“What sex is to the novelist, inflation is to the economist. Discuss.” To this legendary 1970s university entrance exam question, one candidate, legendarily, answered: “It may be said that both inflation and sex are characterised by a rising rate of interest”. That answer would not have passed muster in 2021, a time when inflation was rising sharply while the world’s leading central banks kept their policy rates close to zero, or below. Inflation, the monetary bigwigs told us, was “transitory” and the public’s inflation expectations were firmly “anchored”. They could not have been more wrong.
We Need to Talk About Inflation is a timely contribution to the debate by the former HSBC chief economist Stephen D. King. The title is particularly apt. We have a serious inflation problem – and it’s not solely a question of the current cost-of-living crisis. The more intractable problem concerns our deeply flawed understanding of inflation itself. Part of this problem derives from differing notions about how inflation arises – none of which attracts universal support. As the veteran former Bank of England economist Charles Goodhart told the European Central Bank’s forum in Sintra, Portugal, in September 2021, we no longer have a general theory of inflation. Monetarism, whose most famous advocate was Milton Friedman (1912–2006), had become so discredited that central bankers had ceased to concern themselves with monetary aggregates, Goodhart suggested. Yet only a few months earlier the annual growth in the US money supply (M2) had exceeded 25 per cent – its highest level since 1945. In Europe and the UK the money supply had also ballooned. A handful of monetarist economists, including Tim Congdon of the Institute of International Monetary Research, sounded the alarm bells, but their warnings were ignored.
Central bankers thought they knew better. They pointed out that, in the near term, changes in the amount of money in circulation weren’t tightly correlated with inflation. Besides, as Goodhart had famously demonstrated in the 1970s, the relationship between the money supply and inflation appears to break down whenever central bankers target any particular monetary aggregate with the aim of bringing down inflation (Goodhart’s Law). And there were, they argued, other concerns: the velocity of money (how quickly it passes from hand to hand) was not as stable as monetarists appeared to believe; and at the existential level there was the question: what exactly constitutes money? Given the complexity of our modern financial arrangements, that question is hard to answer.
It is now clear that monetary policymakers made a grave error in turning a blind eye to the soaring money supply. As King points out, great inflations in the past have invariably been associated with debasements of the coinage (the Roman Empire in the third century CE, for example, and England under Henry VIII) or, in more recent centuries, with an excessive issue of paper money. Indeed, monetarism is the original inflation theory. When the French jurist Jean Bodin (c.1530–96) sought to explain what historians now call the “Great Inflation” of the sixteenth century, he wrote that “the principal and almost only [cause] … is the abundance of gold and silver, which is today much greater in this Kingdom”.
In the English language inflation originally referred to a “swelling or puffing up with wind”. By the nineteenth century it had acquired a new meaning: “an undue expansion or increase from over-issue; said of the currency” (OED, 1933 edition). By this definition the world’s central bankers embarked on a serious inflation in 2020 when they underwrote western governments’ hugely expensive response to the pandemic. “Money matters”, says King, one of whose inflation tests includes looking out for signs of monetary excess. Having predicted the arrival of the current inflation, King, unlike most current economists, is not writing with the benefit of hindsight.
In his Sintra talk Goodhart also claimed that the traditional Keynesian theory of inflation – an approach that focuses on imbalances in aggregate supply and demand – had fallen out of favour. One of the main problems with this theory is the practical difficulty of measuring an economy’s capacity. As Keynes saw it, central bankers are supposed to adjust interest rates in line with the so-called output gap (the difference between current and potential output), tightening when that gap is narrow and loosening as it widens. The problem, as King points out, is that the output gap is unknowable: real-time estimates are often subject to later revisions and the measurement issue appears to have worsened with time, as the economy has become more financialized.
Unemployment is often used by economists as a proxy for the output gap. The trade-off between inflation and unemployment is recorded by the Phillips Curve (named after the New Zealand economist Bill Phillips, who devised it in the late 1950s) and by another measure, known as the “non-inflationary rate of unemployment” (or NAIRU) which is the minimum level of unemployment below which inflation is expected to rise. Yet neither of these approaches is robust. In the 1960s Friedman questioned the construct of the Phillips Curve, arguing that once workers started to anticipate inflation, they would demand compensation in advance. At this point the relationship between unemployment and inflation becomes unstable: once this happens “stagflation” arrives, with inflation and unemployment rising in sync. As for NAIRU, this gauge proved so useless at predicting inflation that the US authorities stopped publishing their estimate, as Goodhart reminded his audience.
