Macroeconomics and the Phillips Curve Myth James Forder (p.iii) Macroeconomics and the Phillips Curve Myth Oxford Studies in the History of Economics Series Editor: Steven G MedemaThis series publishes leading-edge scholarship by historians of economics and social science, drawing upon approaches from intellectual history, the history of ideas, and the history of the natural and social sciences It embraces the history of economic thinking from ancient times to the present, the evolution of the discipline itself, the relationship of economics to other fields of inquiry, and the diffusion of economic ideas within the discipline and to the policy realm and broader publics This enlarged scope affords the possibility of looking anew at the intellectual, social, and professional forces that have surrounded and conditioned economics’ continued development (p.iv) Great Clarendon Street, Oxford, OX2 6DP, United Kingdom Oxford University Press is a department of the University of Oxford It furthers the University’s objective of excellence in research, scholarship, and education by publishing worldwide Oxford is a registered trade mark of Oxford University Press in the UK and in certain other countries © James Forder 2014 The moral rights of the author have been asserted First Edition published in 2014 Impression: All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission in writing of Oxford University Press, or as expressly permitted by law, by licence or under terms agreed with the appropriate reprographics rights organization Enquiries concerning reproduction outside the scope of the above should be sent to the Rights Department, Oxford University Press, at the address above You must not circulate this work in any other form and you must impose this same condition on any acquirer Published in the United States of America by Oxford University Press 198 Madison Avenue, New York, NY 10016, United States of America British Library Cataloguing in Publication Data Data available Library of Congress Control Number: 2014939136 ISBN 978–0–19–968365–9 Printed and bound by CPI Group (UK) Ltd, Croydon, CR0 4YY Links to third party websites are provided by Oxford in good faith and for information only Oxford disclaims any responsibility for the materials contained in any third party website referenced in this work Contents Title Pages Acknowledgements Note to the Reader Introduction Chapter The Curve of Phillips Chapter The Role of Samuelson and Solow, American Economic Review 1960 Chapter The Phillips Curve Literature before Friedman’s Presidential Address Chapter The Post-1968 Literature Chapter Attitudes to Inflation Chapter Policymaking and Histories of Policymaking Chapter Explaining the Emergence of the Myth Chapter Conclusions References Index (p.v) Acknowledgements First, I must thank Irene Lemos, who, as well as reading some of the drafts, has been following the progress of the work with what is politely called ‘interest’ She would be entitled to feel the Phillips curve has been wrapped around her neck much too long, but it would all have taken much longer without her encouragement Vivienne Brown, Peter Oppenheimer, Terry Peach, and Mary Robertson made valuable comments on all or much of the text Several parts of the work were presented at conferences I can hardly record everyone who commented over a number of years, but John Aldrich, Roger Backhouse, Richard van den Berg, Mauro Boianovsky, Tony Brewer, Hugh Goodacre, Geoffrey Harcourt, Peter Kriesler, Steven Medema, Renee Predergast, John Vint, and Michel de Vroey all made contributions which in one way or another stuck in my mind The same is true of David Laidler, Richard Lipsey, and John Nevile in correspondence, and Wilfred Beckerman, William Coleman, Andrew Graham, John King, and Terry O’Shaughnessy in conversation Bob Solow and David Vines commented on a version of Chapter John Anderies, Thomas Baranga, Robert Leeson, Jonas Prager, and Nancy Wulwick helped with finding otherwise inacessible materials Max Dalton, Marc Pacitti, Joe Spearing, and Sophie Tomlinson all gave very good research assistance as well as making a number of useful comments Angus Hawkins and George Charleson similarly helped with this project by speeding other projects along (p.vi) (p.ix) Note to the Reader The following are