Capitalisn’t: Is Inflation the Fed’s Fault?

Bethany: A quick note for our listeners. I recorded this episode on the road, and the audio quality is not great. I hope that the quality of the discussion makes up for the bad quality of the audio. I do think this episode is critical to helping us understand what’s happening with inflation.

Ricardo Reis: Central bankers in the last 20 years have become a little accustomed to the cushy position of being seen as the saviors of the world. And so, it was good for them. Write nice books to buy in airports about how you did a great job. There is, of course, an older tradition of central bankers in the ‘80s and ‘90s who were the meanest people in town, not the nicest person in town.

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: The topic of the day continues to be, whether it’s in business media or mainstream media, inflation. How did we end up in this pickle? Where are we going from here? How much is the Fed to blame? And are they taking the right actions to get inflation under control?

Luigi and I thought we would speak to Ricardo Reis, who is an economist at the London School of Economics, and who has put forward a convincing argument that, yes, while the Fed has made some mistakes, they are all understandable. And he pushes back against some of Luigi’s and my more animated disagreement with the Fed.

I’d love to start with a comment that Jay Powell, Federal Reserve Chairman Jay Powell, made recently at the European Central Bank’s annual economic policy forum in Portugal. He said, “I think we now understand better how little we understand about inflation.” And I’d love to hear your thoughts on that comment.

Ricardo Reis: Well, I think it’s always appropriate, especially for a policymaker, to recognize the ignorance that we have, the limits to our knowledge. I don’t think inflation particularly stands out as an area where we know much less than in other areas. We don’t know, certainly, as much as we would like to know. And if your job is to be in charge of inflation, certainly much less than you would be comfortable with.

Having said that, Bethany, we do know some things about inflation, even if we cannot control it quite as precisely as we would like. And, as Jay noted, we are always realizing how those mistakes in control can often be more persistent and larger than we thought. But I would still say that we do know how to control inflation. It involves monetary policy. It involves adjusting interest rates and other tools.

Luigi: Let me push you a little bit on that, because you are being very diplomatic. But the way I would reply to Bethany is that’s a good excuse after you screwed up. You are saying, “Oh! We don’t know very much. In the fog of war, anybody can make a mistake.”

But let me make the opposite case, and please feel free to say how wrong I am. The opposite case is that we knew precisely well that we were facing a big inflationary shock. Now, things got worse, but at the beginning it was pretty clear. Many economists—Larry Summers is one, but Mervin King on our podcast is another—said the fiscal policy was inflationary and the monetary policy should have reacted earlier to stop that. And the Fed failed to do that. Why is my view wrong?

Ricardo Reis: I don’t think your view is wrong. I think it’s ungenerous. I think it is correct that there were mistakes made by central banks a year ago. And, actually, I give a lot of credit to Jay Powell and many of the members at the (Federal Open Market Committee), because they’ve pretty much said so in the last few speeches. First, I think there was, in 2020, the adoption of very expansionary monetary and fiscal policies, in response to what people thought might have been a very deep and persistent recession. And then, it turned out, we learned in 2021, that it wasn’t such a persistent recession, that the economy rebounded very quickly.

At that point, Luigi, one may say, “Well, but the data was uncertain. It took several months for us to be sure about it.” Or it can be a little tougher and say, “Hey, already back in February and April, it was clear that we had, as you said, too-expansionary fiscal and monetary policy and an economy recovery very quickly. Why did it take so long, so many months, really up until 2022, for central banks to acknowledge that and to pivot?”

So that, I think, is a fair first point. Maybe central banks were too tied to promises they had made in 2020 and should not have been so tied. Maybe they were too slow, given the fear of rattling financial markets, which were freezing. Maybe they were too worried about unemployment insofar as being too optimistic about what we could achieve there.

A second one is the extent to which central banks responded to the supply shocks of 2021 and early 2022 by always making a little bit of interpretation that turned out not to be quite right. In 2021, all the supply bottlenecks, the clogged ports, the chips that weren’t being made in Taiwan fast enough, all of those were interpreted as temporary disturbances that monetary policy should help by being looser and letting those not affect the pace of the recovery, as opposed to an alternative view, which is, “Hey, these are all reductions to the potential productivity of an economy, production capacity of an economy, nothing monetary policy could do about it. Focus on inflation instead and raise rates faster.” Central banks always took a view . . . Luigi, is it because their view was not defensible? No, it was defensible. Is it, though, ex post, was it a mistake? Yes, it was, even though it was potentially a defensible one.

