1 – Introduction
1Today, policy discussions in the 1960s are usually associated with the idea of a long-run trade-off between inflation and unemployment given by a stable Phillips curve—a belief that was heavily countered by Phelps [1967] and Friedman [1968]. The debates in the 1960s, however, went farther than just arguing about the optimal combination between unemployment and inflation, that is, in today’s terms, moving along a stable Phillips curve. There also was a lively discussion on the medium to long-run consequences of running the economy at different levels of demand pressure and hence at different combinations of unemployment and inflation. These debates focused on the impact of the rate of inflation on allocative efficiency, on the role of strong demand for capital formation and labour market dynamics, as well as on the overall impact of the state of demand on technical progress.
2The discussion in the 1960s was based on three elements: First of all, growth became a most important policy objective due to the Cold War. Many contributions in the 1960s thus focused on the rate of growth from the point of view of economic policy and not necessarily from a founded theoretical analysis. Second, even though nearly all authors were aware that growth in the long run crucially depends particularly on technical progress, investment was nevertheless regarded as the driving force of the growth process taking place within the timespan important for economic policy. As investment was assumed to depend on the level of aggregate demand, regulating the demand pressure by fiscal and monetary policies seemed to be a promising approach to foster economic growth. In this view, stabilisation policies and active demand management did not only have a short-run influence but were also important for the medium to longer run. These two elements, that is, growth as an objective of economic policy and the important role of demand policies, will be discussed in Section 2.
3The third element in this debate was the perceived trade-off between the rate of inflation and the rate of unemployment as given by the Phillips curve. Even though most contributions did not make reference to Phillips’ [1958] seminal paper, the conflict between the two variables was at the heart of the discussion. This trade-off emerged due to various imperfections in the economy, most notably cost-push forces (for example, aggressive unions), causing inflationary pressures even in the case of excess unemployment. Regulating the level of aggregate demand in this debate thus not only meant to achieve the objective of high rates of growth, but also to balance the rate of inflation versus the rate of unemployment (see, for example, Fellner [1960: 94ff.]).
4Hence, at least on theoretical grounds, inflation and unemployment were thought to be closely connected to the rate of growth even though three different lines of thought can be distinguished: On the one hand, many economists believed that a high-pressure economy would be beneficial for the rate of growth. Most arguments pointed at the stimulating environment for investment due to inflation lowering the real rate of interest and a high level of demand stabilizing sales perspectives. These arguments were based on a Keynesian understanding of growth theories, that is, the Harrod-Domar model [Harrod, 1939; 1948; Domar, 1946; 1947] in which investment plays an important role for the rate of growth. However, many arguments were not backed up by deeper analysis (see, for example, Scitovsky and Scitovsky [1964: 440]). On the other hand, in particular Paish [1958; 1962; 1968] pointed out the positive effects of strong competitive pressures brought about by some slack in the economy. Growth in this framework did not depend on accelerator-type investment dynamics, but on the consequences of strong competitive pressures on firm-level efficiency and the need for innovations in order to survive in an overall weak market. A third line of thought remained very skeptical about a strong influence of the overall level of demand pressure on the rate of growth. Many economists, in particular those focusing on Phillips curve analysis and related policy questions, stayed close to Keynesian growth arguments, but based their skeptical view on empirical evidence which seemed to show that the rate of inflation and unemployment have, if at all, only a small influence on the rate of growth. These three different views will be discussed in Section 3.
5Section 4 will focus on a most interesting contribution by Black [1959] which disentangles these different views within the Phillips curve framework. The conclusion will outline what might be learned from the discussion in the 1960s and what might have been lost since Friedman’s introduction of a “natural rate of unemployment” into the Phillips curve concept.
2 – Growth as an Objective of Economic Policy and the Role of Stabilisation Policies
2.1 – Growth as a Policy Objective in Times of the Cold War
6The discussion about the role of the overall state of demand for the rate of growth started in the 1950s, but became particularly pronounced in the early 1960s due to the slow rate of growth in the USA compared to the Soviet Union, and in the UK compared to the rest of the industrialised world [Wilson, 1961: 4; Johnson, 1963a: 46]. The rate of growth hence became a first priority objective of policy [Tobin, 1964: 1] particularly in the USA due to the Cold War, which also made economists talk about the “Soviet challenge” [Baran, 1960: 119] or the “Russian threat” [Baumol, 1958: 57]. Whereas the USA only reached an average growth rate of 3.3 per cent in the 1950s, the USSR achieved 7.6 per cent [Klein and Bodkin, 1964: 410]. [2] Furthermore, the Cold War made it necessary to discuss growth as a matter of national security in the USA [Newman, 1958: 245; Lewis, 1958: 377; Rostow, 1960: 110; Smith, 1960: 272; Commission on Money and Credit, 1961: 9; Johnson, 1963c: 280; Wilson, 1963: 604ff.; Klein and Bodkin, 1964: 369; Tobin, 1964: 5]. A high rate of growth was regarded to be of utmost importance, since “a major objective of economic growth is to provide an expanding base for actual or potential national security outlays” [Kendrick, 1964: 242].
7Not only the rate of growth as such, but also technical progress was regarded as an essential factor in times of the Cold War. As both were assumed to be interrelated—“if technology helps growth, growth in turn helps technology, and on technology defence largely depends” [Wilson, 1963: 605]—the rate of growth became the dominant policy objective. This obsession with growth went so far that the rate of growth in many contributions was often treated “as an end in itself” [Alhadeff et al., 1964: 531]. Even the “Golden Rule of Accumulation” by Phelps [1961] as an important contemporary contribution to growth theory on how to achieve maximum consumption was either just ignored or bypassed by many authors. Furthermore, individual decisions on saving and investment as the ultimate benchmark for an optimal rate of growth [Tobin, 1964: 2; Kendrick, 1964: 244] were also discarded in most contributions. For example, Musgrave [1958: 609] was clearly aware that “the ultimate objective of economic activity is consumption” but at the same time remarked about the “optimal rate of growth in the economy” in light of the high Russian growth rates that “this may be answered more or less easily by reference to Russia: Whatever we do, the Russian rate of growth is likely to exceed ours, simply because they are at a much earlier stage of the game; therefore, if we want to maintain our relative advantage, we had better grow as fast as we can.”