The fact that the relationship between demand and supply imbalances and inflation is hard to measure doesn’t, of course, mean that this issue should be ignored. In fact, the pandemic involved both a demand shock, as swathes of the world’s population were locked down, and a supply shock, as global manufacturing and trade were brought to a standstill. The central banks erred, it seems, by stoking an excess of aggregate demand in western economies with their support of governments’ pandemic spending at a time when the supply of goods and services remained depressed.
The Keynesian economist and Nobel laureate Joseph Stiglitz maintains that the pandemic supply shock is temporary – a one-off – and that central bankers have made a serious mistake with their recent interest-rate hikes. King is not so sure. He argues that the expansion of world trade in recent decades, in which China played an outsized role, amounted to a positive global supply shock. As globalization advanced the prices of traded goods fell, which in turn dampened inflationary pressures across the advanced economies. However, the trend towards globalization went into reverse after the financial crisis, followed a few years later by President Trump’s trade war with China. As King writes:
Covid simply turbocharged a process of separation that was already under way. Global supply chains, which had previously been regarded as sources of economic efficiency, were now seen as sources of national vulnerability … the speed at which the virus had spread promoted a sense that borders could be a force for good, not merely an unwelcome separation.
Central bankers and politicians were quick to blame Russia’s invasion of Ukraine for the cost-of-living crisis. King points out that inflation was on the rise before Russian tanks crossed the Ukrainian border in February 2022. Still, Putin’s warmongering confirmed that cross-border supply chains are more robust when geopolitical adversaries are excluded from them. Now the talk in policymaking circles is all about “friendshoring” and “nearshoring” – which means outsourcing more manufacturing to countries such as Mexico or Romania and less to countries such as China. King warns that the restructuring of supply chains is an expensive business and will probably push inflation higher.
If central bankers had become sceptical of monetarist and Keynesian inflation theories, as Goodhart suggested at Sintra, they had their own pet theory to fall back on. Inflation, they said, was all about expectations. As long as the public believed that central banks had inflation under control, it would remain under control. Thus, the main job of the central banker was to ensure that the public’s inflation expectations were kept in line with their own inflation target (2 per cent in most advanced economies). Goodhart referred to inflation expectations as the “bootstrap theory of inflation”. The former Bank of England governor Mervyn King (no relation of Stephen) less kindly calls it the “King Canute Theory of Inflation”.
Managing expectations turns out to be as difficult as turning back the tide. After the financial crisis central banks began to issue “forward guidance”, informing the bond markets about where interest rates would be in future. Forward guidance implied, says (Stephen) King, that central bankers were better able to see into the future than anyone else. Since inflation had remained close to target throughout the past decade, they became excessively confident in their ability to control it. Groupthink among the interest-rate setters set in, as evidenced by the unanimous decisions made by the Bank of England’s Monetary Policy Committee (MPC) during the pandemic period – decisions that turned out to be unanimously wrong.
The MPC’s members were also remarkably slow to recognize their mistakes. For instance, between August 2020 and August 2022, as UK inflation climbed from 0.3 per cent to 9.9 per cent, the committee continued to forecast that it would return to target within a couple of years. Its members appeared to be suffering not just from groupthink, but from cognitive dissonance – namely, a failure to absorb information that contradicts one’s established position. Last year both the Federal Reserve and European Central Bank quietly abandoned providing forward guidance.
The issue with attempting to manage inflation expectations goes deeper than the central bankers’ forecasting failure. No one has come up with a decent theory as to how expectations are formed, says King. For his part, Goodhart suggests that expectations are merely an extrapolation of recent experience. In September 2021 the Federal Reserve economist Jeremy Rudd presented a paper provocatively titled “Why do we think inflation expectations matter for inflation? (And should we?)”, which questioned whether expected inflation was a key determinant of inflation. This notion, he suggested, was unnecessary and unsound, and lacked either empirical or theoretical support. Any link between inflation and inflation expectations, Rudd wrote, wasn’t evidence of a causal relationship. Besides, market measures of expected inflation (as provided by the spread between conventional and inflation-linked bonds) hadn’t picked up recent changes in trend inflation. (As if this wasn’t damning enough, Rudd added in a footnote what must be the most curious and sensational comment ever to appear in an official central banking text, expressing a “deeper concern that the primary role of mainstream economics in our society is to provide an apologetics for a criminally oppressive, unsustainable, and unjust social order”.)