I would point also to a third, which is the supply shock or the energy shock of February and March. The perception was, “Well, they’re going to be temporary. You should, what is sometimes called in central banking, see through the shock, i.e., do nothing, don’t raise interest rates. Energy prices are going to come down. The last thing you want to do is cause the recession by overresponding to it.”

Well, another view, though, is that the see-through principle only works if expectations are anchored, if people are not expecting inflation to come. Because if they expect the energy prices to be followed by broader-based inflation, then that broader-based inflation will lead to persistence. Well, what happened? It was more of the latter. The seeing-through was not the right thing to do. Aggressive responses to unanchored expectations were the more important.

So, again, we had a defensible view that turned out to be somewhat wrong. So now, Luigi, I think in all three of them, you could take the Powell, if you want, quote that you said, as in all three of them, we thought it was red. It turned out to be blue. Or you thought it was left, it turned out to be right in all of them. Boy, in my view, we knew the right answer, but diagnosing it in real time was not done correctly.

And then, three strikes. Do we think that those three strikes mean that this is a central bank making a lot of mistakes in a row, or just one that got a little bit unlucky in those diagnoses? That’s the way I would see it instead. I don’t know if I’ve agreed or disagreed with you. Or maybe I’m being way too diplomatic. But I don’t know. At least balanced, I would say.

Luigi: Let me continue a bit on my tirade and say, I appreciate the fact that hindsight is 20/20. It’s easy to ex post. But I think that here, there is a pattern and a motive that makes me worried. Milton Friedman used to say that inflation is always and ever a monetary phenomenon. I’d like to edit the sentence a bit and say that inflation is always and ever a political phenomenon.

In your paper, you point out correctly that one mistake is OK, and multiple mistakes, when they’re not serially correlated, when they’re not always in the same direction, they are OK, because you can always make mistakes. When you tend to have three mistakes in the same direction, then that’s called a bias. And that’s exactly what a monetary authority should not have, a bias. That bias was very supported politically. Inflation was not a big deal until, actually, the beginning of 2021.

Let’s remember, in January 2021, the inflation rate in the United States was 1.4 percent. It was below target. And then we had a stimulus package, an additional stimulus package, that was, according to many, twice as much as what we needed at the time. So, it’s pretty clear to everybody that this is an excessively expansive fiscal policy. The central bankers are basically paid to take away the punch bowl when the party gets hot. So, that’s exactly the moment when they have to take away the punch bowl. And they don’t. And there is huge political pressure for them not to. And they succumb to that political pressure.

Let me add—it’s circumstantial, but it’s interesting—that Jay Powell was running for reappointment in November 2021. And he was not approved by the Senate, confirmed by the Senate, until May 2022. My question is to what extent his career objective or desire to be appointed played a role in his delay, because let’s look at the data.

By December 2021, inflation is already 7 percent. People say this is a result of the war. I’m sorry for my French, BS. Inflation was completely, in the United States, driven before. And, of course, bad luck sort of adds insult to injury, but it was predetermined. So, serial mistakes in one direction that is politically popular, when you’re about to be reappointed, or you need to be reappointed, or you want to be reappointed, to me, that’s the capital sin of any central banker, to be politically driven.

Ricardo Reis: Let me make four points addressing different parts of your question, Luigi. First, do three mistakes in the same direction show a bias? Yes, insofar as there was a series of conditions coming from the last 10, 15 years that led to always looking at reality with a certain prism that all pointed in the same direction. I don’t think that that was driven by political capture by itself, as opposed to a view of the world that put too much weight on the experience of the last 15 years. Too empirical and not enough theoretical, if you want, using the last few years of observations as opposed to a broader sample and more theories. That was the direction of the bias.

Second, on the fiscal stimulus, I think the fiscal stimulus certainly was a contribution to the high inflation. It was not the only one. But you are right. Even if the fiscal stimulus was too high, the central bank, the Fed, could have raised interest rates faster and, in doing so, prevented such an increase in inflation.

However, Luigi, when we’re talking about mid-2021, when I think the Fed—and I was writing about it, so I’m on the record, this is not 2020—when I think the Fed should have started raising interest rates back in roughly August, September, when they didn’t do so, I think it was a combination of the factors that I was saying. And note that those factors also mean that the fiscal expansion, if you want, is a fourth mistake. Maybe it’s a bias. But I put the fiscal as yet a fourth one that points in the same direction and, noting then the previous circumstances, recency bias as being what affected it.

Third point, and then I’ll finally, fourth, get to your political bias, by the way. But third point, which is why inflation went up, one really must emphasize, when inflation gets to 9 percent in December, as you said, sorry, 7 percent in December, and it’s 9 percent now, this is a mistake by the central bank. And it is important to keep central bankers accountable for it.

