Tuesday, October 10, 2006

American Dynamism

Economist A.W. Phillips in 1958 analyzed unemployment and wages in the UK 1861-1957 and concluded that there exists a tradeoff, when inflation was high, unemployment was low and vice-versa. This observation became known as the Phillips curve and became a staple in macroeconomic theory and government (Keynesian) policy.

Governments believed that they could control unemployment and inflation by employing the tradeoff of the Phillips curve. At times they would tolerate a higher rate of inflation as this would lead to lower unemployment. For example, monetary policy could be used to stimulate the economy, raising the gross domestic product and lowering the unemployment rate. Moving along the Phillips curve, this would lead to a higher inflation rate, or so they thought.

In the 1970s, however, the US experienced both high levels of inflation and high levels of unemployment, peaking in a misery index during the Carter years. The Phillips curve suggested that this stagflation could not happen, and the theory came under attack from economists such as Milton Friedman and Edmund Phelps who argued that the failure of the relationship demanded a return to free market policies.

Yesterday Phelps was awarded the Nobel Prize in economics for work that had "deepened our understanding of the relation between short-run and long-run effects of economic policy." (I had recommended the brilliant Linda Elliott of Smith-Barney for her fabulous promotion of my personal financial health, but after the medicine prize disappointment I'm not sure those Swedes are listening to my suggestions.)

The Columbia University economist Phelps was awarded the economics prize for his paradigm-shifting work showing that reducing inflation wouldn't necessarily lead to higher unemployment. He argued that the drivers of inflation went beyond unemployment and wages and needed to include how expectations of people and companies affected their purchasing and employment decisions. Time was an important variable as policies such as reducing interest rates and reducing taxes boost employment in the short term but may create inflation in the long term.

Today, Phelps' ideas of holding down inflation through interest rate hikes and stimulating the economy and employment though tax reductions are key parts of the Bush Administration policy. And, by the way, the lower tax rates also lead to increased government revenues (the Laffer Curve) and reduced deficits. (Now if only we could reduce government spending.)

In the Wall Street Journal today Edmund Phelps has an article called “Dynamic Capitalism”, subtitled “Entrepreneurship is lucrative – and just.” Here are a few excerpts.

“There are two economic systems in the West. Several nations--including the U.S., Canada and the U.K.--have a private-ownership system marked by great openness to the implementation of new commercial ideas coming from entrepreneurs, and by a pluralism of views among the financiers who select the ideas to nurture by providing the capital and incentives necessary for their development. This is free enterprise, aka capitalism.

“The other system--in Western Continental Europe--though also based on private ownership, has been modified by the introduction of institutions aimed at protecting the interests of "stakeholders" and "social partners." The system's institutions include big employer confederations, big unions and monopolistic banks. So different is this system that it has its own name: the "social market economy" in Germany, "social democracy" in France and "concertazione" in Italy.

“Let me use the word "dynamism" to mean the fertility of the economy in coming up with innovative ideas believed to be technologically feasible and profitable--in short, the economy's talent at commercially successful innovating. In this terminology, the free enterprise system is structured in such a way that it facilitates and stimulates dynamism while the Continental system impedes and discourages it.

“Instituting a high level of dynamism, so that the economy is fired by the new ideas of entrepreneurs, serves to transform the workplace--in the firms developing an innovation and also in the firms dealing with the innovations. The challenges that arise in developing a new idea and in gaining its acceptance in the marketplace provide the workforce with high levels of mental stimulation, problem-solving, employee-engagement and, thus, personal growth.

In the Continent's Big Three, hourly labor productivity and labor force participation are lower than in the U.S. The argument has been made that Europeans are happier in their work. But the recent World Values Survey indicates that the Continent's workers find less job satisfaction and derive less pride from the work they do in their job.”

Democrats should be forced to read this entire article daily until they have grasped a rudimentary understanding of economics.

As for the European social democracies, well, their economies just can’t compete with capitalism. For example, the “upheaval at Airbus deepens” with the resignation Monday of its chief executive, “less than a week after rolling out a controversial plan to restructure the troubled aircraft maker.” Christian Streiff ran afoul of politicians in four countries by proposing to have the new A380 assembled entirely in one place (Toulouse) rather than parts in England, France, Germany and Spain.

"If you have to do tough restructuring in Europe, it is important that you have people who have diplomatic and political sensibility," said Airbus parent company, the European Aeronautic Defense & Space Co. spokesman Michael Hauger. "This is an area that Streiff hasn't been that strong." Airbus new CEO is the hyper- sensitive Louis Gallois.

Streiff's resignation could push the European governments to "re-nationalize" the aircraft maker, a move that could hurt Airbus chances to win a multibillion-dollar competition to make aerial refueling tankers for the U.S. Air Force.

Go Boeing!


Anonymous Anonymous said...

Bill - you are totally forgiven now. To be mentioned in your blog (along with NO OTHER FEMALES) was worth waiting for. Thank you! btw: it was an interesting piece. Ciao.


10:22 PM  
Blogger fetching jen said...

what a great lesson today. Thanks Bill. And I agree that Dems should have to read the article DAILY!

11:08 AM  
Anonymous Anonymous said...

Thanks Felching Jen!

1:57 PM  
Anonymous Anonymous said...

Thanks Bill!

Excellent message. (I majored in economics at UCLA.)

I'm always frustrated by the degree to which people with little or no knowledge of economics are perfectly happy to propose all sorts of economic policy options.

We could do ourselves a big favor nationally if we required at least basic economics to be taught to all students, AND if we made sure that the lessons were based on a lot more on Friedman than on Krugman.



4:29 PM  
Blogger element said...

Great article!!!

9:43 PM  
Anonymous Anonymous said...

Well this time the Rebulicans have even got the Sweedes to agree with them. But you must remember that there was gas shortage and the cartels did not exist when the first theory and applied to macro ecconomics. The conditions under which the theory was formed was also based on the parameters presented never taking into account many of the micro areas which have subliminal controls over the macro side. I am not saying you, Phelps and the others are wrong but changes in theory will develop as the topic is broken into smaller and smaller pieces. Well i have been on my soap box long enough. later my friend.

John H

10:29 AM  

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