Is economists' favorite tool to crush inflation broken?

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0:19There's this thing that has kind of been a mystery to me. Why, when inflation really set in recently, why did so many of us assume that to get it under control, there would have to be massive layoffs and unemployment. We now know that isn't true. We didn't need tons of people to lose their jobs to get inflation down. So why were so many of us convinced? That idea, it turns out, comes from somewhere. One person who changed how economists and central bankers think about inflation and how to fight it. I heard his story from none other than Planet Money producer Willa Rubin. Hi, Willa. Hi, Nick Fountain.

1:01All right, where should we start? We should start with his name. Good call. Bill Phillips had a very adventurous life. He was born in New Zealand in 1914. He was an electrical engineer. He worked at a gold mine. At one point, he was a crocodile hunter. He was fairly short. He was a chain smoker. He had a strong New Zealand accent. This is Richard Lipsy. He was a colleague of Bill Phillips way back when. They were friends. And he told us a story about how Bill Phillips became an economist that I love because it captures just how young and weird economics was back in the 1940s when Bill Phillips started off.

1:42Bill Phillips landed at the London School of Economics after World War II. He didn't have much formal economics training, but he gets consumed by an idea that there are underlying forces at work in the economy. And if you could just understand how those forces work, you could keep the economy stable. Right, but Bill Phillips' friend, Richard Lipsy, says he had a pretty unconventional way of trying to study things. He was a bit of a tinker. He was a very handyman. Remember, he was an engineer. And so when Phillips was first trying to understand how the economy worked, he was the type of person, you probably know one, who had to go and build a thing.

2:19He went home and in his garage, he built the famous machine, which was a water flow model of how the economy behaved. A water flow model. This machine is a real thing. You can see one at the Science Museum in London today. It's this giant fridge-sized contraption with compartments and pipes and levers, each representing a different part of the economy. So you had a series of tanks and flows between them, and you had consumers and investors and governments. And to see it, you know, when you're used to just reading it, was really quite spectacular. Lipsy remembers standing next to the machine and pulling levers that controlled different parts of the economy, monetary policy or fiscal policy.

3:07And he remembers water sloshing around from tank to tank. Did you ever have to use the mop in a bucket, or was there a janitor there to clean up afterwards? No, it didn't leak much. It was an engineering feat. And by and large, it worked pretty well. And you realize that controlling the economy was far more complicated than the textbooks told you. But people weren't sold on Bill Phillips' machine when he first rolled it into the prestigious London School of Economics for its debut. Phillips was a nobody, not a real economist. So people showed up to see this thing he'd made, but not for the right reasons.

3:47All the staff, the junior staff, came out to humiliate this upstart idiot. And it turned out after 10 minutes that he knew more than everybody there and they shut up. And on the strength of this, he was offered a job at the London School of Economics. So that's the story of how Bill Phillips got established as an economist. But the reason we're talking about him today is that Phillips' next insight would shape how we understand one of the most fundamental relationships in the economy. Hello and welcome to Planet Money. I'm Willa Rubin. And I'm Nick Fountain. Pretty much as long as economists have been around, they've had this dream that their field could be a science, that their work was to find universal truths that govern the economy and then use those truths to help keep things stable, help make people's lives better.

4:42Bill Phillips applied that scientific approach to two of the most important measures of the economy, unemployment and inflation. He saw that there was a tradeoff between the two, one that maybe you could exploit just like levers on a machine. Today on the show, how a crock hunter turned economist changed the world. Of macroeconomics. You changed the world. I'm saying it.

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5:57Easily track, block, or cancel recurring charges right from the Capital One mobile app. Simple as that. Learn more at capitalone.com slash subscriptions. Terms and conditions apply. All right. Where we last left Bill Phillips, he'd made his water flow machine that modeled the economy, and he'd gotten his gig at the London School of Economics. Yeah, and let's set the scene a little. It's the early 1950s. Macroeconomics is young. It was invented 15 or so years before by John Maynard Keynes. And so it's a heady time for the field. There's a lot of debating, also a lot of cigarettes. The common room was a cloud of smoke and we'd have a glass of sherry or two.

