Video: Night Talk with Mike Schneider December 23rd, 2008

Edmund S. Phelps is McVickar Professor of Political Economy at Columbia University, director of Columbia's
Center on Capitalism and Society and the winner of the 2006 Nobel Prize for Economics. He is a Fellow of the
National Academy of Science and both a Distinguished Fellow and a former Vice-President of the American
Economic Association. This year he was named Chevalier of the Legion of Honor, won the Premio Pico della
Mirandola for humanism and the Kiel Global Economy Prize. His research has spanned economic growth,
including the Golden Rule of saving, microeconomic foundations of inflation and employment dynamics,
structuralist models of unemployment determination, dynamism and inclusion in capitalist and corporatist
systems, and the good economy.

Edmund Phelps joined the Department of Economics at Columbia in 1971 after several years at Pennsylvania and earlier Yale. He was named McVickar
Professor of Political Economy in 1982. He is the 2006 winner of the Nobel Prize in Economics.

Phelps’s work is best known for introducing in the late ’60s an expectations-based microeconomics into the theory of employment determination and
price-wage dynamics. Keynes’s great work of the ’30s had left it unexplained why involuntary unemployment is observed even in the best of times and
why a drop of aggregate “effective demand” causes a rise of unemployment – why not a prompt fall of money wages and prices by just enough to forestall
a fall of employment? The challenge was to resolve these issues while continuing to posit the elementary rationality that economics traditionally ascribed to
workers, consumers and firms.

In Phelps’s “micro-macro” models, attaining equilibrium in the markets – meaning participants’ expectations consistent with their actions – does not generally
eliminate unemployment, not even involuntary unemployment. In a 1968 paper, the economy's firms face a management problem, costly employee turnover,
and a firm's wage policy aims to balance payroll cost against turnover cost. On an equilibrium path, the going wage at each point is generally an "incentive
wage," hence a wage that is more than enough to hire employees; but that results in “job rationing" and thus involuntary unemployment throughout. In a
1969 paper, Phelps sketched an economy of widely separated "islands" in which workers have to decide whether to accept the local market wage or to move
on. Even in an equilibrium scenario, workers on an island with an appreciably inferior wage will get on the boat to try another island, suffering voluntary
unemployment during their search.

The main discovery from these models was the potential for disequilibrium and its effects on economic activity. Errors in wage or price expectations would disturb the volume of unemployment. If, in the labor turnover model, each firm deciding its next wage, say, underestimates the wage being set at the other firms, i.e., the actual wage exceeds the expected wage, the error reduces the firms’ expected turnover and hence their expected costs, thus encouraging them to pay less and hire more, which drives down unemployment. If, in the islands model, the average wage exceeds what workers expect it is, the underestimate prompts some workers to accept a job rather than go on searching, so, again, unemployment drops. In the same spirit, a 1967 paper supposed that an underestimate by each firm of the price being set by the others would encourage increases in output supply and labor demand, raising employment; a 1970 paper introducing the “customer market,” coauthored with Sidney Winter, supplied a basis for this idea. From all this, an answer to the puzzle of Keynes emerged: An unperceived rise in “effective demand,” in driving up the average money wage and the price level, would reduce unemployment if the average firm (or island) did not know or imagine that the general price and wage level had increased by as much as its own – i.e., if the actual price or wage inflation exceeded the expected. A persistent over-estimation of upcoming money wages and prices could cause a protracted depression. The volume deriving from a conference Phelps organized at Penn, Microeconomic Foundations of Employment and Inflation Theory (Norton, 1970), was the first wave in this new macroeconomics. Applications to demand management were made in the 1967 paper and in his monograph Inflation Policy and Unemployment Theory (Norton, 1972).

These prototype micro-macro models contained another departure from convention. The models usually postulated that the equilibrium path of the unemployment
rate depended only on non-monetary considerations, hence not upon the expected or the actual inflation rate. This supposed “neutrality” of money and inflation
(dubbed the natural rate hypothesis by Milton Friedman in his parallel work on disequilibrium labor supply) nicely simplified the analysis of shocks and most econometricians found it descriptive enough in normal cases. The striking implication of this postulate was that, once expectations adjust, the inflation rate that was
targeted by the central bank would have no effect on the subsequent path of unemployment rate and hence no effect on the medium-run steady-state level to which
any equilibrium path (with its distinct starting point) would lead. Thus, raising the inflation rate target might advance an employment recovery but not improve the
end result. This logically inessential but apparently realistic feature of the new models challenged the Keynesian tenet, embodied in the famous Phillips curve, that
monetary or fiscal stimulus could achieve a lower unemployment rate by choosing a higher inflation rate.

