It’s upsetting to see economists discussing something that you would think they would have understood decades ago.
I am talking about inflation.
Right now, macroeconomists around the world are discussing the recent rise in inflation in places like the United States.
They want to know what it is ways.
Is there anything to worry about? Do we have the right tools to manage it? Will it hurt our economies as it did in the 1970s? Or is it rather the inflation of the 1950s?
It is a huge subject. But let’s keep it simple.
Let me quickly explain what inflation is.
Next, I’ll show you why some economists think policymakers can’t forecast inflation very well, and why that’s a big deal.
What is inflation?
Inflation is one of the most important phenomena in economics.
It can also be a major factor in historical events: when inflation gets out of hand, it can cause empires to collapse, societies to collapse, and wars to break out.
So what is it?
At its most basic level, “inflation” refers to a general increase in the price level in an economy over time.
This is the phenomenon that explains why a monetary unit can purchase fewer goods and services over decades.
You can see what this means by looking at old advertisements like the Chrysler ad below, which was printed in Australian newspapers in 1973.
You couldn’t buy a new car like this for $ 7,400 today.
It shows how the value of an Australian dollar – the purchasing power currency – has deteriorated significantly over the past 48 years.
And that explains why the weekly wages have to be so much higher than before.
In the June 1973 quarter, average regular-time weekly earnings were about $ 100, but in the June quarter of that year, they were $ 1,737.
Much of this increase was necessary because the price level has gone up so much.
In fact, between 1973 and 2020, the annual inflation rate was 4.9%.
An item costing $ 10 in 1973 cost $ 96.75 in 2020.
A dollar is not what it used to be.
Where does inflation come from?
We’ll get through this bit quickly.
Inflation comes from many sources, but consider three.
Imagine a situation where everyone in the country receives $ 100,000 each and we all rush to buy a particular property.
If producers do not have time to increase the supply of this good to meet the additional demand, there will be all this additional money competing for the goods., prices will therefore increase to meet the additional demand.
Or consider a second situation.
Imagine a situation where production costs, such as raw materials or wages, suddenly increase for some reason.
A producer might try to protect his profits by passing these higher input costs on to customers in the form of higher prices for their end products.
Or consider a third situation.
Think about how during salary negotiations you always want your wages to go up a little faster than inflation so that your after-tax pay doesn’t go down.
If your bosses agree to raise wages a bit, they might try to pass these higher labor costs on to their customers, in the form of higher prices, leading those customers to ask for higher wages. to their customers. their bosses.
Thus, inflation can be fed into the system in a feedback loop, as producers and consumers are constantly scrambling for a little extra cash over time.
Another dimension to consider
But there is another dimension which is really important.
It has to do with the duration of a price change.
If the prices of certain goods and services start to rise more than normal, will the price spikes be temporary, or slightly longer term, or will they become a structural change?
The answer is crucial.
Why? Because if the price spikes are temporary, the economy should be able to absorb them without too much damage.
But if the price of a vital input in the production process, like petroleum, rises and remains high for a long time, it can harm the global economy.
In the 1970s, the price of oil rose dramatically on several occasions and remained high.
He has seen the cost of production rise for a range of goods and services, which has driven up costs. Higher costs affected demand, slowing economic growth. And workers regularly demanded higher wages to keep up with rising prices, fueling the wage-price spiral.
A lot happened in the 1970s, so that doesn’t explain all the surge in inflation during that decade.
But it was an important element.
And the spike in inflation was severe enough to convince Australian policymakers to radically restructure the economy, to try to get inflation back under control.
For the next four decades, policymakers lived in fear of this happening again.
What happens to inflation?
This brings us to the last section.
This is what makes the current inflation argument so fascinating.
As the global economy recovers from its COVID-induced lockdowns, inflation has increased this year, particularly in the United States.
Global supply chains have been damaged and this results in higher costs in the system.
Think about how the global semiconductor shortage has contributed to a shortage of new cars, and how the price of used cars has gone up as well.
Economists argue over the direction of inflation: is inflation temporary or will it be more sustainable?
Right now, institutions like the Australian Reserve Bank, the US Federal Reserve and the International Monetary Fund believe the higher rate of inflation will be temporary.
But not everyone agrees.
Last month, the European Central Bank hosted a two-day forum to discuss what monetary policy might look like in the future, and it included a debate on “the future of inflation.”
One of the panelists in this debate, Charles Goodhart, set off fireworks.
Goodhart is Professor Emeritus at the London School of Economics. It is as established as it gets. Eton College. Trinity College in Cambridge. A doctorate from Harvard in 1963. A long-time senior official at the Bank of England.
The 84-year-old had things to say.
Economists don’t have a general theory of inflation?
Professor Goodhart told the forum that the world is currently in an extraordinary situation because economists have “no general theory of inflation”.
He said economists had two theories, but those theories had lost their credibility.
“One of them was Friedman’s monetary theory that inflation is always and everywhere a function of too much money for too little good,” he said.
âNow this theory has become so discredited that central banks don’t even mention monetary aggregates at all and seem embarrassed to do so.
“Then, of course, there’s the somewhat interconnected Phillips curve, the relationship between the natural level of unemployment and the rate of inflation, and which also behaves rather oddly.”
He said the void had been filled by a “bootstrap inflation theory” in which economists assumed inflation depended on people’s expectations of future inflation.
âNow, unfortunately, it’s a very weak reed,â he warned.
“This is a very weak reed because in fact inflation expectations are much more associated … with what has happened in the past, from which people tend to extrapolate, than with what is likely. to happen in the future. “
But let’s forget the technical details.
What does Professor Goodhart think will happen to inflation in the years to come?
Cyclical and trend inflation will start to increase
He thinks the world is going to know both a cyclic and tendency rising inflation, driven by major demographic changes and the next chapter of globalization.
Regarding cyclical inflation, he said central banks plan to maintain a very accommodative monetary policy over the next few years to bring unemployment down to levels not seen in decades.
âThis will mean that cyclical inflation will increase,â he said.
On core inflation, which refers to longer-term dynamics, he said working-age populations would start to decline in many countries as populations age.
And that would see the global supply of labor shrink in the decades to come.
“All the factors that led to an increase in the workforce, the reduction in bargaining power that came with it, the decline of unions, etc., all of this will now be reversed,” he said. -he declares.
“This [will make] labor availability, to be out of your ears, to be hard to find, and people will raise wages in order to cope with the labor shortages they will increasingly face, not just temporarily.
“It’s not transient. It’s there for the long haul,” he said.
And to top it all ?
He said the current unprecedented spike in global house prices will fuel inflation dynamics in the years to come.
Anyway, if you’re interested in more, you can watch it in the video below from the 15 minute mark.
Pleasantly, the other panelists disagreed with him.
They continued to assert their âbootstrap theoryâ of inflation.