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In mid-2021, London School of Economics’s Mervyn King, former Governor of the Bank of England, joined the Capitalisn’t podcast and predicted the inflation that we see today. Now he rejoins Capitalisn’t hosts Luigi Zingales and Bethany McLean with a somewhat more optimistic outlook on what may happen next.
King, McLean, and Zingales go back to the basics to unpack what was foreseeable, and what was less so. They discuss the successes and pitfalls of economic models, the risks ahead in policy approaches, and the political pressures that might impact their implementation.
Mervyn King: If central banks say, “Oh, we’ve been successful,” and they use that fall in headline inflation to ease off in the battle against core inflation or domestically generated inflation, then they may find themselves in a situation where inflation does come down, but it sticks around the 4 to 5 percent level, and they need to take further action in order to bring it back to the 2 percent target. And that would mean a much more prolonged recession than we need have.
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.
Luigi: As our loyal listeners probably remember, we had Mervyn King, the former governor of the Bank of England, as a guest in May 2021. This was a time in which there was a debate: will inflation go up, and how much will it go up? And is it a temporary phenomenon or a more permanent one, and so on and so forth?
I asked a question to Mervyn. I said, “Can you make the case for not having inflation at this point?”
Mervyn is a very top-notch economist, so I would have expected him to have an argument, because we economists are the people of on the one hand and on the other hand, but this time Mervyn was a one-handed economist. He could not formulate a coherent argument for no inflation. And that’s the moment I started to worry. It’s only fair that we go back to Mervyn to ask, what do you expect for the future, and what does this mean for our economies?
Bethany: Yes, I thought it was incredibly prescient of Mervyn to have called inflation back in that episode. And I’m laughing to myself as you talk, because a friend just sent me a snapshot of a coffee mug, and the famous word that the Federal Reserve was using to describe inflation at that time was “transitory.” And so, this coffee mug says on it, “The coffee in this mug is transitory.”
But our loyal listeners know that we also have a usual format, and we’re going to do something a little different this time. Luigi couldn’t be present for the interview with Mervyn. And so, we’re going to listen to the interview, and then Luigi and I will discuss where Luigi agrees and where he does not agree, knowing that it is dangerous to disagree if past is prologue. So, without further ado, here’s our interview with Mervyn.
It was actually a year and a half ago that you came on our podcast, and you were almost alone in predicting inflation at the time. Larry Summers was saying there was going to be inflation, but the Federal Reserve and most central banks were saying inflation was not going to materialize. What did you see that everybody else seems to have missed?
Mervyn King: I think it’s not so much that they missed things as that they just were not looking and ignored it. Central banks were all seduced by a theory of inflation that said that inflation is driven entirely by expectations. If people believe inflation will stay low, then they will set prices and wages consistent with it staying low. But the question is, what drives expectations? What anchors expectations?
And in all the models that were created, the answer was, it’s the official inflation target. If central banks say they’re going to hit their inflation target, we’ll all believe it, and because we all believe it, that’s what will happen. Well, this is completely circular. I mean, when central banks say, “Inflation will stay low,” what they’re really saying is it will stay low because we say it will stay low, irrespective of what is going on in the economy.
It seemed to me pretty obvious that during 2020 and again in 2021, central banks decided to do a lot of quantitative easing. In other words, they printed money. And this was a very strange thing to do in those circumstances, because immediately prior to the COVID pandemic, there was a broad balance between demand and supply in the economy. What the pandemic did was to at least temporarily reduce potential supply. And the last thing you want to do in response to a reduction in potential supply is to boost demand, which is what printing money did.
This fancy theory of how inflation works should have been forgotten and replaced by the old, traditional approach, which was that inflation reflects too much money chasing too few goods. The pandemic gave us too few goods, and central banks gave us too much money. And the result, therefore, was pretty obvious. And I remember talking to Larry Summers about this, and what surprised us was that this was not a sophisticated error by central banks. It was a basic textbook error.
And it’s because all the economists working in central banks have been to the same graduate schools and studied the same very clever models. And they wanted to believe in these clever models, and they just forgot that if you got too much money chasing too few goods, you get inflation. And it really is as simple as that.
