“It is probably fair to say that economic policy is now being made in at least a partial vacuum of economic theory. Unlike earlier periods, no one body of theory seems to have a broad acceptance.” Those were the opening remarks of Frank Morris (1923-2000), president of the Federal Reserve Bank of Boston, at a closed-door session of policy-makers called “After the Phillips Curve.” The year was 1978. If the sentiment sounds familiar, it’s because the same discussion is taking place today, nearly four decades later, in the Federal Reserve Open Markets Committee (FOMC), where two acting governors have publicly-questioned the usefulness of the Phillips Curve model, citing an August 2015 paper from the Federal Reserve Bank of Kansas City that found the link between unemployment and inflation to not only be weak, but insufficient as far as predictive capacity is concerned. Criticism of the Phillips Curve, which dictates the trade-offs between changes in inflation and unemployment, is noteworthy because the inflation targeting practice adopted by the FOMC in 2012 is predicated upon it. However, such conjecture is neither new nor bold. After all, seven Nobel Prizes have been awarded for work critical of the Phillips Curve since 1974, while a clear breakdown was observable (i) in the mid-1970s, when inflation was high and unemployment low, and (ii) between 1993-2008, when unemployment fell to record lows and inflation did not rise. What’s more, the central thesis of John Maynard Keynes informing the Phillips Curve – that aggregate demand is maximized at full-employment – is no longer relevant when the working age population (ages 15-64) is in secular decline. This is the case in Japan, where the Ministry of Health is forecasting a 25% decline in the country’s population by 2050. With an unemployment rate of 3.1%, Japan will run out of workers at the current pace of job growth. Think about it. We are at an inflection point.
What makes ‘tomorrow’ different from ‘yesterday’ is the size of the working age population. It’s falling. Having already peaked in the world’s existing economic centers, the global workforce is forecasted to decline 0.2% per annum through 2030, according to United Nations’ data. This trend marks a massive departure from the last 35-year period and it threatens to undermine the economic growth potential in many economies. Meanwhile, China no longer accounts for 5% of global GDP, as it did in 1950 when its population was 29% of the world total and, by comparison, the U.S. does not command 28% of global GDP with only 8% of the total population. Having emerged as the marginal buyer on the export market, China will continue on an upward trajectory, implying a larger role for “state capitalism” and a greater stress on resources. This is not necessarily bad; model examples of state-capitalism include Singapore and Norway, where the latter owns ~37% of the publicly-listed corporates in Oslo. But, it does mean the Anglo-Saxon notion of profit maximization is no longer the central priority of all key players in the game. Factors beyond mere profit have entered the fold, so we can expect unforeseen events to increase in number. For example, when Chinese state-owned companies sign 30-year leases on 5% of the Ukraine, like in September 2013, corn exports can unexpectedly soar 95% out of a war-torn region and cause a 95% drop in demand for U.S. stock. At the extremes, the uneven distribution of resources will remain the driver of wealth and war. Keynes (1920) recognized this when he said: “The perils of the future lie not in frontiers and sovereignties but in food, coal and transport.” Old game, new rules.
The legendary Morris concluded his introduction in 1978, saying: “Perhaps a building block is already in place and will be revealed to us so that we can spread the gospel. That is the background upon which we begin this investigation.” The same sentiment applies to the discussion here. As strange as it might sound, we need to think like Deng Xiaoping, when he told his Communist Party critics in the same year of 1978: “It doesn’t matter whether a cat is black or white, as long as it catches mice.” Adam Smith put forth the same idea, in saying: “The theory that can absorb the greatest number of facts, and persist in doing so, generation after generation, through all changes of opinion and detail, is the one that must rule all observation.” Having come full-circle, it’s time to step-back and reflect: such routine devotion in the face of contradictory evidence suggests a deeper fissure in base rate assumptions. Daniel Kahneman (2010), who received the Nobel Prize for his theory on rule rationality in human-decision-making, refers to such error as base rate fallacy and, by definition, it cannot be solved by taking the average of a larger sample pool. Said differently, repeating the same experiment many times over will not yield a solution. This means we must look beyond the static equilibrium form in classical Anglo-Saxon economics to the business cycle theory developed during the intra-war period in Austria, Russia, and Sweden. Instead of reinterpreting the Phillips Curve, mainstream economists need to embrace the ideas of Knut Wicksell (1851-1926), Nicolai Kondratiev (1892-1938), Joseph Schumpeter (1883-1950), and Friedrich Hayek (1899-1992). To borrow from J.K. Galbraith: “It is a far, far better thing to have a firm anchor in nonsense than to put out on the troubled seas of thought.”