Phelps spent much of the ‘70s replying to a further development from other quarters: to theoretical demonstrations
that a departure from the current equilibrium path would be merely momentary if every economic actor had
so-called rational expectations. (When all the “news” arrives at month’s end, prices and wages would jump
precisely to regain equilibrium.) In frequently collaborative research at Columbia in the 1970s he argued that
if most wage and price setting is nonsynchronous, such a deviation would take time to die out even if expectations
were rational. See, for example, a 1977 paper with John Taylor. This work helped start what came to be known
as New Keynesian macroeconomics. In the early 1980s Phelps argued that if participants believe their preferred
model of sales, employment and prices is not shared by all participants, the deviation might be protracted. Various consequences of this pluralism of beliefs, actual or feared, are analyzed in his paper and other papers in the
conference volume he edited with Roman Frydman, Individual Forecasting and Aggregate Outcomes
(Cambridge, 1983).

While these views went on winning support among macroeconomics experts, the last two decades were testing
times. The ‘80s witnessed a powerful slump in Europe with no evidence of unexpected disinflation or deflation;
the latter half of the ‘90s brought a strong boom to the U.S. economy and northern Europe without evidence of unexpected inflation—all contrary to the simple models. In response, Phelps began in the late ‘80s to develop a
theory of the equilibrium path itself – a theory of the determinants of the natural unemployment rate. The models
built and their first statistical test were set forth in Structural Slumps: The Modern Equilibrium Theory of Unemployment, Interest and Assets (Harvard, 1994).
Subsequent papers in this project include ‘Growth, wealth and the natural rate: is Europe’s jobs crisis a growth crisis?’ ‘The rise and downward trend of the natural
rate,’ ‘Natural rate theory and OECD unemployment,’ and ‘Lessons in natural-rate dynamics.’

At the level of historical understanding, this theoretical development served to underpin hypotheses linking the ‘80s slump to a worldwide rise of real interest rates,
the sharp transition to more moderate productivity growth in the European economies, and the growth of the welfare state to huge proportions, especially on the
European continent. At a more general level, this work pointed to the crucial role for employment determination played by the values (also known as shadow prices) that firms place on the various sorts of business assets with which they operate: the employee with the needed firm-specific preparation, the customer, and nonhuman tangibles such as industrial plant and office facilities. This feature of the theory suggested that the prices of shares traded on organized stock exchanges might be serviceable as observable proxies for the mostly unobservable asset values, which opened up new statistical tests of the theory. See 'Behind this structural boom: the role of asset valuations,' and 'Roots of the recent recoveries: labor reforms or private-sector forces?’ This equilibrium theory of endogenous structural unemployment turned out to supply an explanation of the inflationless booms in the late ‘90s. In their thinking about the long wave of business expansions in the late 19th century, the German School under Spiethof and Cassel suggested that prospects of new industries or new methods requiring further capital, and this interpretation can be translated into an unexpected jump in the values that firms, looking to the new opportunities, place on one or more business assets. (An April 2000 Wall Street Journal essay provides an introduction to this analysis.)

Phelps’s interest in structural booms alongside his interest, dating from the early ‘90s, in the questions raised by the professed desire of some eastern European
countries to build predominantly capitalist economies have led to mounting research on his part into the functioning and performance of capitalist institutions. The
first step, following some years surveying the interwar literature on theory, was to confirm, in a 1996 paper (forthcoming) with Darius Palia, that indeed countries
with more of the economy’s industry under private ownership achieve faster productivity growth, other things equal. The next step was to ask whether the economies that boomed in the late ‘90s (the U.S., Sweden, Finland, Ireland, and so forth) had the sort of instititions and resources that entrepreneurs under capitalism require
to a greater extent than the countries that did not boom (Italy, Germany, Austria, Spain and so forth); the results here were published in a 2001 paper with Gylfi
Zoega. (An August 1990 Financial Times essay presents an elementary exposition.) Phelps and Zoega are now embarking on a broader assessment of the effects
of the institutions of capitalism, with special attention to productivity level and job satisfaction.

Alongside his recent research on capitalism Phelps has also done research on the causes and cures of joblessness and low wages among disadvantaged workers.
His recent book for the general public Rewarding Work (Harvard, 1997) combines these interests. Subsequent papers on these themes include 'A strategy for
employment and growth: the failure of statism, welfarism, and free markets,' an OECD conference paper titled 'The importance of inclusion and the power of
job subsidies to increase it,’ and a critique of proposals for stakeholder grants and universal income benefits titled ‘Subsidize wages.’

Among his other books are Fiscal Neutrality toward Economic Growth (McGraw-Hill, 1965) and Golden Rules of Economic Growth (Norton, 1966), his selected papers in Studies in Macroeconomic Theory (Academic Press, 1980), the reader Economic Justice (Penguin, 1974), a conference volume Altruism, Morality and Economic Theory (Basic Books, 1975), his textbook Political Economy (Norton, 1985), the monograph with J.P. Fitoussi, The Slump in Europe (Blackwell, 1988), and his Arne Ryde lectures Seven Schools of Macroeconomic Thought (Oxford, 1990).