Inflation, past and present

I was in my teens, growing up in a Lancashire mill town, the last time stubbornly high inflation was a thing. It was a scarring experience. My parents’ wages certainly did not keep up. Rocketing food prices gave my mum sleepless nights, so she stocked up whenever something like sugar or tea bags was on special offer. We all became obsessed with switching off lights and turning down heating. Our kind of family was significantly affected – small savings in the bank, no labour market power.

So Stephen King’s We Need To Talk About Inflation: 14 Urgent Lessons From the Last 2,000 Years spoke to me. It also proved prescient, having been written before it was apparent how stubborn the current bout of inflation is proving to be – one of the messages of the book is how hard it is to squeeze inflation out of the macroeconomy. The book takes the historical (and broadly chronological) perspective that will be familiar to readers of Stephen’s previous books, and is a pleasure to read. Not surprisingly, the 1970s chapter was particularly interesting to me. As he comments at the end of this chapter, “Inflation ultimately undermines the fabric of society.” It is profoundly unfair. Yet policymakers persist in trying to tell people who can’t afford food and heat to show wage restraint – they did it then and have tried again now.

There’s also an excellent chapter on what works and what doesn’t in terms of policy responses, given how hard the task is. Price and wage controls generally don’t, albeit with exceptions to address egregious unfairness, although they are easy for policymakers to propose. A clear monetary policy framework with rules that are visibly followed does work, and in particular monetary financing of budget deficits must be ruled out. The takeaway message is that some nasty medicine is unavoidable, but it can work – if somebody will administer it. While Milton Friedman insisted inflation was a monetary phenomenon, this book concludes that it’s ultimately a political one: who will bear how much economic pain and when?

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Rescuing macroeconomics?

It’s always with great diffidence that I write about macroeconomics. Although I’m in good company in being sceptical about much of macro (see this roundup from Bruegel and this view from Noah Smith, for instance), I’m all too well aware of the limits of my knowledge. So with that warning, here’s what I made of Roger Farmer’s very interesting new book, Prosperity for All: How To Prevent Financial Crises.

The book starts with his critique of conventional DSGE real business cycle and also New Keynesian models. Farmer rightly dismisses the idea that it’s ok to mangle the data through a Hodrick-Prescott filter and ‘calibrate’ the model, as in the real business cycle approach. But he also has a chapter criticising the (now) more conventional New Keynesian models. He writes, “Macroeconomics has taken the wrong path. The error has nothing to do with classical versus New Keynesian approaches. It is a more fundamental error that pervades both.” This is the idea that there is an ultimate full employment equilibrium. Echoing Paul Romer‘s recent broadside, he describes both as phlogiston theory. Echoing a number of others, he describes New Keynesian models as being like Ptolemaic astronomy, adding more and more complexity in a desperate and degenerate attempt to keep the theory roughly aligned to evidence.

The book demolishes the idea that there is a natural rate of unemployment (and thus also the idea of the output gap). Farmer argues that there are multiple possible outcomes and unemployment in many of these will persist in equilibrium. His alternative model – also a DSGE approach – replaces the New Keynesian Phillips Curve with a ‘belief function’, assuming that beliefs about future expected (nominal) output growth equal current realized growth.

It seems obvious to me that this approach is preferable to the New Keynesian and certainly RBC models, although this obviousness is rooted in my intuition – of course unepmloyment can persist and there can be multiple equilibria, duh! However, some things about it are less appealing. Above all, Farmer’s assumption that consumption is a function of wealth, not income. He replaces the conventional consumption function with one more purely related to the Permanent Income Hypothesis. This troubles me, although not because I disagree  with his view that the conventional Keynesian consumption function and multiplier are inconsistent with macro data. However, I thought the permanent income hypothesis sat badly with the data also, as it implies more consumption smoothing than is observed. It seems incredible too that many people look forward very far in determining their consumption level even if they do note and respond to asset price changes. Besides, most people have low net wealth – indeed, 26% of Britons have negative net financial wealth.

As the book points out, this change of assumption, and the role of the belief function, have strong policy implications. The debate about austerity, which is in effect an argument about the size of the multiplier (which we don’t know), is a distraction: higher government deficits will not shift the economy to a lower unemployment equilibrium. Instead, Farmer advocates a policy using the composition of the central bank balance sheet to manage asset markets and thus the level of output, and beliefs, through wealth effects (rather than including asset price inflation in an inflation target, as some have advocated). Balance sheet policies are effective because financial markets are incomplete: future generations cannot trade now; parents canot leave negative bequests.

