Capitalisn’t: The Causes and Effects of Today’s Inflation
- February 03, 2022
- CBR - Capitalisnt
The US Federal Reserve may hike interest rates in March due in part to high inflation. But where did this inflation come from? Is it transitory, or is it here to stay? Whom does it hurt the most, and what should be done about it? To discuss these questions, Capitalisn’t podcast hosts Luigi Zingales and Bethany McLean speak with Chicago Booth’s Raghuram G. Rajan, who—when he served as governor of the Reserve Bank of India—was charged with fighting inflation himself.
Raghuram G. Rajan: There used to be an old saying, I think it was William McChesney Martin who always had the best Fed sayings, “When you see inflation in the eyeballs, it’s too late.” Maybe it was someone else. But the Fed sort of threw that out of the window. It said, “We’re going to stare inflation in the eyeballs and wait some more.”
Bethany: I’m Bethany McLean.
Phil Donahue: Did you ever have a moment of doubt about capitalism and whether greed’s a good idea?
Luigi: And I’m Luigi Zingales.
Bernie Sanders: We have socialism for the very rich, rugged individualism for the poor.
Bethany: And this is Capitalisn’t, a podcast about what is working in capitalism.
Milton Friedman: First of all, tell me, is there some society you know that doesn’t run on greed?
Luigi: And, most importantly, what isn’t.
Warren Buffett: We ought to do better by the people that get left behind. I don’t think we should kill the capitalist system in the process.
Bethany: Inflation, it’s a topic on everybody’s minds today. People actually know who Jerome Powell is, because they’re concerned as to what’s going to happen with inflation. Is our current problem with inflation as simple as supply chains getting jammed up in the pandemic? Is inflation transitory, or is it here to stay? And, perhaps most importantly, who benefits and who loses from increased inflation?
Luigi: To discuss this important topic with us, we chose to bring in not only a top economist, but also somebody who was a central banker and, as a central banker, was able to fight inflation. So, he knows from direct experience. This somebody is Raghu Rajan, the former chairman of the Reserve Bank of India.
I think that maybe we should get the listeners on board with some basics. Then we can go deeper, but we need to do something basic at the beginning. I think that a lot of people, me included to some extent, would say, “Why do we have inflation today?”
Bethany: OK. Although I don’t think that that’s a very basic question. But fine, let’s not argue at the start of our podcast. Let’s start by asking our wonderful guest. Why do we have inflation today?
Raghuram G. Rajan: Yeah. What contributes to inflation? One standard way inflation goes up is when people get worried about inflation. They think prices are rising around them, they go to their boss and say, “I want higher wages.” If everybody does that, wages go up, but then bosses increase the prices of stuff that is sold by the firm, and then prices go up. Then people see those prices and say, “I need higher wages to buy that stuff.” And this is what is called wage-price inflation.
That’s what central bankers fear the most, where you get into a spiral, where inflation feeds on itself, and at some point, it reaches a really uncomfortable point where people don’t want to hold money. As soon as they get paid, they take the money to the nearest shop and buy something. This is when you get close to hyperinflation.
Luigi: Sorry, Raghu, Milton Friedman used to say that inflation is always and everywhere a monetary phenomenon. And in your story, you didn’t even mention money supply.
Raghuram G. Rajan: Yeah. Well, nowadays, the new macroeconomics thinks of it as an expectations phenomenon more than anything else. What you don’t want to happen is for people to start getting the sense that inflation is entrenched.
The problem with looking at monetary aggregates is they no longer seem to be that reliable. Between the global financial crisis and the pandemic, the Fed expanded its balance sheet but didn’t seem to see a rise in deposit creation and loan creation out there. That was one reason why, in the past, people have moved away from looking at just monetary aggregates. In times like the ones we experienced, in between crises . . . I almost want to keep saying . . . I want to say, in between war years. It seems like, in between crisis years, it seemed like the Fed was pushing on a string by expanding its balance sheet.
Bethany: Before we continue that thread, can we back up on the topic of basics to have you explain, what are the Fed and central banks in general supposed to do with inflation? What is their role in controlling inflation? And can they actually do that?
Raghuram G. Rajan: Well, essentially, what the Fed can do is slow down activity. What the Fed can do is slow down demand, not so much increase supply. This is why it’s very important for people watching the Fed, is this inflation created by supply shortages only? And if they’re temporary supply shortages, and you believe that supply will come back, then it’s not a problem the Fed can really solve. It can’t get supply-chain snafus to get . . . It can’t deal with those simply by changing interest rates. And so, it has to allow that one to unwind.
The problem comes when it’s really a question of strong demand. And what the Fed can do is slow down demand by raising interest rates, essentially causing the interest-sensitive sectors of the economy to slow down. So, for example, construction. If you raise interest rates, raise mortgage rates, people stop buying housing. That reduces the pace of construction, and that slows down the economy.
Of course, that comes at a cost, because as you slow down demand, then people are fired by the construction industry. It slows down the demand for wood, for cement, for steel, and those industries also start laying off people. The economy slows, but it can come at a cost of greater unemployment.
And typically, the Fed would like to calm things down, not slow it too much so that there isn’t too much more unemployment. Typically, it’s unsuccessful. Why does slowing the economy make any sense under any scheme of things? Why does a little more unemployment make sense?