8Due to this competition with the Soviet Union, Fellner [1960: 98] emphasised that policies aiming at a higher rate of saving in order to foster growth do not necessarily “violate the time-preference scales of the public” as positive external effects of a higher rate of growth (for example on defence) are not taken into account by private decisions. Thus, the optimal rate of growth was not regarded to be determined by individual preferences any longer, but became subject to economic policy. Denison [1962: 69] even went as far as to suggest “that the public be persuaded that acceleration of growth must be made an overriding national goal. Moreover, it must probably be persuaded of this for reasons other than the increase in individual welfare—probably reasons related to the external situation facing the country.” In the same vein Anderson and Cornwall [1961: 174] emphasised that “[i]f we wish to maintain our market system and at the same time to avoid being outstripped by the Soviet Union, some way will have to be found to manipulate the market forces to achieve the desired growth goals.” Time preferences, thrift, and individual decisions as such hence were accepted as indicating an optimal rate of growth in a fair-weather world, but given the threats of the Cold War even Tobin [1964: 6] was not reluctant to state that “[s]ome hazards are great enough to bias our choice to favor the future over the present” as “[a] high GNP might be the difference between victory and defeat rather than the difference between more or less consumption.”
9Growth as a policy objective hence involved strong interventions into the free market economy. This development was met with much scepticism. In particular Friedman [1959], who pointed at the importance of individual decisions so that “[w]hatever rate of change in the statistical aggregate [output] results from the effort of freemen to promote their own aspirations is the right rate,” feared that the Cold War might create a difficult and dangerous environment for economic policy as “departures we must make to survive” may overcharge the corrective forces of a free society. Johnson [1963b: 139] even went as far as to remark that “the recent emphasis on the desirability of a high rate of growth seems to me to involve grafting on to a free enterprise system standards appropriate to a planned economy with military and political ambitions.” Johnson [1963a: 47] therefore critically noted that “[t]he movement towards some form of economic planning for growth has gone farthest in the United Kingdom, with the establishment of the National Economic Development Council” of which also Richard Lipsey, a pioneer of Phillips curve analysis [Lipsey, 1960], was part of the staff [Lipsey, 1997: xxiv]. The National Economic Development Council [1963b: viii] explicitly had the aim “to increase the rate of sound growth.” Such a rate of growth was set to be equal to 4 per cent of national output [National Economic Development Council, 1963b: iii]. In the USA, particularly the Joint Economic Committee [1958], and the Commission on Money and Credit [1961] published studies about the possibility of achieving a high rate of growth while maintaining price stability and full employment.
2.2 – The Role of Demand Management and Stabilisation Policies
10Growth not only became a most important objective of economic policy, it also was thought that economic policy has the appropriate tools to influence the rate of growth by managing the economy accordingly. This optimism is most visible in Samuelson’s [1955: 337] statement that “[w]ith proper fiscal and monetary policies, our economy can have full employment and whatever rate of capital formation and growth it wants.” This optimism about finetuning the economy is also very pronounced in Anderson and Cornwall [1961: 174] as they remarked that “[m]ost economists by now are accustomed to think of the government as an agency for damping fluctuations and at least edging the economy toward full employment.” The economics profession in the 1960s hence was very optimistic about managing the economy and there was the belief that good demand management “ironed out the business cycle” [Harrod, 1967: 19]. In the same vein, Wilson [1961: 3] stated that “the trade cycle, if it has not been altogether conquered, has been much subdued”. It is therefore not surprising that there was also an edited volume published on the possible obsolescence of the business cycle [Bronfenbrenner, 1969: v]. In sum, stabilisation policies had two short-term objectives: On the one hand, “to regulate the pressure of demand for labour” and on the other hand, “to keep the fluctuations of the unemployment percentage within fairly narrow limits” [Godley and Shepherd, 1964: 26]. Fine-tuning the economy with respect to choosing and regulating the pressure of aggregated demand hence seemed achievable by stabilisation policies so that “[i]t is for the Government to decide at what pressure it wishes to run the economy, and to try to keep it there” [Godley and Shepherd, 1964: 26]. This optimistic attitude towards managing the economy is described by Minsky [1968: 45] in retrospect about the early 1960s noting that it was believed that “business cycles as they had been known would be a thing of the past” and that “the perfected tools of economic policy would ‘fine-tune’ the economy so that, period by period, it would stay on a course of sustained growth.”
