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Dec. 17 , 2007

Phelps Calls for New Models to Account for Dynamic Economies

Speaking to a packed house in Low Memorial Library in the fall University Lecture on Nov. 27, Nobel Prize-winning economist Edmund S. Phelps made his case for new economic models that take into account what he calls the “dynamism” of modern economics.

Edmund S. Phelps

Professor Edmund S. Phelps

Phelps, McVickar Professor of Political Economy and the founding director of the Center on Capitalism and Society, won the Nobel Prize in 2006 in part for challenging the long-held economic belief that unemployment and inflation are rigidly yoked together. Inflation, he showed, also depends on expectations of firms and employees about price increases.

In his lecture, Phelps turned his attention to economic dynamism—the chronic commercial innovativeness that is found to varying degrees in the so-called modern economy and is absent in the so-called traditional economy.  High dynamism came to Western Europe and North America in the last quarter of the 19th century, Phelps estimates, then nearly disappeared from France and Germany while jumping to Taiwan, South Korea, Israel and Iceland in the 20th century.  Wherever it arrived it brought a transformation of the economy:  new areas of work, such as product development and marketing, increased participation rates, higher productivity and unprecedented satisfactions—mental stimulation and problem-solving among managers and employees and the thrill of the new enjoyed by entrepreneurs and even consumers.

Yet, Phelps said, the “neoclassical theory,” which is still standard today in classrooms and scholarly research, is not only useless for understanding the causes of commercial innovativeness; it is useless for understanding the transformative effects.  “We require radical changes to economic models to take account of dynamic economies,” he said, “including radical changes to our models of economic activity—the level and ebb and flow in employment and unemployment.”

One reason, he explained, is that present-day theory is premised on the idea that the economic situation at any moment is wholly observable and the variables that constitute this state—productivity, capital and wealth—serve to predict the future course of wages, employment and consumption.

While that may work for traditional economies, which are struck only by random vibrations, Phelps stresses that the state in dynamic economies includes the innovative ideas that have bubbled up.  A difficulty for neoclassical theory is that no one can observe the bubbling up of such ideas.  Yet the “contracts” of neoclassical theory link wages and layoffs to the supposedly observable state.

Another reason, he explained, is that the likely impact of new ideas is impossible to predict in quantitative terms.  “No one in an economy of high dynamism can know,” he said, “what to expect from an innovation.  Thus, it is not the true prospect for an innovation that can prompt the decision of an entrepreneur to develop it or the decisions of firms to prepare for it.  It is their guesses about the unknowable.”

Phelps’s talk was the first of the academic year’s University lectures. Inaugurated in 1971 and sponsored by the Offices of the President and Provost, the University Lecture is a semiannual address given by an outstanding member of the Columbia faculty, celebrating his or her work and academic achievements. The lecture provides a forum for in-depth exploration on a topic of the speaker’s choice. Topics have ranged from Herman Melville and the human condition to the cellular biology of HIV to the influence of jazz music on narrative writing.

Photograph by Eileen Barroso.