Well, because it keeps inflation down, and then you can enjoy many more years of strong, low-inflation growth. But tell that to the guy who’s just lost his job. So, I mean, this goes back to a broader issue, which is, what is the trust between the political class, between the public and the professional class? Economies run well when the professional class has earned the trust and then are allowed to go do their stuff. Because much of what the professional class does is sometimes hard to explain. You have to have a strong sense that this guy is raising interest rates, not because he wants to tank your government and tank the economy, but because it’s in the long-term interests of the country. And it’s a hard sell. I think the problem is, when there is lack of trust . . . and what was it? The Mencken saying, “Every complex problem has a simple solution, which is wrong.”
I think that’s where we get populism. They have very simple solutions, which are typically wrong, but that’s because you can’t explain the complex solution more broadly, and there’s no trust in the elite that they will do the right thing.
Now, last point. I said, when there’s a supply constraint, you typically can’t solve that by the Fed acting. But if the supply constraint is more permanent, or if that supply constraint then creates anticipation of stronger inflation, and you get the wage-price spiral that we talked about earlier, then the Fed may recognize: “Well, there’s really a mismatch between supply and demand. We need to also contract demand to match the lower supply.”
And typically, if these supply constraints are longer-term, that’s when you do that. So, if these pandemic constraints were transitory, as the Fed said for a fair amount of time, it won’t worry about it. But then, they retired the word transitory, because they saw it was much longer-lasting, and it was also feeding into the labor market. The labor market was very tight, and they said: “We really have to do something about this now. We can’t wish it away.”
Luigi: Last year, the CPI, the consumer-price index, went up 7 percent. The index that the Fed uses that is not the CPI—it is the personal-consumption expenditure—we don’t have the full number for the entire year, but it was 5.7, 5.8 percent. The target of the Fed is 2 percent. They’re basically three times target with inflation very low, and they still have not stopped buying bonds. Isn’t the Fed dramatically behind the curve?
We interviewed Mervyn King on this podcast last year, in March, April. And he was forecasting disinflation. We asked him, “Can you give us the best case against inflation?” He couldn’t come up with anything decent to argue. So, this is not unforeseen. And my fear is simply that the Fed doesn’t have the courage to fight to keep prices stable.
Raghuram G. Rajan: Look, I wouldn’t disagree. Well, let me put it this way. There are a fair number of people who have been saying that inflation is coming, inflation is coming. And I count myself amongst them. We’ve been dismissed as broken clocks. “You’ve been saying inflation for a long time.” Part of the problem, to some extent, is many central bankers have been in a sense, prisoners of the last war. The last war was disinflation, desperate to get inflation up. Amongst the things the Fed did was essentially move towards average inflation targeting, without telling you what average over what period. Basically, if you have a long enough average, you can bring everything down to two, right?
Average inflation targeting without telling you what period they would be computing the average over gives them tremendous flexibility. This flexibility was useful when the objective was to get inflation up, because you are trying to tell people, if inflation goes beyond 2 percent, we won’t worry too much, because we really want it to go up a little bit. And to some extent, for people to have higher inflationary expectations, you should hope that the Fed won’t intervene too quickly if inflation goes above the 2 percent target, assuming that it’s really hard for inflation to go up much higher. And so, what you want as the Fed is what Paul Krugman once called “the ability to commit to being irresponsible.”
In other words, don’t act at the first sign of inflation. Let inflation go up a little bit more. And that’s the way to get inflation up from the low levels at which it had been. And the Fed was underperforming its inflation target. I think over the last 10 years, the average inflation was 1.2 percent, while the inflation target was 2 percent. So, all that was to the good when the problem was low inflation.
The problem is that the inflation framework came into play when the problem has become high inflation. And you might say: “Well, what’s the problem? It gives you more flexibility.” Yeah. But when it’s high inflation, you really don’t want all that flexibility, because you want the backbone to attack inflation as you see it.
There used to be an old saying, I think it was William McChesney Martin, who always had the best Fed sayings, “When you see inflation in the eyeballs, it’s too late.” Maybe it was someone else. But the Fed sort of threw that out of the window. It said, “We’re going to stare inflation in the eyeballs and wait some more until we know it’s truly, truly there.”
And the problem, of course, is that with the flexible framework, if the Fed acts now, and as is typical with the Fed tightening, the economy slows down, Congress is going to be hopping mad. “We just spent $6 trillion getting you the best recovery that money can buy, and you just tanked it with a few interest-rate hikes.”
The whole point of having a strong framework was so that the Fed could ignore Congress. With a flexible framework, Congress is going to ask: “You’ve got a flexible framework. Why didn’t you use the full flexibility? Why did you act precipitously in raising interest rates?”
Put differently, you’re saying, “Why didn’t the Fed move earlier?” I think they’ve moved as fast as they could, given the framework they have. Now they’re saying, “Well, we’ve said 3 or 4 percent, it’s 7 percent, maybe we should act.” And of course, they’ve got another element in it, which is, “We won’t act before we stop buying securities, and we told people we would buy securities ‘til March.” So, they’ve sort of locked themselves in.