11Thus, “sustained growth” relied on successful stabilisation policies to damp the business cycle and to keep the economy at full capacity output (see, for example, Smith [1957: 53ff.]; Phillips [1961: 367f.]). This implied that economic policy needed to assure that the growing output of the economy will also be demanded [Musgrave, 1958: 607; Klein and Bodkin, 1964: 377]. In this sense, economic stability not only meant to keep the economy “at a happy mean”, that is, to damp the ups and downs, but to assure “a level of activity very close to full employment” [Turner, 1958: 671]. Stabilisation policies thus had the difficult task to maintain ongoing full employment with minimal fluctuations, which required a sophisticated analysis of the interrelationships between economic variables and appropriate tools to analyse the impact of different policies. One of the first economists to incorporate such new methods regarding stabilisation policies was Phillips [1954; 1957], who applied tools from engineering to the issues of economic stability [Turnovsky, 2000: 296ff.]. Phillips [1962: 9f.] furthermore was convinced that confidence about economic policy is an important stabiliser itself. Phillips’ intuition is that expectations about a sound policy, especially aggressive in fighting severe slumps, will stabilise investment and as such the whole economy because of the thereby created confidence that exactly such an enormous downturn will not be likely to last for a long time. Also Balogh [1958: 232] pointed at the necessity of stabilisation policies to create confidence as otherwise there might be “shocking consequences”, that is, a strong economic downturn, so that “only foolish people will not let sleeping accelerators lie”. Stabilisation policies hence were regarded as necessary to dull Harrod’s “knife-edge” [Solow, 1956: 65]. Samuelson [1957: 569] thus emphasised that preventing the “excesses of the boom” but also “offsetting slumps” will be beneficial for economic growth (see also Kendrick [1964: 239]). Stabilisation policies to achieve a maximal rate of growth were also believed to be necessary in an otherwise neoclassical growth context. For example, Cornwall [1963: 1f.] remarked that the long-run growth rate will depend on supply-side factors if full employment can be achieved by a perfectly functioning price system. If, however, full employment cannot be assured by the market system itself, demand policies are a powerful and necessary tool to increase the rate of growth so that “the system moves toward a long-run equilibrium growth rate determined solely by supply factors, as in the neoclassical world” [Cornwall, 1963: 21]. Thus Cornwall [1963: 2] pointed out that demand policies actually make it possible that the maximum growth rate (restricted by conditions on the supply side) can be fully realised so that “growth can and should be looked upon as a problem of adequate demand as long as an economy is subject to periodic recessions” (see also Nelson [1966: 1186] for a comparable approach, and Johnson [1963a: 65f.] for a related and critical comment on economic policy in Canada).
12However, not all economists at that time thought that damping cyclical fluctuations is a necessary condition to achieve high rates of growth. For example, Fishman and Fishman [1958: 65] pointed out that “[d]evoted followers of Schumpeter may… question whether it is possible to maintain growth without cyclical fluctuations, and whether any attempts to eliminate or even sharply reduce cyclical fluctuations may not result in economic stagnation” as “Schumpeter believed that there is an inherent causal relationship between economic growth and cyclical fluctuations, and that cyclical fluctuations are the mechanism through which growth occurs.” Samuelson [1957: 566] hence speculated that “[p]erhaps the booms and the busts of the last century were the inevitable costs of progress, the necessary price we must pay for vital growth.” In the same vein, Newman [1958: 246] pointed at the “surging and pulsating character” of a growing economy and hence at a possible “conflict between growth and employment as objectives of economic policy.”
13This conflict seemed to be most pronounced if restrictive demand policies were necessary to fight inflationary pressures arising due to cost-push forces, that is, for example, unions pushing up wages independently of the state of demand (see Bronfenbrenner and Holzman [1963: 600ff.] on the cost-push demand-pull debate in the 1950s and 1960s). This dilemma of fighting cost-push inflation by increasing the rate of unemployment made economists think about the long-run consequences of such a restrictive policy. For example, Rostow [1960: 111] asked: “Does control of inflation require in our democratic society a damping of the rate of growth?” In this respect Hoover [1960: 377] remarked about a study of the Joint Economic Committee [1959] that this contribution puts forward the “central thesis of the sacrifice of growth on the altar of price stabilization” (see also Wilson [1961: 3f.] and National Economic Development Council [1964: 8] regarding the stopand-go policies in the UK). In this sense, the Phillips curve trade-off was augmented by a third dimension [Smithies, 1958: 611; Phillips, 1962: 11; Klein and Bodkin, 1964: 386; Scott and McKean, 1964: 2]. Scitovsky and Scitovsky [1964: 429f.] hence pointed out that “[t]he most controversial question… is how inflation on the one hand and unemployment on the other affect the rate of growth of the economy.” Also the Commission on Money and Credit [1961: 12] remarked that “the possibility of conflict among these goals is a very real one.”
14In sum, the discussion about an optimal level of demand pressure was influenced by the Cold War (which made the rate of growth a most important policy goal), the belief in stabilisation policies to overcome the business cycle and to keep the economy at a specific utilisation level (which made the level of demand an important policy tool), and the possible conflict between unemployment, inflation, and growth (which made the optimal level of demand a difficult policy choice). Three different views about this optimal level of demand will be distinguished in the next section.
3 – Three Different Views
3.1 – The Keynesian View
15The view most prevalent in many contributions might be labelled Keynesian since the authors of these contributions particularly stress the role of demand-induced investment for the rate of growth. The rate of investment, as in Harrod’s [1936; 1939] growth model, was at least implicitly assumed to depend on the (expected) growth of aggregate demand. For example, the National Economic Development Council [1963a: 44f.] remarked that “[t]he incentive to invest is also likely to be greater when demand is high than when there is a good deal of excess capacity.” The National Economic Development Council [1964: 7] hence stated that “growth is encouraged by a high pressure of demand.”
