Should we be worrying about inflation?

Now is a very interesting time to be a macro-economist. The shock arising from the covid-19 pandemic is unprecedented in its extent (barring world wars, maybe) and its economic effects. Government responses, with very loose monetary policy combined with generous fiscal measures, is similarly unprecedented. The latter is remarkable in that its generosity is far greater than that shown by governments following the Great Financial Crisis that started in 2007. Economic conservatives have been routed and are grasping for evidence that their once confident assertions about the public debt and deficits have a basis in fact. These generally turn on the question of inflation.

Inflation plays a critical role in macro-economics. In theory it is what happens when supply fails to meet demand across an economy. There a number of reasons that this can happen but the most important, to macroeconomic commentators, is when a when aggregate demand is boosted by a government spending too much or taxing too little. Or, putting the same idea in a slightly different way, when too much money is being put into circulation by government policy. It is one of the points of agreement between orthodox conservatives, whose narrative is that bad things happen when governments intervene, and advocates on the left for Modern Monetary Theory (MMT), whose narrative is that governments can and should spend freely so long as inflation is kept at bay. Things get more complicated when you try to apply the theory to an open economy – one that trades substantially with others – that issues its own currency, but this is usually glossed over.

The theory of inflation had to be redeveloped after the 1970s, when inflation (excess demand) and high unemployment (inadequate demand) co-existed in so-called stagflation. The new theory, working its way through such ideas as monetarism, a craze of the 1980s, to the Neo-Keynesian consensus of the 1990s, built on the idea of inflation expectations. This suggested that inflation could happen simply as a function of the zeitgeist. The standard theory was that therefore it was essential that inflation expectations were “anchored”, and that it was the central bank’s job to do this. This theory has become so embedded that organs such as The Economist, who should know better, report it as fact.

In the first two decades of the 21st Century inflation in the developed world has been stable and quite low (around 2% per annum and often less). This has been hailed as a great success for central banks, who have firmly anchored those expectations. It has also been taken up by MMT enthusiasts as evidence that reticence over government spending and national debt, and especially the demon “austerity”, is vastly overdone.

And so here we are now. Many developed world governments, led by the United States, have thrown caution to the wind in response to the pandemic. This appears to have been remarkably successful in in that the economic impact of the calamity has been relatively limited. But now inflation seems to be breaking out everywhere. Optimists say that this is just the result of temporary supply bottlenecks, pessimists say that over generous economic policies are coming home to roost. Commentators pore over the available data and argue like mad.

If you find all this rather perplexing, you should. Macro-economists inevitably deal in simplified models that represent the actual world but imperfectly. The statistics they deal with, such as income and, indeed, inflation, are similarly imperfect representations of a complex reality. They all know this, but instead of taking on an air of humility, they find it easier to gloss over the difficulties and wallow in the vicarious power of dealing in the fate of millions. In the process most of them have become completely detached from reality.

Inflation is a case in point. What most economists seem to mean by the term is a devaluation of money: the price of everything going up without anything deeper going on. One of the 1980s economists suggested that “Inflation is everywhere and always a monetary phenomenon,” because it couldn’t happen in that favourite fiction of conservative economists, a barter economy. But a general rise in consumer prices may simply be part of a widespread balancing out of things across different markets. In the 19th Century, according to statisticians who estimate these things, there were many surges in prices, but compensated by falls at other times, so that there was no overall rise over the long term. Not coincidentally, money was closely linked to gold at the time, though that is incomplete as an explanation. A more recent example is the inflation that accompanied the economic boom in Ireland after it joined the Euro. This rise in prices was the only way an open economy could respond to a surge in productivity without a now-impossible currency revaluation. That didn’t stop the European Central Bank ticking the Irish government off. Another example came during the austerity years of the British Coalition government after 2010. There was persistent (though not especially high) consumer price inflation. But this wasn’t matched by wages, and it was simply the economy reflecting the reality of lower living standards. I remember one commentator suggesting that the inflation would make debt easier to pay off; nonsense because you pay debts out of income. Inflation then was not reflecting a devaluation of currency.

So what is happening now? Prices rises genuinely seem to reflect shortages in supply relative to demand, both in goods markets and labour markets. These may well reflect temporary bottlenecks. We can expect this to go on for some time as the pandemic has had far-reaching impacts on many supply chains and labour markets. Yesterday our local picture framer was complaining on behalf of his glass supplier that the cost of hiring a container from China had risen from £500 to £8,000 (or something like that), because all the containers are in the wrong places, not to mention the disruption to the Suez Canal. In Britain we have the added complication of Brexit disrupting both goods and labour markets; in that case when the dust settles most people are bound to end up a bit poorer. But the pessimists have a point too. The entrenched inflation of the 1970s started with similar temporary shocks, to the oil market in particular. If it really is all about expectations, this is how it starts. But there is so much noise in the statistics that it is really very hard to see what is going on.

Personally I am less concerned about inflation that many. I think the 1970s-style inflation was mainly a product of unionised labour markets and less flexible supply chains, which gave labour much more power. This certainly had a good side in ensuring a fairer distribution of wealth, but it prevented adjustment to economic realities. In today’s much more open world economy there are other ways than inflation for unsustainable excess demand to play out, in the most developed economies anyway. In the 1990s it may have been right to talk about inflation expectations being anchored by the central bank, but the world has moved a long way since then. Inflation is held in check by the forces of global trade. The stress is taken in the financial system through higher levels of debt and international capital flows. This is likely to end in financial busts rather than 1970s stagflation.