identified by their last name only: Stephen Bailey, James Ball, Daniel Bell, John M Clark, William Dickens, Irving Fisher, Crauford Goodwin, Robert J Gordon, Robert E Hall, Alvin Hansen, A G Hart, David Hume, Terence Hutchinson, John Kenneth Galbraith, Christopher Gilbert, Neil Jacoby, Harry Johnson, Robert G King, H Gregg Lewis, Daniel Mitchell, Arnold Packer, A W H Phillips, Joan Robinson, Arthur Ross, Tibor Scitovsky, David C Smith, Jim Taylor, H A Turner, Richard Wagner Others sharing those last names are further identified when necessary At no point have I felt it helpful to change the emphasis in quotations, so any emphasis is the quoted authors’ own Where I have quoted from reprints, the original dates of publication and the quoted edition are indicated in, for example, the form ‘Keynes (1946/1972)’, rather than the ‘Keynes (1972)’ form that has become commonplace (p.x) Introduction There is one story about the history of macroeconomics that seems to be known to everyone who has studied the subject for more than a few weeks It puts varying interpretations of the Phillips curve at the heart of the development of policy-orientated thinking from the 1960s to the 1980s, and its motif is the idea that economists of that period initially failed to appreciate the importance of expectations of inflation Details of this story vary but the central points are these In what quickly became a classic paper, Phillips (1958) discovered a negative relation between inflation and unemployment; then, either under the influence of Samuelson and Solow (1960) or otherwise, policymakers treated it as offering a selection of inflation-unemployment combinations from which they could choose, depending on their—or their voters’—aversion to the two evils; much work was done investigating this tradeoff and, because of it, inflationist policy was pursued until Phelps (1967) and Friedman (1968a) revolutionized thinking by pointing out that continuous inflation would change expectations and thereby shift the Phillips curve so that there was no long-run tradeoff; and although this was initially disputed, in due course it was accepted One point I hope to make in what follows is that each component of that story is false They should all simply be dismissed, and that should be the end of it That, however, is a minor point The more important point is that the orientation of this story—its general implication, trend, or tendency—is wholly misleading as well The story offers a picture of an economics profession that was still, well into the post-war period, struggling to articulate the simplest ideas, and disputing the obvious even when it was stated It describes an interlude in which either economics was bizarrely primitive o r (p.2) its practitioners were extraordinarily slow-witted That picture needs not just to be dismissed, but also replaced Supposing that I can achieve those things, there will obviously be a further question as to how this story ever came to be told, believed, and become conventional, and responding to that issue is therefore a third objective Indeed, it could reasonably be said that offering some account of the emergence of the story is almost a condition of making a persuasive case that it is only a myth Although I cannot, in advance of all the arguments, explain the acceptance of the story—even dating its appearance precisely takes some effort—I can perhaps say that the best-known early statement of it is found in Friedman (1977) – that author’s Nobel Lecture I hope that I have dissected that particular source sufficiently in Forder (2010a), but a reprise of Friedman‘s story is in order here He stated it as an objective to show that, despite widespread scepticism, it was appropriate for there to be a Prize for economics because, like the sciences, economics progresses by hypothesis formation, testing and rejection, and the formation of further hypotheses He then took the story of the Phillips curve as his example and said that up to that time professional opinion had been through two stages of which the first was one of, the acceptance of a hypothesis associated with the name of A W Phillips (1958) that there is a stable negative relation between the level of unemployment and the rate of change of wages—high levels of unemployment being accompanied