16This high level of demand was assumed to generate inflation via the Phillips relation as employers compete for the last remaining factors of production. On a positive side, this higher rate of inflation was viewed to be beneficial for growth as profits may be higher if wages lag behind prices (see Klein and Bodkin [1964: 411]; for empirical falsification of this argument, see Bach [1958: 37], Kessel and Alchian [1960: 43ff.], and Reuber [1962: 220f.]). This effect might even increase labour supply if workers are trying to keep their standard of living by working more [Bach, 1958: 36]. Also, the real rate of interest might be lowered if the nominal rate does not adjust fully to the higher rate of inflation, so that the marginal efficiency of capital rises and therefore induces further investment [Kaldor, 1959: 289ff.; Scitovsky and Scitovsky, 1964: 463f.]. The rise in prices, it was argued, may create an “optimistic atmosphere” [Baumol, 1958: 51] or a “general spirit of optimism” [Smithies, 1958: 612f.]. This positive effect of inflation for the rate of growth, however, was doubted by many scholars since it implied some kind of money illusion. In particular Johnson [1963d: 64] opposed this line of thought as “[t]his argument assumes that the rate of interest at which entrepreneurs can borrow is unaffected by the expectation of inflation, implying that though borrowers are aware of inflation lenders are not” (see also Wilson [1961: 15]; Johnson [1966: 24]).
17The beneficial influence of a strong demand pressure on investment, however, is only the most apparent one, and the proponents of maintaining excess demand emphasised additional advantages of such a policy since most authors were fully aware that long-run growth also depends on growth of the labour force and, even more importantly, on technical progress. The level of demand was assumed to influence the rate of technical progress due to various reasons: First of all, strong demand may cause shortages and bottlenecks, in particular on the labour market. On the one hand, these bottlenecks were viewed as obstacles to further expansion, but on the other hand it was thought that they would induce research and the application of new means of productions to overcome the shortages. This mechanism was, for example, emphasised by the National Economic Development Council [1963a: 45] stating that “labour shortage provides a strong incentive to invest in labour-saving equipment which will raise productivity.” In the same vein, Scitovsky and Scitovsky [1964: 441] remark “that physical shortages of a productive factor are the most powerful inducements for developing and adopting new methods of production that economize that factor. A full-employment situation, therefore, by creating both a general shortage of labor and specific bottlenecks of specific skills and types of labor is especially favorable to labor-saving innovations and growth.” As every such innovation involves risks and usually huge investments in new machinery, Scitovsky and Scitovsky [1964: 441] argue that the willingness to implement these innovations will be greater if there is high confidence that economic activity will remain on a high level (see also Turner [1958: 682]; Harrod [1967: 16f. 1969: 325]). Furthermore, Scitovsky and Scitovsky [1964: 434] point out that full employment will make unions and workers accept the introduction of such labour-saving technical progress in a cooperative way (see also Balogh [1958: 231]; National Economic Development Council [1963a: 45]). Based on the same arguments as outlined above, the Commission on Money and Credit [1961: 43] concluded that “measures to stimulate aggregate demand to attain low levels of unemployment are basic to an adequate rate of economic growth.”
18The Commission on Money and Credit [1961: 43] also remarked that the induced technical progress usually would lay off workers. Therefore, inter-sectoral or inter-industry movements of labour become necessary. This labour mobility was assumed to depend positively on demand pressure, so that “a strong demand for labour increases mobility and therefore the efficiency of resource allocation and indirectly the rate of growth” (Johnson [1963d: 64]; see also Samuelson and Solow [1960: 190]; National Economic Development Council [1963a: 27]). Thus, a high demand pressure (a low rate of unemployment), was regarded as beneficial for overall growth as structural adjustments might be easier and the overall dynamism of the economy could be higher. In this line of thought, Reuber [1962: 12] emphasised that “the problems of adjusting to changing economic conditions, whatever the source of these changes, is much more difficult when the economy has considerable excess capacity than when it is running at full steam” (see also Bach [1958: 38]). In sum, technical progress and the necessary structural adjustments were assumed to be facilitated by a high demand pressure. At least in theory, a high rate of investment met a high rate of technical progress so that the stock of machinery, which was regarded as the factual incorporation of this technical progress (see also Johansen [1959]; Solow [1960]) received frequent updates and improvements (see, for example, Fellner [1960: 94]). Furthermore, high mobility of labour was assumed to accompany this progressive economic setup.
19This positive relation between growth and the level of demand made the Keynesian view prone to the Phillips curve trade-off. A high level of demand seemed necessary to assure high rates of economic growth, while inflation, at least at a certain point, was still regarded as an evil. This conflict was especially pronounced if an increase in the unemployment rate seemed necessary to achieve price stability, as then inflation had to be traded off against unemployment and a high rate of growth. This problem led Turner [1958: 684] to conclude that “growth cannot be reconciled with price stability” (see also Balogh [1958: 239], Fishman and Fishman [1958: 70f.]). Wilson [1961:9] furthermore pointed at the issue that an anti-inflation policy inflation might overshoot and therefore cause a loss in output and growth (see also Klein and Bodkin [1964: 425]). Chandler [1960: 214f.] therefore cautioned that policies which will “maximize the short-run rate of growth” may lead to such a high rise in prices that necessary restrictive policies will be accompanied by a “disappointment of widely held highly inflationary expectations” which “could be quite damaging to employment, output, and growth”. The Keynesian view hence faced the dilemma that there seemed to be an inherent conflict between unemployment and the rate of growth on the one hand, and the rate of inflation on the other hand.