At the same time, just because things sometimes don’t go the right way is not necessarily because they were captured politically. The central bank right now is raising interest rates, the Fed is raising interest rates quite aggressively, even though the political pressure is still there. Now, the political pressure of what high interest rates will do, if you look at all the talk about recession next year, the impact this will have on the budget in terms of interest payments on government debt and others . . . So, if one wants to point to political causes, why not say, “Well, why were they there a year ago, but not there now?” So, I wouldn’t say the Federal Reserve is captured in that sense.

But, finally, you point to the reappointment process and whether that is the key thing. I cannot reject that hypothesis, Luigi, using academic language. Having said that, I also see no evidence that supports it. To start with, Jay Powell does not set monetary policy. It is a vote of the FOMC with many members, many of those who are not up for reappointment and would not have been influenced by whether they were being reappointed or not.

And when one looks at not just members of the board, but also the independent presidents of every single one of the regional Feds, and look at the . . . Again, fine to point out mistakes they were making a year ago, or options they were making. You see the same explanatory factors, the same reasons, doing the same pivoting in 2022.

So, to say that one out of the many members—who happens to be the chair, so it’s not a small member—it was his particular reappointment that led to it, I find it to be not my favorite hypothesis. I think the one that I put forward with theories, perspectives, mistakes, is a better one, one that fits the data better.

But, to be clear, I cannot reject the hypothesis you set. Let me be clear. My subjective reading of the evidence is that, no, it was not political capture. It was not Powell’s appointment that made a difference. But, hey, we can agree to disagree on that one.

Luigi: Let’s remind ourselves that if you look at Switzerland, inflation in Switzerland now is 3.4 percent. And Switzerland was affected by the energy shock, by the supply chain, by all these other things. So, I’m not saying that those things are not important. But I say that they could be contained at 3.4 percent rather than 9 percent. That’s a pretty big difference.

Ricardo Reis: I completely agree. That’s why I say I completely agree. That’s why I want to blame monetary policy. And let me add one to you, Luigi, Brazil’s inflation has been really low, well below the US. It’s not just Switzerland. And the Brazilian central bank was raising interest rates way back in April last year. So, the Brazilians got it right, not just the Swiss.

Luigi: That adds sort of a little bit of salt on the wound. But let me try one last ditch and then I will move on. One last sort of argument is that we have witnessed, in the last two or three years, an extremely contentious world where, if you don’t belong or go along with the dominant view, especially on social media, you are excoriated, and sometimes even with consequences, in the sense that we have seen, how many? Three regional Fed chairmen resigning because of scandals? So, it’s kind of a shaky environment in which, if you go out as even a regional Fed chair and say, “I am very hawkish and I’m afraid of inflation,” you might get really excoriated in the press.

I remember that I wrote an article back in 2020 in the Wall Street Journal, so a long time ago. And I made the obvious point that if you push a lot of fiscal policy when there are supply-chain issues, you might get high inflation. I got excoriated on social media, because I mentioned the word inflation. That was not something that you could mention for a long time.

So, I agree with you that if the only issue was the appointment of Powell, then the political pressure would not be enough. I think it’s a number of circumstances where it would have taken a lot of effort for the central bankers to sort of lean against the wind. And they just didn’t want to. And now, they pile up because they have to, because at this point, I think it’s their reputation at risk.

Ricardo Reis: Let me agree very strongly with you, Luigi, in that I also feel that the debate, especially as social media modulates it, sometimes strikes me as much too excessive. I mean, I also remember these vicious comments a year ago on team transitory, team persistent. People would be pilloried and called horrible names just because they thought it was persistent or transitory. What the heck?

I mean, who would have said that the serial correlation of inflation will lead you to being called everything from a racist to not liking people, to whatnot? But in the context of these policy debates, yeah, I think that’s true. I mean, we see there’s a lot of pressure for conformers. And being the person that, within these policy committees, speaks out, can lead to a lot of pressure and a lot of heat and a lot of really nasty comments.

Having said that, Luigi, I mean, I think people really have to sometimes remember their mandate, the great honor and privilege that it is to serve your country in a public-policy institution, and to remember that you have to follow that mandate. Luigi, maybe they don’t. And if they don’t, they should be a little bit ashamed of themselves. A good way to put this is that I think in five years, no one is going to remember all those times where you were insulted on social media. In five years, people are going to remember you as being a member of the FOMC that let inflation go up to 9.1 percent. But I agree with you that it is hard. I’ve had my own, what do you call them? Pileups or pile-ons on Twitter, where you get accused of everything and the next. And they are very painful, for sure.