by falling wages, low levels of unemployment by rising wages (Friedman, 1977, p 454) And that, This relation was widely interpreted as a causal relation that offered a stable trade-off to policymakers So that, Economists then busied themselves with trying to extract the relation … for different countries and periods, to eliminate the effect of extraneous disturbances, to clarify the relation between wage change and price change, and so on In addition, they explored social gains and losses from inflation on the one hand and unemployment on the other, in order to facilitate the choice of the ‘right’ trade-off (p 455) Then, citing four of his own statements from the 1960s concerning the idea that expectations would adjust to continuous inflation, thereby eliminating the tradeoff, he said, (p.3) Some of us were skeptical from the outset about the validity of a stable Phillips curve … and What mattered for employment, we argued, was not wages in dollars or pounds or kronor but real wages—what the wages would buy in goods and services He proceeded to explain the idea that behaviour would adjust to anticipated inflation so as to shift the Phillips curve, and in due course, summing up, he claimed, The age-old confusion between absolute prices and relative prices gained a new lease on life (p 469) And, In this intellectual atmosphere it was understandable that economists would analyze the relation between unemployment and nominal rather than real wages and would implicitly regard changes in anticipated nominal wages as equal to changes in anticipated real wages So that, The hypothesis that there is a stable relation between the level of unemployment and the rate of inflation was adopted by the economics profession with alacrity It filled a gap in Keynes’s theoretical structure … In addition, it seemed to provide a reliable tool for economic policy, enabling the economist to inform the policymaker about the alternatives available to him But he said that, as time went on, inflation rose, the inflation–unemployment relationship seemed to disappear or change, and Many attempts were made to patch up the hypothesis by allowing for special factors such as the strength of trade unions But experience stubbornly refused to conform to the patched-up versions (p 469) The failure of those patched-up versions was, at the time he spoke—so he said—bringing acceptance that there was no stable tradeoff, meaning that macroeconomic policy could have no durable effect on unemployment (p.4) Whilst I appreciate that the claim that this story is fictitious may at first seem startling, I take it that is not true of the claim that the story is important It is, after all, a story which is widely repeated —it features in textbooks and lectures, and in brief reports, as well as more elaborate accounts of history In all these it is treated as a piece of commonly understood wisdom Sometimes it is the basis of further arguments, sometimes just recited as background More than this, though, the events described in the story are also treated as a key part of the development of the post-1980 consensus It is thus a major part of the rejection of Keynesian economics and of the story of the origins of early twenty-first-century policymaking presumptions As a piece of history—or fake history—then, its importance can hardly be doubted In considering something which has become so central to what is believed about macroeconomics, and yet is so misguided, there initially appears to be a dilemma as to whether to try to write an alternative history of the thought of the period, from which it would emerge that the conventional story has no basis; or to address directly the constituent parts of that story, dispensing with each in turn, and hope that a better history emerges from that A problem with the first course is that it would be an attempt to dismiss the story substantially by ignoring it: the Phillips curve is simply not prominent enough in the economics of the 1960s for that approach to lay bare the extent to which the things subsequently said about it are definitely false It would also make it very hard to explain the emergence of the conventional story On the other hand, the second approach is not easy to execute because appreciating what was meant when the Phillips curve and related matters