Part of why they’re locked in is because the Fed moves slowly, deliberately, and tries to telegraph what it wants to do. The problem when inflation is rampant is that may make them too slow. Of course, people are saying: “Well, if you act in March, act more decisively at that point. Raise interest rates, not by 25 basis points, but by 50 or more.” And so, there are a lot of calls for the Fed to move faster when it does move. But the reason why it’s moving relatively slowly is because they changed the framework in order to deal with the previous problem, low inflation.
Bethany: How problematic is the layer of politics surrounding the Fed? And is it new in the history of the Fed or in the history of central banks, or thus it’s always been? And what I mean by that is that the Fed, feeling itself the only game in town in the decade between the war years, I’ll use your framework, made a big deal about its ability to solve unemployment by lowering rates to help fix the unemployment crisis. And now it strikes me that it’s awfully hard for them to go back to Congress and say, “We’re going to cause unemployment.”
And is that a new phenomenon that the central bank is more entrenched in politics, perhaps, than it was in the past? And maybe part of that is also because now Congress has seen what the Fed can do. And we saw what the Fed could do in the financial crisis, but we really saw what the Fed can do with the pandemic, right? And that ups the ante for the Fed in some interesting ways, it seems to me.
Raghuram G. Rajan: It’s a great point. I do think that central banks have inserted themselves into politics by doing a fair amount, but also claiming to be able to do a lot more. So, central bankers will never tell you, “We’ve run out of tools.” We always have a bazooka or two that we’ll still bring out if need be. And I think this is a little bit of the problem, the expectation that the central bank can do anything and that it’s also willing to do anything, basically all the constraints on say, intervening in markets . . .
In the 1990s, everybody was aghast when the Hong Kong Monetary Authority started buying shares. There was a sense that they had crossed a line between central banking, which was basically moving the short-term interest rate, and actually intervening in securities markets.
Now, this is rampant. Every central bank intervenes in securities markets and moves long-term interest rates up, down, moves share prices up, down. I mean, the Bank of Japan has been buying shares for a long time now. So, it’s almost as if there are no constraints on what a central bank can do. And of course, if there are no constraints, politicians say, “Why don’t you do some of the things we want? And if you’re not helping us keep unemployment relatively (low), there must be something you can do that you’re not willing to tell us. And if you’re not doing it, it must be because you are an elite institution that cares only about yourself and people of your class.”
Having introduced themselves into the political arena, they also have a communication problem, which is, central banks could intervene a lot in every dimension when inflation was relatively low. You could expand the balance sheet significantly with no effect. With inflation much higher, now you’re seeing some of the costs of balance-sheet expansion. For example, given that the Federal Reserve finances itself through overnight interest rates, as interest rates go up, the Federal Reserve has to raise interest rates. What it pays people who are invested in Federal Reserve paper will keep going up, and the Federal Reserve will start making losses.
At some point—people calculate around 2.25 percent—when the interest rates go up above 2.25 percent, the Federal Reserve will have to go to Congress and say, “We’re now making losses.” And the check that the Federal Reserve writes to the federal government will no longer be there. In fact, it will require some replenishment of the Federal Reserve balance sheet over time.
These are the kinds of problems that arise once you’re in an environment of high inflation with a very large balance sheet. The costs of financing that balance sheet start going up. You didn’t have much cost when inflation was close to zero and you were paying close to zero interest rates, but once inflation picks up, all these new problems will come. Lots of interesting developments waiting to happen.
Bethany: You touched on this a little bit before, but I wanted to go back and explore it in a bit more depth. I think there’s a tendency in our short-term-driven world to think of any inflation we’re suffering now as resulting from the pandemic and the response to the pandemic. But I think, based on what you’ve said, that you would also trace some of it back to pre-pandemic policies, namely quantitative easing, super-low interest rates. Is there a way to think about what part of the inflation conundrum is due to policies that were in place even pre-pandemic, and what part of the inflation conundrum can be traced to the pandemic and the pandemic response itself? And I know that there’s no analytical economist answer to that. I’m searching for a journalistic answer.
Raghuram G. Rajan: Well, at these low interest rates, the Fed has been trying desperately to get activity up, but what it succeeded in over time, with all these different measures, including the initial pandemic response, was to give markets a sense that the Fed had their back. And that’s problematic, because if the markets and financial conditions are strong, even as the Fed is saying, “Maybe we need tighter conditions. Maybe we need to raise interest rates,” what that means is it takes much stronger Fed action to actually move markets and cause markets to tighten financial conditions to slow down activity. But in the meantime, what that also does is perhaps create . . . when the market fully realizes that the Fed is serious, a substantial fall in financial-market prices.
And of course, that creates a whole new dynamic of its own, which is part of what we are seeing nowadays. A lot of market participants say, “Well, the Fed says four rate hikes this year, maybe.” But I don’t think they can do that, because as they start doing that, the market is going to take fright. The market will fall. And if the market falls enough, people are going to lose confidence. They’re not going to buy that Peloton they were thinking of buying. Demand will fall, and the Fed will have to back off. So, we are protected any which way. And then, I mean, it creates strange dynamics, because the Fed can’t slow down the economy until it moves interest rates in a really serious way that’s really tough. And then that could create more of the fall. It creates weird dynamics.
The market-Fed interaction didn’t used to exist before. As the Fed has come out with a whole set of new tools, as the Fed has come to back the market when the market falls significantly—as, for example, happened in December 2018 and has happened again with the pandemic—there is this strange dynamic playing out.
