One common platitude held by economists is that a silver lining to this period of escalating unemployment is that inflation must moderate. Unfortunately, economics is not immune to the practice of accepting what is purported to be “common knowledge” as gospel truth. A perfect example of this is the theory of the Phillips Curve.
So I have set out to bust the myth of the Phillips curve. And question: do high rates of unemployment bring about low rates of inflation? And, conversely, do lower rates of unemployment engender higher rates of inflation?
I set out to find the origins of this Keynesian Fed-lore. It appears as though Fed elders have disseminated this myth based on the belief that employment rates dictate demand in the economy and thus directly affect inflation rates.
Even the mainstream Wall Street Journal’s chief economics correspondent Jon Hilsenrath reported that a rule of thumb in economics is that for every 1 percent higher in unemployment rates than the long-term average of 5 percent, there is downward pressure on inflation of 0.3 percent.11 Apparently, Jon wasn’t around for the 1970s’ high unemployment and high inflation or the 1980s’ and 1990s’ low unemployment and high inflation. This shows how deeply ingrained this Fed-lore is.
After all, doesn’t that sound precise? There seems to be an exact science behind it. He went on to explain that this is because people who become unemployed create slack in the economy, which brings about deflation. Did you follow that logic? Fewer goods and services to absorb the money supply creates deflation?
Sounds convincing, Jon; now it’s my turn. Economics is part science and part philosophy. But the Phillips Curve theory stands up to neither. Looking back since World War II, we find that the data do not support a correlation between employment rates and inflation. The highest rate in unemployment (10.8 percent) occurred in November 1982. At that time, the year-over-year increase in consumer price inflation was 4.5 percent. The lowest rate of unemployment (3.8 percent) occurred in April 2000. At that time, the CPI registered just 3.0 percent, so contrary to the popular Fed- lore, inflation was actually lower during the lowest period of unemployment than it was during the time of highest unemployment.
Taking a look from the standpoint of inflation, we see no apologies for the theory here either. Consumer price inflation hit an all-time high of 14.76 percent in March 1980. According to theory, we should expect to see a very low rate of unemployment.
In fact, we see the rate was 6.3 percent, which is historically higher than the average of 5.0 percent. Later, inflation hit a low of 1.1 percent during June 2002. The Phillips Curve suggests that unemployment rates should have been historically quite high. But at that time, the rate of unemployment was 5.8 percent—slightly higher than the historic average and far below the high water mark of 10.8 percent.
The Phillips Curve doesn’t hold up to historical data, and it doesn’t hold water as a matter of economics or philosophy either. That’s because inflation is a monetary phenomenon. And during times of government intervention—like today—excess money supply created by the Federal Reserve in order to combat a recession has led to inflation. When people lose their jobs, the number of goods and services in an economy shrinks. In that case, excess money supply loses its buying power and prices rise. Conversely, during a robust job market, more goods and services are available to soak up any increased money supply.
All we have to do is look at the graphs shown in Figures 4.1 and 4.2 to see that this Fed-lore myth is easily BUSTED!
Figure 4.1 Consumer Price Index—All Urban Consumers
Figure 4.2 Philips Curve Graph
Source: Bureau of Labor Statistics (www.bls.gov).
We know that the Fed has been mandated with price stability. However, since their creation we have lost 98 cents’ worth of purchasing power on the dollar. Therefore, prices have been anything but stable. But the irony is that in 1977, at one of the most infamous times of price instability, Congress made the decision to task the Fed with an additional mandate of maximum employment. Just so you understand Fed/government semantics, as I mentioned earlier, by desiring stable prices, they mean prices rising 2 percent a year; and by maximum employment, they refer to an unemployment rate of 5 percent. Now I could write a soliloquy questioning why you would saddle an agency with an additional task after they have completely failed in carrying out their original objective, but this chapter is long enough, so just pause for a moment to revel in the irony and we will continue.
The Fed has a dual mandate of stable prices and maximum employment. But what may come as a surprise to most is that they have a distinct preference in their
mandates. The Federal Reserve under Ben Bernanke has a clear bias toward fulfilling the goal of maximum employment. Given the situation where unemployment is high and prices are relatively stable, the Fed has opted to pursue a policy of higher inflation in the hopes of engendering lower unemployment rates.
What the Fed doesn’t understand is that full employment can exist in perfect harmony with stable prices. That’s because having more people producing goods and services can never by itself lead to an environment of rising aggregate prices. And, most important, an increasing rate of inflation actually increases the rate of unemployment. Not only do these facts make sense economically but also are borne out in the historical data.
Each and every time the Fed has increased the money supply and sent prices rising, the rate of unemployment has risen, not decreased. The simple reason for this is that inflation diminishes the purchasing power of most consumers. Falling real wages means fewer discretionary purchases can be made. Falling demand leads to increased layoffs, and unemployment rises as economic growth falters.
