Inflation will be what we expect it to be.
Thursday, June 19, 2008 at 04:23PM Today I came across the citation for the 2006 Bank of Sweden (Nobel) prize in Economic Science awarded to Edmund Phelps. To my amazement, Phelps's prize-winning work is an exact expression of my unschooled, street-level explanation for why we had intractable "stagflation" in the 1970s and early 1980s and why we didn't later. Reading further, I learned that three different theories on what causes inflation have been successively the conventional wisdom since I studied economics in college. Listening to the current debate raging around me, I would guess that a lot of other people also missed these and other developments in economics since they graduated. Here, briefly, is how each of the first two theories was adopted, met with spectacular failure, and was replaced, and what the current theory (mine) holds.
In the early 1960s, there were two competing explanations for the causes of inflation and what the federal government could and should do to control it. The mainstream school typified by Paul Samuelson believed there was an unavoidable inverse relationship between the unemployment rate and the inflation rate and that government could manage the necessary tradeoff using Keynesian methods (monetary and fiscal policy). The insurgent monetarists led by Milton Friedman argued that inflation is always and everywhere a monetary phenomenon (i.e., dependent only on the quantity of money in circulation). Meanwhile, Edmund Phelps began to develop in the late 1960s the idea that actual inflation was caused solely by inflationary expectations of real people at street level and that the unemployment rate was almost totally independent of the inflation rate.
The Phillips Curve
In 1958, economist Alban Phillips published a paper describing his statistical finding of an inverse relationship between the inflation rate and unemployment rate in the United Kingdom in the 20th Century. Other economists including Paul Samuelson and Robert Solow took up this idea and developed it further. According to the theory, government could not accede to the demands of the owners of capital to hold down inflation without increasing unemployment and, conversely, successful efforts to stimulate employment would increase inflation. The idea was illustrated in textbooks with "Phillips curves." Details are here. The Keynesian legacy that was an important part of mainstream economics into the 1970s underpinned the conventional wisdom that the federal government should use fiscal and monetary policy to guide the economy along the Phillips curve and resolve the tension between capital and labor to attain a reasonable balance between inflation and unemployment while stimulating growth.
The Phillips curve and the whole Keynesian tradition suffered a crisis in the 1970s when the theory failed so spectacularly that it became indefensible. In the 1970s, the US had simultaneous and persistent high unemployment and high inflation, along with slow growth in real GDP. The Phillips curve did not admit this possibility and could not explain incontrovertible data from a very troubled current economy. From the beginning, a problem with the Phillips curve was that it is based on real world statistical analysis but lacked any persuasive theoretical explanation for why the unemployment and inflation rates should be so tightly linked. Its inability to explain the 1970s suggests that the Phillips curve was just a statistical fluke—a representation of coincidences that had occurred in the past and might not occur again.
Keynesian economics never recovered from this crisis because the way had been opened to try the ideas of the insurgents. Jimmy Carter appointed Paul Volker to head the Federal Reserve in 1979, and he immediately began to implement monetarist theory by tightening the money supply to ramp down inflation. Then Reagan was elected in 1980, and for the next 12 years the practitioners of Reaganomics, which included a large dose of monetarism, controlled the economic policy levers and gained prestige in the universities.
Only money matters.
Volker is widely credited with ending the stagflation crisis of the late 1970s by continually pushing up short-term interest rates in an effort to reduce the money supply. To many, he was and remains a hero, but the Fed's actions were so draconian and the economic carnage so vast that they scared many people, including reportedly Volker himself. Having focused for the first time solely on the money supply, the Fed belatedly discovered that the traditional measure of the money supply was misleading because additional money was being created outside the bank deposit system in the form of money markets and other devices. The Fed was trying to control growth in the "money supply," but it couldn't measure it reliably and certainly not in real time.
Anyway, as the Fed proceeded down this road, it raised short-term interest rates as high as 13.5% and the prime rate got to 20.5% in 1981. Eventually inflation was crushed, but so was economic growth and employment, leading in the early 1980s to the longest and deepest recession since the Great Depression. Although there are still monetarists who contend that "only money matters" and that the Fed should limit itself to managing the money supply, the much more widely held view now is that "money matters, but so do other things."
The inflation rate will be what we expect it to be.
With Keynesian/Phillips curve economics and monetarism both apparently unable to explain the real world and provide workable policy guidance, there was receptivity to the work of Phelps. Phelps approached his work by considering first how people make decisions at the firm level and how such decisions would tend to aggregate into a macroeconomic result. He concluded that actual inflation is determined solely by expectations about future inflation. In other words, if I expect I need to grant a 4% wage increase to cover expected inflation and to remain competitive in the labor market, and that I can raise prices 4%, I will take actions based on those expectations, so will everybody else, and the result will be 4% inflation. According to the Nobel Prize citation, this view is now widely accepted (although I would say that, like every other economic theory, it may well prove to be wrong).
That supports what I said in an email to Ben Stein and posted as An ounce of business experience is worth a pound of economic theory. Inflationary expectations in the 1970s were high and apparently irresistible, as perceived by me, but low in the 1990s largely because, I thought, Wal-Mart was everybody's largest and fastest growing customer and it refused to accept price increases. It may not be the key to the universe or even true, but I'm happy to have a Nobel laureate to cite in support of my epiphany. Regrettably for the mainstream economists of the last 50 years, they insist on expressing themselves only in mathematical models, and street level psychology and expectations may be pretty difficult to measure and load into a model. Regrettably for government officials, actually changing the inflation expectations of millions of individual actors is probably a lot more difficult than changing an interest rate.
Skeptic
To be clear, while I think street-level expectations about inflation have been significant in the past, I don't think they were the only significant factor in the past, and I certainly don't think they will always and forever be the only factor that matters. There is too much complexity in the economic system to reduce it to a simple mathematical formula. Even in tomorrow's weather forecast, the meteorologist will say something like 20% or 50% or 80% chance of rain--he/she usually doesn't predict just rain or no rain. The meteorological art is way ahead of the economic science art in understanding what it doesn't know.
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