were discussed does involve breaking away completely from the ideas of the conventional story That is hard to without something to put in its place So, attempting to steer between these difficulties, I proceed as follows Each of the first four chapters addresses some aspect of the conventional story—first the significance of Phillips (1958); second, the role of Samuelson and Solow (1960); third, the content and objectives of the econometric ‘Phillips curve literature’ of the 1960s; and fourth that of the 1970s In those last two cases, the idea of the ‘Phillips curve literature’ is a broad one, encompassing all the varieties of work that have later been included under that heading and hence many discussions of the relationship between inflation and unemployment (or the lack of it) which the authors did not describe using the language of the ‘Phillips curve’ In all four cases 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also expectations of inflation arbitration 106 Australia 98, 105–6, 141, 161, 242 balance of payments 143–4 Ball, R J 94 Belgium 234 Bhansali, R 168 bottlenecks see inflation, bottleneck Brittan, S 168 Brookings model 100 Brookings Papers on Economic Activity 90, 94 Brown, A J 180–1 Brunner, K 161 Buchanan, J 161 business cycle 119, 149 Callaghan, J 152–3, 167, 168, 169, 249–50 Canada 58, 74–5, 80, 97, 105, 141, 173, 241 Bank of 235–6 Choussudovsky 169 conscious cognition 92 cost of living 15, 28–9, 60–1, 85, 87, 248 cost-push inflation 111–16, 130–1, 141, 145, 172–3, 197, 200 debated 37–8, 41–2, 71, 121 definition and incomes policy 187–9, 194 and union power 25, 55, 57, 95–6, 124, 152 currency: flight from 121 optimal areas 200 demand: deflation 234 excess 151, 187 for herring 19 policy 16, 115–16, 147, 153 demand-pull inflation 9, 111, 141, 172–3, 194 debated 38, 41, 71 definition and incomes policy 187–8, 194 in the UK 151 demand-shift inflation 38, 119, 235 see also lubrication argument devaluation 71, 144 Dicks-Mireaux, L A 94, 198 Dow, J C R 94, 198 economic growth 107, 116–19, 121–3, 125 Economica 17 econometrics 67, 190–1, 198 econometric failure 7, 215 Phillips curve literature 4–5, 9–10, 15–29, 51–60, 81– 106, 111, 138, 141, 179, 189, 198, 204 technique, limitations of 7, 67, 233, 241 unimportant 7, 107 economics: high-pressure 118, 123 methodology 211–13 relationship generalisation 65 as science 19–22, 31, 211–13, 217 stable behaviour 21–2 economics community 216–17 Eisenhower, D D 111, 120 employment: full 91, 129, 224 (p.302) overfull 129 policy 141, 197 and price stability 198 and trade quantities 144 see also unemployment equilibrium, long-run 206 European Central Bank 202 European Economic Community 232 European Monetary Union 137, 167, 206 exchange rates 221 expansionary policy 224 expectations of inflation 1, 39, 51, 82, 160, 174, 189–91, 203, 238, 240, 251 and adjustment 81, 84, 89, 117, 128, 183, 192, 200, 209 conscious cognition 92 early understanding 5, 157–8, 182–3, 204–5 Friedman on 65, 153, 165, 172 and harmless inflation 128, 150 inflation 76, 100–1, 199 interpretations of 212–13 origins of 81–9 rational and adaptive 86 tropistic 86, 209, 237 variable coefficient 104 see also anticipations of inflation; rational expectations expectations measurement 101, 102, 103, 173, 199 fairness 28, 77, 115, 197, 222 falsification 19, 20, 211–13, 215 Federal Reserve-MIT model 99 Fellner, W J 87 Fisher, I 215 Ford, G 158 France 98 Friedman, M 81–2, 87, 94, 135, 152, 153–4, 158–9, 165–6, 185–6, 203, 209–11, 217 Nobel Lecture 2–4, 62, 179 responses to 100–6 game theory 27 Goodhart, C A E 168 Gordon, R A 196, 211, 212 government spending 150 Greenspan, A 158, 161 Hall, R E 196 Hamilton, E J 119 Hansen, A H 119 Harrod, R 180 Heath, E 146 Heller, W 128 Hines, A G 212 income: aspirations 113–14 indexation 84 money and real 82–3 redistribution 85 incomes policy 69, 147, 239–40, 247 and cost-push 187–9 effective 97, 129–30 failure 29–30, 194 Guideposts 56, 73, 169, 189, 229–30, 237 incomes 17, 29–30, 58, 69, 95–6, 127–30, 144–5, 147, 187–9, 194, 198, 208, 239– 40, 247 and the Phillips curve 127–30, 198, 208 UK 17, 58, 144–5 and union militancy 95–6 indifference curve 34 industrial relations 222 inflation: acceleration 129, 201, 237 actual and expected 63–4 against 69–70, 107, 108–11 attitudes towards 107–39 bottleneck 