The third problem, I think at this point, is really government debt and Federal Reserve debt. That with government debt so high, as you see increases in real interest rates, in order to slow down activity, the Fed will have to get real interest rates up. In other words, the difference between the nominal interest rate, which is the interest rate the Fed can affect, minus the inflation rate.
If the Fed starts moving real interest rates up, the cost of servicing all this debt . . . Remember, debt to GDP in the US is now 125 percent. It was much lower in the past, but the costs of servicing that debt will also increase quite substantially as the government has to pay higher real interest rates. And of course, the Fed also has a large balance sheet. The Fed will have to pay. That’s basically what you want to look at, the combined balance sheet. And if the combined balance sheet has a lot of short-term debt, which reprices quickly as interest rates pick up, you’re going to see the fiscal costs show up quite quickly.
And when you have debt to GDP of 125 percent, the cost can be quite substantial very quickly. I mean, assume we go to a real interest rate of 2 percent, and let’s say the real interest rate over the last so many years was -0.5 or -1. You’re talking about a 3 percent increase in real interest rates, which means a 4 percent increase in your budget deficit as a fraction of GDP. That’s a pretty significant amount. It makes all this infrastructure bill and all look like peanuts in comparison.
Luigi: But so, do you think that substantially we’re going to have high inflation because the Fed and the political system in general don’t want to scare off investors before the midterm elections? Every time you raise interest rates, you’re going to have an impact on the 401(k)s of a lot of people. And they’re going to be very unhappy if their 401(k) goes down. So, it used to be the case that the Fed was afraid to tighten up because of unemployment. It seems that now it’s more afraid to tighten up because of the financial markets.
Raghuram G. Rajan: Well, it’s a balancing act. I don’t think the Fed . . . If you asked any of the Fed voting members, “Are you taking the financial markets directly into account?” They would say, “No. God forbid that we do that.” But indirectly, they have to pay attention for the very reasons that the market understands. If the market tanks, all those guys who are now spending some of their winnings in the market by buying a lot of goods and services are going to back off. This is the famous wealth effect. There is a sense that economic activity can slow down considerably.
It could also bring some of the people who’ve retired on the substantial increases in their 401(k) back into the workforce as they realize that some of that has evaporated. So, which way all this moves is hard to tell. What I’m saying is, the Fed is in an environment it hasn’t been in before. I think we are going to get a fair amount of the need to fight inflation. And the Fed will have to make some moves. And then, a lot depends on how the complex interaction between the market, the financial market, the labor market, and the Fed sort of plays out.
Luigi: OK. Thank you very much, Raghu, for your time. That was fantastic.
Raghuram G. Rajan: Thank you. Bye.
Bethany: I’m always fascinated by economic concepts that seem obvious and predictable, and like everybody understands them, and then when you actually look closely at them, it turns out nobody really understands them. And so, I think inflation is one of those things. It’s an obvious word. We all know what inflation is. It matters a lot. And it turns out that economists don’t necessarily understand it, for sure can’t predict it. And even don’t recognize it necessarily when it appears to be happening. And I find things like that, that are on the surface very straightforward and underneath, anything but straightforward, to be really fascinating.
Luigi: I think that the problem is actually more severe, that the incentives might not be in the right place. To be honest here, a lot of people have predicted inflation. A lot of people who did not predict inflation admitted they were wrong. I listened to two debates between Paul Krugman and Larry Summers, one year apart. And in the second one, Paul Krugman was very honest in saying, “I was wrong.” What is very complicated and where, honestly as economists, we still don’t know a lot, is how expectations get ingrained in the economy and how they get transmitted and so on, so forth. The fact that there was a push, a cost push to our inflation because of the disruption in the supply chain, because of the adjustment of the economy, all of a sudden, we spent much more on goods and much less on services.
And the economy’s not so flexible. If, all of a sudden, everybody wakes up one day and they want a Peloton bike, the price of Peloton bikes will go through the roof. And now everybody’s sick and tired of the Peloton bike, and the Peloton bike company is almost in crisis, and you can find them secondhand at a fraction of the cost. So, these spikes do occur.
Now, the question is, to what extent do these spikes get ingrained in mechanisms so that not only a few products would get more expensive, but everybody expects to receive a higher salary and so demands a higher salary? And then that higher salary is incorporated into the price, and so on and so forth.
Bethany: But when you say economists were widely predicting inflation, there was one group of economists who weren’t. And correct me if I’m wrong, or if this is too much of a blanket statement, but the Fed itself was saying there would not be inflation. You mentioned incentives and with the incentives to not say there’s inflation. So, let’s pause on that before we go to this question of how inflation expectations can shape inflation itself, because I think this idea of incentives is very important.
We talk a lot . . . One of the key tenets of the United States is that the Federal Reserve is independent, but there have been times in its history where the Federal Reserve has not been so independent. And I don’t know if that’s what you meant by the question of incentives, but independence is a tricky concept, right? Especially when there is something that is such a political hot button like inflation.
Luigi: Yeah. I am a little bit at odds with most of the economics profession, because most of the economics profession is enamored with this independence of central bankers. Number one, this is a little bit exaggerated. What does it mean, really, independence? It means who you cater to in your decisions. The Fed might be more independent from the politicians, but it might be more dependent on Wall Street.
