Michael Roberts. Edmund Phelps: free markets and inflation expectations

Edmund Phelps: free markets and inflation expectations

by Michael Roberts

American Edmund Phelps recently died at the age of 92. Phelps was a classic free market mainstream economist from the monetarist school and winner of the 2006 Nobel Memorial Prize in Economic Sciences (the Riksbank prize in reality).

Edmund Phelps

Phelps researched and taught at Yale University until 1966. He then moved to the University of Pennsylvania, where he wrote the papers that made him famous. He was founding director of the Center for Capitalism and Society at Columbia University, from 2001 to its closure in 2024. In 2013, he published the book, Mass Flourishing, a statement of his belief that “modern values” — a shared desire to create, explore and meet challenges — are the wellsprings of economic dynamism, but were being lost because the innovative ‘competitive free markets’ were being suppressed by ‘corporatism’ and the dead hand of the state.

In the 1960s, along with arch monetarist Milton Friedman, Phelps strongly opposed the Keynesian view that central banks and government should try to manage employment and inflation. He claimed that this approach could only end in an inflationary upsurge.  Phelps argued that central banks can control long-run inflation, but have little control over long-run average output growth at the same time. When two objectives become incompatible as they did in the stagflation of the 1970s, Phelps insisted the best policy for the monetary authorities would be to bring ‘inflation expectations’ down, even if it meant raising interest rates at the expense — at least temporarily — of jobs. The stagflation of the 1970s and early 1980s in the major economies discredited Keynesian macro management and appeared to vindicate Phelps.  Phelps became a leading theorist of the neoliberal period that followed, supporting ‘balanced’ government budgets, privatisation and low inflation.

Phelps argued that capitalist economies cannot reduce the unemployment rate by accepting high inflation, something that economists had, until then, assumed to be the case, based on the Phillips curve. That was because if public spending increased, all the ‘economic agents’ (ie households and businesses) would ‘expect’ to see higher inflation, then demand higher wages (workers) and higher prices (bosses). Inflationary expectations would nip in the bud any desired economic growth and the associated fall in unemployment.

Phelps was right that Keynesian macro management that aimed to deliver full employment without inflation was impossible – but not for the reasons he cited, which was too much government spending.  I and others have shown that the failure of Keynesian policies was primarily due to the falling profitability of capital in the 1970s.  At first, central banks lowered interest rate in the hope that this would boost the economy.  That policy was reversed in the early 1980s by US Fed chair Volcker.  But what really broke inflation of the 1970s was the major slump of 1980-82, that saw US manufacturing decimated and unemployment rising sharply.

In recent years, Phelps’ expectations theory has been increasingly adopted by central banks and mainstream economists as monetarist and Keynesian theories of inflation have been found wanting in the Great Recession of 2008-9 and in the pandemic slump of 2020. During the post-pandemic spike in inflation in 2022, the economic advisers to the Biden White House put it like this:“Over the longer-term, a key determinant of lasting price pressures is inflation expectations.”

But Phelps’ theory does not explain why inflation began in the first place.  The theory removes any objective analysis of price formation. Once inflation is rising for other objective reasons (in the case of 2022, clearly due to global supply shortages), expectations may come into play.  But all the empirical evidence shows that only if inflation has been running high for months, do ‘economic agents’ factor this into their future outlooks. In this sense, expectations are largely adaptive—i.e. backward-looking rather than purely forward-looking.  They do not drive inflation, but instead follow it.In analysing Phelps’ theory of inflation, economist Jeremy Rudd points out that: “at best, only circumstantial evidence of a causal relationship in which expectations determine the long-run properties of inflation; it could equally well reflect a situation where respondents to these surveys are making reasonably plausible inflation forecasts in response to observed changes in actual inflation.”  He concluded, “A review of the relevant theoretical and empirical literature suggests that this belief rests on extremely shaky foundations, and a case can be made that adhering to it uncritically could easily lead to serious policy errors.”

Phelps continued to argue that inflation was caused by excessive government spending and ‘expectations’ of rising inflation. But the global financial crash of 2007-8 and the ensuing Great Recession of 2008-9 put paid to that theory. Inflation in the ‘real economy’ remained low in the early 2000s and government budget deficits were small, but still there was the biggest slump since the 1930s. As Phelps admitted: “Economists also failed to see the inherent dangers. The majority of my colleagues were simply not capable of believing that the market could fail. After all, they spent the past thirty or forty years preaching that whatever price the market sets must be right.”  However, that critique applied to Phelps himself.  

Phelps stood firm against those who wished to revive Keynesian policies in the wake of the great slump.  Monetarist theory had failed, because it was not prices in the shops that had got out of hand, but financial asset prices, which eventually collapsed and triggered the crash. But let’s not return to Keynes, said Phelps. “The thoughts of some have turned to Keynes. His insights into uncertainty and speculation were deep. Yet his employment theory was problematic and the “Keynesian” policy solutions are questionable at best… At the end of his life, Keynes wrote of “modernist stuff, gone wrong and turned sour and silly”. He told his friend Friedrich Hayek he intended to re-examine his theory in his next book. He would have moved on. The admiration we all have for Keynes’s fabulous contributions should not sway us from moving on.”

Nevertheless, the global financial crash did bring a change in Phelps’ thinking.  After 2009, like many other mainstream economists caught napping, he recognised that “some parts of the market are not sufficiently regulated”.  Governments would have to monitor bank lending to make sure that it was used for productive investment rather than for speculation in financial assets and property. I’m afraid Phelps’ hopes on achieving that have been sorely dashed since 2009 with continued credit-fuelled speculation in the stock market, bank runs and the rise of cryptocurrencies.

Throughout, Phelps continued to advocate free market capitalism with fervour: “policy must aim to build a business sector of high dynamism and broad inclusion. The research task is to identify the institutions that are pathways to dynamism and the institutions that are obstructions.”  For Phelps, socialism was only one threat to business dynamism, the other was corporatism—”a system where established businesses and entrenched special interests collude with governments to stifle bold, uncertain innovation in favour of stability and protectionism”. 

Phelps continued to advocate the ‘deregulation’ of labour markets ie ending any labour job rights with no say from employees. As he put it: “The less frequently employees have to look for new positions in which they need to exercise their full potential, the more the innovative strength of companies declines. Models such as the co-determination that is practised in Germany can be particularly harmful. For example, if a decision to move a plant from one town to another was submitted to the employees, they would always vote no, even though it might be in the best long-term interests of the company and society.”

In his last years, Phelps severely criticized Trump’s economic policies for trying to control the economy and tell companies what to do. This was “like economic policy at a time of fascism.” He called for free trade internationally, prudent fiscal measures and the maintenance of the independence of the Federal Reserve from government interference – a true free market neoliberal to the end.