The 12.2 percent year-over-year (YOY) rise in the CPI that occurred in November 1974 led to the cyclical high of 9 percent unemployment during May 1975. Likewise, in 1979, the YOY increase in the CPI reached a high of 14.6 percent in March and April 1980, which was followed by another cyclical high 10.8 percent unemployment print in November and December of 1982. Once again, YOY CPI increased from 1.2 percent in December 1986 to 6.4 percent in October 1990. That again corresponded with the rise in unemployment that occurred from the 5 percent level in March 1989 to 7.8 percent in June 1992.
Today, we find that unemployment is ranging at about 8 percent due to the credit crisis and Great Recession. Bernanke believes he can bring that figure down by creating inflation. However, the unemployment rate just can’t seem to respond to his Keynesian playbook. It is obvious he understands how to drive inflation. However, the rate of unemployment will only increase as long as the Fed mistakenly holds the belief that printing money can solve the employment situation.
Doubling down on this flawed theory, the Fed launched QE3 ($40 billion of MBS purchases every month) and stated that it will remain in effect until the labor market
“improves substantially.” He also promised that, “the Committee will continue its purchases of agency mortgage backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved. . . .” In other words, the Fed will continue to counterfeit money until there is a substantial decline in the unemployment rate. He since launched QE IV with a total of
$85 billion of debt monetization with a specific target of 6.5 percent on the unemployment rate.
But there are two major problems with this measure. The first is that the Fed Funds rate has been near zero for the past four years and mortgage rates are at all-time lows.
Also, the money supply (as measured by M2) is up over 10 percent from 12 months prior. Therefore, onerous interest rates cannot be the cause of our high unemployment rate. And the money supply is already growing well above productivity and labor growth, so there is already a superfluous amount of money creation. The other major
problem with his plan is that the unemployment rate doesn’t fall when the dollar is devalued. Rather the middle class gets dissolved and the inflation rate is rising.
The first round of QE began in November 2008. At that time, the unemployment rate in the United States was 6.8 percent. The second round of QE began in November 2010 and ended by July 2011. However, after printing a total of $2 trillion and taking interest rates to virtually zero percent, the unemployment rate had risen to 9.1 percent.
After four years of money printing and interest rate manipulations, the economy still lost 16,000 goods-producing jobs and 368,000 individuals became so despondent looking for work that they dropped out of the labor force in one month alone. And the unemployment rate has been hovering around 8 percent for over 43 continuous months. Mr. Bernanke must believe that $2 trillion worth of counterfeiting isn’t quite enough and zero percent interest rates are just too high to create job growth, so he’s just going to have to do a lot more of the same. But by undertaking QE IV, the Fed is tacitly admitting that QEs 1, 2 and 3 simply didn’t work.
Here is why printing money can never lead to economic prosperity. The only way a nation can increase its GDP is to grow the labor force and increase the productivity of its workers. But the only “tool” a central bank has is the ability to dilute the currency’s purchasing power by creating inflation. Central bank credit creation for the purpose of purchasing bank assets lowers the value of the currency and reduces the level of real interest rates. Interest rates soon become negative in real terms and consumers lose purchasing power by holding fixed income investments.
Investors are then forced to find an alternative currency that has intrinsic value and cannot be devalued by government. Commodities fill that role perfectly and prices rise, sending food and energy costs much higher. The increased cost of those nondiscretionary items reduces the discretionary purchases for the middle class. The net effect of this is more and more of middle-class incomes must be used to purchase the basics of existence. Therefore, job losses occur in the consumer discretionary portion of the economy.
The inflation created by a central bank also causes interest rates to become unstable.
Savers cannot accurately determine the future cost of money, and investment activity declines in favor of consumption. Without having adequate savings, investment in capital goods like machinery and tools wanes, and the productivity of the economy slows dramatically.
The result is a chronically weak economy with anemic job growth. This condition can be found not only in the United States but in Europe and Japan as well. These stagflationary economies are the direct result of onerous government debts, which are being monetized by their central banks.
I predicted that QEs 1, 2, and 3 would not work. I now predict that QE IV and all the coming QEs will fail as well, causing the unemployment rate to rise along with the rate of inflation. In fact, I believe the unemployment rate will increase sharply over time. That will force Mr. Bernanke to choose which mandate (full employment or stable prices) takes precedence. I believe he will choose the former. That means this round of quantitative counterfeiting will last as long as he is chairman of the Fed.
What the Fed has accomplished is to enable Washington to amass $6 trillion of new
debt since the Great Recession began in December 2007. It has not only prevented an economic recovery from occurring but has catapulted the United States toward a currency and bond market crisis in the next few years.
In reality, the Fed needs to uphold only one mandate—that of stable prices.
Fulfilling that mandate by keeping in check the growth of money supply is the only way to ensure that our economy displays full employment and maximum economic growth.
Unfortunately, Bernanke is under the misconception that he can counterfeit his way to full employment—he can’t. The only thing he has been effective in creating is an enormous bubble in the bond market. When this bubble is broken, unemployment will skyrocket—proving that Bernanke’s inflation is not the facilitator of low unemployment but the linchpin to soaring unemployment.
The myth of the Phillips Curve—BUSTED!