small dataset that in some cases there is a tradeoffs between labour market pressure and accelerating inflation, ...”

      This is inaccurate.

      (i) “The original Phillips curve is about the relation of the rate of unemployment and the rate of change of the wage rate. Phillips studied more than a century's worth of data and established the stable inverse relation for the United Kingdom. Phillips's original curve was a remarkable empirical finding.” (2012, Sec. 6)

      (ii) It is the bastard Phillips curve of Samuelson-Solow which initiated the ensuing discussion and it is this dilettante construction which was later found wanting.

      If the Phillips curve debate proves one crucial fact beyond reasonable doubt it is that the representative economist is an utterly confused confuser. This goes down the line from Samuelson/Solow, to Friedman, to Wren-Lewis and finally to Blissex.

      Kakarot-Handtke, E. (2012). Keynes’s Employment Function and the Gratuitous
      Phillips Curve Desaster. SSRN Working Paper Series, 2130421: 1–19. URL

  4. I think it is very important to distinguish between the different experiences of the UK (the 'home' of the original Phillips curve) and the US. Between 1949 and 1967 the UK was a fairly small open economy with a fixed exchange rate. This had two major consequences: it meant that the policy dilemma was the choice between full employment and a balance of payments crisis (rather than accelerating inflation), and it meant that the rational expectation of inflation was world inflation, which could be regarded as exogenous to the domestic economy. So for UK macroeconomists and policy makers part of the reason why knowledge transmission occurred with a lag was the need to realise that the Bretton Woods regime had collapsed permanently (which did not become clear until the early 1970s). The situation in the US was rather different: even though the dollar was theoretically pegged to gold until 1971, the share of trade in the economy was much smaller, and the balance of payments was not seen as a constraint on policy. So Friedman's argument that pushing unemployment below the natural rate would lead to accelerating inflation (via the adaptive expectations mechanism) was much more relevant.

    1. «the share of trade in the economy was much smaller, and the balance of payments was not seen as a constraint on policy.»

      That's a bit of backward projection: obviously the current USA establishment is now very happy with a massive trade deficit in order to import wage-deflation from China.

      But as the quote from J Kennedy from 1963 shows, before 1971 the establishment was quite worried about the gold outflow.

      In any case after the large 1971 devaluation of the dollar the vast increase in the dollar price of oil and other commodities were considered huge problems, and there were large oil shortages, leading to rationing, even in the USA, and the massive inflationary price-push shock from imports that happened was considered a big issue at the time, even if international trade's share was not as large as that of many european countries.

    2. "So Friedman's argument that pushing unemployment below the natural rate would lead to accelerating inflation (via the adaptive expectations mechanism) was much more relevant."
      Well, a lot of employment contracts then automatically gave a pay rise of at least the level of inflation, so there was no need for rational expectations to get a transmission mechanism.
      Add to that a massive imported inflation via a quintupling of the unit price of your key energy source and stagflation pretty logically follows.

  5. Dear Mr. Wren-Lewis

    I am a economics student at UCL, but I live in Oxford. I am finding my course very unfulfilling. I have read your blog for a couple of years now and it has been on of my main inspirations to take up a degree in economics but I am starting to regret that as I find I learn more meaningful economics outside of term time rather than in.

    I wanted to ask you if you could recommend me any books or journals worth reading to get a better understanding of the macroeconomy?


  6. «If it wasn’t a belief in a long run inflation unemployment trade-off, what was it that allowed inflation to gradually rise during those two decades? Forder has a lot to say on this, but the following is my own take. I think two things were critical: the idea that demand management was primarily designed to achieve full employment, and that full employment had primacy over the objective of price stability.»

    And here we have another version of the usual neoliberal story of the completely imaginary "wage-price" spiral of the 70s and 80s, according to which nasty greedy workers pushed up their wages and this caused endogenous price inflation.

    The story that is instead apparent from the numbers of the 1960s, 1970s, 1980s is that the great inflation was the product of huge government "global security" oriented spending in the USA, and other factors that caused the USA to switch from a net exporter to a net importer, and the international dollar shortage of the 1940s and 1950s to become slowly a dollar glut, which resulted not many years later in the decision to devalue the dollar by a huge amount, the *symptom* of which was the end of the gold standard.

    The huge devaluation of the dollar was in effect a "cram-down". The oil producers refused to be crammed down and increased massively the price of their product after the dollar devaluation, and the Fed Board decided to "accomodate" the huge exogenous price shock, to avoid undermining the USA government's global security policy, and this created a massive eurodollar recycling problem.