I think models can be very useful. But what they’re good at is helping you to think through something that’s very complicated, and you abstract from lots of things that are going on, and you’re trying to focus in the model on one key point of an argument and get your head around it. And then you throw the model away, and you take that insight into the world. Models give you insights, not forecasts. I think the big mistake was for central banks to think that the models that have been written down could be used for forecasting purposes. There were a number of people who did see this point and made the point, but central banks were attached to their models. I think what’s very interesting is to see how Jay Powell has now basically thrown all of that away, along with, I think, the idea of forward guidance. He must be pretty livid with his economists, I think.
Bethany: But help me understand this. How could an inflation target become a theory? I think, as you’ve said, that it seems redundant. It seems circular. It seems insane.
Mervyn King: It’s all those things. But if you go back before that, monetarism was the clear explanation of what drove inflation. And whether it was Milton Friedman really focusing on the monetary base or whether it was other people, there was this view that money lay behind inflation. And it didn’t prove to be a particularly successful forecaster during the 1980s, in particular, when there was a lot of financial innovation going on. So, people got disillusioned with this.
And I think, in combination with a wish to get away from the politics associated with Milton Friedman, people decided to construct a theory of inflation without money in the model at all. Now, at one level, this is sort of mad. It’s insane, as you said, Bethany, because inflation is a fall in the value of money. Well, how can you talk about the fall in the value of money without thinking about the demand and supply of money?
It’s quite difficult, and the trouble with it is that when you get down to simplifying the whole point of it, you need something to determine the nominal side of the model as opposed to the real side of the economy. And the only thing they had was the inflation target. But that is circular, as you said. The whole value of looking at money is not to pretend that it’s a mechanical guide to policy at all, but it’s a check.
And when people in the spring of 2021 should have noticed that the amount of broad money in the American economy was rising at 25 percent a year, the fastest rate since the end of the Second World War, the main question you should then ask is, “So, what’s going on?”
Bethany: You mentioned that you thought Jay Powell was quite angry at his economists and was thinking differently now going forward. Is he thinking differently? Is the Fed thinking differently? Are central banks thinking differently? Do you think economists will be trained differently, or is this adherence to models and belief in them so overwhelmingly appealing that nothing will change?
Mervyn King: Well, I fear that the adherence to models as the criterion that one uses to judge an economist or someone, whether they should get tenure in a university or have done well in their exams, it’s pretty much ingrained. And I think we need to find ways of relaxing it. But it isn’t so much the models as such as the way they’re misused. I don’t know what Jay Powell thinks now, but there’s a big shift in the tone of his speeches.
He’s abandoned forward guidance. He’s gone to meeting-by-meeting decisions. That’s what should always have been the sensible thing to do. And what I find most striking about his speeches is that the person he talks about most now is Paul Volcker. Now, of course, Paul Volcker was the most unpopular person in the US when he raised interest rates to 20 percent to combat inflation. But 20 years later on or 40 years later on, he is St. Paul.
And I think Jay Powell has a very good understanding that he doesn’t want to be known as the Arthur Burns of the Fed, who was the chair who thought about trying to bring inflation down but never did it to the extent that was needed. So, he left behind a legacy of high inflation. He wants to be the Paul Volcker, mark two, and to be known as St. Jay, or St. Jerome, rather, would be better, I think, in a few years’ time.
And I think, therefore, he’s not going to be easily pushed away from a path of raising rates to a level that will bring underlying inflation back to the target. In one sense, the problem is not continuing because, whereas in 2020 and ’21, central banks printed far too much money, this year, they have not done it at all. And so, the rate of growth of broad money, for example, has fallen to really pretty low levels.
In due course, underlying inflation will indeed fall back towards the target. Underlying inflation—I like to think of it as domestically generated inflation, but you could think of it as core inflation—is essentially excluding temporary movements that have been brought about by sharp changes in individual prices, like from overseas, which could be the exchange rate. But in the case of the US, it is more likely to be global energy prices and global food prices.
