The Big Economic Lever

by Alex Mayyasi

Just for you newsletter readers, we wanted to share a favorite, short excerpt from our book, Planet Money: A Guide to the Economic Forces That Shape Your Life, by Alex Mayyasi, available in book stores starting today!

Bill Phillips — the creator of the so-called “Phillips Curve,” which is still central to economic discussions — took a really creative approach to studying the economy.

Phillips was born in New Zealand, and after stints hunting crocodiles, mining gold, and working as an electrical engineer, he studied economics in London after World War II.

One example of his creativity: in 1949, Phillips actually built a sort of Rube Goldberg machine in his garage, with water flowing back and forth between different tubs and chambers. He said it was a model of the British economy.

He showed it off at the London School of Economics (LSE), and, according to his friend economist Richard Lipsey, “all the staff came out to humiliate this upstart idiot.” Phillips showed how water flowed from the Treasury tank to chambers representing health and education (as the government spent money) and then got pumped back to the Treasury more or less rapidly as you pulled a lever to tweak the taxation rate. “It turned out after ten minutes that he knew more than everybody there, and they shut up,” says Lipsey. They offered him a job at LSE.

Julian Frost for Planet Money: A Guide To The Economic Forces That Shape Your Life NPR/WW Norton)

Phillips soon found himself drinking sherry with other economists and debating the principles of the newish field of macroeconomics — the study of growth and productivity not just among individuals, but on the level of entire countries. His obsession was figuring out how to make life in a market economy less chaotic.

Economic history is a story of booms and busts. Bubbles and bursts. Before World War II and the Great Depression, stock market crashes and various “panics” (the Panic of 1873, the Panic of 1907) occurred roughly every 20 years, and then more often. Overall a lot of panicking, sandwiched between periods of growth, or even booming growth.

Economists call this yo-yoing pattern of growth and contraction the business cycle. After the Great Depression, John Maynard Keynes, an economist whose personal life was full of love affairs with leading literary figures, suggested that governments could prevent, or at least moderate, these booms and busts. One of his chief insights was that the government itself could be a balancing force, increasing or decreasing its spending like a counterweight.

Is the economy irrationally exuberant, with tons of rapid, expensive hiring and new investment? Then Keynes believed the government should lower spending like a parent turning down the music at a raging party. Is the economy struggling, with layoffs and wary investors afraid to lend? Then Keynes believed the government should increase spending, contributing some new energy to perk up hiring and business activity.

But Phillips and his peers had a sense that inflation played a role, too, since it was linked to unemployment. When unemployment is low, workers have more bargaining power to demand raises. If Latin tutors and widget-factory workers get paid more, that pushes up the price of language classes and widgets, and the idea is you get inflation. This theory of inflation came to be called a wage-price spiral. (Another option for tamping down inflation and an overheating economy is increasing taxes so companies and families hire and spend less. Weirdly this idea has never caught on!)

One day, a fellow professor told Phillips he had the perfect dataset to test the theory: 100 years of the UK’s wage and unemployment data. Phillips took the data home and tinkered.

On Monday, he returned with a graph, which Lipsey describes as wowing the room. He’d plotted the data and created an elegant curve that showed an inverse relationship between unemployment and wage rate
growth, which was a major contributor to inflation. It seemed to confirm a clear trade-off between employment and inflation, with changes in the inflation rate changing the employment rate, and vice versa. High inflation and low unemployment went hand in hand

Phillips’s graph spread. Other economists found the same curve in data from other countries, including the United States. In 1961, Paul Samuelson and Robert Solow dubbed it the Phillips Curve, and Samuelson put it in his textbook Economics. In the White House, advisers cited the Phillips Curve to describe this trade-off between employment and inflation. Governments began treating it almost like a manual—policymakers could pick a point on the curve and aim for it.

The original Phillips Curve
Julian Frost for NPR/ WW Norton in Planet Money: A Guide to the Economic Forces That Shape Your Life

Its principal users were central bankers. In the UK, the central bank is the Bank of England. In the United States, it is the Federal Reserve. Generally speaking, it’s central banks’ responsibility to manage inflation. When Phillips first developed his graph, though, even central bankers had only a rudimentary understanding of inflation, because it was a new era for money itself. Up until the 1930s and the Great Depression, many countries had used the gold standard—allowing anyone to turn in currency for a fixed amount of gold—as a way to “back” a currency and ensure that it held at least a certain value. Today, we have fiat currency: money backed by nothing but faith that the government will manage the money supply responsibly and not screw up too badly. The Phillips curve became a manual for managing inflation, at least up until the 1970s, when the American economy started acting… differently. Economists were forced to adapt and update the anti-inflation playbook. But that’s another story.

Today’s newsletter is excerpted from Chapter 18 of our book, which is in stores today, Planet Money: A Guide to the Economic Forces That Shape Your Life. (If you spot it in a bookstore, let us know what section it is in.)

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