The Fed, the Phillips Curve, and AOC

In 1977, Congress reformed the 1913 Federal Reserve Act, tasking the Federal Reserve with three main objectives: maximize employment, maintain stable prices, and moderate long-term interest rates. Often, these three objectives are boiled down to what is known as the Fed’s “dual mandate” to reach full employment and maintain price stability.

In mainstream economics, the price level and employment rate are often linked by the Phillips curve (pictured above), an economic model that states there is an inverse relationship between the unemployment rate and inflation. Put simply, as unemployment falls, prices rise. As more people are hired and wages rise due to competitive pressures within the labor market, aggregate demand increases and pushes the price level up.

The Phillips curve has guided economic policy in the United States for decades. In fact, Gregory Mankiw, a professor of macroeconomics at Harvard, cited the trade-off between inflation and unemployment as one of the “Ten Principles” of economics in the first chapter of his immensely popular textbook, Principles of Economics. Mankiw served as Chairman of the Council of Economic Advisers under George W. Bush from 2003-2005 and also served as an economic adviser to Mitt Romney’s campaigns in 2008 and 2012. Originally released in 1997, Principles of Economics has sold more than one million copies, generating an estimated $42 million in royalties for Mankiw.

Despite the prevalence of the Phillips curve in mainstream economic thought, the data tells a different story:

The US is in the midst of its longest economic expansion in history, beginning in June of 2009 and continuing through today. The unemployment rate has shrunk from a high of 10% in 2009 to only 3.7% — yet inflation has remained subdued as unemployment has decreased. This, of course, directly contradicts what Mankiw and the Phillips curve tell us about the economy.

This is also not the first time the concept of the Phillips curve has been questioned. Milton Friedman originally proposed the concept of a “natural rate” of unemployment in the late 1960s. In the 1970s, the United States experienced what’s known as stagflation — high unemployment along with high inflation. Economists searched for alternative explanations. Elaborating on Friedman’s “natural rate” concept, Franco Modigliani and Lucas Papademos introduced the “non-accelerating inflation rate of unemployment” or “NAIRU” in 1975.

In contrast to the Phillips curve, the gist of the “natural rate” or “NAIRU” theory is that if unemployment drops below a certain “natural” level, say 5%, inflation will occur, inflation will accelerate, and very bad things will happen. The Fed operates under this thinking today. Here’s a quote from Fed Chairman Jerome Powell in January of 2019:

In other words, the Fed’s NAIRU estimate (at least in part) determines policy choices when it considers its dual mandate of maximizing employment while maintaining price stability. If unemployment starts getting too low, the Fed will attempt to slow the economy down so wages do not increase and set off inflation. Let’s take a look at the Fed’s NAIRU estimates:

As we can see, the NAIRU estimate has ticked lower and lower since 1980. We’ve seen both the NAIRU estimate and unemployment rate drop substantially yet no significant corresponding inflation. Perhaps it’s time for the Fed (and the Congressional Budget Office) to revise its models when it comes to maximizing employment.

Love her or hate her, this was the heart of what Alexandria Ocasio-Cortez was driving at while questioning Jerome Powell last week:

Why is all of this important? Real wages in the United States have been stagnant for decades:

Despite the stock market continuing to hit all-time highs, workers aren’t seeing wage growth. In Powell’s words:

Powell conceded that workers have lost out on their share of national income, saying “Go back to the turn of the century: What you saw was a decline in the labor share, and that has not been reversed…” A first step toward remedying that problem could be jettisoning the notion of the unemployment/inflation trade-off from the Fed’s modeling and policy interventions.

Response to Ben Hunt’s MMT Criticism

Here are my quick responses to the key points Hunt makes in this post:

This is the power of theory in the service of political expediency, the power of post hoc rationalizations gussied up as “theory”.

Scott Fullwiler addresses this point here:

“MMT is the sovereign-friendly justification for deficit spending without end.”

MMT advocates generally say the sovereign should deficit spend until it reaches full employment domestically while maintaining price stability, not that it should spend endlessly for the sake of spending. The real limit here is inflation. The burden is on Hunt to prove otherwise.

“Historically, this argument has been used by sovereigns to support wars without end.”

Ah, can you imagine the United States participating in wars without end?

If anything, MMT advocates say the US should deficit spend to reach full employment domestically instead of employing its people to fight in wars without end.

“MMT is the theoretical justification for QE without end.”

Actually, MMT argues that QE was essentially a worthless/ineffective policy maneuver.

MMT is the theoretical justification for the economic policies of Trump and his Wall Street fellow travelers alike, who want nothing more than to keep the market punchbowl in place and well-spiked with pure grain ZIRP alcohol forever and ever, amen.

Wall Street behaving irresponsibly is almost as hard to imagine as the US fighting in endless wars.

MMT believes in permanent ZIRP, correct. However, permanent ZIRP eliminates an interest income channel for the private sector. One of the goals of permanent ZIRP is ultimately to shrink the financial sector. Currently, interest paid on government securities is “free money” for bondholders, which are mostly wealthy individuals, corporations, funds, etc.

Warren Mosler (one of MMT’s “founders”) addresses this in my podcast around the 33:00 minute mark here.

So don’t tell me that the crowding-out effect of sovereign debt on the real economy isn’t a bad thing. Because it is. This is how entire economies are turned into zombies. Don’t tell me that the monetization of sovereign debt, explicitly or implicitly, isn’t a bad thing. Because it is. This is how a middle class is destroyed.

Deficit spending is how entire economies are turned into zombies and the middle class is destroyed? I suppose we should file the financial crisis and a withering middle class away with endless war and Wall Street behaving irresponsibly as things that are impossible to imagine happening in the real world.

MMT argues that it was the budget surpluses under the Clinton Administration that led to a drain of the private sector’s savings & expansion of private debt. This bubble burst in 2001 then really burst in 2008. Notunderstanding MMT is how you destroy a middle class and turn entire economies into zombies. Notice what happened to the private sector’s financial balances after instances of the government running budget surpluses:

The example to look at here is Japan, which has a 250% debt-to-GDP ratio, low unemployment, low inflation, and negative interest rates on government debt.

“Crowding out” is a textbook theory that doesn’t reflect how government spending actually works, at least in the case of the US. “Crowding out” also assumes that interest rates must rise as the government spends/“borrows” more money. This is not necessarily true, as the interest rate on government debt is always a policy choice and is not set by market forces.

This is addressed at length here.

When the private sector “buys a bond,” it is essentially trading a non-interest-bearing government asset (a dollar) for an interest-bearing-bearing one (a treasury security). Selling bonds is a policy choice; the government is providing highly liquid, safe, interest-bearing assets to the private sector while draining reserves from the interbank payment system in order to defend a target interest rate. Deficit spending is expansionary as it adds net financial assets to the economy.

This post was originally published on 1/19/2019 on Medium.