The problem, I think, is that having allowed inflation to rise and lost credibility, the split of a given part of nominal demand over the next two to three years may be much more in terms of inflation and less in terms of real growth. And so that I think inflation, underlying inflation, core inflation, could prove sticky. That remains to be seen. But we’ll find out.
I think in Europe, the bigger risk in all this is that because headline inflation is maybe twice as high as core inflation . . . Headline inflation is simply the change in, say, consumer prices that are measured by the CPI inflation and will almost certainly come back down next year, because it’s unlikely that, whatever happens in Ukraine, energy prices and food prices will continue to rise at the rate they did earlier this year. That headline inflation will fall pretty sharply.
If central banks say, “Oh, we’ve been successful,” and they use that fall in headline inflation to ease off in the battle against core inflation or domestically generated inflation, then they may find themselves in a situation where inflation does come down, but it sticks around the 4 to 5 percent level, and they need to take further action in order to bring it back to the 2 percent target, and that would mean a much more prolonged recession than we need have.
Bethany: So, where are we now? Or maybe a different way to ask this is, what are the big risks that central banks should be thinking about now?
Mervyn King: I thought for a minute you were going to tempt me into trying to make a prediction, but I won’t make predictions. But I’ll talk—
Bethany: Don’t worry. I know better.
Mervyn King: —I’ll talk about the risks. Look to where we might be a year from now. I think it would be reasonable to think that the one-off increase in energy and food prices will have unwound. We don’t know what will happen in Ukraine, what kinds of things could happen. But I don’t think there’s an enormous risk that we’ll see a repetition of the scale of price increases that we saw in the spring of this year. That means that it’s likely—although we don’t know—that headline inflation will come down by this time next year and, quite conceivably, by a lot.
What’s less obvious is what will happen to the underlying inflation that lies behind it that’s generated by domestic wages being pushed up because of a tight labor market. Much will hinge on whether . . . central banks keep saying, “We are determined to bring down the underlying component of inflation.” And if they keep saying that, then I think, within a couple of years, we could be right back to where we were.
I think the risk is that central banks will see inflation starting to come down over the next year, at a time when the economy is in recession, and say, “Gosh, we’d better cut interest rates to shorten the recession.”
If they do that, they won’t immediately see any rise in inflation, because the base effects of the increase in energy and food prices will bring headline inflation down. But what will happen is that we will stop seeing any further reduction. Inflation will come down and get stuck at around, I don’t know, 4 or 5 percent or something like that. That’s the big risk, I think, that they declare victory too soon, because they’re not looking at what’s going on in terms of underlying inflation.
Bethany: Don’t you think that there will be immense political pressure for them to declare victory too soon? And do you worry about how that political pressure will play out?
Mervyn King: I do. I mean, I think that’s one of the big risks.
Bethany: In the popular press, there are still these questions, “Are we going to have a recession?” And you see various economists at various investment firms saying, “There is a narrow path through which we won’t have a recession at all.” You seem to be saying that a recession is both inevitable and necessary. Am I correct in that?
Mervyn King: Well, nothing is ever certain, but I find it hard to produce an argument that says how we can bring down inflation to 2 percent on a sustainable basis over the next two years without a very sharp slowdown in the economy and a rise in unemployment. And I think it’s going to be difficult to engineer that loosening of the labor market without having some kind of recession. It’s less likely in the US, perhaps. But in the UK, we think we probably are already in recession.
Whether it’s technically a recession or not, it will not feel good. It will feel as though we are teetering on the edge, or perhaps, we’re in a recession. And, of course, that will generate the political pressure between now and the next presidential election.
Bethany: What does this mean in terms of asset prices? We’ve gotten very used to a world, really, since even before the global financial crisis, long before that, of declining interest rates. And now, if we’re in a world of possibly rising interest rates and higher interest rates for good, what does that mean in terms of all asset prices, including home prices?
Mervyn King: An asset price is really the value today of the future stream of incomes that it will generate, whether it’s in the form of dividends, if it’s a business, or coupons, if it’s a government bond, or housing services, if it’s a house. And if you increase the rate at which you discount those future incomes, even if those incomes don’t change at all, then the present value goes down. And that, I think, is what’s been happening right through this year.