If I want to step down, and I want to go and give speeches and be celebrated as a big hero on Wall Street, if I cause a 30 percent market crash on Wall Street, I think my chances are probably not very good that I’m going to give a lot of good speeches on Wall Street, and I’m going to be loved on Wall Street. Now, it doesn’t mean that I necessarily act only in the interests of my speeches, et cetera. That is too narrow, but I think we’d be foolish and would be the only place in the world in which economists think that money does not have an impact.
Bethany: I want to ask a question about that. I’m looking at a quote from Mohamed El-Erian that he said back in the spring of 2020 in this chapter I’m writing. And he said, “The market feels very strongly that it is basically holding the Fed hostage.” But is this a good thing or a bad thing? In other words, these competing conflicts or incentives that you’re outlining that challenge the independence of the central bank, are you simply being a realist and acknowledging that they exist, or would you argue that they should exist? That it’s a good thing to have these competing conflicts out there.
Luigi: Certainly, I’m a realist. I recognize they exist. Most American economists are not. One of the few advantages of being Italian is that you see things so clearly because they’re not even covered up in Italy, that you kind of see cynicism everywhere. In America, there is a little bit of a coverup. Unless you’re really cynical, you don’t see them. It’s not that they don’t exist in America, it’s just that they’re sort of protected better. What is disappointing is, I can see that maybe the chairmen lean a little bit in one direction or the other. You would expect that the research departments should be independent and should say what they really think because they’re objective economists.
Now, two of my colleagues wrote a very nice paper looking at research on quantitative easing. Funny thing is that if you work in a central bank, you think that quantitative easing is great. If you don’t work in the central bank, you think quantitative easing is less great. Research, surprise, surprise, is impacted, or the outcome is impacted, by incentives, which is something that any economist should think is obvious. But now, I made this point several years ago in an article, and everybody has booed me by saying, “No, no, we do science, and we’re not impacted by incentives.” And I said: “Wait a minute. We do science in a vacuum?”
Bethany: How broadly is the economics profession affected by the Fed? It seems from your description of this paper that maybe it’s not so much. It’s economists inside the Fed and outside the Fed. But I was talking to someone for this book I’m working on who pointed out to me that the Fed is one of the larger employers of economists out there, and that most economists want at some point in their career to pass through the Fed, or they certainly want to be included at Federal Reserve conferences and be featured speakers, et cetera, et cetera. And so, there’s a widespread incentive throughout the economics profession not to do anything to displease the Fed. Is that true, in your experience?
Luigi: I think that that statement is a little bit exaggerated but is not completely wrong. It’s costly to be outside of that club, let’s put it this way. Are you going to distort reality in order to belong to the club? Hopefully not, but on the margin, you’re more likely to say something softer, but it’s not only at the Fed. Think about this also in international circles. I don’t want to sound like this crazy conspiracy theorist, but central bankers do meet regularly in various places. And to be fair, occasionally I have been invited to some of these meetings.
It is a small club. People who kind of violate the norms of that club, they are kept outside. So, people are very careful not to be kept outside of that circle. I think this is actually some manifestation of the phenomenon that social psychologists call groupthink. And that is particularly pronounced in groups that feel superior to the rest of the crowd, and central bankers clearly are in that group. So, I think it’s very, very appropriate.
Let’s come back to that question you raised at the beginning about the idea of the expectation of inflation actually helping to dictate inflation. How much of the phenomenon is that? Is there a way to separate it out and say, “OK, pause, world. If we all agree that we’re going to collectively believe there’s no inflation, does that mean there won’t be inflation?”
Luigi: At some level, yes. The problem is, how do you maintain that collective belief in spite of the evidence? If there is a shortage of waiters, the prices of restaurants probably will go up. And in fact, we have seen prices going up and quality of services going down.
Now, the question is, I am a factory worker and I see the costs at my diner going up, I ask for a higher wage. Now, if everybody asks for a higher wage, eventually inflation will become generalized. If I, a worker, decided not to ask, or I ask and I don’t receive, probably there will be just a relative price adjustment, but nothing more.
But in the process, I, worker, end up being a little bit poorer, because I receive the same salary, and my daily lunch costs more. And so, if I need to accept more reduction in the standard of living, then inflation is not going to continue. And so, this is when I want to make my pronouncement, that Milton Friedman used to say that inflation is always and everywhere a monetary phenomenon. I want to change it and say that inflation is always and everywhere a political phenomenon. Because inflation is the result of a fight for income distribution. And the question is how that fight is going to be resolved.
I sort of intuited that as a kid growing up in Italy in the 1970s, when there was a period of very massive social unrest in Italy, and the result was very high inflation. In the same period in Germany, there was no major social unrest. Inflation was kept very low. Think about the situation in the United States. Until very recently there wasn’t a lot of social unrest. Inflation was very low. Now there is major social unrest and surprise, surprise, you see inflation going up. So, the way in which I think you want to think about inflation is thinking very simply about demand and supply of inflation. Who is in favor of high inflation? In principle, everybody says, “No, I am against it,” but the point is, who might benefit from high inflation, and who might lose from high inflation?