6:42If it was me, it would be two. And the thing that Bill Phillips was constantly talking about in the common room was that obsession that got him into economics in the first place. How to avoid the huge swings of living in a market economy. So Phillips starts looking at these two things that can really throw off an economy, inflation and unemployment. He knows intuitively that there's a connection between the two. Everyone at the time sort of got this. When unemployment is low, people have bargaining power. It's easier for them to ask for raises. And those raises, you know, wage growth, make prices go up.

7:21But just how to turn that observation about unemployment and inflation into something really concrete, a tool for guiding the economy, that was the real question. So one day, a Friday, the legend goes, Phillips is talking about his quest. And a fellow professor says, hey, I think I know the exact data set that'll help you crack open the case. It's about 100 years of collected wage and unemployment data, all from the United Kingdom. Phillips gets his hands on the data set and then pulls a classic Phillips. He goes home and makes something. He went home on Friday and he came back on Monday morning.

8:00Everybody said, wow. Yeah, because what he found was a clear tie between unemployment and inflation. That in times when most people have jobs, a.k.a. when unemployment is low, inflation tended to be high. And the opposite was true, too. When a lot of people were out of work, inflation tended to be low. You can see it in the graph that Phillips had drafted over that weekend. On one axis is the unemployment rate, and on the other was the growth rate of wages, which at the time was a major cause of inflation. On his graph, Phillips drew a line, kind of more like a curve, roughly following those data points.

8:43He came back with this drawing, and here it is. Here's the curve. And we're still talking about it today. Yeah, yeah. Over the next few years, his idea starts to catch on. Lipsy works with Phillips, writes a follow-up paper that backs up the original finding. Other economists start testing it out with data from different countries. One of them, Paul Samuelson, says it largely checks out for American data. He gives this thing a name, the Phillips Curve. And then in 1961, Samuelson puts the Phillips Curve in his textbook, which is like the textbook that generations of economists get trained on. So the curve is gaining in popularity.

9:22But weirdly, Phillips kind of exits the scene not long after this. He moves to Australia, doesn't think about the curve much anymore. But it doesn't matter. By this point, the Phillips curve is bigger than him. Because the Phillips curve made a lot of economists think maybe they'd done it. Unlocked a stable law of economics. You could pick a point on the curve and aim for it. It was a kind of recipe for economists to use. Yeah, at this moment in history, there's this new faith that economists can shape people's lives for the better in really tangible ways. In the White House, economists are describing this tradeoff between unemployment and inflation in briefings with JFK and LBJ.

10:06The Phillips curve had gone mainstream. When you hear Lipsy talk about these times, it kind of sounds like some of the best times of his life. It's the 60s. World War II is a fading memory. There's a sense of optimism, freedom. That was a great time in England. You know, Carnaby Street and the Beatles. Love, love we do. Kingston Trail, the Limelighters, Peter, Paul and Mary. If I had a hammer, I'd a hammer in the morning. I'd a hammer in the evening. And that was a wonderful time. In 1967, Lipsey got on a plane to the U.S. He was going to attend the yearly American Economics Association conference.

10:50And he was going to fly first class, which sounds like it was amazing. The head waiter would come. We'd start with vodka and Russian caviar. Then you'd have hors d 'oeuvres by the thousands. Wow. You had French wines of all sorts. You had main course. They had roast beef on a trolley and then dessert and then fruit. Liqueurs of every sort. So talk about having too much to drink on a trip. What Lipsy didn't know yet was that at this conference, the Phillips curve would enter a whole new era because Milton Friedman, the most famous economist of his time, was about to give a speech. It happened on the final night.

11:33Friedman walks up on stage. What did he look like? Little man. I mean, in stature, I can't tell you anything more. Up on stage, Friedman more or less says, sure, you found something interesting there. But the idea that the Phillips curve precisely maps out a stable relationship between unemployment and inflation, one that'll hold up in the long term? No way. For example, he says the Phillips curve doesn't really account for what's called inflation expectations. This is the idea that once people experience high inflation, they start to expect it, and then they change their behavior. What were you feeling when you were watching him do these critiques?