We’ve seen stock prices fall quite a lot. House prices may or may not come down, but they’re certainly going to be falling relative to incomes. Bond prices, government bond prices, have fallen. I think we are going into a period when all assets will be priced to reflect a higher level of interest rates. And I call this the great repricing. We had the great stagnation after the Great Recession, which, in turn, followed the financial crisis. And I think we are going through the great repricing, and it’s not a bad thing.
What we have to get away from is the idea that central banks are there to put a floor underneath asset prices. They’re not. And we need interest rates to go back to more normal levels so that the economy can function in a way that . . . Interest rates are the most important signal, in many ways, to guide resources between savings and investment, between more-profitable and less-profitable companies. And we’ve been through a decade in which we suppressed this role of the interest rate, and I think that’s been potentially quite damaging.
Bethany: And so, there is, effectively, a silver lining to what’s happening now. It may be hard to see, but there may be a silver lining. Am I being too optimistic?
Mervyn King: No, this is very interesting, because I’ve always said that a central banker is someone who knows that to every silver lining is attached a cloud. But, actually, there is a cloud here to which there is attached a silver lining. And I think it’s a question of being courageous now and recognizing that we do need interest rates to return to more normal levels, a difficult period for a few years in which we come to terms with lower asset prices and higher interest rates.
And I think that will mean that a lot of the zombie companies that have stayed in existence for the last decade or so, because they could survive when interest rates were effectively zero, will be forced out and have to own up that they can’t repay their debts.
And the great silver lining is that the resources tied up in these zombie companies of labor and investment will now be free to shift to companies that are more profitable and can afford to meet the higher interest rates. And that means that productivity will go up, because resources will be employed in more-productive, more-profitable companies, rather than companies with lower profitability and lower productivity.
And I see no reason why we can’t get back to a world in which productivity grows by, on average, 2 percent a year, which it did from 1900 until pretty much up towards the financial crisis. And I think there’s quite a big divide between economists who believe that productivity growth belonged to a special era from a sort of late 19th century to the late 20th century, maybe very early 21st century, when there were great productivity improvements, because we came across marvelous inventions like motorcars and urbanization and airplanes . . .
The first group thinks that productivity growth, basically, if it hasn’t quite come to an end, it’s much lower than it used to be, and we have to get used to much lower growth rates of productivity. And other economists believe that the stagnation of the past decade reflected some macroeconomic disequilibria. And once interest rates get back to normal, then we will have the opportunity to deal with the debt problems, where there’ll be a lot of debt restructuring that has to go on. But once we’ve dealt with that debt restructuring, then resources will shift to companies that can provide higher productivity growth. And that means, given that I think the amount of innovation is just as great today as it was 50 years ago, if not more so, then we will see productivity growth rates going back to the more traditional level.
Bethany: Yes, I love this, because when Luigi and I recorded our last podcast with you, I think we said at the end of it, we don’t see how he’s not right, and this is very depressing. In this particular podcast, I’m thinking, this sounds like he’s right, and this is very optimistic and hopeful. So, I think that’s a good note.
All right, Luigi, what did you think of the interview? Do you agree with Lord King, speaking broadly, or do you disagree?
Luigi: Actually, this time I tend to disagree. I’m not known to be a defender of central bankers, but I think he has been a bit too critical and nonchalant with the central banks and with their model. My understanding—and I might be wrong here—but my understanding is that they made a mistake that is not too far from what he’s describing but is not as bad as the one he’s describing. So, he made a point of saying, “It’s all about expectations.” It seems like a little bit silly that these guys say, “It’s only expectations, and we control the expectations, and so, nothing will happen.”
I think that the model the central banks were using was a model that was based on expectations and the so-called Phillips curve. The Phillips curve is from an economist who first looked at the relationship between unemployment and wage increases, and so, wage pressures. The central banks tend to look at the risk of inflation coming from two sides, either from wage pressure that is generally driven by unemployment, or by an increase in expectations. And what is interesting about this particular crisis, at least at the beginning . . .
