Last week The Economist published a special report on the world economy by Henry Curr, who took as his subject the strange behaviour of inflation statistics. This is a worthy topic, but, all too typically of that news magazine, he retreats from saying anything too radical. And yet radical thoughts are warranted.
This is because, when economic orthodoxy was reformed after the nightmare of the 1970s, inflation took a central role. The core tenet of this orthodoxy is that the main way of managing the booms and busts of a country’s overall economy is something referred to as “monetary policy”. I use quotation marks because the semantics of the idea have become a problem: what sounds like one thing ends up by being another. By and large it has come to mean, in the orthodoxy, the management of interest rates in the domestic currency. The idea is that by lowering interest rates (“loosening”), you increase levels of aggregate demand in the economy, and by raising them (“tightening”) you reduce it. This, it is suggested, is a much better way of managing the economy than through taxes and public spending (fiscal policy – at least this piece of the jargon is well-defined), whose effect on demand is more direct, but brings with it problems of political management. How do you tell when policy needs tightening or loosening? Well, inflation, of course. It becomes too high if policy is too loose, and too low if it is too tight. The ideal method of managing the economy is through an independent central bank with an inflation target.
Buttressing this belief is another one: that the primary driver of inflation is public expectations. This was an important theoretical development, largely driven the economist Milton Friedman, after the “stagflation” of the 1970s destroyed the previous understanding that inflation depended on the tightness of the labour market. Inflation expectations interact with monetary policy and the combined result dictates how well the economy as a whole operates. If inflation expectations are high, and monetary policy is tight, then you have high inflation and high unemployment. In a well functioning economy the central bank maintains inflation in a Goldilocks zone of about 2% while keeping economic growth ticking over at some natural healthy rate driven by productivity and changes to the size of the workforce, keeping unemployment low. The central bank anchors public inflation expectations because the public know they will be punished by high interest rates and unemployment if they start asking for big pay rises. This is a caricature, but the point is that inflation is central to the story.
Which means that when inflation starts to behave strangely, the whole edifice is threatened. Or it would be if the power of orthodox thinking did not exert such an iron grip on policy makers. Mr Curr points out that inflation has indeed been behaving oddly, but fails to point out that this undermines the evidence for orthodox economic beliefs, meaning that more radical ideas need to entertained.
How is inflation behaving oddly? In the developed world, and to a lesser extent elsewhere, inflation is strangely dormant, and does not seem to respond to changes in interest rates or less orthodox monetary policy, and neither to fiscal policy, to the extent that it has been tried. He discusses some reasons why this might be. Globalisation might mean that inflation is dictated at the level of global economies rather than national ones; the link between wages and prices has been loosened; technological developments have so changed what we buy and how that measuring prices has become arbitrary. This analysis is fine as far as it goes. What it boils down to is that prices and wages are determined in a radically different way to the 1970s, which provided the evidence base on which the current orthodoxy is based. Then large trade unions and manufacturing businesses, such as car makers, loomed large over the whole process. Now both are much diminished, while a vast new labour reserve in China has entered the picture, exerting its influence in all sorts of direct and indirect ways. The giants of modern industry, Google, Apple and so on, employ very few people compared to the old days of Ford and General Motors, and most of their manufacturing, such as it is, is done outside the countries where product is sold.
Common sense suggests that when the way economies function changes, you have to manage them in differently. Alas economists prefer the analogy that managing an economy is like driving a car: you don’t have to worry what is happening under the bonnet. What happens under the bonnet of a car has changed a lot since the 1970s, but you still drive it in much the same way. So it is with economic management, Mr Curr seems to say. Managing inflation expectations is still the central problem in his view. They are too low for monetary policy to work properly and need to be jogged up somehow. This probably involves more global coordination. He suggests that fiscal policy needs to play more of a role in economic management, and that central banks should target nominal GDP rather than inflation (an idea I first tread about over 40 years ago). But he dismisses the idea of Modern Monetary Theory (MMT), which gives fiscal policy a central role, as “wacky”. To my mind it is no wackier than the idea, popular among orthodox economists, that policy makers should raise the level of inflation so that negative real interest rates can become a tool of their beloved monetary policy.
But Mr Curr avoids talking about two questions that really need to be addressed. The first is that if inflation is anchored to a low and fixed level, then what other consequences are there of an overheated economy? And hows do they matter? An obvious one is a current account deficit (i.e. importing more stuff than you export), but when some countries, notably in the north and centre of Europe, seem to adopt a surplus as a matter of public policy, that might not be so dangerous. The UK has been running a huge current account deficit for years will little obvious ill-effect. It is all very ill-understood. What is clear to me is that the answer lies in the complexities of the global financial system. That much was shown by the financial crash following 2007, and yet economists are strangely reluctant to take this on. The orthodox belief about the financial system is along the lines that “it all nets out to zero” and so they don’t need to worry too much about it. The crash was a malfunction of the car’s engine that needs a mechanic to fix, and doesn’t change the way you drive the car.
And this leads to the second question, which is what is the proper role and scope of monetary policy? There are some disturbing questions about the orthodox interpretation, which focuses so heavily on the short-term interest rate charged by central banks to commercial banks. The era of monetary policy has seen an explosion of private sector debt, which is one of the things that destabilised the system in 2007. The first question is whether this really is more benign than the explosion of public sector debt feared by those economists in the 1980s. It has promoted greater inequality between rich and poor, and between generations (since one of the collateral effects has been an inflation of the price of land, largely held by the elder generation).
In fact I think that monetary policy should not focus on inflation, but on financial stability as a whole. This is happening in practice, but the institutional mandate is unclear, which make it much less effective. Secondly I suspect that the MMTers are right that fiscal policy are right that fiscal policy should play the central role in the regulation of aggregate demand. Where they are wrong is ascribing inflation as the primary warning signal for overheating, for the same reason as this is wrong for monetary policy. If it provides a signal at all, it will be too late. They also seem blasé about the political risks.
Perhaps Mr Curr’s article represents an incremental advance towards such a change in thinking. But it is hard not to be disappointed that orthodox economists are so little interested in the evidence for their core beliefs and unwilling to subject them to more fundamental challenge.