Pointing, though, to two further factors that I think play an important role. Groupthink. If I were heading either a regional Fed or a board, maybe not now, but 12 months from now, I would do a serious reflection on the last 24 months and ask, “Did enough people tell me?” Heck, let’s go back to my answer of 20 minutes ago when I said, “Hey, you interpret it as blue. It could have been red. You interpret it as left, it could have been right.”

I hope there were a lot of people in the building saying right, and ultimately, they chose left, and, oops, it turned out that, ex post, was wrong. If there weren’t enough people saying the opposite, then yes. Then we have a very serious problem. I’m not a Fed insider, and so, I won’t speculate on that. But, certainly, I think there has to be that pushing against groupthink and the extent to which there was some or not.

But second point, I do worry a little bit, Luigi and Bethany, that central bankers in the last 20 years have become a little accustomed to the cushy position of being seen as the saviors of the world. The ones who saved us from the financial crisis, that will keep unemployment low, that have delivered the lowest inflation we’ve ever seen in 20-plus years.

And it was good for them. Write nice books to buy in airports about how you did a great job. There is, of course, an older tradition of central bankers in the ’80s and ’90s who were the meanest people in town, not the nicest person in town. You were the one who brought recessions. You were—at the time, sadly, mostly men—but very tall, very bald, and very mean-looking, where you were always the one who was taking the punch bowl away. And, boy, I’m sure that wasn’t comfortable. But, hey, it was the right thing at the time, given the challenges then.

To what extent people are ready for that transition, ready to be unpopular, ready to realize that your mandate does require you to be unpopular is, I think, a very, very valid question. And when that plays into what you were saying, Luigi, when we talk about some political influence, here, perhaps going more—I guess personal’s not the right word—but more in terms of, yeah, sometimes you have to get ready to be vilified a little bit to do your job. And maybe it’s much harder today with social media and all those Twitter pile-ons and so on.

Bethany: I wanted to explore two other possible sources of bias in the Fed’s decision-making and get your reaction to each of these. One is the idea that the Fed is too concerned about asset prices, too concerned about the behavior of the market. Do you think that’s true? Do you think they’re concerned at all? And, if so, do you think maybe their concern for the market and for asset prices is an appropriate level of concern?

And then, a second possible source of bias is that, in the wake of congressional inaction after the global financial crisis, or limited congressional action, there’s an argument—Mohamed El-Erian wrote The Only Game in Town—that the Fed began to feel it was the only institution that could fix things. And another source of bias, perhaps, became an overweighting of the dual mandate toward fixing unemployment. That began to subsume all else, because the Fed felt that they were the only ones who could do anything about this. Do you think those two sources of bias are real? And, if so, do you think they were appropriate sources of bias?

Ricardo Reis: I think those two factors are definitely there. I think they definitely played some role in 2021. But I wouldn’t put an overly large emphasis on them, especially now, in 2022, when we’re looking at policy. Let’s start with the asset prices. A central bank certainly has to worry about financial stability. And insofar as through its actions, if it was inducing a lot of undue, unnecessary volatility in markets, the central bank would be doing bad things.

Having said that, we know that markets react to lots of things, most of which have nothing to do with the central bank. And a central bank that pays too much attention to asset prices is one that risks missing its main target, which is inflation. So, yes, we should care about financial stability, but not too much.

Given that, look, in 2021, again, we need to explain why it did take so long to pivot those six, seven months, maybe a little more, I guess you could push it all the way to nine months, that the Fed was behind the curve. I think it played a role, this taper tantrum, kind of, overinfluence. I mean, there was a doctrine that has been given different names, so, I guess I won’t use one. Sometimes it’s called the Yellen doctrine, when Janet Yellen was chair of the Fed.

But, anyway, the view that first you should stop buying bonds, start at the central bank. So, stop QE. Then, you do QT. You start reversing, and then you raise interest rates. I don’t know. The support for that from me was always very weak. Well, it was just because once we increased rates when we were still buying six years ago, and markets got a little confused for a few weeks.

That view you see again in central-bank speeches played a role in 2021 because, yeah, sure, if you’re only going to raise interest rates after you stop QE, after you could do it, and because you want to sequence that, then immediately it says that you’re going to take three, four meetings to do anything, again, with the idea this will create financial stability, I see not so much reason for it. I think it was a total recency bias. So, I think there, yes. That contributed to a little bit of a delay. Right now, though, I don’t see the Fed being afraid of rocking markets as needed. I see them very focused on their goal, on their inflation goal.

