Edmund Phelps: The Prophet of Productivity Booms and Busts
Edmund Phelps, who died last week at 92, won the Nobel Prize in Economics back in 2006 for his work on the deep structure of unemployment, inflation, and expectations. But one of his most provocative ideas—the productivity business cycle—has still not received the attention it deserves.
That’s a shame because Phelps ideas are exactly what we should be paying attention to right now.
American economist and the winner of the 2006 Nobel Memorial Prize in Economic Sciences, Edmund Phelps, at a conference at the Ministry of Economy in Paris on November 21, 2017. (ERIC PIERMONT/AFP via Getty Images)
The U.S. economy has come to an unusual crossroads. Productivity is accelerating, the labor market remains historically tight, and workforce growth has stalled. Conventional wisdom treats the tight labor market and stalled workforce growth as warning signs that growth could be hampered. This has become one of the leading arguments for easing back on immigration restrictions and expanding foreign worker visa programs. We need more workers, the business lobby is constantly telling President Trump.
Phelps’s theory suggests something different: if productivity is arriving without a prior hiring boom, this may be the rare cycle that delivers gains in output without first producing an employment boom that has to be painfully unwound.
The heart of Phelps’s innovation theory, developed in the 1980s and 1990s, was deceptively simple and deeply counterintuitive. Productivity booms don’t necessarily begin when productivity gains show up in the data. They begin earlier, when entrepreneurs and investors come to expect future productivity gains.
When businesses see new technological opportunities, the shadow value they place on business assets rises—especially trained employees, installed capital, customer relationships, and organizational capacity. Companies rush to hire, train, invest, and expand in anticipation of future productivity improvements. This boom is real. Employment expands, wages rise, asset prices climb, and the economy accelerates.
But when the productivity gains finally arrive, they don’t necessarily produce a second boom. The hiring and investment that the gains would justify may already have taken place. The future has been capitalized in advance. The realized productivity gain then marks the end of the boom rather than the beginning of a new one.
The Great Depression as a Productivity Hangover
That’s the crucial Phelpsian insight. Expected productivity gains are expansionary. Realized productivity gains, if already anticipated, can be disinflationary, disruptive, or even contractionary—not because productivity is bad, but because the economy has already adjusted to the expectation of it.
Phelps used the 1930s as one of his historical examples. The productivity surge of that decade—electrification, automobiles, radio, modern manufacturing—wasn’t accompanied by a normal expansion. In his framework, those gains were partly the delayed fruit of the investment boom of the 1920s. The economy had built, hired, and capitalized around expectations of future productivity. When the gains arrived, they didn’t automatically pull us out of the Great Depression.
During the Great Depression, unemployed men line up outside a soup kitchen opened by gangster Al Capone in Chicago, Illinois, in November 1930. (Bettmann/Getty Images)
Phelps wasn’t denying that the monetary policy of the 1930s or the regulatory and fiscal policies of the Roosevelt administration’s New Deal exacerbated the Depression. Instead, he was embarking on something deeper and more important. Namely, describing a structural mechanism creating economic cycles: productivity can arrive after the economy has already made the investment and employment commitments that productivity was expected to justify.
That’s still often lost in our discussions of how the economy is developing. Policy arguments generally treat productivity gains as straightforwardly good: more output, lower inflation, higher real wages, stronger growth. And they are good. But Phelps saw the complication. The timing and expectations matter. The difference between anticipated productivity and realized productivity can determine whether a boom continues or ends.
Today’s economy may have solved this problem in an unexpected way: by preventing the anticipatory hiring boom from happening in the first place.
What The Trump Labor Market Means for Phelps’ Cycles
Immigration enforcement and slower population growth have sharply constrained workforce expansion. Companies have struggled to hire even when they wanted to expand. They’ve had little ability to hire ahead of future productivity gains. The labor market is tight in the way labor markets get tight when workforce growth slows and borders restrict movement. Businesses in the U.S. today face a simple constraint: they cannot hire the way they used to. There’s no ready pool of unemployed labor to reach into and pluck out new workers.
And this changes the productivity cycle.
Without a large over-hiring phase, there is less excess labor to shed when productivity materializes. Firms still want productivity gains. They need them to manage cost pressures, maintain margins, and expand output. But those gains aren’t arriving after a classic labor-market boom. They’re arriving in an economy where companies have been forced to do more with scarce labor.
That’s what makes the current combination so unusual: productivity accelerating in an environment of labor scarcity. This isn’t a demand-side miracle created by loose policy. It’s a structural condition. Firms are being pushed toward innovation because they can’t hire their way out of constraints. When productivity arrives, it doesn’t necessarily trigger the painful employment correction that usually follows an overbuilt boom.
This is where incoming Fed chairman Kevin Warsh’s argument about artificial intelligence and monetary policy fits naturally. Warsh has argued that AI represents a genuine supply-side productivity shock, not merely demand-pull inflation dressed up as growth. If that’s right, then accommodating those gains with lower interest rates isn’t a concession to inflation. It’s a recognition that the economy’s supply capacity is improving.
Under a Phelpsian framework, the policy goal should be to let productivity gains flow through the economy without forcing an unnecessary contraction. Rate cuts in this setting aren’t simply “loose money.” They can be the mechanism that prevents firms from overreacting to realized productivity gains by pulling back too sharply on hiring and investment.
This also explains why the tight labor market may be protective against recession rather than a precursor to it. In the standard story, a productivity acceleration can be dangerous because it follows a period of overexpansion. Firms hired in anticipation of the boom, and when productivity finally arrives, they discover they no longer need as much labor. Layoffs ensue, consumer confidence cracks, spending falls, and the risk of a recession becomes large.
But if firms never get the chance to over-hire, the adjustment is likely to be much smaller. Wages stay elevated because labor remains scarce. Consumption doesn’t collapse. Productivity gains support margins and output rather than triggering mass layoffs. Growth can sustain itself without the deflationary hangover that often follows an overextended boom.
There are risks, of course. The over-investment may not be in labor this time. It may be in data centers, chips, power infrastructure, software, or inflated equity valuations. A Phelpsian cycle can still emerge through capital markets even if it doesn’t emerge through payrolls. But that only sharpens the point: the question isn’t whether productivity is good or bad. The question is where the economy has already overcapitalized the expectation of future productivity.
Phelps death leaves us without one of the few economists willing to think seriously about how the structure of the economy shapes the path of growth. But his ideas suggest that the current combination of tight labor and accelerating productivity may not be a crisis waiting to happen. It may be the rare productivity cycle that delivers sustained growth without the usual hangover.
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