3.2 – The Paishian View
20In contrast to the Keynesian view, some economists proposed that an overall restrictive policy would be necessary to foster growth. This view was particularly held by the British economist Frank W. Paish, at that time professor at the London School of Economics. Paish [1962: 331f.] supposed that “the permanent maintenance of the small proportion of unused capacity suggested here would be more likely to increase than decrease the rate of growth of capacity.” For Paish [1962: 94], especially very high levels of employment raise the problem of “bottle-necks” in the economy which were thought to be an obstacle for growth, as well as a cause of inflation and misallocation (see also Baumol [1958: 50ff.]; Wilson [1961: 17]; National Economic Development Council [1963a: 44]; Phillips [1968: 229]). Furthermore, Paish [1968, 22] argued that overall efficiency would be increased by a higher level of unemployment and slack of demand as there is “the need for firms to be efficient in order to survive”. Those firms which were able to stay in the market due to high demand are now sorted out or forced to raise their efficiency as their “costs of production are above the average” [Paish, 1962: 94f.; see also Paish, 1958: 104f.]. Paish [1968: 22] therefore concluded that “[a] condition of excess demand… provides an ideal climate for keeping inefficient firms alive and thus for slowing down the improvement in the average efficiency of the system as a whole.” Furthermore, the Commission on Money and Credit [1961: 42] remarked that it might also be possible that high demand renders the use of old machinery and less skilled labour necessary and profitable, with negative effects on average productivity. Moreover, full employment may cause higher demand for consumption goods but not for investment goods. Therefore, Bronfenbrenner [1963: 115f.] stated that “[i]nsofar as full employment is associated with high consumption while rapid growth requires high saving and investment, there is a trade-off here too.” Klein and Bodkin [1964: 417] thus came to the conclusion with respect to the USA that “[t]his is the American problem in a nutshell—too much consumption and too little capital formation holding down the rate of economic expansion.”
21Also Long [1960: 152ff.] pointed at the positive effects of a higher rate of unemployment: From the late 1940s to the late 1950s in the USA, real GNP per worker rose faster at high levels of unemployment while at the same time inflationary pressures were weak [Long, 1960: 153]. This might be explained by the following three different effects of a higher rate of unemployment [Long, 1960: 156]. First of all, there is a “lubrication effect”: A larger worker pool is advantageous for an economy in continuous development as emerging enterprises then have the possibility to acquire more workers than usually released by dying industries (see also Minsky [1961: 2]). This larger worker pool thus makes a high rate of growth compatible with price stability as otherwise rising industries would have to bid away resources from other sectors which would result in wage and price increases. Second, there is an “insecurity effect” in the sense that a high level of unemployment will discipline wage demands of workers and unions and will furthermore discourage unnecessary job hopping. Third, the “pencil-sharpening effect” will set in: Slack in the economy and thus increased competition will force employers to increase productivity and to resist high wage claims in order to keep costs down. In sum, all three effects of a higher unemployment rate might be considered beneficial for achieving both a high rate of growth and price stability.
22Sumner [1968: 304ff.], however, criticised these arguments and conclusions. Particularly the effect of permanent slack in the economy on investment is in the focus of attention as there are good reasons to assume that permanently unused capacity will be detrimental for overall long-term expectations and therefore for investment and the rate of growth (see also Scitovsky and Scitovsky [1964: 442]). Also a study by Junankar [1970: 290] directly aimed at investigating Paish’s hypothesis came to the conclusion that “[i]n all the models investigated spare capacity affected investment adversely. Thus the policy implications… are that in order to stimulate investment and through it growth, the economy should be run within the full capacity zone.”
23The advantage of Paish’s view with regard to economic policy is that growth and price stability are not conflicting policy objectives as they are in the Keynesian case. To the contrary, the resulting price stability due to excess capacity was assumed to be an important prerequisite for growth. For example, Jacoby [1958: 645] points at the issue that inflation distorts investment decisions by making the distinction between real and nominal values more difficult (see also Eckstein [1958: 361]). Furthermore, inflation may lower the rate of saving [Jacoby, 1957: 20]. Price stability also was assumed to indirectly have positive effects on the rate of growth: a specific contemporary argument against running the economy at high levels of employment and in favour of price stability was the difficult task of maintaining a balance-of-payments equilibrium in a fixed exchange rate system like Bretton Woods—a particular issue at that time in the UK [Wilson, 1961: 17ff.]. Disequilibria in the balance of payments might especially arise in periods of high growth as imports also rise strongly (for example, to overcome bottlenecks; see National Economic Development Council [1963a: 44]), while exports may be hampered by the domestic rise in prices (see the empirical investigation by Ball et al. [1966]). Thus, there was a perceived trade-off between growth and keeping the balance of payments in equilibrium [National Economic Development Council, 1964: 6; Klein and Bodkin, 1964: 414f.]. This was also emphasised by Dow [1964: 399ff.]: Running the economy at a low demand pressure and thus at higher unemployment and in its wake greater price stability was regarded as a precondition for achieving a high rate of growth while keeping the balance of payments in equilibrium. Thus, some excess capacity and therefore “greater price stability seems desirable, partly for its own sake, but largely as a means of getting the growth of exports to pay for the imports needed for faster growth” [Dow, 1964: 403].
24Harrod [1963: 89], however, remained critical regarding the suggested beneficial consequences of low inflation due to slack in the economy: If investment is forestalled as a reaction to excess capacity, the growth rate will be equally weak and inflationary pressures thus may arise regardless of high unemployment as “it is easier to prevent an inflationary rise of incomes if you are growing at a higher rate.”
25In sum, the Paishian view suggested some excess capacity to increase the rate of growth while keeping inflation in check. The trade-off in this line of thought hence was very different to that of the Keynesian view: Growth and low inflation on the one hand, a higher rate of unemployment on the other hand.
3.3 – The Sceptical View and Empirical Evidence
26Besides these two lines of thought, there were also economists who were very skeptical about any influence of the overall level of demand on economic growth. For example, Johnson [1963b: 141] stated that “there is no a priori reason why, other things equal, the rate of growth should vary with the average level of unemployment” and that “there is no a priori reason for expecting a higher normal level of employment, accompanied presumably by a higher rate of price increase, to produce a higher rate of growth.” These economists remained skeptical not necessarily on pure theoretical grounds, that is, they not always based their arguments on the neoclassical growth model [Solow, 1956; 1957; Swan, 1956] in which the steady state rate of growth depends solely on the growth rate of the labour supply and technical progress.