This is a policy debate I’ll be leaving to those who are more knowledgeable than me – although of course those who know what they’re talking about will also have their own horses they’re backing in the race. It is striking that these macro debates rage around the same small amount of data, which is insufficient to identify any of the models people are battling over. In his excellent book about forecasting, The Signal and the Noise, Nate Silver pointed out that weather forecasters reacted to weaknesses in their models and forecasts by gathering many more data points – more observatories, more frequent collection. I see macroeconomists downloading the same data over and over again, and also ignoring the kinds of data issues (such as the effects of temporal aggregation) that time series econometricians like David Giles point out. So something like the David Hendry model-free approach, as set out in his recent paper, seems the best we can do for now.

My reservations should not stop anybody from reading Prosperity for All. It is an accessible read – undergraduate and maybe even A level students could cope with this  – and the model is available at I’d like to have seen some discussion of non-US data, and also structural change/non-stationarity. It’s also a short book, and as a macro-ignoramus I’d have liked some sections to be explained more fully. But these are quibbles. This is an important contribution to the debate about macroeconomics, and it’s an important debate because this is what most citizens think economics is all about, and macro policy has a profound effect on their lives.

I’m keen to read other reviews of the book now. I’m sure Roger is more right than the conventional DSGE approach – but also think the how-to-do macro debate is far from settled. How open-minded are more conventional macroeconomists?


Mainstream macro and Minsky the maverick

I was one of the many economists who had barely heard of Hyman Minsky, still less read any of his work, before the financial crisis. One of the many who, seeking to understand, quickly devoured his [amazon_link id=”0071592997″ target=”_blank” ]Stabilizing an Unstable Economy[/amazon_link]. And found it pretty sensible. Macro isn’t my field, but there didn’t seem to be anything in that book a sensible mainstream macro person should have objected to. Should being the operative word. Because of course everyday, mainstream DSGE models in use in 2008 ruled out the very possibility of a crisis, whereas Minsky believed in their inevitability in some shape.

[amazon_image id=”0071592997″ link=”true” target=”_blank” size=”medium” ]Stabilizing an Unstable Economy[/amazon_image]

This week I’ve been reading Randall Wray’s [amazon_link id=”0691159122″ target=”_blank” ]Why Minsky Matters[/amazon_link], which is a useful and accessible overview of both what Minsky said and – as the title puts it – why it matters. I recommend the book (perhaps particularly to mainstream macro people!).

[amazon_image id=”0691159122″ link=”true” target=”_blank” size=”medium” ]Why Minsky Matters: An Introduction to the Work of a Maverick Economist[/amazon_image]

The first chapter gives an overview of Minsky’s arguments. The second chapter was to me the most interesting. It’s called ‘The Road Not taken’ and sets out the broad mainstream approach against which Minsky developed his arguments. This is the neoclassical synthesis, whose foundations were laid by John Hicks and Alvin ‘Secular Stagnation’ Hansen in the early years after Keynes’s death, then by both ‘Keynesians’ like Patinkin and Tobin and ‘Monetarists’ such as Friedman. Wray argues that these camps disagreed largely over parameter values, and that they essentially bowdlerised Keynes by ignoring his emphasis on investment, finance and uncertainty.

Debates about what Keynes ‘really’ meant in [amazon_link id=”1502423588″ target=”_blank” ]The General Theory[/amazon_link] are not all that interesting – and by the by a good reason for emphasising the importance of maths as well as words in economics. The mathematical notation is a way of enforcing logical consistency and expressing arguments with precision; the words can then explain more clearly, and introduce reality while keeping it rooted in logica and clarity. Anyway, what’s interesting about the chapter is its brief account of how finance vanished from macro, to our great cost.

[amazon_image id=”1502423588″ link=”true” target=”_blank” size=”medium” ]The General Theory of Employment, Interest, and Money (Classic John Maynard Keynes)[/amazon_image]

The later chapters of Wray’s primer set out Minsky’s views on specific issues, starting with his now-famous financial instability hypothesis: that market forces must be constrained in finance to prevent instability, but the consequent stability is itself destabilizing. The final chapter ends with some thoughts about how to proceed in the face of this paradox – in Wray’s view, tougher regulation especially of the shadow banking sector, and a smaller financial sector overall focusing on industrial investment. I agree, not least because the [amazon_link id=”0691169853″ target=”_blank” ]contribution of the sector to GDP is overstated[/amazon_link] (as Sir Charles Bean also pointed out in his recent interim report on economic statistics), and its contribution to economic welfare might well be a net negative.

This seems like common sense. I don’t entirely understand the unwillingness of the political classes to address the finance problem (despite the lobbying and campaign contributions)  – will it really take another crisis? The reluctance of people who did pre-2008 macro to ditch their human capital is entirely understandable, and I’m constantly told that anyway there has nevertheless been a lot of change in macroeconomics. Still (and to repeat, this is not my field) I’d be interested to know what proper macroeconomists think about Minsky now. If Minsky is still, as the book jacket claims, a maverick shunned by the mainstream – why?