Second one, on The Only Game in Town, it is certainly the case that there was a view that the so-called Phillips curve is very flat. That is that whatever the Fed does has some huge impact on unemployment but not so much of an impact on inflation. Boy, if you have that view, let’s just focus monetary policy on unemployment, on the dual mandate. I think that view, very much based on the data from 2015, ’16, ’17, all the way to 2020, was a misguided view in some regards, was an example of recency bias. It led to, indeed, an overambition on unemployment in 2021.

Moreover, the second point that I note of this view that all these supply shocks, none of that is going to affect the production capacity of the economy. Yes, let’s talk about all the supply shocks, tell fun stories about how this sector got affected, supply chains, reglobalization, all of that. And then for the next part of the speech, talk about how unemployment of 4 percent or 3 percent is perfectly sustainable. Hold on. All those supply shocks should mean an economy that’s not quite as productive, that’s going to have somewhat higher unemployment. Well, not making that jump and still thinking that lower and lower employment was always fine, would always be perfectly sustainable with low inflation, I think is also an element of that.

Having said that, Bethany, let’s note, though, that there is one game in town when it comes to inflation, and that is the central bank. So, you’ve got to get your job done right. That is your town. When inflation is 9 percent, don’t tell me that, “Oh my God, I’m playing too many games in too many towns.” No, no, no, no. Your town is inflation. If you got that one wrong, you do deserve to get a little bit of flack, insofar as you have.

Luigi: Now, in passing, you mentioned one fact that I think is quite important. The central bank has gotten used to having a huge impact on the economy by reducing interest rates. And this game worked very well until they reached what is called a zero lower bound because they can’t decrease rates. They can, but it’s not very effective below zero percent a year.

I’ve heard many central-banker types arguing that it would be nicer if the central bank were to regain a little bit of that flexibility. How do you regain that flexibility? You have a higher targeted inflation rate. Instead of 2 percent, 4 percent. I suspect that in the back of the minds of a lot of central bankers, there was this issue is, yeah, if we let inflation go a little bit higher, what’s the big deal, because maybe eventually we’re going to actually change the target to 4 percent and everybody will be better off, because after all, there’s nothing magic between 2 percent versus 4 percent. Why not 3 percent, except that it’s an odd number, but it’s not an economic theory. This is kabbalah. So, in the back of the minds of a lot of central bankers, there was an asymmetry of costs. And they said, at the end of the day, if we let inflation run a bit higher, we’re going to regain some of the power we lost. So, it’s not a big deal.

Ricardo Reis: Yes. I think that’s certainly something that one would hear. Let me be a little more nasty than you were, Luigi. I think if you look—but I won’t mention names—at some speeches at some major central banks a year ago, you do have direct quotes of people saying when inflation was just 3 or 4 percent, no problem. We know how to bring it down anyway, so we can bring it down in the space of a few months. Since it’s been 12 months, those speeches are a little more . . . I wouldn’t like to show them to the people who gave them. But if you’re good enough at Google, you’ll find them.

Look, there’s nothing magic about 2 versus 4 percent. Indeed, theoretically, I think there’s good arguments for why you may want to be at something like a 3 or 4 percent instead of the 2 percent we settled on. It might have been a much better design to say that—and the Bank of Canada does this, by the way. Every five years, there has to be a review. And that review, a slow steady review that takes a few months, and maybe announce, our new target is 2.5 percent for the next five years or it’s 3 percent. And that would, I think, not be such a big issue.

However, Luigi, there is something magical about 2 percent. And what’s really magical about 2 percent is you said your target was 2 percent. You promised you’d deliver 2 percent. You, the central bank, you repeatedly, in every speech, said, “Look, I can deliver 2 percent.” Once you’ve done that, you have to deliver 2 percent. Me, as I bargained with my boss for my wage, I trusted that it was 2 percent. So, I agreed on a wage increase and I arranged my savings counting on it being 2 percent. So, now, don’t give me 9 percent or even 4 percent. No, that really is a reason for me to be upset at you, the central banker.

The second one, if you think that you live in a world in which, on average, interest rates are going to be very low, that means that, very often, when you want to cut them, you run out of space very quickly. That means that, very often, you find yourself thinking, “Boy, I wish I could set interest rates lower.” Monetary policy is too tight most of the time. Therefore, you think, “Boy, because monetary policy is too tight most of the time, inflation is too low most of the time.”

Boy, even worse, because I can’t respond to low inflation by cutting interest rates, maybe it’s become self-fulfilling. We end up being in this trap of deflation. And there’s very good economic theory showing that where, because you know that I can’t stop it, deflation becomes persistent. This is very much the story, the Japan story, told of the last 20 years. This view that the long-run interest rate was going to be always very low, and so, you should welcome when things are a little higher is one that is not really the strongest supported, in my view of the data.