So if there’s trouble ahead we are looking in the wrong place. Is there trouble? Financial asset markets certainly look as if they are in a bubble, but the banking system looks a lot healthier than it was in 2007, when the last great financial crisis started to gather momentum. In Britain I think things are going to get much bumpier as the government tries to bring its budget deficit (currently an eye-watering 11.5% of GDP, though less than America’s 13.9%) back to a new normal. But there are so many uncertainties as to what a sustainable new normal will look like, that this very hard to predict. This is going to dominate politics from 2022 on as there is no coherence to the government’s message on this.

Interesting times indeed.

6 thoughts on “Should we be worrying about inflation?”

  1. To answer the question in your title, you might be surprised to know I would say ‘yes’. This is not to say that inflation will kick off as some are predicting, but it might do. The Government has been running large deficits which has meant that many of the rest of us have been running a surplus. The principle of the sectoral balances. We’ve been saving money , or at least those of us lucky enough to carry on with more or less the same income, because there has been nothing much to spend it on. No football, no holidays, the pubs have been shut etc etc.

    So what happens when, or should that be if, we do get back to something like normal? Will we binge spend and create an inflation problem or will we go more carefully and spend in a controlled manner? That’s not going to be a decision of government.

    If the former, the mistake that the Government/BoE will likely make will be to apply a monetary remedy to a fiscally created problem. Rather than raise taxes to slow the economy they will raise interest rates too sharply and crash it instead!

    1. I suppose my point is that the operation of markets currently means that price rises are likely to be temporary, and either not repeated, or even corrected. There are fewer mechanisms for a wage-price spiral to get going. But that’s not much more than a hunch, in reality. Funnily enough the Chancellor is preparing the ground for a fiscal correction, but the politics look hard.

  2. @ Matthew,

    “……….its budget deficit (currently an eye-watering 11.5% of GDP, though less than America’s 13.9%) back to a new normal…..”

    I thought I’d at least partially convinced you to look at the macroeconomy in a different way but you do look like you’ve slipped back a bit! 🙂

    First of all there isn’t a “normal” or anything to get your eyes too watery about when it comes to Government deficits. Anymore than there is an “normal” position for your steering wheel or your accelerator when driving your car. You should be concerned that you don’t drive too hard and overheat your engine, and so risking your own safety, but I’m not sure “worry” is the right word, which was a point I was intending to make in my previous comment.

    Sometimes a deficit of 11.5% or even 13.9% is appropriate. Sometimes its more appropriate to have closer to a balanced budget. The levels of Govt spending and taxation are partly about the political questions of how much the government wants to be involved in the economy, the desire to avoid us all drinking smoking and polluting the environment too much. and the redistribution of wealth between rich and poor but mainly they are economic regulators which Govts should use wisely to keep the economy on sensible course.

    1. Point taken. In fact the UK 11.5% looks perfectly appropriate (less sure about the US case). My main reason for thinking so is that the current account deficit is 4.5% – quite high by international standards, but not compared to recent performance. The country has little difficulty in attracting capital to fill the gap. But conditions will change so that is no longer the case. Whether it is helpful to talk about a “normal” is a good question.

  3. “and advocates on the left for Modern Monetary Theory (MMT), whose narrative is that governments can and should spend freely so long as inflation is kept at bay. Things get more complicated when you try to apply the theory to an open economy – one that trades substantially with others – that issues its own currency, but this is usually glossed over.”

    Maybe I could have a try of ‘unglossing’ it?

    First of all the term ‘spend freely’ is somewhat pejorative. The MMT line is that interest rates should be kept fixed, many would say at 0%, and the government should control the overall spending levels in the economy to correctly regulate it. If everyone else is spending more then the government should spend less/tax more, and vice versa.

    The MMT policy is to have a guaranteed job for everyone rather than a pool of unemployed workers. The idea is that this acts as an buffer against inflation as Warren Mosler neatly explains in this article.

    Exchange rates should be allowed to float rather than be pegged to another currency. Even worse is to use someone else’s currency , which governments have little or no control over, as in the euro using countries. The MMT line is then pretty much what you’d then expect it to be. The exchange rate is determined by the monetary flows in the current and capital accounts. If foreigners want to save their money with us they provide the capital inflow to offset the outflow of a current account deficit. Just what they should be allowed to spend their money on via the capital account is a political question.

    It wouldn’t be correct to suggest we have to sell expensive London property to absentee owners simply because we ‘need the money’. The worst that could happen would be that the capital and current account would be closer in balance with a lower pound to match.

    Over the longer term any variations in the currency exchange are simply a reflection of relative inflation rates.

    1. Yes there is a bit of the pejorative in there. And I don’t think I’d accuse you of glossing over the open economy implications – which comes more from American advocates. I see that the exchange rate must float. What I have never got my head round is that if the government runs a budget deficit, this will tend to lead to a current account deficit. This will, in the absence of any other considerations, lead to an appreciation of the currency (overvalued currency leads to a deficit and vice versa), which will tend to reduce inflation. Inflation won’t be much of a constraint because in this frictionless scenario because demand is satisfied by increased imports. But at some point this breaks because persistent funding by foreign capital creates stress, and this, very often means a financial crisis. Now I suppose you could say that the capital markets will determine th exchange rate, so that an unsustainable current account deficit does not build up – and if the budget deficit is too big it will lead to inflation instead. But these are the capital markets that led the Euro in a very dark place in the 2010s…

      I haven’t investigate the job guarantee idea – but it is an interesting one.

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