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.
I’m pleased that you don’t think MMT is wacky! I’m not a economist by training but it is the only theory which makes any sense IMO.
The question of inflation is still important. When it is low there will be a greater tendency to save. One person’s savings becomes another person’s debts, so it’s inevitable that Govt debts and deficits will rise in such circumstances.
Japan has a Govt Debt to GDP ratio of some 240%.This is fine and just a sign of a high level of savings. It is also fine if inflation is low. But if inflation starts to rise at the same time as interest rates remain low there will be a natural inclination to spend more before prices start to rise.
Then we’ll see Govt deficits and debts fall. But this will be a bad thing! It will be a sign that the Japanese population has lost confidence in the currency. That could be disastrous if that turns into a panic.
There’s no reason we couldn’t have similar Debt to GDP ratios. If we do we’ll be fine providing inflation is kept low. MMT has quite a lot to say about how to do that and still maintain full employment. You wouldn’t think so from the number of accusations that we want to create another Weimar republic or Zimbabwe situation though!
Japan is a good example of why context is so important, even though most macroeconomists love to generalise. Government debt is sky high, and the central bank keeps buying lots of it up (supposedly “printing money” in the right wing narrative), and yet inflation is stubbornly low. Behind this, as you say, are high levels of domestic savings, and I would add a current account surplus (a conventional economist would say these two sides o).
The question I am trying to pose is what if inflation is locked in by cultural or institutional factors? If the government starts to stoke up demand more than the economy can bear, then inflation still stays low. Imports flood in, and the economy starts to depend on external financing. This could lead to a financial bubble, which when it bursts reduces demand by creating a recession as businesses become bankrupt. As you know, I think this is pretty much what happened to the UK in 2008.
In the case of the UK, we have a large current account deficit and low unemployment, so it isn’t self-evident that high levels of government debt are sustainable, even if inflation stays low. But it might well be sustainable, in the right circumstances. My worry about MMT is that not enough thought is being given to the potential risks, which might in turn inform policy.
I’ve read all this again, including the Economist special report you’ve linked to, and it still isn’t clear to me why there is any suggestion of “strange behaviour” with respect to inflation.
I well remember the high inflation of the 70s which was at least partially cured by Mrs Thatcher’s squeeze on the economy in the early 80s. She then ran a much tighter monetary and fiscal policy. There was a lot of talk about monetarism at the time based on a widely held, but erroneous, belief that the quantity of money, or money supply, simply had to be controlled and, hey presto, inflation would be controlled too. That didn’t work. But, nevertheless the Thatcher govt was doing what many Keynesians would have suggested they do anyway. If you squeeze the economy then inflation will fall.
Monetarism then quickly morphed into interest-rate-ism. As you say the idea was “..by lowering interest rates (“loosening”), you increase levels of aggregate demand in the economy, and by raising them (“tightening”) you reduce it. ” Except that isn’t quite right.
It’s the rate of change that matters. So if we lower interest rates from , say, 5% to 4% we have a rate of change of -1% which encourages more borrowing and therefore more spending. But if interest rates then remain at 4% the rate of change goes back to 0%. Another way to look at it is to say that a reduction in interest rates creates more new borrowers and new spender for a time but they add to the pool of old borrowers, who aren’t big spenders because they are paying off their loans.
So over a period of time any so called monetarist control of the economy is going to end up with interest rates which are close to zero and, at the same time a high level of private debt, which is profoundly deflationary. Hence the ultra low inflation we now witness.
If governments find they can spend more without it causing extra inflation as the Economist article suggests, why is that a problem?
Well the Economist does not provide a convincing argument to your last question. It simply says that in end there will be inflation, and that this could happen in a non-linear way, so that a country flips low inflation to a high inflation very quickly. That’s fine as far as it goes, but there’s no clear model and no clear evidence.
I think conventional economists would suggest that you are over-simplifying with your rate of change argument, though they do worry about the zero lower-bound, and central banks running out of “firepower”. High levels of private debt son’t have to be deflationary: banks have an incentive to replace repaid debt with new debt. But the evidence does seem to point in your direction!
I still think that there is more to the lack of inflation that a lack of demand, due to excessive levels of private debt, and the report does go to some length to try and demonstrate this. And it really isn’t hard to find alternative explanations for low inflation.
@ Matthew,
You’ll not be surprised to know that I still think you have it the wrong way around. You’ve said:
“If the government starts to stoke up demand more than the economy can bear, then inflation still stays low. Imports flood in, and the economy starts to depend on external financing.”
First of all, there is no evidence that inflation will always stay low under such circumstances. But just for the sake of argument, let us suppose it does, and the extra demand leads to an increase of imports. Even from a neoliberal viewpoint, what is wrong with that? The only way the current account can be in deficit is if the capital account is in surplus. That means foreign owned money is happy enough to park it back from where it originated.
It’s really quite rare for Governments to go out to seek loans in the same way as you or I might if we needed money, and I’m not suggesting they should. But what to do about an influx of what sometimes might be termed “hot money”. There may, at times, be reasons for wanting to keep it out and so preventing the currency from appreciating too much. But this is to digress slightly.