27Most notably, Phillips [1962: 13f.] stayed within the Keynesian growth model, but his calculations about the implications of a higher average unemployment rate and hence a smaller amount of investment led him to the conclusion that the effects of running the economy at a (slightly) higher rate of unemployment are “extremely small”. Furthermore, the resulting “possible extra incentive or compulsion to invest in cost-reducing equipment” [Phillips, 1962: 14] might counter any negative effect of a higher rate of unemployment. Thus, for Phillips [1962: 14], the rate of growth depends on structural factors like “the willingness to save, and the more general influences of educational improvement, research, and so on”. On all these structural determinants of the rate of growth “very small changes in aggregate demand and unemployment” would not have a big influence. In sum, Phillips [1968: 229] concluded that “[i]n my view the objective of… growth is almost independent of the objectives of short-term economic management”.
28Tobin [1964: 4ff.] also took the point of view that full employment and the rate of growth are not interrelated goals. An economy may profit if unemployment is removed, as this enables a generally higher consumption path without trading off consumption today against consumption tomorrow. However, in the long run, it is the growth of capacity and not fluctuations in its utilisation that determine the rate of growth. Furthermore, a too high demand pressure above the growth rate of capacity will be frustrated by inflation. Demand policy hence should be focused on the optimal combination between unemployment and inflation (as given by the Phillips curve) and not on influencing the rate of growth. In this sense, Tobin [1964: 4] concluded that “[f]ull employment is, therefore, not a reason for faster economic growth; each is an objective in its own right.”
29Most economists remaining sceptical based their position on empirical research and evidence. For example, Johnson [1963c: 279] remarked with respect to the bad growth performance of both the USA and the UK, while there was high unemployment in the USA and low unemployment in the UK, that growth and the rate of unemployment do not seem to be interrelated.
30Most interestingly, the very first study which explicitly calculated gains and losses of lower unemployment and higher rates of inflation, Reuber [1962], did not further discuss the influence of different levels of unemployment and inflation on the rate of growth as Reuber [1962: 7] came to the conclusion “that there is no discernible relationship between the longrun rate of economic growth and either the stability of prices or the level of unemployment” (see also Reuber [1962: 87ff.]; Reuber [1964: 113f.]). Therefore, the Phillips curve only shows a trade-off between unemployment and inflation on which economic policy has to focus [Reuber, 1962: 10]. The rate of growth thus should be fostered “by other branches of government equipped with instruments that are better suited for influencing such factors as education and long-run capital accumulation, on which the long-run rate of growth seems mainly to depend” [Reuber, 1964: 115].
31With respect to the role of inflation for the rate of growth it was found empirically that the influence of the rate of inflation was negligible in most cases [Bach, 1958: 34ff.; Eckstein, 1958: 373; Bhatia, 1960: 108ff.; Wilson, 1961: 6ff.; Allais, 1969: 378]. However, some exceptions are worth mentioning: even though mild inflation as such might even be beneficial for growth [Johnson, 1963b: 140f.; Johnson, 1963d: 61; Conard, 1964: 95f.], sudden and unanticipated changes, that is, a high variance in the rate of inflation, were found to be an obstacle for growth [Klein and Bodkin, 1964: 412]. Even deflation, if steady and predictable, may not conflict with rapid growth [Friedman, 1958; 251ff.; Johnson, 1963d: 64]. Dorrance [1966, 94] thus concluded that the rate of inflation becomes only important in times of strong increases or decreases as “rapid inflation seriously inhibits growth.”
4 – Growth and the Phillips Curve
32To disentangle these different views about the factors responsible for growth, Black [1959] reviewed this debate in a Phillips curve framework. Actually, Black [1959: 146] chose an upward-sloping aggregate supply curve in employment-inflation space (see Figure 1). The relation hence is not exactly a Phillips curve, but is nevertheless much in line with the main idea of the Phillips curve that higher demand pressure causes wages and thus prices to rise. Moreover, the curve strongly resembles the one used by Phillips [1954: 307f.]. [3] Additionally, the reason for the shape of the curve comes close to the bargaining power explanation given by Phillips [1954: 307f.] as Black [1959: 146] also points at the higher bargaining power of different groups in the economy the closer the economy is to full employment. Furthermore, an unequal distribution of demand across sectors (very much in line with Lipsey [1960, 17ff.]) and the emergence of bottlenecks are additional reasons why inflationary cost-push pressures arise in the economy before full employment is reached. In general, the stronger the market imperfections are, the more pronounced the conflict between inflation and unemployment becomes [Black, 1959: 149].
33The location of the curve is assumed to depend on two forces: The curve as well as the level of full employment (which coincides with full capacity utilisation) F will be shifted horizontally to the right due to technical progress and population growth. [4] Moreover, it can be endogenously shifted to the right by induced investment which depends on the (previous) level of demand [Black, 1959: 149]. Vertical shifts arise due to adjusting inflation expectations, “as both buyers and sellers get attuned to regarding a given rate of increase of prices as normal”. [5] In sum, both shifts are not independent of the level of aggregate demand and the thereby achieved rate of inflation and the level of employment (and output). However, horizontal and vertical shifts are opposing forces. Whereas horizontal shifts to the right allow a higher rate of aggregate demand at the same rate of inflation, upward shifts of the relation increase the conflict between inflation and unemployment. Therefore, given the three parameters of the relation, that is, the slope of the aggregate supply curve, the strength of induced investment, and the elasticity of inflation expectations, Black [1959: 150] points out that there might be an “optimum rate of growth of monetary demand, which will serve in the long run to maximise the rate of growth of actual output”. This idea of an optimum level of aggregate demand is depicted in Figure 1.
