Friday, November 25, 2011

Tripped by the Phillips curve

The link between unemployment and inflation once used to move according to a predictable relationship as mapped on what is known as the Phillips curve (PC) (see chart on the left). The curve was named after Bill Phillips (1914-1975), a New Zealand economics professor, who had observed wage inflation and unemployment rates in Britain in earlier decades. The negative sloping curve reflects the inverse relationship between inflation and unemployment: a rise in one is accompanied by a fall in the other.  This relationship held out in the 1960s.

By 1970, the relationship started to give in (see the left-hand  panel of the chart below). Even Milton Friedman came up with his own hypothesis on unemployment, which is the straight line Long Range Phillips Curve (LRPC), as seen in the above chart. By the subsequent decades, the relationship went haywire (see right-hand panel below). The Economist even devoted an article, "Heroes of the zeroes", whence I've sourced the charts in this post, on the Phillips curve.

Another way of presenting the relationship between inflation and unemployment is the Misery Index chart from Bloomberg (see below). Looked from this perspective, it is obvious that there's no relationship whatsoever between the two even as early as the 1920s and 1930s.  Most economists are good at rationalising events which would have been easily disproved had they been more discerning with their observations.

Bill Phillips's observations either were flawed or he had restricted them to those years which had conformed to his hypothesis. Those were the days when globalisation and technological change were minimal. Once these conditions were gone, the politicians would in time lose control of the economy. One thing leads to another. It's no wonder that they are now losing control of politics. Once the horse has bolted, closing the gate now is useless. It's time for the politicians themselves to bolt because the public has no more trust in them. Those crafty enough have seduced the technocrats to stick their necks out in order to save the politicians' necks.

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