The assumed relationship between inflation and employment, unemployment really, has been tortured in the last half century. Given the constant mistakes economists make in this regard, it is fair to conclude that they really don’t have much idea at all about the connection. There is a fatal conceit contained within the orthodox views here that starts with misunderstandings about money itself.

From the very earliest days of economics, there has been this aching desire to map out an economic system in all its fine details. From David Hume to John Stuart Mill, Simon Newcomb to Irving Fisher, they all believed that money and the economy followed hardened relationships that if studied enough could be revealed and thus allow for centralized “optimization.” Going back even to the very first stirrings of what would become political economy and then just economics, it was easy to figure that some relationship between money and economy existed. Copernicus wrote in 1517 (published in 1526) his Monatae cudendae ratio, claiming,

We in our sluggishness do not realize the dearness of everything is the result of the cheapness of money. For prices increase and decrease according to the condition of money.

Over time it became clear that as prices changes so too did the real economy. From that view it isn’t far to wonder if some central organ could manipulate prices, via money, they might then control the economy. First, however, they had to figure out how any of it actually worked.

In 1885, Simon Newcomb introduced in Chapter XV of his Principles of Political Economy his “equation of societary circulation.” The form is immediately recognizable even though it was at this point sort of stunted. He introduced the idea of “rapidity” which is now termed money velocity but on the other side of the equation it was focused entirely on the real economy aggregates; his mathematical view left off borrowing and markets.

When Irving Fisher wrote his econometric thesis in 1911, The Purchasing Power of Money, he dedicated it to Newcomb and the advance of quantitative theory. “To the memory of Simon Newcomb, great scientist, inspiring friend, pioneer in the study of ‘societary circulation’.” Fisher’s development above Newcomb’s was to add all possible monetary uses, including speculation. His equation of exchange was not what we see today, but rather used “T” instead of “Q” which included all bank clearings at that time capturing large volumes of purely financial transactions. For Fisher’s version, money (M) times velocity (V) could end up in purely financial imbalances as well as economic.

After Simon Kuznets developed the modern version of economic aggregates in the 1930’s, Fisher’s view of a holistic financial approach fell apart into more discrete packages. By the late 1950’s, British economist AW Phillips “discovered” a tight correlation between consumer inflation and unemployment. Studying perhaps the best historical data to that point, Phillips observed a seemingly steady inverse correlation between those factors in UK estimates going back to 1861. The “Phillips Curve” was published in 1958 and found immediate favor especially among economists already seeking to fulfill the optimization dreams of quantity theory.

Economists Paul Samuelson and Roger Solow published that next step in 1960, as they posited that Phillip’s assumed solid correlation would allow policymakers a lever of economic control. Where Phillips brought up his curve, Samuelson and Solow made it “exploitable” in especially money relationships. As they wrote in their 1960 paper,

In order to achieve the nonperfectionist’s goal of high enough output to give us no more than 3 percent unemployment, the price index might have to rise by as much as 4 to 5 percent per year. That much price rise would seem to be the necessary cost of high employment and production in the years immediately ahead.

In other words, they thought it acceptable for government policy to “buy” higher employment (lower unemployment) through rising prices; and they did so because of this faith in quantity theory where economists could define all relevant terms including any factors dealing monetarily. It was an abject failure, as the world would find barely five years later and then struggle with for a further seventeen in what we call now the Great Inflation.

It was such a clear disaster that by 1980 both Republicans and Democrats had denounced it and the Keynesian theory behind it. So thoroughly discredited was this approach that the US Senate produced a bipartisan document denouncing any such “demand side” approach. In the 1980 election, George Bush actually decried Ronald Reagan as being not sufficiently a “supply sider” because he dared include in his tax cut proposals some that were intended for taxpayers rather than just businesses (“demand side” was his infamous “voodoo” charge).

But where 36 years ago it was settled that attempts to influence “demand” was “voodoo”, today “demand” policies have not just been rebirthed they are all that are even offered. “Stimulus” still takes the form of what Solow and Samuelson were writing about in 1960, only it has been updated (so its proponents claim) to include more complexity as if that were all along the mistake. Complexity is made to stand in for comprehensiveness though in reality it is a very poor substitute. We know this because of the stunningly elegant statistical models that have been created that at their core still share the same basic flaws that have thwarted everyone from Newcomb to Fisher to Arthur Burns (and now Alan Greenspan, Ben Bernanke and Janet Yellen follow in the same incapacity).