So from this POV the ability to run a current account deficit is actually a good thing. It shows there is a level of confidence in economic management. The time to worry is when we can’t do this!
There are always predictions of hyperinflation. They tend to come from those who don’t know what they are talking about or, perhaps from those who want to encourage everyone to move into gold for a time so they can sell short when the price reaches a peak.
The “rate of change” argument is a slightly more complex than the mainstream version. So who’s “oversimplifying”? The point about lax credit control is that it doesn’t lead to an overall increase in demand over a longer time period.
Say an individual wants to buy a car. He can save for the car over a number of years. When he is saving he is providing his own deflationary contribution to the wider economy. Then he buys the car and provides a stimulus.
If he’d borrowed the money the stimulus comes first and the deflationary contribution follows later. If lots of people are all doing this at different times then everything averages out and there’s no significant macroeconomic effect.
However, if the government orchestrates the borrowing and spending patterns of the general population through constant interest rate adjustments there will be a very significant effect. High levels of private debt will always be deflationary. Because we do have to repay our debts. The repayments do take up a chunk of our income which we’d otherwise spend on something else.
You’ve finished by saying “it really isn’t hard to find alternative explanations for low inflation.” But you’ve earlier asked “How is inflation behaving oddly?” Which implies you don’t really have a good explanation. As I’ve already said, I don’t really believe it is behaving at all oddly. We’d always end up where we are now after years of monetarist “regulation”. ie very low inflation but high levels of private debt.
First, I don’t claim to have the answer to the puzzle, though I’m happy to speculate a bit. I think the evidence points in different directions. My guiding philosophy is that to understand macroeconomics you have to get under the bonnet and understand how an economy is actually working at the time. Macroeconomsts with physics envy instead try to establish general rules based on aggregate statistics, which can link one time period to another. I think there have been profound changes since the 1980s and before, which need to be reflected in economic policy. The problem is that evidence is always backward looking and applies to different contexts to the current one – so there has to be a strong element of risk management.
Is inflation behaving oddly? You would expect the extraordinary stimulus policies in Japan to have some effect on inflation, but the effect is marginal. Similarly you expect to see more signs of wage or price inflation in other countries where unemployment is low. Instead you see bigger business profits. Might this actually reflect a chronic lack of demand and low productivity? Maybe. Or maybe it reflects structural issues in the new economy. Or both.
Is a current account deficit a sign of potential financial instability? It often is, but not necessarily. You are right that it requires incoming capital. Instability arises if this foreign capital is denominated in a different currency, or if the capital tries to make a sudden exit. Currency exposure does not seem to be a big deal in the UK at least. But I don’t think that foreign capital is going into long-term industrial or infrastructure investment either. Much of the financial system is opaque, so although the risks don’t look nearly as high as they were in 2007 it is hard to rule out potential problems. I read that current account deficits are a surely predictor of financial instability than budget deficits, but a floating currency reduces the risks. I’m no neoliberal on such things – just because the market seems happy doesn’t mean that there isn’t going to be trouble.
So where does this lead me? I think a looser fiscal policy is fine in principle, but it needs to be directed to projects which help build up the long term health of the economy and public wellbeing – not digging holes and filling them in again – or gratuitous tax-cuts.
I think we can both agree that the government’s policy should be directed towards the public wellbeing and we don’t want to rely on the effect of trickle down tax cuts for the rich or digging too many holes just for the sake of finding something for everyone to do!
If you actually read what Keynes had to say on the latter point, I think it’s quite clear he was saying that digging holes and filling them in again was literally how the old gold based monetary system operated. He was also making the point that Governments could create their own artificial gold by stuffing bank notes into bottles, burying them, and allowing the private sector to tender for the privilege of digging them up again. Of course, he also made the point that it would be silly to do that.
I must say that I was amused by your comment that the “evidence is always backward looking” with the implication that this ‘problem’ is somehow worse for economists. It’s just the same for everyone too!
If we can avoid the nonsense of abolishing cash and moving towards ever larger negative interest rates then I also think we can agree that, like it or not, fiscal control of the economy becomes the only available option left.
I quite like it but you obviously don’t. Maybe that’s just a left or right issue?
The backward-looking nature of evidence is a philosophical problem for everybody, though for economists it is acute since they find it especially hard to keep the context constant. I despair that this is so little understood when everybody rushes to justify policies on the grounds of being “evidence-based” (and attacking such things as alternative medicine, for example). That’s fine as far as it goes, but it leaves you with many gaps. I wish people showed more understanding about the limitations of evidence!
I agree with you that fiscal policy is the only show in town, and it is true that I worry about some of the implications for that. There are plenty of useful things a government can do with public spending that we aren’t doing enough of now – but the issues is governance – how do we stop it developing into an inefficient crony-state? That does reflect a diffeence in political philosophy. But I do wonder if a coalition between socialists and liberals is possible, based on looser fiscal policy. It should be.