How can economic stagnation be stopped?

Edmund S. Phelps

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, 2006

Edmund S. Phelps has strong opinions, and he’s not shy about expressing them. In the 1960s, he was a young economist more interested in exciting discoveries than prizes, leaving his position at RAND Corporation to become a pioneer of modern economics instead. He challenged well-established theories on the trade-off between inflation and unemployment, and worked on the ‘Golden Rule’ of capital formation. Today, he discusses how economic stagnation might be stopped and why it’s important to give everyone a chance to flourish.

A New York state of mind

If you met Edmund S. Phelps for the first time and didn’t know who he was, you’d probably guess he was an English teacher. Musician. Or literary critic. He’s read everything worthwhile and quotes long gone philosophers. Indeed, Phelps is a man of the arts. But he’s also a macroeconomist and professor at Columbia University.

Firm handshake, inviting smile, he talks about how much he enjoys New York: the theatre, the museums, and the opera. He’s a cosmopolitan who enjoys dinner parties, lively dialogues and the diversity of the place he calls home. How does that go together with the rather serious world of economics?

Why economics?

Phelps might have actually become a philosophy teacher, if it hadn’t been for his parents. While studying humanities, his father asked if he could do him a favor, and take at least one economics course. "What could I say? Of course I did." He didn’t regret his choice, as he got nothing but straight As.

It’s a challenge to touch on all the things he’s worked on throughout his long career, from employment theory to monetary theory, inflationary dynamics, growth theory and public finance. But let’s start with an obvious choice, the reason he’s called a pioneer of modern economics.

At a glance

Born: 1933, Evanston, Illinois, USA

Field: Macroeconomics

Prize-winning work: Analysis of intertemporal tradeoffs in macroeconomic policy

Must-read book recommendations: Charles Dickens’ David Copperfield, Brontë’s Wuthering Heights, and Mann’s Magic Mountain

What he needs to be happy: His wife Viviana, having his next journey planned, music

What he can do without: A car, a country house

Performance skills: Sings Old Man River for dinner guests (and film crews)

How do markets really work?

The work Phelps is best known for deepened, as the Nobel committee put it, the profession’s understanding of the relation between short-run and long-run effects of macroeconomic policy.

In the area of employment economics there was this idea of wages being really rigid, that’s just the way it is.

But that wasn’t good enough for a young man with an open mind and the urge to discover new things. So he started his research on the link between employment, wage setting and inflation.

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Phelps realized that economic models hadn’t taken into account the fact that humans make decisions without having all the information or knowledge they need. It was an important insight that shed light on the way markets work, and supported a new approach to employment and wages.

Back in the old days, more inflation led to less unemployment. It seemed that that’s how the world worked, except sometimes when it didn’t.

The human face of economics

Phelps remembers the battles he had during the early years of his career. His research challenged the accepted views of the 1960s and earned him some criticism by those in the profession who didn’t want life-like actors in their economic models. What Phelps felt was a more realistic approach to macroeconomics, others dismissed. He admits it wasn’t a lot of fun back then. But he remained stubborn, he assures with a smile on his face.

How can we revive people’s "innovative spirit"?

The importance of Phelps’ work is obvious, whether it’s his ideas about employment theory, or the Golden Rule Savings Rate he established on the basis of Robert M. Solow’s research in Growth Theory. But he’s not that interested in talking about his major contributions of the past. He gets most excited when discussing the things that matter to him today. What makes nations prosper? Why is there a decline in innovation in most of the Western countries? And how can we revive what he calls people’s "innovative spirit"?

When Phelps talks about countries being low on innovation, it’s easy to protest that we live in a society where people are creating new things every day. There’s Silicon Valley, after all. "Silicon Valley is just a small part of the economy," he points out. "What happened is that innovations stopped in the heartland of the country." And it’s the working class people deeply connected to that heartland who have been suffering.

The importance of meaningful work

"It must be painful to earn a low income when all around you there are people swimming in money," Phelps suggests. He makes it clear that it’s not about material goods alone. "The government throws a lot of money around for food stamps and public housing," he explains. "But that’s no substitute for having a life." What’s missing then? Phelps can easily sum it up: meaningful work. He illustrates how all the money spent on welfare programs doesn’t do anything to make the careers of the working poor more meaningful, more satisfying.

For jobs to be rewarding they have to engage people’s attention, and their mind a little bit, make them care enough to put in a day’s work.

What makes nations prosper?

Phelps has written a book that can be regarded as a kind of late manifesto: Mass Flourishing. How Grassroots Innovation Created Jobs, Challenge, and Change. He takes his readers on a journey from the early 19th century, when prosperity was exploding in many countries, to the years after World War II, when Europe and the United States lost their former dynamism.

A key element of his book is to show the connection between a decrease in innovation and a decrease in job satisfaction - a loss of "good jobs" that offered ongoing challenges and the chance to imagine and create things.

Phelps explains the need for every country to create an economy that is a "vast imaginarium". There are lots of ingredients necessary to make that possible, and Phelps admits he hasn’t found the perfect recipe yet, but continues to discuss how economic stagnation might be stopped. His thoughts are led by what he learned from studying philosophy.

David Hume said there wouldn’t be any progress in the world if it weren’t for human creativity. I never lost sight of that thinking. People are not just learning and stumbling on things, they’re also imagining possibilities.

How do we create a more dynamic economy?

One of his close friends is economist and Nobel Laureate Joseph E. Stiglitz. They are both members of the Center on Capitalism and Society, which was founded by Phelps in 2002 to initiate new research on economic instability, inclusion and growth.

Stiglitz emphasizes how they’re on the same side when it comes to the question of declining dynamism: "The focal point of economic attention should be on what leads to a more dynamic economy and society, not just what leads to more static efficiency. And that’s what Ned’s work has been focusing on."

A more dynamic economy for Phelps means preventing what he’s called "corporatist maladies".

If every job is protected, how can an innovator break into an industry with a new and better thing to produce?

To find a way back to past dynamism, Phelps says we need to make inroads into established industries and avoid too much protectionism. One of his favorite examples to illustrate this is Europe. "European culture is very corporatist, there’s almost nothing that isn’t protected."

Why is Europe in so much trouble?

"When I become pessimistic about America, I think about Europe and then I feel better about my country," Phelps admits. He thinks Europe is in bad shape and worries about its future. The southern countries have been struggling for years, the United Kingdom has voted to leave the European Union, populist voices are getting louder every day - and there is no productivity growth.

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In Stockholm for the Nobel Prize Ceremony in 2006, Phelps told the audience at the banquet that he didn’t do his work for money or prizes but for the excitement of it. You can easily imagine him having been a restless professor back in the day, eager to make a theoretical discovery. This might have changed a little in the meantime.

What I’m doing now isn’t exactly so much fun. I’m trying to figure out what it’s like to be in the working poor, what they want in life and what satisfactions they’re getting.

Are subsidies to low-wage jobs the way forward?

This focus has turned Phelps into a radical advocate of subsidies to low-wage jobs, which he thinks would encourage companies to hire more low wage-people and pull up their rates. It’s his mission to keep campaigning for those at the bottom of society. Edmund S. Phelps, caught somewhere between the claim for subsidies and an argument for deregulation. It’s hard to tell where he’s located on the political scale. But he’d probably fight against a classification anyway.

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