12:18I thought it was quite interesting. You weren't annoyed? He was poking holes in your work. I can't speak for my emotions at that time, but I certainly took on board the expectations thing. Friedman had said that the Phillips curve as it stood was too simplistic. And that amounted to a warning to all of the economists who were counting on it. That at the very moment they needed the Phillips curve to help them guide the economy the most, it would break down. Alan Blinder, another famous economist we talked to, was a grad student when Friedman made his big speech. So this 67 speech, it kind of sent shockwaves across the world, right?

13:06Yeah, well, I mean, you exaggerate a little. Most of the world pays no attention to anything that happens in economics. Blinder is a straight talker. And he says that Freeman's warning didn't take long to come true. Because after those loose, riding high moments of the 60s, the 70s was kind of a rude awakening. You can hear it in the music of the day. Shout out to my favorite band, The Clash, literally singing about unemployment.

13:35Every job they offer used to kick you out the dock Career opportunity, the one and never knock Blinder was in the U.S., far away from any British punks. But he still remembers the supply shocks that made him sit in long lines at the gas stations in the 70s. He remembers the high inflation. He remembers the unemployment spiking. This combination was so bad, it got its own name. It got the name stagflation. Both are moving in the wrong way. We don't want inflation up. We don't want unemployment up. What does stagflation feel like for someone who's never lived through it like me? Well, it felt lousy.

14:09It felt lousy. And also, according to the Phillips curve, stagflation was not supposed to happen. When either unemployment or inflation went up, the other was supposed to go down. Friedman had absolutely been proven right. And that meant economists needed to go back to the drawing board and keep up their search for that fundamental truth. Keep looking for that roadmap that would help them guide the economy. That's coming up after the break.

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16:28If macroeconomics was in its adolescence when Phillips first drew his curve, this next part of the story is a coming-of-age moment. Because that simple observation about how inflation and unemployment are linked, it needed to grow up. This is a thing that happens pretty often in science. It's healthy, actually. People think they have a good picture of what's going on, and then someone comes along and says, actually it's way more interesting and complicated than you thought. Like atoms, you know, the smallest things that are out there. It turns out those are made of protons and neutrons and electrons.

17:05Would you look at that? Yeah, that's kind of what happens with the Phillips curve. After Friedman's critique and the mess of the 1970s, economists are rebuilding the curve. They take this relatively simple relationship, unemployment, inflation, and turn it into a more complex equation. So those inflation expectations, economists make sure those are in there. Also the supply shocks that they just learned about. And also what's called the natural rate of unemployment. Basically, everything they knew that influenced how inflation and unemployment played out got added. And this is how we got to a new and improved Phillips curve.

17:43The Phillips curve 2.0. And the reason we called Alan Blinder is that he got to use this Phillips Curve 2.0 at an important moment for the U.S. economy. 1994, when he gets the job of vice chair of the Federal Reserve, second in command. Best job of your life? Yeah, probably. Probably. It's cool to be able to pick up the phone and people do what you want. Yeah, they mostly did, although as in many bureaucracies, they didn't always do what you want. They always said they would do what you want. And sometimes a week later, you say, wait, they didn't do that. You had to call them again. Blinder gets the job at a tricky time to be a central banker.

18:28It looked like inflation was going to start going up, which is scary if you're a Fed official. You don't want to be the vice chair who lets inflation rear its ugly head on your watch. So Blinder shows up for his new job, and the pressure is on. One of the first things I did was ask for a briefing from staff, and they are good at this, on the Phillips curve. And when the vice chair asks, 20 research economists spend the weekend trying to figure out. Yeah, yeah, yeah. And if it was the chairman who asked, it would have been 50 research economists. Was this literally one of the first things you did when you got there?

19:06Yeah, it might have been the first. Because this is one of the most pressing questions of the age? It was. It was. The Fed had, just before I joined, started raising interest rates to fight inflation. So question number one, two, three, four, and five was all about how far would the Fed have to go to prevent inflation from going up? How far would the Fed have to raise interest rates to cool the economy? What Blinder gets back from his researchers is a bunch of different scenarios, not just one Phillips curve, but a whole stack of them, showing all these possible outcomes for the economy based on different economic measures.