At the beginning, this inflation did not go through expectations and did not go through wage increases. And that is what caught them by surprise. And so, I think that, in this view, it’s closer to what Larry Summers was saying, which is, you give a big chunk of money to people without increasing the production of the country. People are richer in nominal terms but not in good terms. And so, how do you reconcile the two by increasing prices?
Bethany: So, are you arguing that inflation wasn’t foreseeable, or are you arguing that it was foreseeable but for different reasons than the ones that Mervyn cites?
Luigi: Excellent question. I think it was foreseeable but for different reasons than the failure that Mervyn King portrays. It’s not too far off, but I think he makes it look even worse. I think it’s bad enough as it is. I think he makes it look even worse. The reality is, in the last 40 years, inflation was coming in those two ways. And so, the model got rooted in this particular way.
People who are older . . . and it helps to be older, because you remember the 1970s, where there was a big cost push. But the cost push is more the story of 2022. It’s not necessarily the story of 2021. The story of 2021 is really a limited supply and increase in demand in a world in which you couldn’t instantaneously import twice as much, produce twice as much, et cetera, because there were some bottlenecks.
If you give a lot of money to people and you don’t make it easy to produce more, the only way that will manifest is through higher prices, which, by the way, means an increase in the markup. If wages don’t increase and prices increase, who benefits? Our companies. So, the irony is that, probably, I heard a lot of the leftists saying, “Oh, the fault of inflation is on companies.” They’re not completely wrong.
I heard, actually, an analyst from a major investment bank say that 60 percent of the inflation in 2021, early 2022, was due to markup increases, not to costs or other factors. The irony is that this is combined with what the left actually really wanted, which was money in the hands of people.
Bethany: But is that fair to companies? And I can’t believe I’m the one saying fair or unfair to companies. Is that fair to companies, in that you would expect the markups to come in advance of inflation?
If you have a well-run company that has its finger on the pulse of the global economy, then you would expect markups to come in advance of inflation, because they know the inflation is coming, and they’re getting out ahead of it in order to protect their profits. They’re not inventing it where nothing exists. I can’t believe I’m playing devil’s advocate and suggesting a more fair way to look at corporate America’s actions. But here we go.
Luigi: No, you’re really good as devil’s advocate, even if you don’t look very devilish. I think it’s an excellent point. However, this is where the Fed model might play a role. They look at expectations. So, what you’re saying is the reason why companies are increasing their prices is an expectation of future inflation. So, that’s the expectation element, which is very important. But there wasn’t that expectation. That’s what makes it difficult to explain why companies increased their prices.
And if the cost of wheat went up 10 percent, should the cost of bread go up 10 percent? And the answer is no. Because of the cost of bread, only 20 percent is the cost of wheat. The rest is the rent, the wages, and all the other stuff, which have not gone up, unless you expect everything to go up. So, if there is a one-time increase in the cost of wheat, you don’t expect bread to go up 10 percent. However, it’s easier for companies to say, “Look, the wheat went up. It’s not my fault. I’m not a bad guy. I increased the price of bread.”
Bethany: So, I think I understand, obviously, Mervyn’s point, and I understand your point and Larry Summers’ point about putting all this money in the hands of people. What do you think is going to happen? Was the wage inflation that we’ve seen foreseeable, the increases in wages? Was that . . . and the unemployment numbers? One of the things that interests me about the pandemic is how every piece of conventional wisdom, almost the moment it became conventional wisdom, it was disproven.
So, in this case, the conventional wisdom during the early stages of the pandemic and even through the summer of 2020 was how utterly devastating this was going to be to workers, how utterly devastating this was going to be to employment and how unemployment was going to reach these unimaginable rates. At what point should it have been clear that wasn’t true?
Luigi: So, first of all, I want to make it clear. I will divide 2021 and 2022. 2021 was more of a bottleneck in the supply curve, increases in markups. That’s what explains inflation in 2021. Then, 2022, you have the big shock of the war . . . The price of oil had gone up even before, there’s the big shock of the war. You start to see wage increases. And the last inflation report was so scary because you started to see significant increases in wages, even if these increases are below inflation.
So, people see their real wages going down. That’s important to understand. The labor market is a more complicated story. The fact that you could have an increase in prices going through an increase in markups because you have an imbalance between demand and supply, this is something that was relatively easy to understand if you had not been brainwashed with a model that forces you to look only at two variables.