What you see in the data is that it is true that over the last 10, 15 years, 20 years even, interest rates on government bonds have been really, really low in advanced economies. Well, we can point to reasons having to do with productivity, demographics. But let’s just point to a more basic one. As a bondholder, I lose money on a government bond if you either default or you inflate me away. Well, default probabilities are pretty low for rich economies. And, in the last 20 years, central banks delivered. They delivered low inflation. So, yes, government bonds are really safe, and I was happy to hold them under ridiculously low interest rates.

But if you look at the returns that were being earned in the US economy on investments by people who were buying bonds of corporations that were risky, BBB or lower, if you look at the returns on stocks, on private equity, on venture capital, on a lot of other things, what you see is, actually, relatively high interest rates or rates of return that hadn’t really fallen in the last 20 years.

So, once you realize that what’s really happened in the last 20 years is this big discrepancy between government bonds, what the central bank controls, interest rates on deposits at the central bank versus interest rates on lending to the government at the five-year or the two-year. And so, the things that central bankers naturally worry about versus what is really the return on the US economy.

And you see there’s been a big discrepancy between these. You start thinking about whether you should really welcome the high inflation so much, and whether you should have worried all that much about being stuck in that deflation with too-tight policy. And why? Because if it’s that wedge between those returns in the private economy versus lending to the government that has increased, then you think, maybe a few basis points is not so important for unemployment, for growth, but maybe we should focus more on aggregate supply reforms in the allocation of capital that are leading so many people to invest in these very-low-return government bonds, as opposed to in the productive capacity of the US economy.

Maybe you worry that not so much about the self-fulfilling deflations, but the self-fulfilling inflations where the inflation expectations accumulate more. And you worry a little less about the tight monetary policy, and you worry a little bit more about the tightness of financing conditions and others that lead to such high returns being required for entrepreneurs in the US economy. So, a combination of all of those leads you to be less worried about the too-low interest rates, about the lack of space, and be a little more worried on aggregate supply, efficiency in the financial markets, old-fashioned raising interest rates to control inflation.

Bethany: I have a tangential question of sorts. It strikes me that, back to where we began this episode, that when Powell said we don’t really understand much about inflation, one could say the same thing about QE. And this may be a sort of basic question. But I’m curious here if there’s agreement on the role that QE has played in inflation, or if you have a perspective on it, even if it’s not in agreement with everybody else, if there is no agreement. And then what it means, if anything, in terms of the Fed’s ability to fight inflation going forward, that it now has this enormous balance sheet. Does that create some sort of awkward nexus between fiscal and monetary policy, given the need to continue to finance our massive debt?

Ricardo Reis: Is there a complete professional consensus on QE? Absolutely not. We certainly know much less about it than we know about the impact of interest rates on inflation. I think that the weight of the evidence is that when you want to hit at inflation, go at it through the interest-rate channel, then there’s a more contentious and harder view about to what extent has QE affected asset prices in some direction, repressed some spreads, led to searches for yield. There, I think there’s a lot of plausible arguments, some strong convictions, not a whole heck of a lot of evidence so far, I think, that I would be very confident in knowing which way it was.

However, turning to the second part of your question, which is fiscal implications. There, absolutely, QE has fiscal implications, even if only because, look, what is QE? It is the central bank issuing a liability of the central bank, deposits of banks in the central banks, to buy a liability of the Treasury of the US government, i.e., US government bonds. They’re both liabilities of the state. The state owes you. Either the central bank right now owes a lot to banks, which have very big deposits at the central bank, often called reserves, versus if you want instead the debt of the Treasury in the form of the Treasury bonds and bills that the Fed bought.

For sure, this is fiscal in nature that we’re changing liabilities. What does this imply, though, for the near future, Bethany? Let me make two, maybe, or two and a half points. First, the impact that raising interest rates has on the fiscal position of the government. Well, when you did QE, what you did is that you bought 10-, 15-year government bonds by issuing debt to the banks, which have a floating rate. What does that mean? The interest rate paid is exactly the same one that you hear Jay Powell and his colleagues agreeing on changing in that FOMC meeting.

What that means is that when interest rates rose really quickly, as we saw in the last six months, if the US government borrowed on a 10-year government bond, hey, who cares? Interest rates went up on new bonds. But I borrowed, we only talk in 10 years, we fixed interest rates for 10 years. When you have the floating rate like we have now, that means that the impact of this on the overall fiscal position is much higher. That is, QE led to now a bigger fiscal footprint impact of monetary policy in terms of how much that debt costs the US taxpayer, as opposed to the bondholder of bonds. That’s number one.