19:48And from what Blinder could see, these forecasts pointed to inflation trending up. So he makes his call. So did you vote to hike rates? I did. And when you did that, essentially what you were doing was? Yeah. Making a choice on the Phillips curve. You were saying we want to increase unemployment just slightly. Just slightly. Cause a little bit of pain, but not tremendous pain so that we can keep inflation good. Correct. Blinder wanted to walk a fine line, stamp out inflation without causing a recession. What we're calling a soft landing these days. Right. So Blinder and his team, they continued to consult their new Phillips curve forecasts and they continued to hike rates for about a year.

20:35And that was just right. We did get the soft landing. And you asked about the nicest job. It's really nice to have praise gushing in all over the place for the soft landing that the Fed had miraculously achieved. It was sort of like Blinder and his colleagues had delivered on the original promise of the Phillips curve. They'd used it to keep inflation down, keep the economy stable. It was the best because, you know, the view in the markets, we were a bunch of geniuses and did everything exactly right. Blinder left the Fed in 1996, fully believing in the Phillips curve or the Phillips curve 2.0.

21:16For him, it was a roadmap. With it, he could navigate the graphs of unemployment and inflation and figure out a way forward. The fundamental idea of the Phillips curve, that in order to get inflation down, you needed people to lose their jobs, that had become gospel. But if you ask Blinder now, are you a true believer in the Phillips curve? No, I'm no longer a devotee of the Phillips curve. I've seen the error of my ways. What happened that made him stop believing in the Phillips curve? Well, after Blinder got his perfect soft landing, inflation more or less stayed still for decades from the late 90s until just a couple of years ago.

22:02And this was a time when so many things were happening in the economy. There was a tech boom. There was a tech bust. There was the Great Recession. Unemployment took some wild swings, but inflation didn't really budge, which is not what the Phillips curve. Even the Phillips Curve 2.0 said should happen. All this was very disconcerting to Blattner. If you don't understand what's driving inflation up or down, you've lost an important tool and you're wandering a little bit in the forest when it comes to predicting inflation. You've lost maybe the most important tool that monetary policymakers have, right?

22:41I think, you know, not everybody would say that, but I would say that. That's terrifying. That means that we can't control. Yeah, it's terrifying. The reason it wasn't terrifying was until around 2022, inflation just wasn't the problem. So the reason it's terrifying is that if you lose your Phillips curve, you don't quite know what to do if you need to bring inflation down. Which, of course, we need to do now. It's the Fed's main focus today. And it's not like economists have entirely given up on the Phillips curve and its way of understanding the economy. It's more like the Phillips curve needs another round of rethinking.

23:26Back when Bill Phillips first came up with his curve, it was a comforting idea. Maybe there could be laws of economics just like there are laws of physics. Right. And it's natural to see something happen over and over again in the world and think it's some sort of law, some sort of universal truth that you can lean on. But the story of the Phillips Curve shows that that is really hard to do in economics. Economists can make observations and use them as guides. They can even update those observations over time. But economies aren't static. They're complex. They're made up of people who respond to the economy and change it in the process.

24:03Which means that economists might never get to universal truths. They'll always be learning as history unfolds. They'll always be playing catch-up.

24:18This episode was produced by Sam Yellowhorse Kessler. It was edited by Molly Messick and engineered by Maggie Luthar. Sierra Juarez, check the facts. Many, many thanks to Anne Owen and Ricardo Reich for talking to us for a long, long time about Bill Phillips' work and helping us understand it. I'm Nick Fountain. And I'm Willa Rubin. This is NPR. Thanks for listening.

24:53Professor Blander, do you know who Christopher Walken is? Give me a hint. That rings a vague bell. Famous actor. He was in like Batman. Oh, yeah, yeah. Yeah. We were telling people around the office that we were interviewing you, and they were like, we think Mr. Blinder is the Christopher Walken of economics. I don't know what you feel about that. I don't know if that's a compliment or an insult. It's absolutely a compliment. Okay, I'll take it then. This message comes from Apollo Global Management, who believes the global industrial renaissance is transforming the world. Over the next decade, industries like energy, infrastructure, and technology will need an estimated$75 to$100 trillion to modernize and meet demand.

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