IT SURPRISED few professional economists that Dr. Edmund S. Phelps, professor of political economy at Columbia University, was awarded the Nobel Memorial Prize in Economic Science. The scope of Phelps’ work has had a broad impact beyond professional economists because it affects the salaries we are paid and the economy’s health.
Until Professor Phelps published three papers between 1967 and 1970, economists and policy-makers labored under the concept of the “Phillips Curve.” That simple convex curve illustrated what economists believed to be an almost one-to-one trade-off between inflation and unemployment. Wages would increase and inflation would follow if too many people had jobs and the labor market became tight. Conversely, prices would stabilize or perhaps decline if there was unemployment, like the Great Depression of the 1930s.
Professor Phelps revolutionized this thinking. He found that inflation could be caused by the expectation of a general price increase, as well as full employment itself. Professor Phelps actually predicted “stag inflation” in the 1980s when rapidly rising interest rates and unemployment resulted in a downward spiraling economy.
Professor Phelps demonstrated that what people and firms did actually mattered. Prior to his work, most economists believed companies would pay workers a salary equal to the minimum amount that would attract a worker. He disagreed. Professor Phelps documented a phenomenon known as “efficiency wages,” where businesses might rationally choose to pay wages at a somewhat higher rate than is necessary to attract workers. This, he said, would reduce expensive turnover and improve employee morale.
Spikes in unemployment might also have irreversible, destructive consequences because workers would become discouraged and leave the market, he argued. In a good summary article in The Chronicle of Higher Education and the New York Times, Professor Phelps explained that just as inflation can have devastating effects on business owners’ expectations, unemployment can have poisonous effects on workers’ long-term hopes.
Professor Phelps assumes that employers’ and employees’ attitudes about work and the economy’s future have a significant impact on the economy. That’s why the Federal Reserve Bank now pays significant attention to consumers’ and producers’ perception of the economy. It is why recent administrations have worked to assure an economy of moderate growth, while assuring significant stimulus from investments.
President Clinton’s comment, “It’s the economy, stupid,” during his first presidential campaign emphasized that what people think about the economy creates it, as well. The Bush administration’s insistence on reducing taxes and stimulating investment to grow the economy is focused as much upon people’s attitude about the economy as it is on creating the investment pool which leads to economic growth and wealth creation. Simply put, if people believe their employers and the economy are doing well, they believe they will, too.
This reasoning has led Professor Phelps to some interesting, if not idiosyncratic, public policy proposals. He would like to see the federal government, for instance, provide tax subsidies to businesses, which would give the money to low-wage workers as income. He opposes direct government payments to individuals because he believes the money should flow through businesses in order to raise workers’ self-esteem.
“It’s better for the worker to see the total compensation coming from the firm,” he said, because it leads to self-respect and higher productivity.
The Columbia professor will receive $1.4 million from the Nobel Foundation at a ceremony in Stockholm, Sweden, on Dec. 10. Whether the money will be given to Columbia first — his current employer — so that it can be awarded to him was not revealed. What is apparent is that Professor Phelps’ self-esteem is neither inflated nor recessed. He has been teaching at Columbia since 1971 and lives in New York City. He doesn’t have a weekend home, according to the New York Times. He simply enjoys writing and studying economics.