24, 113, 123, 141, 150, 224 case for 5, 34–7, 51 causes of 37–8, 40, 47, 121, 124–5, 145, 224 expected and experienced 100–1 foreseeable 117 and growth 107, 116–19, 121–2, 123, 125 harmless 150, 155 and income redistribution 85 long-term effect 76 marginal costs of 129 momentum 92–3, 115, 147, 173, 212–13 (p.303) normal 66 optimal 69 rapid 233 rising 193–4, 199, 213 slow 119–22 stabilized 128 threshold 104 wage-push 113, 114 zero equilibrium 69 see also anticipations of inflation; cost-push inflation; demand-pull inflation; expectations of inflation; lubrication argument; price stability; tradeoff inflationary policy 13–14, 33, 49, 70, 103, 160, 162 inflationism 5, 68–75, 135–6, 167 explanations 76–80 with and without the Phillips curve 123–32 inflationist policy 204–5 information, incomplete 134 Institute of Economic Affairs 126 institutional change 57 International Monetary Fund 147, 153 Ireland 231, 239 Italy 97 Japan 58, 78, 98 Jay, P 153 job vacancies 95 Johnson, L 142 Journal of Political Economy 181 Kennedy, J F 125, 156, 169, 224, 227 Keynes, J M Keynesian: multiplier 230, 243 policy 226 Keynesian-Phillips model 177 Keynesianism 47–8, 155, 185, 196, 221, 223, 228 anti- 4, 7–8, 24, 108, 138, 161, 164, 193, 201 assessment of 37 a gap in 22–3, 45, 165–6, 185 in inflationary policy 160 New 214 official adoption 141 Klein, L R 94, 198 Korean War 37 labour: excess demand for 160 marginal product of 24 labour force size 53 Latin America 78 Lerner, A P 88 Lipsey, R G 94, 180, 208 Lipsey-Phelps-Friedman model 105 low-demand policy, effects of 36 lubrication argument 157, 200, 202, 210, 213, 251 dating of 183–4, 186–7 and expectations 85, 99, 103 and price rises 79, 199, 126 see also demand-shift inflation Lucas, R E 161, 165–6 macroeconomic models 99–100, 134 manpower policy 126–7, 138, 246 market forces 54–5 Marxism 219 Maudling, R 250 Meltzer, A H 161 microeconomics 134 monetary expansion 192 monetary unions 208 see also European Monetary Union monopoly power 141, 145, 188 Monthly Labor Review 87, 89 neoclassical synthesis 28 neoliberalism 167 New York Times 186–7 New Zealand 98, 231, 242 Newton, I 208 Nixon, R 146, 158 Office of Business Economics model 100 oligopolies 141, 145, 188 Opie, R 168, 169 output, and prices 22 Paish, G 168 Phelps, E S 82, 87, 159, 161, 165–6, 180, 182, 203 Phillips, A W H death of 208 (p.304) his work 11–18 little influence 9, 10 negligible paper 207–8 Phillips curve: accelerationist 174, 177 American 35–49 beginnings of myth 154–61 breakdown 147 diagram 9, 34–5, 38, 69, 126–7, 222, 224 early responses to 220 eye-catching 18 famous papers 172 flat 91, 96, 214 and inflationary policy 162 long-run 21, 32, 41, 49, 160, 174–5, 177, 200–1, 249 loops 14 meaning of 8–9, 138, 172–9, 214 misdatings 180–1 myth in surveys 162–3 myth in textbooks 161–2 no such thing as 201 old and new stories 197–205 and policy 156–9 routinization 163–9 shift 35–6, 135, 177 short-run 174–5, 177, 200–1, 210–11 simple 176, 177, 186 six-point methodology 14–16 stable 127, 152, 159, 177–9, 226, 227, 239, 247 survival of 213–17 three roles 197–8 unstable 42–3, 46–7, 49, 225 use of expression 9, 90 vertical 47–8, 74, 92–4, 97–9, 101–2, 105–6, 134, 138, 156, 158, 166– 7, 176, 178, 183, 193, 205, 213, 215, 218, 237–9, 242, 247 Phillips curve literature 4–5, 7, 16, 26 after Friedman 81–106 before Friedman 50–80 informal 206 non-econometric UK 94–7 Phillips-Lipsey theory 180 policy choices 45–7, 202 conflicting goals 42, 148–9 credibility 137 demand 16, 36, 115–16, 153 effectiveness 198–9 employment 141, 197 inflationary 13–14, 33, 49, 70, 103, 160, 162 manpower 126–7, 138, 246 price stability 141 regional 96, 198, 241 stabilization 141, 209 stop-go 143, 151–2 policy making 99, 141–7 commentary on 147–54 policy menu 9, 35–6, 40, 45–6, 69, 91, 97, 105, 111, 142–3, 154, 157, 163– 6, 172, 195, 214, 222–4, 226–9 see also tradeoff political business cycle 136, 169, 200 Popperianism 18–22, 211–13 price change 172 coefficient 64–5, 66, 189 equations 173 non-linear response to 93–4 and unemployment 44–5, 55 and wage setting 60–7 price index: bias 120, 141, 142 choice of 119 price rise, delusion of 83 price stability 207 attitudes towards 108–11 definition 202 dilemma 224 and employment 198 see also inflation prices: administered 113 commodity 114 controls on 