The Armchair Economist
For many years, good evidence indicated a powerful correlation: Times of high inflation are times of high employment, and vice versa. By the late 1960s, this observation had survived rigorous statistical testing and was generally accepted as a scientific truth. Accepting that truth as a basis for policy, politicians attempted to manipulate the inflation rate as a means of controlling unemployment. The result was contrary to all expectations: a decade of stagflation—high inflation and low employment combined. Then in the 1980's, inflation fell dramatically, and, after an initial severe recession, employment opportunities expanded at unprecedented rates. The old statistical regularities seemed to have been turned on their heads.
What had changed? It is impossible to answer that question without a theory of how the inflation rate affects individual employment decisions. In 1971, Robert Lucas offered the first example of such a theory.
Imagine Willie Worker, currently unemployed not because he has literally no job opportunities, but because his opportunities are so unattractive that he prefers unemployment. Willie's best wage offer is $10,000 a year, which would barely cover the cost of getting to work. If the wage were $15,000, Willie would take the job.
One night, while Willie sleeps, there is a massive inflation, causing all prices and all wages to double. The employer who offered $10,000 yesterday offers $20,000 today That's still not good enough, though. In a world of doubled prices,Willie doesn't want to work for less than $30,000. He remains unemployed.
Now let me change the story only slightly. The morning after the night of the great inflation, Willie is awakened by a phone call from an employer offering $20,000. At this point, Willie has not yet read the morning papers and is unaware that prices have changed. He happily reports for work. Only on his way home, stopping at the supermarket to spend his first paycheck, does Willie discover the cruel truth and begin composing a letter of resignation.
This highly stylized fable captures a potentially important aspect of reality. One way that inflation can increase employment is by fooling people. It makes job opportunities look more attractive than they really are and entices workers to accept jobs they would reject if they knew more about the economic environment.
We can tell pretty much the same story from the employer's viewpoint. Suppose you own an ice cream parlor, selling ice cream cones at one dollar apiece. If you could sell them for two dollars apiece, you would expand your operation, but you've learned by experimenting that two dollars is more than the traffic will bear.
If all prices and wages—including all of your costs—were to double, then you'd be able to sell cones for two dollars, but that two dollars would be worth no more than one dollar was worth yesterday. You would continue as before.
But suppose that prices and wages double without your noticing. You notice only that your customers suddenly seem willing to pay more for their ice cream cones. (Probably you first discover this when traffic picks up, because your one-dollar cones have begun to seem like quite a bargain to customers whose wages have doubled.) You expand your operation and hire a lot of new workers. Even after you discover your mistake, part of the expansion is irrevocable: The new freezers are in place, the new parking spaces are under construction, and you might want to keep at least some of those new employees.
The Lucas story implies not that inflation puts people to work but that unanticipated inflation puts people to work. In his story, fully anticipated inflations do not affect anyone's behavior. A (highly stylized) history of modern macroeconomics would go something like this: Inflations fool workers into accepting more jobs and employers into hiring more workers. Governments notice that inflation is consistently accompanied by high employment and decide to take advantage of this relationship by systematically manipulating the inflation rate. Workers and employers quickly notice what the government is up to and cease to be fooled. The correlation between inflation and unemployment breaks down precisely because the government attempts to exploit it.
Let me be entirely explicit about the analogy. Throughout the history of football, there has been no distinction between fourth downs and last downs. If economist A asserts that 'teams punt only on fourth down' and economist B asserts that 'teams punt only on last down,' then nothing in the historical data can distinguish between their hypotheses. Anything that goes to confirm economist A's theory will go to confirm economist B's theory, and vice versa. Both theories will predict equally accurately until the rules change. But after the rules change, when the last down becomes the third down instead of the fourth, one theory will continue to be correct while the other goes drastically wrong.
Throughout the history of corn flakes, there has been no distinction between corn flakes purchased and corn flakes eaten. If economist A asserts that 'families purchase two boxes of corn flakes per month' and economist B asserts that 'families eat two boxes of corn flakes per month,' then nothing in the historical data can distinguish between their hypotheses. Anything that goes to confirm economist A's theory will go to confirm economist B's theory, and vice versa. Both theories will predict equally accurately until the rules change. But after the rules change, when the government provides each family with two boxes of corn flakes over and above what they purchase for themselves, one theory will continue to be correct while the other goes drastically wrong.
Throughout the two decades following World War II, fluctuations in the inflation rate were largely unanticipated. There was no distinction between inflation and unanticipated inflation. If economist A asserts that inflation puts people to work and economist B asserts that unanticipated inflation puts people to work, then nothing in the historical data can distinguish between their hypotheses. Anything that goes to confirm economist A's theory will go to confirm economist B's theory, and vice versa. Both theories will predict equally accurately until the rules change. But after the rules change, when the government starts systematically manipulating the inflation rate in foreseeable ways, one theory will continue to be correct while the other goes drastically wrong.
With nothing but history as a guide, predicting human behavior in a fixed enviroment is easy; predicting human behavior in a changing environment is impossible. In New York in the summertime, I carry an umbrella to work if the morning sky is mostly gray. If you watched me for a while, you would probably notice this pattern and get good at predicting when I was going to carry an umbrella. But in Colorado in the summertime, I never carry an umbrella to work, because it is virtually certain that the regular afternoon thunderstorm will be over before I leave the office at 5:00. Move me to Colorado and your predictions will go completely haywire.
An economist who understands why teams punt knows what will happen if you change the rules; an economist who understands why people buy cereal knows what will happen if you give out free corn flakes; an economist who understands why people accept certain job offers knows what will happen if you manipulate the inflation rate; and an economist who understands why I carry an umbrella knows what will happen if I relocate to a desert.