The Trade-Off Between Inflation, Employment, and Growth
The Trade-Off Between Inflation, Employment, and Growth
34At the aggregate demand level Y, the rightward shift of the curve due to induced investment and the upward shift due to adjusting inflation expectations (dotted supply curves) are such that the combined forces (dashed arrow) correspond to the maximal possible rightward shift of the schedule (dashed curve) and at the same time of the full capacity boundary (dashed vertical line). A higher level of aggregate demand such as Z does not induce the same capacity-expanding effect of investment [6] while at the same time inflation expectations are strongly elastic (in the figure this would even cause a combined upward shift of the relation). On the other hand, a lower level of demand X, while causing only a minor adjustment of inflation expectations, may fail to induce a strong rise in investment so that the combined rightward shift of the relation will be weaker than that in Y.
35Black [1959: 152] hence concluded that with this model it becomes possible to disentangle different views about the interdependencies between unemployment, inflation, and growth. Believers in classical economic principles and of “a dynamic version of the quantity theory of money” would argue that there is no pronounced conflict between inflation and unemployment (so that the curve is more like a kinked supply curve) and that inflation expectations are strong. Investment decisions in this line of thought are not based on recent output levels, but on the long-run profitability of investment projects which depend on secular productivity developments and the interest rate. Thus, any increase in aggregate demand will not succeed in accelerating the rate of growth as the vertical forces are always stronger than the horizontal ones. Keynesians, however, build their proposal of increasing aggregate demand upon the assumption that inflation expectations are rather inelastic or at least that induced investment more than compensates any upward shift of the relation. An increase in aggregate demand hence is optimal even in the case of a conflict between inflation and unemployment as there is always a positive level of demand pressure to maximise the rate of growth.
5 – Conclusion
36The discussion has shown that there was a lively debate in the 1960s about the optimal demand pressure to maximise the rate of growth. Three elements of this debate stand out and are worth recalling: First of all, the Cold War made the rate of growth a most important policy objective. This overriding importance of the rate of the growth made it acceptable to discuss means to foster a growth rate higher than indicated by individual preferences. One of those instruments considered was—besides encouraging and promoting research, education, and technical progress—the level of demand pressure. The state of aggregate demand was considered important as demand-dependent investment was regarded as one of the driving forces of growth. The second element of this debate was the belief that it is indeed possible to choose the level of demand via fiscal and monetary policies. This element hence included an optimistic view regarding the power of stabilisation policies to damp cyclical fluctuations and to fine-tune the economy. Together, these two elements built the basis for the discussion about an optimal pressure of demand to maximise the rate of growth (see, for example, Anderson and Cornwall [1961: 163]). However, the choice of the aggregate demand pressure not only had implications for the rate of growth, but also for the level of unemployment and the rate of inflation. This third element in the debate, the Phillips curve, pointed at the possible conflict between all three goals as discussed by Black [1959].
37Many economists believed that a high demand pressure will have the benefit of removing unemployment as well as fostering growth by creating an optimistic outlook and due to positive effects of a higher rate of inflation on investment. Bruno and Easterly [1996: 139] therefore summarise that “the traditional view that inflation was destructive [to growth] no longer seemed so compelling. It was the Golden Age of the Phillips Curve, in which inflation and growth were positively related” (see also Brown [2001: C32]). This Keynesian view can be called a “carrot theory” [Lipsey, 2010: 171] which relied on the idea that “the best way to get more investment is to have a rising demand for end-products and an assurance that this will continue. Look after the aggregate demand for end-products and investment will look after itself” [Harrod, 1967: 11]. However, the assumptions on which these arguments rested are questionable, in particular the non-adjustment of the nominal rate of interest to a higher rate of inflation.
38Critiques of this approach, most notably Paish, did not target this assumption in particular. Rather the argument that technological change will proceed faster and investment will be higher in a buoyant economy was criticised by the Paishian view. This line of thought feared that a high demand pressure and the absence of the risk of failure will weaken market forces as it will free firms from the competitive pressure to innovate in order to survive. This view hence can be called a “stick theory” [Lipsey, 2010: 171] which was based on the assumption that “[f]or a high rate of growth of output per man-hour we need an economic climate in which all producers are under continual pressure to keep down their costs” [Paish, 1968: 22]. This view, however, can be criticised in the sense that a temporary crisis may indeed assure the survival of the fittest. But ongoing slack in the economy may sooner or later harm the willingness to invest and to take the risk usually associated with innovations.
39Both approaches have in common that growth was considered as a variable that can be influenced in the short and medium run by appropriate demand polices. It is, however, striking to note that many contributions did not take fully into account the neoclassical proposition that in the long run the rate of growth solely depends on population growth and technical progress, so that, for example, a higher rate of saving and investment will only have transitional effects. Not only this issue, but also the fact that many contributions ignored important theoretical concepts like the “Golden Rule” might be best explained by the pressing issues of the Cold War, so that policy debates focused on the years immediately ahead. In this respect Tobin [1964: 9] emphasised that even if in the long run there is no choice about the rate of growth, but only about consumption levels, the transitional period might be very long so that practically and within the timespan of economic policy, society can choose among different rates of growth. Moreover, there was a theoretical gap (to be closed by Cass [1965] and Koopmans [1965], based on Ramsey [1928]) with regard to the choice of the optimal growth path in a transitional period to the “Golden Rule” consumption level. Johnson [1964: 24] critically remarked about this issue that “[i]t is of little help to know where one should be going, if one is not told when one ought to arrive.” The definition of an optimal rate of growth as an objective of economic policy hence was regarded as more difficult than other goals of economic policy like full employment and price stability [Musgrave, 1958: 597; Commission on Money and Credit, 1961: 31; Reuber, 1962: 35f.; Johnson, 1963d: 65f.]. The Cold War furthermore might explain the general emphasis on the rate of growth of output, and not always the rate of growth of per-capita income: For example, Kendrick [1964: 249] remarked that although per-capita income is a better measure for the quality of growth (see also Klein and Bodkin [1964: 379]), growth of output as such (even in the case of declining per-capita income at the same time) is nevertheless “of significance from the military… viewpoint”.
