Federal Reserve Chairman Ben Bernanke has been taking a lot of flak for his series of speeches at George Washington University over the last few weeks. Commentators have marveled at his mischaracterization of the gold standard and his defensiveness at the suggestion that loose Fed monetary policy of the early and mid-2000s played a role in causing the housing bubble—and thus the Great Recession.
But today I come to praise Bernanke, not to bury him. There are some nuggets in these speeches that are positively meritorious. They should be put in lights and applauded.
In particular, in his second speech on March 22, Bernanke totally piled on the Phillips curve. The Phillips curve, you might remember, is that scourge of monetary policy the world over that holds that there is a trade-off between unemployment and inflation. The logic is that money-printing that gooses inflation will in turn increase employment, in that low interest rates will make it easier for firms to hire people.
In the 1950s, when the doctrine was first elucidated, and in the 1960s and 1970s, the Phillips curve gulled central bankers left and right, above all at the U.S. Fed. The memory of the Great Depression of the 1930s and its hideous unemployment rate was still fresh, and the Phillips curve appeared to offer a magic bullet for precisely that problem. Print money and get inflation—a disamenity, to be sure, but a mild one—and watch the most dreaded thing of all, unemployment, decline.
Back then the United States did not have inflation-immune tax structures (the more money you made every year, nominally, the higher a tax rate you were subject to), so inflation just led to higher tax bills and the decline of real income—and thus unemployment. The real Phillips curve, it turned out, should have shown not an indirect relationship between inflation and unemployment, but a direct one.
Finally in the 1980s the Fed abandoned trying to cause inflation, and the income tax was indexed for increases in the price level. As a practical matter the Phillips curve was finished. The economy responded by going on a 25-year tear, as unemployment and inflation both plummeted.
You could muck this history up, if you are uninformed or want to be obfuscating, or you could get it right. Bernanke chose the latter at GW. His words:
“It was a general view [in the decades before 1980] that unemployment could be kept at the low level like 3 or 4 percent. And by keeping inflation a little bit higher, you would be able to get that better performance, that higher employment level. [I]n the prosperity of the ’50s and the early ’60s, the Fed began to follow that approach. There was actually quite a subtle issue here which was that economic theory and practice in the ’50s and early ’60s suggested that there was a permanent tradeoff between inflation and employment, the notion being that if we could just keep inflation a little bit above normal that we could get permanent increases in employment, permanent reductions in unemployment. And that was a view that was taken by many economists during that time. It was actually Milton Friedman, the famous monetary economist, who wrote in the mid-’60s quite prophetically that this was going to cause trouble.”
Bernanke then went on to insist that the view (which he did not identify as that of the Phillips curve, after a New Zealand economist of that name, by the way) had no credibility in point of fact and operation at any time throughout its period of doctrinal hegemony. He showed that it supervised nothing to its credit in the 1950s, it stirred inflation in the 1960s, and it was central to the miserable stagflation of the 1970s and early 1980s where in exchange for things like 13% inflation, the economy was rewarded with double-dip recessions.
I have had occasion in these columns to note that over the years, economists have found it useful to feast on the folly that was the Phillips curve. By my count (and this is based on an analysis of the citations), no less that seven Nobel Prizes in economics have been given for work that has cast doubt and suspicion on the Phillips curve. Bernanke, again to his credit, kept returning in his speech to the earliest of this Nobel-garnering work, Milton Friedman’s numerous takedowns of the Phillips curve in the 1960s and 1970s.
Which does leave one question dangling. Why is Bernanke so cavalier with courting inflation these days, in his own conduct of monetary policy? The answer probably lies in the Fed’s pet statistic for inflation, the Consumer Price Index, especially the “core” measure that excludes things that really do go up in price, food and gasoline. In other words, another Nobel for trouncing the Phillips curve is still out there waiting in the wings for some clever economist who points out that you see with most clarity the direct relationship between unemployment and inflation when you measure the latter in gold.
Books on the topic discussed in this essay may be found in The Imaginative Conservative Bookstore. Originally published at Forbes.com the essay is reprinted here with gracious permission of Brian Domitrovic.