    All this transmitted the cram-down shock wave through the value chain, and unionized workers reacted to sharply rising prices driven by oil and commodity inflation by demanding higher wages, which was temporarily successful. At that point because of the exogenous price shock caused by the falling dollar and oil and commodity producers and unionized workers resisting the cram-down it was creditors and businesses who were forced to take the cram-down as massive losses on existing bond valuation because of increasing nominal interest rates and much reduced profits.

    Eventually creditors and businesses fought back and thanks to Volcker and Reagan managed to push the costs of the cram-down onto unionized and non-unionized workers, and debtors, and the cram-down continues today: in the USA median hourly wages have been flat or declining since 1973, and the interest rates have been falling for decades, generating enormous capital gains for creditors.

    Most other anglo-american economies just followed the leader, in various particular ways, and most of the world economy was deeply affected.

    It was a gigantic price-push shock caused by USA government dollar policy, not
    by greedy unions causing wage-push price increases.

    1. Really, really good summary, synthesizing a lot of different elements. Can you get this published? It should be standard textbook material. But it isn't...

  7. BTW to show how gigantic the changes were in the 1960s an interesting quote by V Bonham-Carter diary dated May 14th 1963:

    «[President Kennedy] went on to describe how [de Gaulle] was now blocking all progress in Europe- in defence, economic, etc. I asked him how he thought this road-block could be broken. He said, 'The root of the matter is that not only you in Britain but we in the USA have now become debtors and not, as we always used to be, creditors. The gold reserve has ebbed at the following rate (he then gave the figures for the last few years).»

    The big change had been happening for a while, the other symptom was that in 1961 many IMF "title XIV" (not quite convertible currency) members had become "title VIII" (convertible currency) members, obviously because their trade situation had much improved thanks to the switch from dollar shortage to dollar glut:
    «Ten members of the International Monetary Fund today [February 15] announced the formal convertibility of their currencies within the meaning of the articles of agreement of the Fund. The 10 are the United Kingdom, the 6 members of the European Economic Community—that is, Belgium, France, Germany, Italy, Luxembourg, and the Netherlands—together with Sweden, Ireland, and Peru. These actions are heartily welcomed by the United States. They represent the culmination of the efforts of the 10 countries to achieve one of the major objectives set forth in the Fund articles. They constitute further evidence that the system of monetary cooperation embodied in the Fund is working successfully. Most of these countries announced the convertibility of their currencies for nonresidents some 2 years ago.»

    That was basically what eventually destroyed the Bretton Woods system for which the IMF had been created, so the last bit of the quote is quite ironic.

  8. In the 2050's it was said that those societies of an earlier period that were predominantly partial to economic folk tales full of shallow platitudes were "terminally gullible."

  9. «the way to deal with deficient demand was by ‘structural reform’»

    "structural reform" when it is not a euphemism for redistributing from workers to rentiers has a very proper meaning: a way to deal with deficient *income*, that is production.

    Otherwise the way to deal with deficient demand caused by deficient production is the greek way: instead of producing more, sell assets and spend the proceeds on imports. That surely remedies deficient demand per se, without any need for "structural reform" :-).

  10. Prof. Wren-Lewis makes an excellent point about the schism twixt policymakers and economists. Withal, a number of commenters above have mentioned the exogenous shock of the oil crisis in 1973 & 1978. It's well to recall that at the time, in the mid-70s, economists found themselves nonplussed by phenomena like stagflation, for which conventional economics seemed to offer no explanation.

    We now understand that supply-side shocks from outside the economic system played a role, but one that is not likely to be repeated given how fully invested the OPEC producers are in the Western stock markets. In 1973, the Saudis et al. did not have such large sums tied up in Western economies as they do today, and so had correspondingly less reluctance than today to do (in retrospect) crazy things like launch a total oil embargo.

    The point AXEC makes that the original Philips curve contained many more variables than the simplified Samuelson version also seems telling.

  11. How to save the economy from storytelling economists
    Comment on ‘The F story about the Great Inflation’

    There is political economics and theoretical economics. In political economics it suffices to tell a good story, in theoretical economics scientific standards are observed. Because economists since Adam Smith pursued these two hares with varying intensity consistency eventually got out of sight. More precisely, economists failed to develop a theory about how the market economy works that satisfies the criteria of material and formal consistency.

    The Phillips curve debate is a case in point. Originally, Phillips presented an astounding empirical relation between the rate of unemployment and the rate of change of the wage rate. After a little conceptual shell gaming it was about unemployment and inflation. And after some additional wish-wash about expectations the ending of the story was that there is no way to escape natural unemployment.

