Many economists - including, we suspect, the U.S. Federal Reserve – treat unemployment and inflation as negatively-correlated elements of the economy. When the labor market runs too hot, the theory goes, inflation tends to rise. When the labor market is weak, inflation troughs.
The argument is similar to capacity utilization at a factory or the excess capacity that might exist within an industry. Unemployment is a sign that the economy is running below its capacity. When an economy runs below its capacity, unemployment rises and prices become weak. When economic capacity is being fully utilized, unemployment declines and prices start to rise.
Unemployment and inflation are tradeoffs under this theory, which leads to an obvious policy conclusion. When unemployment rises and prices are weak, the bureaucrats should do what they can to goose the economy. Goosing the economy leads to more economic activity, which better utilizes economic capacity, which leads to lower unemployment. When the slack in the economy disappears and prices start picking up, they ease off the stimulus in order to slow the economy.
One way bureaucrats goose the economy is by lowering interest rates. Low interest rates stimulate the economy. Higher interest rates slow the economy. The U.S. Federal Reserve, then, uses interest rates as a thermostat of sorts. If the economy is running too hot, it dials down the thermostat by raising rates. If the economy is running too cold, it dials up the thermostat by keeping rates low. By adjusting the thermostat, the Fed can help eliminate economic fluctuations, or at least reduce their severity.
Most of us accept the thermostat narrative without question. Anyone involved in business is generally aware of the effects of capacity utilization. When capacity is tight, producers gain some pricing leverage and start hiring people. Prices go up and unemployment goes down. When demand turns down and creates excess capacity, producers compete on price and start laying people off. Prices go down and unemployment goes up. We get it. It makes sense.
The problem with the thermostat narrative is it doesn’t match what we actually see in the real world.
According to the thermostat narrative, the economy in Zimbabwe with inflation running 200% a year must be really humming. Capacity must be oh so tight. The same must be true with Argentina and Haiti with annual inflation rates of 80% and nearly 50%, respectively. The reality is that all three of these economies are experiencing both high inflation and high unemployment.
Even mainstream economists have been forced to admit that the thermostat narrative doesn’t work in extreme situations like Zimbabwe, Argentina, and Haiti. The conditions have to be just right.
It was the 1970s in the U.S. that first threw a wrench in the gears of the thermostat narrative. Inflation averaged 8% for the entire decade and spiked above 12% in 1976 and 1981. Unemployment was persistently high in the decade as well and flirted with 10% a time or two. The thermostat narrative didn’t seem to apply to the U.S. in the 1970s. Like Zimbabwe, no tradeoff existed between inflation and unemployment. Both were high.
That forced the mainstream economists to alter their theory. The negative correlation between inflation and unemployment breaks down in extreme conditions. The thermostat, in other words, breaks down in certain situations.
We see the breakdown of the thermostat under extreme conditions as a huge red flag. How do extreme conditions come about? How did the U.S. in the 1970s cross into the extreme? How did Zimbabwe, Argentina, and Haiti get to be extreme? The answer is quite obvious: extreme conditions themselves are created by dialing up the thermostat a few too many times.
A thermostat is a very dangerous tool to give to bureaucrats, in our view. It leads not to economic stability, but to economic instability.
The curious thing about the thermostat narrative is it not only leaves Zimbabwe, Argentina, Haiti, and the U.S. in the 1970s unexplained, but it also leaves countries like Singapore largely unexplained. Inflation and unemployment in Singapore sure don’t seem to be negatively correlated: they are both running around 2% at the moment, which is incredibly low for each. Annual inflation in Singapore, in fact, has averaged just 2.4% for six decades. Unemployment during those six decades has rarely exceeded the “normal” unemployment rate of 3.0%. Singapore, it seems, has managed to flourish with low inflation and low unemployment.
Switzerland is another example. Unemployment and inflation are each running about 3% in Switzerland, again quite low for each. Switzerland, like Singapore, has had multi-decade runs of very low inflation combined with very low unemployment.
The U.S. has also had multi-decade runs of low unemployment and low inflation. In the first six decades of the 19th century, the purchasing power of the U.S. dollar actually increased. The U.S. dollar bought 50% more goods and services in 1860 than it did in 1800. That is an “inflation” rate of -0.7% a year. While quantitative statistics for unemployment and national output are difficult to come by for that period in history, the U.S. economy by all accounts flourished during those years. The U.S. was a poor country compared with its European counterparts at the start of the period and ended the period with a standard of living better than most of its European counterparts. That was six decades of prosperity with negative inflation.
Curiously enough, there were no bureaucrats turning thermostats during that period.
The Dutch had one of the most impressive economic runs in world history in the 100 years following its independence from Spain in 1588. The Dutch in that period went from a standing start to having the highest standard of living in all of Europe and likely in all of the world. Historians call it the Dutch Golden Age. Inflation was just 5.0% for the entire period, or about 0.05% per year. Unemployment was consistently low, inflation non-existent, and the standard of living went through the roof.
The Dutch, it is important to point out, had no thermostat to guide them through that period.
In every case of long-term prosperity we examine, no negative correlation exists between unemployment and inflation. Curiously enough, no inflation exists at all and there are no bureaucrats with thermostats.
Karl Popper tells us we need just one observation to completely falsify a theory. We just listed eight. The pathway to prosperity, in our view, doesn’t involve a thermostat. Handing a thermostat to a bureaucrat leads not to prosperity, but to impoverishment. Perhaps it’s time to take the thermostat away from the bureaucrats.
