Nobel, but not novel

An outstanding feature of the 20th century was the attempt by economics to achieve intellectual sophistication. Nowhere was this truer than the problem of unemployment and how to tackle it. In the Depression years and later, communism appealed hugely to the jobless. For this and presumably for other reasons, an important idea was developed by John Maynard Keynes, namely that governments could and should intervene in keeping unemployment low. The counter-argument was that the Keynesian solution of public spending would result in inflation, especially if politicians lost restraint in the effort to please voters. The key policy challenge, therefore, became one of achieving the right mix of inflation and unemployment. This almost classical trade-off was enshrined in the Phillips Curve, which ruled the roost until the mid-1960s.

In 1968, however, the monetarist Milton Friedman and another young economist called Edmund Phelps (who was barely 35 at the time) came up with a new idea in separate and independent papers. They argued that, because there were structural rigidities in the labour market""how do you teach a 55-year-old machinist to become a computer wizard, or persuade people to move to new locations""you had to think in terms of a "natural" rate of unemployment. That is, some people would always be unemployed. They further argued that only this natural rate was consistent with a "non-accelerating-inflation rate of unemployment", or NAIRU, because it sought an automatic upper limit to government intervention. Mr Phelps also argued that expectations of inflation changed over time, and this in turn would change the trade-off between inflation and unemployment""so there was not much merit in seeking to reduce unemployment today at the risk of higher inflation because the expectations of higher inflation that resulted would then change the game and cause increased unemployment. Mr Friedman got the Bank of Sweden Prize in Economics 30 years ago, and Edmund Phelps too has now been rewarded""though nearly four decades after the work for which he has been honoured, a time frame in which his idea has moved from novel status to mainstream thinking.

In terms of its importance, though, it is hard to quarrel with the choice because inflation and unemployment remain two fundamental issues for policy. Most economists rate Mr Phelps' work very highly, and many well-known names have therefore welcomed his choice for this year's Nobel""though Indians and many others will be disappointed that the prize has proved elusive yet again for the redoubtable Jagdish Bhagwati, who, like Mr Phelps, teaches at Columbia University and whose name had figured (and done well) in the betting that went ahead of the announcement on Monday. For one thing, Mr Phelps has never strayed very far from the real world, and has grappled with real issues, like how much money you should save. For another, he introduced micro-economic calculations into a macro-economic problem, and therefore introduced some crucial variables that have helped to refine both theory and policy. And in terms of the impact on policy, Mr Phelps' work has served to demonstrate that the better policy option is to aim at low inflation""which, in comparison with the stagflation-fighting policies of the early 1970s, has become the international hallmark today.

Of course, economists assume that productivity is constant, which makes things hard when technology leads to huge productivity gains. If fewer people can do the same or a greater amount of work, what would NAIRU be? Economies like India would do well to learn from an earlier stalwart, W Arthur Lewis, whose two-sector model probably described the country's dilemma and predicament better than NAIRU does.