Invest and Trade Profitably with Jon Johnson

I’ve heard a lot of talk about the Phillip’s Curve and its so called accuracy. Would you please share your thoughts on its performance and accuracy as to the market’s present and future activity?

August 30, 2000

The Phillips Curve is an economic theory that is avidly followed by some and equally disdained by others. Basically it is the ‘speed limit’ theory describing economic activity in relation to inflation. In general, the ‘Curvers’ believe that there is a limit to the level of growth that can be sustained without inflation. Too much employment, solid wage growth and a bustling economy send fear into these economists. In short, real prosperity is something they want to avoid because they believe strong growth leads inevitably to inflation.

This is the bug that got into Greenspan’s head in the late 1990’s. He became convinced that inflation had to be just around the corner because GDP growth was strong and sustained while unemployment was very low. He cleverly couched his fears in terms of ‘new’ inflation indicators, but the underlying theme was that there was too much prosperity and it scared him. We still remember Broaddus, one of the FOMC members at the time, stating that employment needed to be lower. Again, prosperity was the fear of these economists. They espoused free markets, but when we actually had prosperity they reverted to their old textbooks and crashed the economy. Ironically, they did exactly what the 1920’s central bank did, i.e. chased non-existent inflation with rate hikes and lowering the money supply until the market and then the economy cracked. They feel their theories were correct, but that is like taking credit for putting out a 4 alarm fire after you started it.

The fascinating thing is, the Phillips Curve has, outside a six year period in US economic history, never applied to the real world facts. Economists who were Curvers were baffled in the 1970’s when there was economic decline, high unemployment, but soaring interest rates. That did not fit the equation, but they kept treating it as if it did, applying PC (Phillips Curve, not politically correct) theories. All that caused was the worst recession since the Great Depression. It is an example of how the theory did not apply in a bad economic time.

Indeed, the recession did not end until supply side theories were put into place in the early 1980’s using the Laffer Curve. That theory plots taxes revenues against tax rates. At too high of rates there is no incentive to take risks and invest and thus tax rates fall. If you lower taxes from high levels, the economic activity increases and thus tax revenues increase. Lower tax rates equals more tax revenue. That set off a binge of investment that led to the 20 year boom. GDP and tax revenues soared, unemployment tanked. Inflation? It was a no-show even up to the point where the Fed crashed the market and economy in fear of non-existent inflation.

These are just two examples, one a good time and one a bad time, where the Phillips Curve did not apply to the real world facts. Unfortunately, there are many who still adhere to this discredited theory. They may not say it openly, but when things are good they start to play defense instead of staying on offense. The Fed is this way. When you hear talk of economic ‘speed limits’, that is just a euphemism for the PC. That is the real fear once more, i.e., that we have a prolonged expansion and the Fed fears the wrong things will cause inflation.

Prosperous, productive, employed people don’t cause inflation. They are part of the reason we have prosperity. Policies that limit investment, restrict money from where it would naturally flow, and promote demand over supply are the cause of inflation. If supply is not restricted it will not only meet demand but it will create demand. An example is the PC. There was no market for PC’s and as you recall in the early days of the devices the common question was why would anyone need a computer. The PC made its own market when everyone realized in fact they did need a computer. It was not the market demanding a computer for the home, it was the investment in technology that made the PC possible that created the market. People generally don’t need many of the products nanotechnology is producing (e.g. nano-fiber self-cleaning pants versus cotton pants), but once they see them and what they can do there is demand for them. Supply creating demand.

The fear for the economy is that the Fed adopts policies that are PC related as opposed to free market related, and it cuts off the money supply once more. After Greenspan leaves there will be a power vacuum. The administration will need to appoint a strong free market thinker to fill his place and fight off the many on the Fed (now that McTeer is gone) who believe there is a ‘speed limit’ for the economy. The market last week was pondering the Fed getting too aggressive, just as we have discussed earlier this year as one of the keys to the market’s performance in 2005. If the Fed gets too aggressive and does not provide any insight into when it will quit hiking rates, and if it continues contracting the money supply into the future, the economy could have a real struggle in the summer.

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