Inflation expectations may be unstable, difficult to measure and resilient to central bank control, but history suggests that they have influenced the course of past inflation episodes. When workers expect that price rises will continue to accelerate, unions start to demand inflation-busting pay increases. When inflation becomes unstable, money becomes a hot potato, passed on rapidly from one hand to another. As the circulation of money accelerates, inflation accelerates: a self-fulfilling prophecy.
During the Weimar hyperinflation the rise in German prices far exceeded the relative increase in the number of paper marks in circulation. After the currency stabilization of November 1923, which restricted future note issuance and put Germany’s finances on a more stable footing, inflation dropped like a stone, even as the amount of money in circulation rose. Only the dramatic collapse in the public’s inflation expectations can explain this outcome.
Central bankers also pay insufficient attention to the relationship between inflation and government debt, says King. After 1945 decades of inflation gradually eroded the vast British and American war debts. “Left to their own devices”, writes King, “governments cannot help but be tempted by inflation.” The economist John Cochrane of the Hoover Institution at Stanford has revised informal observations about the “fiscal theory” of inflation into a formal theoretical model, which states that inflation occurs when the public debt becomes too large relative to the state’s tax-raising capacity and its ability to pay off its liabilities from future fiscal surpluses.
The actions of monetary policymakers in recent years have increased the likelihood of a debt-induced inflation. Zero interest rates and enormous central bank purchases of government debt (often referred to as “quantitative easing”) encouraged governments to embark on an epic spending binge. During the pandemic fiscal deficits on both sides of the Atlantic rose to the highest levels ever seen in peacetime. Since 2007 Britain’s national debt relative to GDP has more than doubled. “Would government debt have risen quite as far without being ‘underwritten’ by central banks?” King asks. Probably not.
Having acquired a large chunk of outstanding government bonds, central banks now pay interest on reserves. (These represent the central bank liabilities accrued through quantitative easing.) Central bank reserves are best seen as short-term government debt. Crucially, their interest cost is determined by overnight lending rates. As King writes, “in effect, the overall shorting of the maturity structure of public debt – an inevitable consequence of quantitative easing – increases the fiscal sensitivity of monetary policy decisions”. In plain English, government funding costs are set to balloon when the central bank raises rates. This may partly explain why central bankers were so slow to tighten when inflation picked up during the pandemic. Going forward, there is a danger that monetary policymakers will prioritize the stability of government finances over the control of inflation (what economists call “fiscal dominance”).
We Need to Talk About Inflation is a damning critique both of central bank actions over recent years and of the economics profession’s shaky grasp of inflation. King writes lucidly, avoiding the jargon that makes economics impenetrable to the lay reader. This short volume brims with common sense, and its “fourteen lessons” – from “Money matters” and “Public attitudes matter” to “Democratically elected governments cannot help but be tempted by inflation” – are laid out clearly and accessibly. Despite its claim to present inflation lessons from 2,000 years of inflation, however, the historical analysis is skimpy. There is no mention, for example, of the great Chinese monetary convulsions of the twelfth and thirteenth centuries – the first recorded paper money inflations.
King also overlooks the sociological aspects of inflation – an approach that gained popularity in the 1970s. In The Rise and Decline of Nations (1982) the American economist Mancur Olson argued that inflation occurs when powerful groups within society – what he calls “distributional coalitions” (such as employees vs companies, public sector workers vs taxpayers or the young vs retirees) – become engaged in a fierce struggle for a greater slice of the economic pie. Inflation increases the size of the pie, even if each share is worth less in real terms. Given rising levels of inequality and societal conflict in the West, this bodes ill.
Inflation is an extremely complex phenomenon that isn’t captured fully by any single economic model. It should also be considered that the various competing theories – monetarist, Keynesian, expectations-driven, fiscal and sociological – are not mutually exclusive. Each contains an important insight without telling the whole story. If the dogmatic tribes of economists had the courtesy to listen to each others’ views, their understanding might improve. There is certainly plenty of room for improvement. As the chairman of the Federal Reserve, Jerome Powell, confessed last summer, with a modesty and contrition uncommon in central banking circles, “I think we now understand better how little we understand about inflation”.
Edward Chancellor is a financial historian. His latest book, The Price of Time: The real story of interest, won the 2023 Hayek prize. The paperback will appear later this year