104 creep 130–1 determination 71 freeze 146 ideal 188 import 228, 232 and output 22 real and nominal 51 producer power 24–5 productivity 73, 105, 118, 120 (p.305) profit 73, 173, 207, 233, 246 and demand policy 16 and fairness 28–9 and wage determination 52–3, 56, 66, 211–12, 215 quit rates 53, 134, 230 rational behaviour 206, 208 rational expectations 102 see also expectations Reagan, R 164 regional policy 96, 198, 241 rental vacancies 248 Robinson, J 180 Samuelson, P A 165–6, 203, 204, 208, 217 Sargent, T J 161, 165–6 Schultze, C L 184, 185, 191, 234–5 search model 92, 200, 134–5, 251 social conflict 109–10 social justice 114 social welfare 130 Solow, R M 165–6, 191, 203, 204, 208, 217 South Africa 231 stagflation 216 Stewart, M 169 stop-go policy 143, 151–2 structuralism 78 Sultan, P E 181 supply: and demand 29–31, 62, 164, 194, 229 L-shaped curve 22–6, 37, 115, 221, 249 Sweden 98, 124, 231 Thatcher, M Times, The 151 Tinbergen, J 208, 215 Tobin, J 168, 169, 183, 185, 191 trade quantities, and employment 144 trade unions see unions tradeoff (between unemployment and inflation or wage change) 9, 177, 200– 1, 204, 208, 222–3, 226–7, 249 accepted 34, 44–5, 46–9, 64, 98, 185 deterioration 89–94 estimates of 94 and incomes policy 127–8 and inflationary policy 69–70 optimal 67, 72 rejected 12, 80, 166 temporary 165 in UK policymaking 167–9 see also policy menu unemployment 68, 159, 200 adjusted 92, 214, 216 causes of 56–8 demand deficient 192 dispersion 92, 96, 103 equilibrium 74 frictional 134 and inflation 200 and market pressure 92 natural rate of 65, 85, 92, 104, 130, 153, 159, 192–3 overfull 247 policy 194 and price changes 8, 9, 11, 18, 23, 44–5, 55, 98, 203, 231, 238, 242 rate of change of 147, 207, 211–13, 215 structural 150 versus quit rate 53 see also tradeoff unionization 32, 96 unions 199, 234, 237–8, 239–40 aggressiveness 56–7, 68, 207, 211–12, 215 dislike of inflation 244 groups of 112 individual bargaining 121, 124–5 irresponsible 152 and the price level 24–5, 141 strikes 113 and the wage bill 30 and wage determination 95 wage mark-up 55, 197 see also wage bargaining United Kingdom 75, 79, 161, 167, 194 budget 192 Conservative Party manifesto 248–9 Labour Party manifesto 248–9 National Institute of Economic and Social Research 148 Phillips curve literature 94–7 policy commentary 148–9, 151–3 policymakers 143–4, 146–7 (p.306) Radcliffe Committee 118 Regional Employment Premium 241 unemployment causes 56–8 United States 58, 75, 78, 194 breakdown of Phillips curve 90 Commission on Money and Credit 118 Council of Economic Advisers 40, 111, 120, 128, 149–50, 159, 161, 164, 167, 195 Economic Reports of the President 142, 143, 146, 156–7 Employment Act 141 Federal Reserve 7, 99, 130 'New Economics' 156, 166, 195 Phillips curve 35–49 policy commentary 149–50, 156–9 policy thinking 118 recession 125 steel prices 113 tax 192 variables, real and nominal 195, 233–4 Verdoorn's Law 118–19 Vietnam War 194 Volcker, P von Mises, L 87 Wachter, M L 176, 196 wage: contours 29 controls 104 determination 26–31, 52–3, 59, 95, 197–9 drift 242 markup 55 rounds 29, 52 setting 60–7 stickiness 134 wage bargaining 55, 64, 71, 173, 197, 210, 237–8 collective 243 compromise in 27 and cost of living 60–1 escalator agreements 87 indeterminate 27–30 a scientific enquiry 52, 199 see also unions wage change: and excess labour demand 160 industrial countries 101–2 inter-industry 55 lags 90–1 rate of 215 understanding 50 and vacancies 95 wages: adjustment 28, 55, 76–7, 241 award 106 equilibrium 61 indirect impact on 66 marginal productivity theory of 26, 38, 65, 67, 222 real and nominal 48, 62, 243 worker differentials 28–9 Wagner, R 161 Wallich, H C 88 Werner Report 137 Wharton model 100 Wilson, H 168 .. .Macroeconomics and the Phillips Curve Myth James Forder (p.iii) Macroeconomics and the Phillips Curve Myth Oxford Studies in the History of Economics Series Editor:... Samuelson and Solow (1960); third, the content and objectives of the econometric ? ?Phillips curve literature’ of the 1960s; and fourth that of the 1970s In those last two cases, the idea of the ? ?Phillips. .. understand the idea of expectations shifting the Phillips curve, or any of the rest of it Whatever may be said of the econometrics, the theoretical orientation and the policy ideas of the authors