The second point is actually more subtle, which is, number one, we missed a lot of immigrants. Immigration went basically to zero. This is hard to estimate. But I suspect that a lot of illegal immigrants, especially in places like New York in 2020, they left. There is a significant reduction in labor supply, and this is underreported because, of course, nobody keeps track of the numbers of the illegal immigrants. But they are the ones that serve in many of the restaurants, and so on and so forth. So, I think they play a big role.
The second was a significant reduction in labor supply due to a number of things. The first one and the saddest one is long COVID. The second is people being afraid of the situation, so, if I am 68 and still working, before the pandemic, I was making some extra money, and it was maybe fun or not so painful. The moment the pandemic shows up, I don’t want to be infected, and I withdraw from the labor force, and I’m not going to come back.
And, number three, a lot of dual-income families decided that they have to go to a one-income family because of the disruption in schools. You have small kids. You know how difficult it is to run a household with small kids, and so, before it was worth it, and now it is not. All these factors together really changed the labor supply.
Bethany: This is a question I still struggle with, even after talking to Mervyn and having talked to a number of other people about it. What role does asset-price inflation play in overall inflation? And I still remember former Fed Chairman Ben Bernanke saying in the wake of the financial crisis that we’re going to engage in QE and try to boost the stock market, because that’s going to put more money in people’s hands, and that’s going to lead to increased spending, which you’d think would be a direct link between asset-price inflation and overall inflation.
And yet, which is a second component of the question, that didn’t happen in the decade after the financial crisis. And so, I think another factor that went wrong in predictions of inflation was that every skeptic I knew said inflation is coming during the decade after the financial crisis, and asset-price inflation came, yes, but other forms of inflation did not. And why didn’t it materialize, in your view, in the decade after the financial crisis?
Luigi: There is a mechanical component, and there is a theory component. The mechanical component is to what extent an increase in asset prices leads to high inflation automatically. And the answer is, very little, except through the obvious channel, which is house prices, because a big component is rent, and rent is related to asset prices. However, it is not that fast, and rents have a funny relationship with house prices.
If house prices are expected to drop, like today, nobody builds any houses, and everybody wants to rent. So, the price of rent goes up temporarily, but the house prices are dropping. On the other hand, when everybody expects house prices go up, then everybody wants to buy. And so, if you are in the business of only renting, you get a deal for renting. In a sense, rent, at least in the short term . . . of course, in the long term, they need to stabilize in a reasonable rent-to-price ratio, otherwise . . .
But in the short term, you can have this perverse phenomenon that house prices are going up and rents are going down or remaining stable, or house prices are going down and rents are going up. So, the mechanical link is not as clear.
The second question, which is a more interesting one, is to what extent money is linked to inflation. And this is where I tend to disagree with Mervyn, because the way he presented the list in the interview with you was, it is the big money that led to inflation.
But then this begs the question that you asked, which is, what about 2008? We expected big inflation. Inflation did not come. So, why was that the case? And I think that the big, big difference is, number one, in whose hands that liquidity goes. And, also, what do we consider the relevant prices that inflate? So, imagine for a second that we organize a big subsidy to rich people. We give every billionaire another billion.
Do you expect the price of bread, milk, to increase? No. The billionaire will not buy more milk. Even the price of normal cars and anything that normal human beings use will not be affected, because demand will not go up. What will go up will be exotic locations. If I want my house in front of Lake Michigan, or even more importantly, in front of the Verrazzano Bridge and whatever, then those prices skyrocket. If I want my van Gogh, that van Gogh, the price will skyrocket, and so on and so forth, right, which, by the way, is exactly what we saw happening in the period after the financial crisis.
Now, the difference between the great financial crisis and the pandemic response is that not only did we increase the supply of money, but we put a bunch of checks in the hands of ordinary Americans, and ordinary Americans don’t buy expensive houses in front of the Verrazzano Bridge. They don’t buy van Goghs. They actually buy cars, electric supplies, TVs, and meals from medium and lower-level restaurants. And those are the things that were in short supply, especially since the mismatch is that the supply of this stuff was restricted as a result of the pandemic, as a result of the fact that it was difficult to import goods from China, as a result of the fact that a lot of restaurants had fired a bunch of people during the pandemic, et cetera.
