September 5, 2019

The end of Mankiw and his Phillips Curve

Comment on David Glasner on ‘Mankiw’s Phillips-Curve Agonistes’

Blog-Reference and Blog-Reference and Blog-Reference

Gregory Mankiw starts his history of the Phillips Curve with gossiping and name dropping: “The economist George Akerlof, a Nobel laureate and the husband of the former Federal Reserve chair Janet Yellen, once called the Phillips curve ‘probably the single most important macroeconomic relationship.’ So it is worth recalling what the Phillips curve is, why it plays a central role in mainstream economics and why it has so many critics. The story begins in 1958, when the economist A. W. Phillips published an article reporting an inverse relationship between unemployment and inflation in Britain. He reasoned that when unemployment is high, workers are easy to find, so employers hardly raise wages, if they do so at all. But when unemployment is low, employers have trouble attracting workers, so they raise wages faster. Inflation in wages soon turns into inflation in the prices of goods and services.”

David Glasner immediately spots the fatal mistake of Mankiw’s account: “I must note parenthetically that, as I have written recently, a supply-demand framework (aka partial equilibrium analysis) is not really the appropriate way to think about unemployment, because the equilibrium level of wages and the rates of unemployment must be analyzed, as, using different terminology, Keynes argued, in a general equilibrium, not a partial equilibrium, framework.” Unfortunately, David Glasner then gets lost in supply-demand-equilibrium blather.

The Phillips Curve (better: bastard or NAIRU Phillips Curve) is the centerpiece of standard employment theory. Economists get employment theory wrong for 200+ years.#1-#5

The materially/formally inconsistent NAIRU Phillips Curve has to be replaced by the correct macroeconomic Employment Law which is shown on Wikimedia.#6

From this equation follows:
(i) An increase in the expenditure ratio ρE leads to higher employment L (the Greek letter ρ stands for ratio). An expenditure ratio ρE greater than 1 indicates a budget deficit = credit expansion, a ratio ρE less than 1 indicates credit contraction.
(ii) Increasing investment expenditures I exert a positive influence on employment.
(iii) An increase in the factor cost ratio ρF≡W/PR leads to higher employment.

The complete Employment Law contains in addition profit distribution, the public sector, and foreign trade.

Items (i) and (ii) cover Keynes’ familiar arguments about aggregate demand. The factor cost ratio ρF as defined in (iii) embodies the macroeconomic price mechanism. The fact of the matter is that overall employment L INCREASES if the AVERAGE wage rate W INCREASES relative to average price P and productivity R. Roughly speaking, price inflation is bad for employment, and wage inflation is good. This is the exact opposite of what microfounded supply-demand-equilibrium economics teaches.

The testable macrofounded Employment Law tells one that the best policy to stabilize employment on a high level is price inflation of zero and wage inflation equal to productivity increases. The 2 percent inflation target has always been political idiocy based on defective theory.

Egmont Kakarot-Handtke

#1 NAIRU, wage-led growth, and Samuelson’s Dyscalculia
#2 Keynes’ Employment Function and the Gratuitous Phillips Curve Disaster
#3 NAIRU and the scientific incompetence of Orthodoxy and Heterodoxy
#4 Full employment, the Phillips Curve, and the end of Gaganomics
#5 For more details of the big picture see cross-references Employment/Phillips Curve
#6 Wikimedia AXEC62 Employment Law

REPLY to David Glasner on Sep 9 and Blog-Reference on Sep 10

You say “… a supply-demand framework (aka partial equilibrium analysis) is not really the appropriate way to think about unemployment, because the equilibrium level of wages and the rates of unemployment must be analyzed, as, using different terminology, Keynes argued, in a general equilibrium, not a partial equilibrium, framework.”

In methodological terms, this means that economics has to perform a Paradigm Shift. However, a move from partial to total equilibrium analysis is NOT the right thing to do. Economic analysis has to advance from microfoundations to macrofoundations. This is what Keynes attempted 80 years ago. He failed and the exact point of failure is in the GT on p. 63: “Income = value of output = consumption + investment. Saving = income − consumption. Therefore saving = investment.” Keynes moved to false macrofoundations but economists did not realize it to this day.

In order to go back to basics, the elementary production-consumption economy is for a start defined by three macroeconomic axioms (Yw=WL, O=RL, C=PX), two conditions (X=O, C=Yw), and two definitions (profit/loss Q≡C−Yw, saving/dissaving S≡Yw−C).

Money is needed by the business sector to pay the workers who receive the wage income Yw per period. The workers spend C per period. Given the two conditions, the market-clearing price is derived as P=W/R (1) for any level of employment L. So, the macroeconomic price P is, under the condition of market-clearing X=O, determined by the wage rate W, which has to be fixed as a numéraire, and the productivity R. This is the most elementary case of the macroeconomic Law of Supply and Demand.

The average stock of transaction money follows for a start as M=κYw, with κ determined by the payment pattern. In other words, the average quantity of money M is determined by the AUTONOMOUS transactions of the household and business sector and created out of nothing by the Central Bank. This, to begin with, refutes the commonplace Quantity Theory because M is NOT among the determinants of P in (1).

In the general case, consumption expenditures C are not equal to wage income Yw. Accordingly, the market-clearing price is now given by P=ρEW/R (2), with ρE≡C/Yw.#1 An expenditure ratio ρE greater than 1 indicates credit expansion = dissaving, a ratio ρE less than 1 the opposite. The ratio ρE establishes the link between the product market and the money/capital market.

Now we have deficit-spending, i.e. ρE greater than 1, yields a one-off price hike. If deficit-spending is repeated period after period the price remains on the elevated level and there is NO inflation. No matter how long the household sector’s debt increases, there is NO further price increase. The same holds for the government sector. A constant government deficit does NOT cause inflation. Because macroeconomic profit is given by Q=(G−T)−S the financial wealth of the Oligarchy grows in lockstep with the public debt, if S is set to 0 for a moment. So, the negative effect of private/public deficit spending is NOT on inflation but on distribution.

The macroeconomic Law of Supply and Demand makes it clear that inflation only occurs if the wage rate W increases in successive periods faster than productivity R. As a matter of principle, this can happen at ANY employment level. It is NOT a precondition that employment is close to the capacity limit. This is merely a false interpretation of the original Phillips Curve.

Methodologically, it is NOT the case that economic analysis has to apply general equilibrium instead of partial equilibrium. Microfoundations in any shape or form are a lethal methodological blunder. Economics has to move from false Marshallian/Walrasian microfoundations and false Keynesian macrofoundations to true macrofoundations. Both Keynes and Hawtrey have to be buried for good at the Flat-Earth-Cemetery.

#1 Wikimedia AXEC101b Macroeconomic Law of Supply and Demand