Number two, how is that cost paid? The institution paying it now is actually the Fed. What the Fed has right now is a ton of 10-year bonds paying silly, low interest rates that we had in the last few years. And the Fed now is starting to pay higher and higher interest rates to the banks on the deposits they have. What that means is that the Fed over the next six months already is going to start effectively losing money in the sense of, boy, having a lot of expenses, much more than its interest income.

What that means is that the Fed is going to stop sending a really nice dividend, like it did every year, to the US Treasury. And that’s going to persist for many years. That also has political implications in that the Fed may really, plausibly, depending on how things move in the next few months, even end up with equity that is lower, potentially even negative, which by itself doesn’t really matter for a central bank compared with a corporation, but which politically can cause some issues, especially as the Treasury realizes it’s not going to get a dividend for the next three, four, five years on account of that.

And then the third point or the half point. First of all, we have a very big reduction in the real value of the debt that the US government had borrowed. In other words, you inflate away some of that debt because that debt makes a promise in dollars, and those dollars are worth less nowadays. On the other side of the scale, Bethany, comes the fact that you now have to raise interest rates to fight that inflation. That means you’re going to pay higher interest rates on that debt.

But it is important to note that what is a very big mistake, and one that we learned in the ’80s and ’90s, and in many countries, and that we should not forget is, not raising interest rates, that is much worse. That is the beginning of every high-inflation regime. That is even the beginning of many sovereign-debt crises, because when you let inflation get out of hand and you don’t raise interest rates because you’re afraid of its implications, what that means is that those same bondholders that took a big hit this year and next year, they’re going to start thinking, “Hold on! I’m not going to get burned again. You’d better now pay me a much higher interest rate in the future to borrow.” Those much higher interest rates mean it’s much more expensive for a government to borrow. And that often triggers fiscal crisis.

Luigi: I know we’re going over time, but just one quick answer to this question, because you raised a very debated topic on the internet, which is the relationship between market power and inflation. Where do you come down on that debate?

Ricardo Reis: I mean, as a general rule, I always come down as there’s lots of shocks hitting the economy. Market power may matter, may push inflation up or down. But, ultimately, monetary policy can deal with it. And that is a very important lesson in macroeconomics, Luigi. Everything affects everything, absolutely. Shocks, market power, they affect inflation, unemployment, everything affects everything.

But when it comes to inflation, we have realized that a central bank can respond to all of those things and steer inflation the right way. Let me use an analogy which may be childish or inappropriate, but you may find useful or not. If you ask me, “Ricardo, why did you get wet this morning when it rained a little bit?” Here I am. I could tell you, “I got unlucky, the clouds.” I could point to the way in which I was walking on the pavement that had nowhere for shelter. And yet, Luigi, I would always point out, yes, but Ricardo, you had an umbrella. It’s not a perfect umbrella. You’re still going to get a little bit wet. But if you open it, you’ll stop getting your head wet.

Luigi: At what point should Jay Powell resign? At what level of inflation, in order to restore credibility, should he resign?

Ricardo Reis: He should not resign. I strongly believe he should not resign.

Luigi: Even if inflation is 20 percent, he should not resign?

Ricardo Reis: I think he should do as he has done in the last few months, aggressively respond to inflation. I think he’s done a great job in the last two to three months. I think that with the current policies, in 12 months, inflation will be coming down. I am reassured by what they’re saying, by their independence, by their models. I don’t think inflation’s going to go to 20 percent, Luigi. And I absolutely think he should not resign because it’s 9 percent. He should live it through, bring it down and deliver low inflation and go down in history, not for the maybe slight mistake, but for responding to it quickly and for dealing with it. And I actually do think they are.

Bethany: Luigi, what did you think of the discussion?

Luigi: First of all, he points out that mistakes have been made. I think it’s important, because now we are in the situation of, it’s bad luck, it’s a series of bad luck. It sounds a bit like the story, oh, it’s transitory, not our fault. So, mistakes were made. And what I was impressed by was his conviction that these mistakes will be fixed in a reasonably short period of time. I’m a little bit less optimistic about that.

Bethany: Why are you less optimistic about that?

Luigi: Because we have not seen the pain. Imagine that we are going to see a recession starting, particularly coming into 2024. That is an election year. And, God forbid, Trump is running. The polls suggest that he is winning. People start saying to Jay Powell, “It’s your recession that is causing Trump to win the next election.” Will he have the courage to stand up to that?