It is not that you can reconstruct a supply overnight, and so, when you fuel demand at the moment where supply is restricted, you are bound to have a spike of inflation. What I will emphasize, because we keep saying money, but as an economist, we need to distinguish between monetary policy and fiscal policy, what really put money in the hands of ordinary people was fiscal policy, and in particular, it was the third stimulus package of Biden as he got elected. I think that that is crucial. Now, the question is, how long will it take for that effect to fade?
Because let’s now move a little bit into the direction of what is the future reserving for us, because we had that spike, then we add the double whammy of the Russian invasion of Ukraine. And now, we are in the situation of, what do we expect for the future, and how do you bring inflation under control? Do you need to have a recession to do that? And this is where I think expectations do play a big role. I was looking the other day at the Twitter account by Jason Furman, who is a former CEA under Obama. He had a very beautiful graph of the dissavings that American families are creating now. Most Americans are really spending above and beyond what they normally do, and this has been financed by all the money they received during the COVID period.
That money, however, is not infinite and, sooner or later, will come to an end. So, one thing we need to factor in, which is not obvious, is what is the impact on disinflation or inflation of that ending? Because the risk is that we fight the past rise with increasing interest rates, and then there is always a delay in our interest-rate walks, and then they start to kick in precisely at the time in which this drug ends. So, we are all on ecstasy that we got during the COVID period. If we end up that the famous punch bowl of the monetary economy is withdrawn at the same time as the ecstasy ends, then we’re really down to have a major hangover.
Bethany: The agony and the ecstasy. It sounds like you also disagree with Mervyn about the future and are more in the camp of . . . Uh-oh. I’m going to be a little bit provocative here . . . but are more in the camp of the many progressives who are saying that the Federal Reserve’s interest-rate hikes need to come to an end. And I do think that’s an interesting component of all of this, which is the increased political pressure on central banks, including the Fed.
But Mervyn’s worry seems to be that the Fed will stop raising interest rates too quickly as a result of this pressure, and he thinks we actually are transitioning into a new world of higher interest rates. It sounds like you’re more in the camp of people who are worried that the Fed is going to keep raising interest rates for too long.
Luigi: I’m not so sure that’s my only worry. I recognize that there is this factor, and I recognize that the choice is made difficult by the fact that there is this factor. Now, let me tell you about the other factors at play. One is a very dual labor market. If you are a waiter in Boston or New York, you are having the time of your life. There is huge demand. Your job is very easily substitutable. You can go from restaurant A to restaurant B in a second. Your wages will go up. So, there is definitely pressure on that front.
That’s not true of a lot of other jobs. The market has become much more segmented, particularly with dual-career families, et cetera. You have an arrangement with your company, et cetera, that you can’t easily replicate instantaneously in another place. Either in the old days or today, when the only variable that you care about in a job is how much you’re paid, competition works very well. In a world in which you price differentiate, and yes, maybe you are paid a little bit less, but your work schedule is flexible, so that you can go and pick up the kids when your spouse is doing something else, et cetera, are you going to try to move to another place to get another job? Probably not. Without that threat, I’m not so sure your wage will go up. And to what extent is there bargaining power of workers to push that throughout? I don’t see that as paramount at the moment.
On the other hand, I am worried that nobody at the Fed has the courage to induce a recession to bring down inflation from 4 to 2 percent. Do we all want to reduce inflation from 9 and 8 percent to 4 percent? Yes. I think that no Fed person with any degree of respectability is ready to defend inflation at 8 percent.
However, the famous target of 2 percent that was proclaimed by Bernanke is a bit of a made-up number. Why 2 and not 1 or 3 percent? I can tell you why not zero, because, at some point, I wondered, why not zero? If you really prize stability, in the English language, that means inflation of zero. So, why not zero? And the answer is because we don’t measure quality very well. And so, if you really force prices not to change, because quality increases, de facto, you are pressuring deflation.