And you know that typically the big losers in unexpected inflation are people with a nominal claim. So, they are either bondholders or retirees on a fixed salary. However, think about it, in this moment this constituency is at the weakest historically in the United States. Why? Because most bonds . . . not most, but a big chunk of the bonds are held by the Fed. So, it’s not that you and I lose because there is unexpected inflation. This is all in the federal budget.
Number two, a disproportionate amount of retirees now are, or start to be, on a fixed-contribution, defined-contribution pension rather than defined-benefits pension. If I am a defined-contribution retiree, I care more about the stock market than I care about the bond market or about inflation.
Now, in the old days, in the ’70s, people were saying that inflation led to lower stock prices. Today, I was looking at some stock reports. People correctly today use the real expected rate to discount shares. So, today, because of inflation, this real expected rate is negative. Stock prices are really high. If you had to fight inflation and bring the rate to a more positive territory, stock prices would go down.
Bethany: I like this theory. I love the idea of it being a political phenomenon rather than a monetary phenomenon. But I want to push back on one aspect of this and then ask you to explain something a little bit more that I don’t entirely understand. The part I want to push back on, I’m not sure you’re right about retirees, because the very, very, very low inflation and super, super low interest rates are making it very hard for pension funds to earn a return.
And I think if you looked at it, the majority of retirees are still dependent on their pension funds, and pension funds are in crisis, in part because they can’t earn a good return on their bond holdings. They’re funneling desperate chunks of money to private equity in an effort to get their returns up to the level that they need to be. And a lot of retirees today, I think, live on fixed income. Where I might be going wrong here is that higher inflation may not necessarily be correlated with higher interest rates. I think it eventually is. The question I had is, why would . . . I’m not sure I’m clear on why the Fed would benefit from higher interest rates.
Luigi: Think about the Fed as simply a driver that follows directions given by different social pressures. There’s no doubt that in the late ’70s, early ’80s, there was huge pressure to keep inflation down. We forget now, but a Democratic president, Jimmy Carter, appointed a governor, Volcker, who fought inflation by bringing interest rates through the roof. And that was an extremely politically costly move, but it came at a time when people were fed up with inflation. I think now the question is, let’s look at who in society pressures for high and low inflation. On the retirees, Social Security is indexed to inflation, as far as I know. Social Security benefits increased 6 percent in 2022, thanks to the inflation the previous year.
So, they are covered with indexation in a way that most people are not. There is a component of people who have a lot of their retirement in bonds, and they clearly suffer now, but they’ve been suffering for a long time, because interest rates have been low for a long time. And, as you said, eventually, when interest rates would go up, they might benefit, but at the moment, they’re not doing particularly well. And most of them have moved to the stock market, because that’s the only way, with basically a zero interest rate on government bonds, at least in the short term, you don’t support yourself in retirement without moving everything into the stock market.
And so, you do depend on the stock market, and the stock market depends on the real interest rate. And so, if I, all of a sudden, need to produce disinflation, so I need to reduce inflation, I need to raise interest rates and bring the real interest rate into positive territory, which will negatively impact the stock market.
Bethany: I still don’t agree with this argument, because something like 80 percent of stocks are owned by the wealthiest Americans, and the bottom, say 50 percent, of America owns no stocks whatsoever. I’m guessing at the numbers, but the dispersion, the magnitude, is shocking. And so, for all those people who don’t own stocks and aren’t benefiting from inflation, even if they don’t have a bond portfolio or a pension that needs returns from a fixed-income portfolio, they for sure are going to suffer from the increased cost of milk, the increased cost of food at grocery stores, that will not be affordable.
I actually see inflation as hurting lower-income Americans far, far more than it helps, and hurting a really broad spectrum of lower-income Americans, because people don’t have stock-market wealth. And I think that’s one of the major things that . . . Back to our conversation with Raghu, I think that’s one of the major things that post-financial-crisis policy got wrong, is that it primarily benefited people who already owned financial assets like stocks and left a whole host of people behind. And now, as inflation is kicking in, thanks in part to those policies that boosted stocks to crazy levels, those people are also going to bear the cost, bear the brunt, of rising prices.
Luigi: I completely agree. I’m not saying that inflation is good for everybody. I was trying to outline a political economy of inflation, starting from who benefits, and you anticipated correctly who is going to lose out in this game. Now, the question for you is, imagine I tell you that the top 20 percent of the people in the income distribution benefit, and the bottom 50 percent lose, who is more politically influential?
Bethany: Oh, right. The top. I thought your argument was that a broader swath of Americans benefited from higher inflation than we thought. I don’t think the swath is very broad at all. I completely agree with that last point, which is that, if the top 20 percent, even the top 2 percent, is going to benefit, then that’s what we’re going to do. It doesn’t matter if it sucks for everybody else. I think we’ve proven that in our policies for the last decade, if not longer.
Luigi: No, but also, think about the groups that tend to be very influential in our political system. Number one are the rich people, we already said. Number two, they tend to be the older people. Why? Because they have more time and they were . . . And that’s the reason why I emphasize the retirees, because I think in the ’70s, the retirees were a big constituency against inflation. I don’t think it’s there anymore.
Bethany: That’s where we disagree, because I think it’s what retiree you’re talking about. If you’re talking about the older, well-off retiree with a big portfolio of stocks, yes. I think you’re right. If you’re talking about most retirees across America, I think you’re wrong, because they don’t own stocks, and they are going to be hurt terribly by the rising cost of necessities.