    This conclusion lacks a sound theoretical foundation. To make a long argument short, the most elementary version of the correct employment equation is given here:

    From this equation follows inter alia:
    (i) An increase of the expenditure ratio rhoE leads to higher employment. An expenditure ratio rhoE>1 indicates credit expansion, a ratio rhoE<1 indicates credit contraction/debt repayment.
    (ii) Increasing investment expenditures I exert a positive influence on employment, a slowdown of growth does the opposite.
    (iii) An increase of the factor cost ratio rhoF=W/PR leads to higher employment. This implies that a HIGHER average wage rate W leads to HIGHER employment. This explains the original Phillips curve but is contrary to conventional wisdom. It is, though, easy to prove that conventional wisdom is a mere fallacy of composition (2015).
    (iv) A price increase lowers the factor cost ratio and is conductive to lower employment. This explains stagflation.
    (v) The complete employment equation is a bit longer and contains in addition profit distribution, public deficit spending, and the trade balance with the rest of the world. All variables are measurable, the structural employment equation is testable.

    Point (i) and (ii) is old Keynesian stuff. Let us focus here alone on the factor cost ratio as defined in (iii). This variable formally represents the price mechanism which, however, does not work as Orthodoxy imagines. As a matter of fact, overall employment INCREASES if the average wage rate W increases relative to average price P and productivity R. This gives one the lever to improve the employment situation all over the world and to fend off deflation without rising debt and without artificial capacity growth.

    According to pre-Keynesian Orthodoxy the price mechanism as embodied in rhoF should spontaneously establish full employment. More precisely, a falling average wage rate should restore full employment. The consistent structural employment equation says that the OPPOSITE is true.

    The overlooked irony of the original Phillips curve is that it clearly shows a POSITIVE correlation between average wage rate and employment that should have cast doubt on the familiar supply-demand-equilibrium story.

    The core of the employment problem is that the price mechanism does not work as orthodox economics says and this has nothing to do with wage or price stickiness but with the fact that theoretical economics never could really emancipate itself from political economics and thus arrive at a consistent theory about how the monetary economy works.

    Egmont Kakarot-Handtke

    Kakarot-Handtke, E. (2015). Major Defects of the Market Economy. SSRN Working
    Paper Series, 2624350: 1–40. URL

  12. I think that Friedman 1977 is an unsuccessful attempt to try to rationalise macroeconomic policy in the 1960s and 1970s. As historians like Edward Nelson have been arguing for MANY years, it's a mistaken one. While obviously you wouldn't expect policymakers to be candid about a long-term Phillips Curve trade-off if they were trying to exploit it, that's not the most plausible account of the Great Inflation we have.

    The best story seems to be the following: policymakers consistently overestimated the size of the output gap, leading to a secular inflationary trend. In addition, during the 1970s in the US and from an earlier period in the UK, nonmonetary views of the causes of inflation held considerable sway, leading to flawed "cost-push" policies regulating incomes & prices. A shift towards a monetary view of inflation and gradually less optimistic estimates of output gaps shifted things in the 1980s and 1990s, although even in the late 1980s policymakers in the US (and moreso in the UK) were overestimating the scope for noninflationary expansion, leading to a "mini-inflation" under Lawson and in the early Greenspan years.

    This is more problematic for policymakers of that period than the Friedman 1977 explanation. In that story, misguided economists fed policymakers bad theory and policymakers earnestly followed this and inadvertently caused the Great Inflation. In the output gap story, a basic assumption of discretionary policy- that it would be possible to accurately estimate output gaps- proved to be incorrect. And modern inflation targeting still depends on getting the output gaps right. And we still can't do it, as Carney's surprisingly forgotten experience of connecting interest rate decisions with the unemployment rate exemplifies. Yet another reason to favour NGDP targeting.

  13. The Phillips curve as intelligence test
    Comment on W. Peden on ‘The F story about the Great Inflation’

    The second section of your post starts with: “The best story seems to be the following: ...”

    You don't get the point, do you? The Phillips curve debate clearly shows that economists cannot rise above the level of storytelling because already after the first step logic breaks down and confusion sets in.

    Please note: storytelling is the antithesis of science.

    “If one takes seriously what Popper says about falsifiability and the critical attitude, then the methodological practice of economics is not only mistaken, it is stupid and intellectually reprehensible.” (Hausman, 1992, p. 275)

    Egmont Kakarot-Handtke

    Hausman, D. M. (1992). The Inexact and Separate Science of Economics. Cambridge:
    Cambridge University Press.


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