The Method Used to Develop the Phillips Curve Is More Akin to That of the German Historical School

The Phillips curve is named after the British economist A. W. Phillips (1958), who in a pathbreaking article investigated the statistical relationship in the UK between the annual rate of change of money wages and the annual rate of unemployment. Later versions of the Phillips curve examined the relationship between unemployment or the rate of growth of output and, alternatively, the rate of change of product prices, and the deviation between actual and ‘expected’ inflation. 

Inasmuch as the Phillips curve is an important component of mainstream economics, its development remains a curious paradox. Logical positivism is the conventional methodology of the neoclassical mainstream and this methodological doctrine has been severely criticized by economists working within the Austrian methodological perspective. Logical positivism involves the construction of theory that is tested by empirical evidence. The resulting empirical evidence may lead to modification of the theory and further testing, but the initial theory construction always precedes empirical testing. The Phillips curve developed purely as an empirical relationship with only ad hoc theoretical rationalizations provided. Only later were attempts made to develop a theory that would ‘explain’ the statistical relationship. This method is more akin to that of the German historical school, of which criticism by the Austrian school has been much more severe. The series of currently recognized policy errors that followed from attempts to exploit the Phillips curve serves as an excellent but unfortunate example of the problems associated with ‘letting the facts speak for themselves.’

—Don Bellante, “The Phillips Curve,” in The Elgar Companion to Austrian Economics, ed. Peter J. Boettke (Aldershot, UK: Edward Elgar Publishing, 1994), 372.

The Critical Difference between New Classicism and Austrianism Lies in Differing Treatments of the KNOWLEDGE PROBLEM

The New Classicists accept the Monetarist propositions about the long run and argue that the assumption of “rational expectations” allow those propositions to apply to the short run as well. In effect, the New Classicists deny the significance of Hayek’s distinction between two kinds of knowledge. Market participants behave “as if” they actually know the structure of the economy. They react to monetary expansions in ways that compensate for price and interest-rate distortions. So long as expectations about future price and interest-rate movements are not systematically in error, there will be no intertemporal discoordination, and no discoordination of any other kind that can be attributed to the monetary expansion. In this view, a Hayekian trade cycle anticipated is a Hayekian trade cycle avoided. 

The rational-expectations argument is nothing new to Austrian theory. In fact, Mises (1953) recognized the kernel of truth in the argument long before the appearance of John Muth’s (1961) classic article. He warned the advocates of inflationary finance against ignoring Lincoln’s dictum: You can’t fool all the people all the time. In the early 1940s Ludwig Lachmann (1977) called the Austrian theory into question on the basis of what was, in effect, a rational-expectations argument. The rise of the New Classicism in recent years has refocused attention on the role of expectations in trade cycle theory. Without doubt, the course of the trade cycle is influenced in a fundamental way by the expectations of market participants. But the idea of rational expectations is not quite the show stopper that the New Classicists believe it to be. Again, the critical difference between New Classicism and Austrianism lies in differing treatments of the knowledge problem. 

It is peculiar for economists to assume that market participants know, or behave “as if” they know, the structure of the economy. After all, economists have had disagreements among themselves for more than 200 years about how the economic system works. Some believe that the economy works in the manner envisioned by Keynes or by his many interpreters, some believe that the economy is more  accurately depicted by the Classical model, and some believe that the economic relationships identified by the Austrians are essential to the understanding of the economy’s structure. There are important differences even within each of these three theoretical frameworks, and there exist still other, more radical alternatives such as Marxism and modern Institutionalism. 

It would be an amazing feat for market participants either individually or collectively to single out not only the correct theoretical framework but also the parametric values that are currently applicable. And if they actually performed this feat (or behaved “as if” they had performed it), the question of just how they did it would be the most challenging question the economics profession has yet faced.

—Roger W. Garrison, “Hayekian Trade Cycle Theory: A Reappraisal,” Cato Journal 6, no. 2 (Fall 1986): 443-444.

Austrian Business Cycle Theory Incorporates Aspects of a Number of Alternative Theories, e.g., Classical, Phillips Curve etc.

At first, the Austrian theory of business cycles appears very different from other main schools of macroeconomic thought. Yet a comparison shows that it actually incorporates a number of features of alternative theories. Garrison (2001; Ch. 12) provides a useful—if stylized—overview, summarized in Figure 1. 

In the Classical view, the economy operates on the production possibilities frontier (ppf), and agents have a choice between consumption and investment, which therefore tend to move in opposite directions. Over time, higher investment implies faster growth, which leads to a ppf that moves up and to the right more quickly. A choice for higher immediate consumption tends to slow growth. In the Classical view, there is no room for short-term fluctuations, only secular growth. 

In the Keynesian view, the economy is generally not on the ppf. Left to its own devices, the economy suffers from a chronic lack of demand, leaving it in a continuous state of semi-depression. Expansionary economic policies can increase demand and move the economy towards the ppf. Note that investment and consumption generally move together, in response to increases and decreases in aggregate demand. 

Real business cycle theories see all fluctuations as caused by real shocks. Markets are assumed always to be in equilibrium, and there are no departures from the ppf. Business-cycle related movements that appear to take the economy off the original ppf are considered to be the result of movements of the ppf itself, driven mostly by stocks to productivity.

Theories that incorporate a Phillips curve postulate a (temporary) tradeoff between inflation and unemployment. An unanticipated monetary expansion will allow the economy to operate beyond the ppf, but only temporarily, as long as it takes prices to adjust. The policy-induced boom is unsustainable; eventually, prices will rise and the economy will settle back on the ppf. Expectations-augmented versions of the theory require a continuously accelerating rate of inflation to sustain production beyond the ppf. 

Austrian business cycle theory incorporates aspects of a number of these alternatives: it draws heavily on classical theory by stressing the preference-based tradeoff between consumption and investment, but acknowledges the potential for the economy to operate beyond the ppf, as in Phillips-curve based theories. But in Austrian theory, the economy does not simply return to the ppf after the boom. The initial credit-induced changes in investment were not based in preferences and thus prompted a mismatch between the structure of production and planned future consumption. This triggers a change in intertemporal relative prices, raising the interest rate, which triggers a recession. Attempts by the monetary authorities to stave off recession are doomed to failure; the economy needs time and unfettered interest-rate signals to readjust its capital base to the structure of demand. 

—Stefan Erik Oppers, “The Austrian Theory of Business Cycles: Old Lessons for Modern Economic Policy?” (working paper no. 02/2, International Monetary Fund, 2002), 14-15, https://www.imf.org/external/pubs/ft/wp/2002/wp0202.pdf.