Luigi: Yeah. But compare a retiree with an employee of McDonald’s. They both are not particularly wealthy. Now, the retiree, as far as I know, has an automatic indexation of Social Security. So, he or she does not need to do anything and is hedged against inflation. If I am the employee of McDonald’s, I don’t have a natural . . . And remember that we discussed with Eric Posner all the literature about monopsony.
One thing that comes out of that literature is, employers seem to have disproportionate bargaining power vis-à-vis the employees. In the ’70s, what in part brought the other side to the table with inflation is that there were very strong unions that kept demanding higher and higher wages.
And so, if I was on the side of the managers or the rich people, et cetera, I said: “Wait a minute, this is an escalation. We need to slow it down.” But today, this is not true. Today, the employee of McDonald’s this year is 7 percent poorer, and he actually needs to act or to threaten to leave or to do all these things in order to simply catch up to where he was last year. I think that the retirees are better off than the employees.
Bethany: I think I agree with that, and I agree with the broader point you’re making. I definitely agree that the retirees are better off than the McDonald’s employees. I simply don’t know how much retirees can live on just Social Security and how dependent retirees might be on a fixed-income portfolio, and how much even retirees living on Social Security are affected by the cost of staples like food and gas.
Luigi: If they don’t live only on Social Security, they’re living on something else, which is a portfolio. This is the fraction that you call rich, because they have a portfolio. How is that portfolio allocated? And I’m saying that after 10 years of zero rates, I don’t think that that portfolio is much allocated in bonds.
Bethany: I think this becomes a much more complicated question, and it might not be worth getting bogged down in this, because a lot of those people are dependent on payments from their pension plans. Pension plans are in very shaky territory because of years of very low interest rates. As a result, they’ve sunk a lot of money into private equity in a desperate hope that it’s going to be able to make up the returns they haven’t been able to get. So, the phenomenon is just broader than that. But I don’t know the numbers.
I don’t know that anybody has ever looked at this and said, “OK, let’s take the entire class of retirees in America, and let’s look at what they live on, and what would benefit them and what would hurt them across all income spectrums. And who’s in what bucket?” I’m arguing just theoretically that, I think, based on belief, that there are a lot of people that higher interest rates would help, but I don’t know the answer to that.
Luigi: But suppose that we are very cynical. And I’m not saying that’s the case. suppose that Jay Powell does whatever Joe Biden asks him to do. What does Joe Biden want as far as inflation? And so, let’s go and say, who voted for Joe Biden? Especially the marginal voters are kind of suburbanites, pretty wealthy individuals. The counties with the lowest level of wealth went disproportionately for Donald Trump. On the margin are people that are relatively rich and that relatively benefit from inflation.
Bethany: Agreed. You and I are in agreement on the broader point. We’re breaking down on one little micro aspect of this point that I think is not worth arguing about, but I think Biden has actually already made that clear. Didn’t he just have a pretty bad off-mic moment when a reporter dared to ask him about inflation, and he called the reporter a stupid ass or some such terminology, because he said inflation is good. Don’t you understand? Inflation is a good thing.
Speaker 10: Do you think inflation is a political liability?
Joseph R. Biden Jr.: That’s a great asset, more inflation. What a stupid son of a bitch.
Bethany: I think we already have the answer to your question about Biden.
Luigi: Thank you. So, Biden actually supports inflation. And then the question is, do we think that Jay Powell will be the guy standing against the floor, especially because if he wants to fight inflation now, he needs to raise interest rates that will lead to, in the short term at least, a drop in stock prices and a significant slowing down of the economy—which, in case Biden is not already going to lose the midterm elections enough, would be a rout? I don’t see that happening.
Bethany: I agree for a slightly different reason. I think that Jay Powell and the Fed are facing a version of what prosecutors faced in the wake of the financial crisis. And let me explain that. In the wake of the financial crisis, there was an argument that we can’t prosecute any crimes that might have happened because we just bailed out all these financial institutions. And if we start prosecuting them, they’re going to go right back into the tank, and then we did this giant bailout for no reason. So, this time in the pandemic, through all the money that the Fed threw at the system, we bailed out a lot of players. We bailed out hedge funds, we bailed out private-equity firms, we bailed out companies that would have gone bankrupt.
And if the Fed starts raising interest rates dramatically, a lot of that gets undone, because a lot of that system depends on an ever-continuing flow of cheap debt. And so, I think there’s an argument that you undo some of the rescue package that you . . . You render the money that was spent useless by cratering the system two years after you spent it, because firms that were rescued in that would be facing some of . . . maybe not the same imminent collapse that they faced in the spring of 2020, but there are a lot of zombie companies out there that are dependent on continued low interest rates. And so, it’s not just the stock market that would crater should rates rise.
Luigi: Yeah. On this point, you’re absolutely right, because one factoid that few people realize, because it’s counterintuitive, is bankruptcies of firms went way down during the crisis, not way up.
Luigi: And so, if you think there is a natural attrition of firms becoming obsolete and dying, we are overdue for firms sort of dying of natural attrition. And so, certainly, increasing rates will bring quite a dramatic cleanup.
Bethany: And now it’s time for this week’s capital-is, capitalisn’t. We wanted to focus on Larry Fink, the somewhat controversial head of BlackRock, who’s made waves in recent years for his stance on corporate responsibility. And he just came out swinging in a recent letter.
