Re-thinking That ‘70’s Inflation Show

The Federal Reserve has recently received much criticism from economic conservatives who claim it has ignored inflation, thereby risking a rerun of the 1970’s inflation show. In response, renowned Princeton economist Paul Krugman has come to the Fed’s defense arguing today’s inflation is fundamentally different from that of the 1970s.

Krugman is right, but his arguments do more than defend the Fed. They also unintentionally demolish the foundations on which central banks have based monetary policy the past twenty-five years. In effect, re-thinking the inflation of the 1970s also compels re-thinking economic policy.

The essence of Krugman’s argument is that we are not watching a rerun of the ‘70’s show because this time round there is no mechanism for creating a price – wage spiral. That is because unions are now dead so that workers are unable to ask for wage increases that match prices. As an example, Krugman contrasts the United Mine Workers contract of 1981 which bargained a three year eleven percent annual average wage increase with current conditions. Where now are the unions demanding 11-percent-a-year increases? Indeed, where are the unions, period?

Today’s reality is indeed characterized by absence of a price – wage spiral mechanism, and it is the reason why the Fed’s easy monetary policy is unlikely to cause general inflation. However, that raises a critical additional point.

Recognizing that the inflation of the 1970’s was the result of a price – wage spiral triggered by conflict with unions over income distribution, compels rejection of the theory of the natural rate of unemployment. This theory has dominated economists’ thinking about inflation for over a generation and has twisted public thinking.

The late Milton Friedman was the originator of the theory of the natural rate of unemployment, yet according to Friedman unions have absolutely nothing to do with inflation. Instead, inflation is everywhere and always an exclusively monetary phenomenon. For Friedman, the only role of unions is to increase unemployment, which fundamentally contradicts the union wage – price spiral story of inflation

That means if the union price – wage spiral story of inflation is correct (which it is), Friedman’s natural rate theory is wrong and policymakers should abandon it. Instead, the focus of policy can formally return to probing the boundaries of full employment.

Moreover, since inflation involves conflict over income distribution, there remains an unsolved policy challenge of how to fairly distribute income at full employment without triggering inflation.

Seen in this light, it becomes clear that Friedman’s natural rate theory has been used to justify running policy in a business friendly way. Thus, in the 1980’s high interest rates were used to tamp down inflation, thereby causing unemployment and weakening unions by weakening manufacturing. In effect, fighting a price – wage spiral with high interest rates is a form of class based policy that breaks the spiral by undercutting the bargaining power of workers.

A final implication concerns the economics profession and its teaching of economics. In the 1980s Friedman’s natural rate of unemployment theory became the mainstay of economics textbooks. However, if the union wage – price spiral story of inflation is correct, it is time to re-write those textbooks. Today’s students deserve a theory that explains both the inflation of the 1970s and why the Fed is right in downplaying current inflation fears.

Natural rate theory asserts the economy self-organizes with full employment, and that inflation is the result of monetary policy trying to push the economy beyond the natural unemployment rate. The theory is fundamentally ideological and it flooded into the academy as part of the conservative capture of economics in the 1970s. It has always struggled to fit the facts, and now may finally be the time to discard it.


Originally published at Thomas Palley and reproduced here with the author’s permission.

6 Responses to "Re-thinking That ‘70’s Inflation Show"

  1. Guest   June 18, 2008 at 12:38 pm

    There may be several other factors that would prevent the wage-inflation spiral. Wages have anyway lagged productivity in the past few years. Also, this time the shock from food and oil prices seem to have a permanent impact on U.S. prices. So here’s the dilemma: if wages are capped in order to prevent the wage-inflation spiral, American workers’ plight will be exacerbated who are failing to cope with rising prices, falling wealth and as long as consumers remain under pressure, consumption and hence the economy won’t recover

  2. Guest   June 18, 2008 at 1:01 pm

    With an aging population and declining labor participation rate (and its implications on labor supply and wages), a low unemployment rate trend will have implications for the monetary policy.

  3. Anonymous   June 18, 2008 at 1:06 pm

    While social and institutional factors have keep wages low (esp. since 2000), many argue recovery from the current crisis will have implications on (improving) income distribution with enactment of several policy reforms – tax, worker safety net, unions (Democrat govt). In fact, many even see resemblance of current inequality trends with the pre-1929 inequality in the American society. So, it may be just a matter of time that wage pressures would start resurfacing.

  4. Guest   June 18, 2008 at 1:30 pm

    Wage pressure has persisted in the economy but has been region or sector specific as many firms face shortage of skilled labor (In fact, high Wall St pay is also attributed to the same factor) and some state economies perform well (on oil, gas, exports).However, in the present scenario where the consumer in under stress, producers may be reluctant to pass on higher input costs (incl. wage costs) to prices as they know demand will be hit.

  5. akmi   June 18, 2008 at 4:42 pm

    Should the Fed care about inflation in other parts of the world when 65 countries use the USD as some kind of anchor, multiplying the inflationary effect of a weaker USD? Won’t global inflation (mostly due to commodity prices) come back to slap the U.S. in the face (in the form of persistently higher inflation) even if there is no wage-price spiral here (though there are some in Europe, Asia and the Middle East now)?

  6. Anonymous   July 16, 2008 at 11:06 am

    "…it becomes clear that Friedman’s natural rate theory has been used to justify running policy in a business friendly way. Thus, in the 1980’s high interest rates were used to tamp down inflation, thereby causing unemployment and weakening unions by weakening manufacturing."The line quoted above badly undermines an otherwise interesting argument. Mr. Palley’s personal view of the world (and apparent ascription of sinister motives to a large swath of his fellow human beings) may not allow him to entertain this idea, but I believe that weakening of domestic manufacturing started long before the disinflation of the 1980s, primarily as the result of an increasing relative tax burden on corporate income. Additionally, how can one claim with a straight face that "causing unemployment" would support domestic business enterprises?? Or ignore the negative effects that tighter money had on businesses (or "capital", if your inner Karl prefers)? Would you argue that, based on the opposing directions of the Fed and the ECB, that the U.S. is now friendlier to unions than Europe is??As for wage spiral mechanisms, why are unions believed to be the only possible factor for creating a supply-demand imbalance in labor markets? Stop assuming that domestic economies are closed. That worked in the 1930s and 1940s, but those years were anomalies. Think globally instead: China and India are not exporting ‘wage deflation’ any longer, and are now outsourcing elsewhere; the driving factor is investment, which is determined by financing possibilities, which are influenced very heavily by monetary policies of the world’s major central banks. Now again, think globally: Where do the major central banks’ target rates stand relative to the expected rate of real growth in the world? What effect is this having on the prices of most tradeable goods and services, and in turn, wages in fast-growing parts of the world? What effect will this eventually have on aggregate price levels for all goods worldwide? It appears that yet another generation of policymakers and voters is about to learn that major central banks should not be used for any policy objective other than global price stability (96 years of Federal Reserve behavior to the contrary notwithstanding). Anything else just lets other types of policymakers off the hook for their errors, while creating a higher risk of the type of financial upheaval we’re living through now.