Aggregating is not adding up

I’m browsing through Alfred Marshall’s [amazon_link id=”1932512136″ target=”_blank” ]Elements of the Economics of Industry[/amazon_link]. He wrote that earlier economists:

“Paid almost exclusive attention to the motives of individual action, But it must not be forgotten that economists, like all other students of social science, are concerned with individuals chiefly as members of the social organism. As a cathedral is something more than the stones of which it is built, as a person is more than a series of thoughts and feelings, so the life of society is something more than the sum of the lives of its individual members. It is true that the action of the whole is made up of that of its constituent parts; and that in most economic problems the best starting point is to be found in the motives that affect the individual….. but it is also true that economics has a great and increasing concern in motives connected with the collective ownership of property and the collective pursuit of important aims.”

And still increasing, given the public good characteristics of digital goods. The problem of aggregation seems to me an important one, rarely discussed, and exactly where the rational expectations revolution and real business cycle theory went wrong. It isn’t only a question of heterogeneity. There’s the fundamental question raised here by Marshall, that you don’t simply add up individual preferences or outcomes to get aggregate versions.

[amazon_image id=”B00882NQLM” link=”true” target=”_blank” size=”medium” ]The Economics of Industry: By Alfred Marshall and Mary Paley Marshall (Classic Reprint)[/amazon_image]

Economists? Hubris? Surely not?

The title of Meghnad Desai’s new book, Hubris, had led me to expect a jeremiad about the failings of economics, with a faint feeling of resignation. Not that the charges are (all) undeserved, just that it’s become rather familiar. However, my expectations were confounded. The book is a very accessible and clear history of macroeconomic thought, seen from the perspective of what economists have done over the decades – what ideas, what models they have used. It makes an excellent follow-on companion to Tim Harford’s [amazon_link id=”B00ABLJ6OE” target=”_blank” ]The Undercover Economist Strikes Back[/amazon_link], being a bit less general, and introducing more economic terminology and verbal (largely) descriptions of models.

[amazon_image id=”0300213549″ link=”true” target=”_blank” size=”medium” ]Hubris: Why Economists Failed to Predict the Crisis and How to Avoid the Next One[/amazon_image]

A lot of the material covers territory that will be familiar to professional economists, but it is set in the context of how macroeconomics got itself into the position of being not only unsuccessful at predicting the financial crisis but literally unable to do so. Macro models excluded the logical possibility of sustained and serious disequilibrium. Desai also includes some economists who are not part of the usual story, for reasons that become apparent in the final section of the book. Marx and Hayek of course, but also Kondratiev, Wicksell, Richard Goodwin. (I’d never heard of Goodwin – he provided a mathematical, ecology-inspired model of the wage share.)The book explains how alternative views came to be not even attacked, simply ignored, in modern macro. It includes a section on Keynes and the reinterpretation and reinvention and finally co-opting of ‘Keynes’ over the years

The final section sets out briefly Lord Desai’s own framework for macroeconomics. He sees the evolution of the economy in the aggregate as the outcome of a disequilibrium process, with Kondratiev cycles driven by demography and technology and shorter “class struggle” cycles of changing labour and profit shares superimposed, in the context of a globalised economy. This is clearly more realistic than some of the DSGE macro models that are clinging on to life, albeit less useful for forecasting.

The long wave perspective is quite interesting and plausible. One other point that I wholly agree with is the narrowness of traditional macro models in their nation by nation focus: “National income data began to be estimated and published in a small way in the 1930s. After the war and thanks to the Keynesian revolution, national income measurement became a pivotal tool of policy making … This has shaped the themes and strategies of research in macroeconomics. New classical macroeconomics has been very much concerned with analyzing US time series. … The older tradition had less accurate data but it’s vision was systematically global rather than inter-country.”

The book also, rather gloomily, sees the world as being at the start of a long wave downturn, in for a structural version of secular stagnation, with decades of falling prices ahead. “Could the global economy  repeat the 19th century’s experience of the Great Depression of 1873-96.”

I’m not so gloomy but this might be possible. It would anyway make enormous sense for macroeconomists to link their work with growth theory and thinking about innovation, including work on long cycles such as [amazon_link id=”1843763311″ target=”_blank” ]Technological Revolutions and Financial Capital: The Dynamics of Bubbles and Golden Ages[/amazon_link] by Carlotta Perez. Mind you there are lots of things it would be sensible for macroeconomists to do, but the hubris lingers on.