Speaker 11: He writes the following. He says: “Make no mistake. The fair pursuit of profit is still what animates the markets, and long-term profitability is the measure by which markets will ultimately determine your company’s success.” So, I asked him about whether some people who may be reading that sentence should interpret that as a bit of a walk back from previous claims that he’s made.
Bethany: He doesn’t see his stance on corporate responsibility. He sees it as totally commensurate with capitalism and that he still believes the focus should be on bottom-line profits, because if you’re doing things that are good for society and in everybody’s long-term best interests, then they’re going to be good for the bottom line, too.
Larry Fink: So, there is no walk back. I’ve always said about a corporation and its purpose, and those companies who have a strong purpose are going to have more durable profitability.
Bethany: And we wanted to focus on that. Is Larry Fink’s stance on the world a capital-is, or a capitalisn’t?
Luigi: I have mixed feelings, because on the one hand, I understand where he’s coming from. Number one, he is running $10 trillion in assets, and he has a fiduciary duty to maximize the long-term interest of those investors. So, it is impossible for him to say, “I’m going to sacrifice long-term profits in order to pursue my goals.” That would be kind of a violation of his fiduciary duty.
On the other hand, investors are interested in something more than just money. Money is important, but there are other considerations. And my favorite example is, imagine that there is a proposal in the company that says, “We want to stop the company from giving political donations to various politicians.”
This is not in the long-term interest of the company, because with political donations, they capture the regulators and the legislators, and they make a lot of money. On the other hand, as citizens, we don’t like that. So, my long-term interest is different from my long-term economic interest. And so, I want to be able to vote as a shareholder to block political donations. Larry Fink is saying, he’s not going to do it, because he only looks at the economic long-term interest.
Bethany: I agree with your second point. I think he’s saying something a little bit different, though, which is that he’s trying to insist that they are one and the same. He’s not saying that there are certain things that could not be in a company . . . that are good for the world, but that are not in a corporation’s long-term financial interest and that therefore he’s going to vote against those things. He’s saying they’re one and the same.
I think he’s trying to have his cake and eat it, too. There’s a wonderful line. My favorite closing line in literature is at the end of The Sun Also Rises, and it’s, “Isn’t it pretty to think so?” And it applies to so many things.
And this is one of those cases where, yeah, it’s really pretty to think so. It’s really pretty to believe that everything that we want to see a corporation do would also be in that corporation’s long-term financial interest, but it just ain’t so, right? And so, I think Fink is trying to have it both ways. I understand why he would want to have it both ways, I think, but that actually is sort of the question for me. He seems to have a lot invested in standing for something larger than corporate profits, and I don’t understand what he’s trying to stand for.
Luigi: Oh, I think you’re right. I think it’s a marketing ploy, because he’s afraid of being cornered for the power he has. I think that Larry Fink is probably one of the most powerful people on Earth. By controlling $10 trillion in assets, if he decides tomorrow to say, “Every CEO should jump,” every CEO would jump, because you don’t want to be on the cross . . . How do you say it in English? Crosshairs? Of Larry Fink. People realize pretty quickly how powerful he is.
And in fact, we see that Senator Warren and Senator Bernie Sanders, they actually are asking him to do X, to do Y. He’s terrified that there will be political pressure and political retaliation. So, he’s trying to say, “I can’t do anything else and I’m not that powerful. And I’m actually a nice human being that cares about the environment,” and so on and so forth.
Bethany: Right. I agree with you. I’m torn on whether it gets a capital-is or a capitalisn’t. I think it’s a capital-is, because Larry Fink has the right to say whatever he wants to say, and then we all can decide whether we’re going to believe it or not. And I don’t want him not being able to write his shareholder letter for some reason.
On the other hand, the part of it that I don’t like is that it’s not true. There’s a deceit at the core of this. There’s an attempt to have it both ways. And that bothers me innately. I like a more brutal kind of honesty than that.
Luigi: That’s the reason why both you and I are not in marketing.
Bethany: Probably true, probably true.
Luigi: But I agree with you. I think that I would like to see more honesty in that, but it’s a common feature. I think everybody tries to have their cake and eat it too. The politicians, the marketing guys, the investors, everything. And as an economist, I’m trained that everything is tradeoffs, so I’m used to thinking in term of tradeoffs. And I’m thinking about who pays for the cost of tradeoffs. I think that the decision should end up being on the shoulders of who pays the cost, because it’s very easy to be grandiose with somebody else’s money.
Bethany: Yep. I’m going to come down on the side of saying it’s a capitalisn’t for precisely the reason you just articulated, because there are tradeoffs. And if we are going to move the world forward, we have to have an honest discussion about what those tradeoffs are. And if we pretend that there are not tradeoffs, as Larry Fink is pretending there are not tradeoffs, then we’re never going to have those conversations.
And I think that that prevents us from talking about what a corporation’s real responsibilities are, and should they be to something other than the bottom line? Do they need to be to something other than the bottom line? I think what he’s doing is actually preventing a necessary conversation in corporate America. I’m going to say it’s a capitalisn’t.
Luigi: I agree. We should give a little bit of the kudos to Tariq Fancy, because he called it earlier on, in our earlier podcast, that this was just a marketing ploy.
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