40However, not all demand-oriented contributions regarded a high level of demand as the only necessary and sufficient condition for a rising output level. Technical progress, for example, was considered as a “key factor” by the National Economic Development Council [1963b: 29ff.] and the Commission on Money and Credit [1961: 34] emphasised the importance of education “to take full advantage of” technical developments. Nonetheless, even these long-run growth forces like technical progress and ongoing increases in general efficiency (for example improved labour market dynamics) were assumed to also depend partly on the level of aggregate demand. In particular, investment was regarded as an important way to incorporate technical progress into the economy.
41A third group of economists doubted that the pressure of demand has a strong and remarkable influence on the rate of growth. These economists took the point of view that growth depends particularly on technical progress and that the temporary effects on output due to a rise in the utilisation level of available resources needs to be distinguished from the long-run growth of capacity. Also Phillips belonged to this group, even though he argued within the framework of Keynesian growth models. Nevertheless, Phillips believed that the driving forces of growth are research and education and not demand-induced investment. Empirical studies found only a small influence of the rate of unemployment or of the rate of inflation on economic growth—at least as long as the variance of inflation remained low.
42The contribution by Black [1959] tried to disentangle these different views within the Phillips-curve framework and focused on the optimal demand pressure in order to maximise the rate of growth. The trade-off between inflation, unemployment, and growth hence took centre stage. This debate found its end in the late 1960s with the introduction of Friedman’s “natural rate of unemployment” as the more the economy was regarded in the sense of Friedman [1968], the less did a discussion of these issues make sense—as the choice between inflation and unemployment vanished so did the thereby connected questions. Since then, monetary policy is assumed to be neutral (also with regard to the rate of growth) as pointed out by Friedman [1968: 11]. In the framework of Black [1959], this implied that now the economy was regarded as in the classical case, built upon the assumption of elastic price expectations and low induced investment (and without a structural conflict between inflation and unemployment).
43However, some modern theoretical approaches, like evolutionary theory based on the assumption of endogenous and path-dependent technical change, still point at the likely case of an important role of the state of aggregate demand and the long-run consequences of monetary and fiscal policies. Factors like capacity utilisation, the level of unemployment, and the rate of inflation in such a framework can still cause long-run impacts in the economy [Lipsey and Scarth, 2011: xxxff.]. On these grounds Lipsey [2010, 167ff.] suggested that the concept of a unique natural rate of unemployment should be replaced by a non-accelerating inflation band of unemployment (see Figure 2).
The Non-Accelerating Inflation Band of Unemployment
The Non-Accelerating Inflation Band of Unemployment
44This implies that various combinations between inflation and unemployment can be possible since the system will not have a unique equilibrium (a natural rate of unemployment) any more, as different levels of unemployment can be compatible with the expected rate of inflation (credibly fixed by the central bank) around which the actual rate of inflation fluctuates. Therefore, the economy may end up, depending on the overall environment including endogenous technical change and economic policy, in the range of the ellipse E but also F, both solutions being compatible with an expected rate of the credible inflation target of the central bank (here: 2 per cent). [7]
45In such a framework, some arguments of the debate in the 1960s, for example under which circumstances—in this discussion high demand as in the ellipse E or strong competitive pressure as in F—technical progress will be incorporated faster into the economy are probably worth to be considered even today.
Notes
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[1]
University of Hohenheim, Department of Economics (520h), 70593 Stuttgart, Germany. E-mail: johannes.schwarzer@uni-hohenheim.de.
I thank John Black, Olivier Bruno, Harald Hagemann, Niels Geiger, Richard Lipsey, and two anonymous referees for most helpful comments and suggestions. All responsibility for the views expressed in this paper as well as for any remaining errors is of course mine alone. -
[2]
It is worth noting that some economists were less concerned with the apparently high growth rates of the Soviet Union. Particularly Nutter [1962] pointed at the possibility of inaccurate statistics which probably overstated Soviet growth rates and at special factors (for example “the expansion of territory and resources”) which might have boosted growth rates of the Soviet Union in the short run.
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[3]
Black [1959: 145, n. 1] also thanked Phillips for “comments and suggestions” so that it can be assumed that Phillips probably was not too opposed to Black’s assumptions. However, John Black, in a letter to the author dated 2 February 2014, remarked that “I simply cannot recall what he said, on paper only as we never met.” Therefore, one should not “infer any approval from Phillips.”
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[4]
Following Leeson [1997: 158f.], these horizontal shifts might be also in line with Phillips [1954: 307f.].
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[5]
Lewis [1958: 379ff.] also discusses some of these shifts in a price-level output diagram.
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[6]
Black [1959: 150f.] referred to Hayek’s business cycle theory [Hayek, 1931] and his emphasis on the misdirection of investments in times of the boom (see for a discussion Hagemann and Trautwein [1998: 299f.]). Hence, even though the absolute amount of investment might be higher in Z than in Y, the actual effect on enhancing productive capacity will not necessarily be greater.
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[7]
The experience of the macro economies of many first world countries since the advent of successful inflation targeting conforms to this evolutionary view. See for a deeper discussion and empirical evidence Carlaw and Lipsey [2012].