But whether that factor is 1, 2, or 3 percent, nobody knows. I think 2 percent is because, honestly, it’s an even number. You don’t want to have an odd number, right? Do you want to have a target of 3 percent? But now that the cat is out of the bag, imagine that inflation goes down to 4 percent next year, and you are the chairperson of the Fed, and you have promised repeatedly the inflation target is 2 percent. Everything is based on 2 percent. In a sense, you have an obligation to crank up the interest rates in order to bring inflation to 2 percent. Are you willing to do that and cause a recession to go from 4 to 2 percent?
Bethany: I think whether it’s an inflation target or other facts that are put forward in the world, there is a tendency for some things like this not to be questioned and for nobody to ever say, “But why?” So, I think it’s really great that you raised that question about the 2 percent, and it actually never occurred to me. I guess I just assumed there was something magical about that 2 percent number. And most of the time, if you’re assuming there’s something magical about something, you should probably start asking more questions. So, that’s number one.
I guess the second thing that I’m taking out of what you’re saying is that if you did have this moment of clarity when we spoke to Mervyn in the spring of 2021, where you said, “He’s right, inflation is definitely coming,” we’re in a much more uncertain world now. In other words, you don’t look at the future and say, “I can see clearly.”
Luigi: At the end of the day, I feel that, long term, I will be surprised if we go to 2 percent fast. And I know that I’m against most market predictions, because most market predictions suggest that we should converge to 2 percent in a couple of years. I think that it will take a while to converge back to 2 percent. Now, whether that means we are going to have 6 or 7 percent, no, I think that that will not last for long, but I don’t see a world in which we converge back to 2 percent.
I also am a little bit perplexed by Mervyn’s argument on the repricing of assets. What you are discounting is some nominal cash flow with a nominal rate. Imagine for a second that the real rate is constant, and you increase inflation by 5 percentage points. That should increase the numerator by 5 percentage points, it should increase the denominator by 5 percentage points, and the ratio should be the same.
Now, to be fair, there is a theory that goes under the name of Modigliani-Cohn, based on the famous Franco Modigliani in the 1970s, which says that people are affected by a nominal illusion, and so, they discount real cash flow or not inflation-adjusted cash flow, by a nominal rate. And then, of course, it looks terrible. So, the question is, can companies keep pushing cost increases through prices? And if so, is the real rate changing or not?
Now, by experience, in a phase of disinflation, we have seen the real rate going up, because people don’t trust. And so, I can see that there is a temporary repricing for this. But if I were to tell you tomorrow that we all agree that we will go from 2 percent inflation to 4 percent inflation, and everything increases accordingly, asset prices will remain the same.
Bethany: But part of the core of Mervyn’s thesis is that a world of higher interest rates is actually a healthier world. That does make sense to me. There’s a certain kind of appeal, not for a 14 percent interest-rate world, but for a 5 or 6 percent interest-rate world. And am I wrong in thinking that?
Luigi: No, I don’t think you’re wrong. But, again, it’s interesting to start thinking about why, because when the cost of borrowing money is higher, you are less likely to experience asset bubbles, because people are more keen to invest in assets that produce cash flow and not just to bet on future price appreciation. And so, a phenomenon like the crypto craze is less likely to take place, and this might lead to a better allocation of resources.
However, the idea that Mervyn has that this will fix our growth and productivity problem is predicated upon the fact that we have an infinite amount of investment opportunities and growth opportunities, which is not always the case. In particular, growth opportunities that desperately need our capital . . . So, one aspect that we should discuss in a future podcast is we grew up in a world in which firms needed a lot of physical capital, and that was very convenient, because we have a lot of people who need to finance their retirement. And so, the match was made in heaven.
Now, we still have a lot of people who need to finance their retirement, but firms need much less physical capital. A lot of the value is in human capital that is not easily appropriable. So, as a result, where are you going to put all your money if you want to finance your retirement? And in a world of growing population, real estate sounds great. But in a world of shrinking population, real estate is not great. Go and talk in Cleveland about how well houses have performed or in Detroit, and you’ll figure out that ain’t good.
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