Where “demand” policies were a clear failure by the 1980’s, the economic history of the 1990’s was revised to some Great “Moderation” which we are supposed to believe reestablished this quantity theory in its finally useful format. It has led to the idea of “rules based” monetary policy and even the possibility of central planning “filling in the troughs without shaving off the peaks.” In other words, the whole idea of the “moderation” was to build up soft central planning largely through central bank interference.

A good part, if not all, of this claim to efficacy rests upon the 1990’s. By mainstream accounts, it was the “perfect” marriage of the “maestro” with what was even thought at the time to be another “permanent level of prosperity.” Even though economists had to spend the next decade trying to explain why it didn’t follow into the 21st century, they still hold fast to their interpretations of that “golden age.” It should be, by now, very telling that orthodox monetarism views both the 1920’s and the 1990’s as their respective apexes in Federal Reserve history.

In the fall of 2002, economists Laurence Ball of Johns Hopkins and N. Gregory Mankiw of Harvard attempted to justify this modern view of monetary conditions. In writing about NAIRU, the non-accelerating inflation rate of unemployment, they were essentially updating Samuelson and Solow by marrying that view with Milton Friedman’s devastating critique (first delivered in the 1960’s). There was still some “exploitation” to be had by policy, but NAIRU had to be settled first to figure out what that meant. In other words, NAIRU is a nod to the reality that any relationship between unemployment and inflation is not permanent. Why that has been so has never been sufficiently addressed, so it is just ignored and swallowed up by this biased history, necessitating increasingly absurd explanations and misdirection.

The second issue is why the NAIRU changes over time and, in particular, why it fell in the second half of the 1990s. This question is more difficult, and the answer is open to debate. Most likely, various factors are at work, including demographics and government policies. Yet one hypothesis stands out as particularly promising: fluctuations in the NAIRU appear related to fluctuations in productivity. In the 1970s, the NAIRU rose when productivity growth slowed. In the 1990s, the NAIRU fell when productivity growth sped up.

In the view of “rules based” exploitable correlation, a higher NAIRU suggests that monetary policy can “buy” very little additional employment maximum while a lower NAIRU seems to indicate far more flexibility to “go for it.” The problem, as was clear again in the 2000’s, was that what is claimed as productivity as a baseline or true potential seems to have abandoned these economists just when it should have instead been richly paying off in fulfilled promises of permanent prosperity.

In May 2007, Janet Yellen discussed this problem at one of the more important FOMC meetings of that era.

Relative to the second half of the 1990s, both the pace of productivity growth in the IT sector and the pace of investment in equipment and software have slowed, and these factors have probably depressed trend productivity growth slightly in recent years and are likely to continue depressing it somewhat going forward.

But the hypothesis that the recent decline in productivity growth is mainly structural does not seem to me to square well with the broad range of available evidence. Recall that in the 1990s there was a whole constellation of evidence—including a booming stock market, robust consumption, and rapid business investment—that was consistent with a hypothesis of a lasting increase in the rate of productivity growth. In contrast, over the past year or so, business investment in equipment has been very sluggish and more so than seems warranted by the deceleration in business output.

If the second half of the 1990’s represented your belief of a “golden age” you were, like Yellen and the rest of them, utterly perplexed by the 2000’s (and that was before the panic and Great Recession). If, however, you were merely awake during that period with a bare minimum requirement of technical appreciation you saw only bubble and thus needed no academic concept to bridge the seeming gap to “growth in the IT sector and the pace of investment in equipment and software.” Just noticing pets.com oraskjeeves.com was more than sufficient as an explanation for that elevated “productivity” and more so why it wasn’t repeated in the 2000’s. There was no mystery there.

The economy of the 2000’s is really the economy of the eurodollar. Economics viewed its rise under their own terms only to find that everything they assumed of those terms turned into “unexpected” global disorder. Until they break out of these rigid and ancient monetary assumptions and dreams, they will never be able to go forward (assuming, however, that they even want to).

>> Read Part 2: Coming To Terms With Money