Bethany: That’s actually a really interesting question. We give him credit for the courage in standing up to perhaps some pressure behind the scenes, even though at least what the Biden administration has said officially has been, “We want Jay Powell and the Fed to do whatever it takes to fight inflation.” There may be more pressure behind the scenes. But you’re right, the pressure that there has been so far may be a very small taste of the pressure that there is to come.

I appreciated his nuanced defense of the Fed. I’m particularly interested in this idea of recency bias that they were so stuck on what had happened in the wake of the financial crisis. It was very much the conventional wisdom for a period of time. I mean, for the MMT episode we did, it was that you could spend as much as you wanted and have these huge spending bills, and inflation would never rise again, and you’d be able to notice it as soon as it did, and you’d be able to curtail it right away. And so, that very much was the conventional view coming out of the last decade.

Luigi: Oh, absolutely. And, of course, all these things matter together. As economists, we like to have one single cause. But the reality is much more complex. I do believe that the recency bias is important and weakened the internal resistance. If you are the Fed and you have always been hawkish on inflation, and you have been wrong for the last 20 years, it’s a bit difficult to resist and insist. And especially if you are an open-minded person, if you’re not ideological, you’re going to compromise. And this is the problem, when there is a big political push in one direction and the kind of theoretical framework to defend against this big political push is weak, then the political push is going to prevail easily.

Bethany: I thought he raised a really interesting point. And if any of our listeners know the answer to this, I would love to know the answer, too, which is just how much conformism was there, is there, inside the Fed. In other words, were there lots of voices saying, “No, no, no. We think we need to start raising rates now. We need to stop QE”? Or was the decision that was made pretty unanimous? And what tale does it tell, if the decisions that were made along the way were unanimous, about the level of dissension within the Fed? I’ve heard that dissension is not welcome, that it’s an institution where dissension is not welcome, that there’s a lot of deference to the views of the chair. And then it takes a chair who really solicits dissension in order to get it. And I’d be very curious to know what that answer is here.

Luigi: I think this is an excellent point. But this is where diversity is important, because there are plenty of places in the world where inflation has been a problem recently and even today. So, if you get an Argentinian economist, he will tell you everything about inflation, and he will have a lot of experience of inflation in a way that a young American economist will not have. And there are plenty of very good Argentinian economists or Brazilian economists. So, you could use that to your advantage if you really think strategically on that dimension.

Bethany: He made a point talking about private-sector returns versus returns on government bonds and what that meant. And he had a point along those lines in his paper as well, where he wrote, if the source of these lower payments is a rising gap between the return on private capital and the return on government debt that is induced by the specialness of public debt, then monetary policy should ask how it contributed to that specialness. And, I have to admit, I didn’t understand that point and I didn’t quite understand what he was saying in the last point he made. But I thought it sounded really interesting. So, can you explain it?

Luigi: It is really interesting. I think that the idea is the following. We tend to think people can substitute easily between some safe debt, some risky debt, some equity. Imagine that, for institutional reasons, like you are a pension fund, or you’re an insurance company, and you have to put 20 percent, or 40 percent, or whatever number, into bonds, or for psychological reasons, you are really afraid of large fluctuations. There is a group of people who only invest in bonds. Then all the QE, et cetera, is really a tax on those people, because it’s not true that their return to capital has gone down. The return to capital, if I invest in a factory to produce widgets, that return has not gone down, and certainly the return in the equity market, until recently, has not gone down. What has gone down is the return on government bonds.

His claim is that we may have abused this power, because part of the effectiveness of the monetary policy is based on the fact that not everything is substitutable, because if everything is a perfect substitute, then the impact will be very small. And they say, no, not everything is a perfect substitute. But if some stuff is really not a perfect substitute, then this really acted as a major tax on a group of people at the advantage of others.

Bethany: That’s a really interesting argument. Do you think it’s right?

Luigi: Yeah, I think it is definitely right. I recently saw a paper about very risky bonds that were not graded at junk-bond status yet. In technical terms, they were BBB. They were still investment grade; they were not junk bonds. In this recent period, those bonds ended up having a slightly lower yield than expected, because so many people were in high demand for something that was investment grade but at a high return. And the paper was calculating that amounted to a transfer of $300 billion from one group of people to another, because the bond market is huge. So, even 20, 30 basis points, multiplied by a huge base, and for a number of years, we’re talking about real, real money.

Bethany: In that argument, who’s the loser? What group of people is being stolen from? And what group of people is benefitting?

Luigi: It depends a lot on how you are holding your money. I would say that probably the most heavily taxed were the middle class, because the middle class tends to have some financial wealth but does not invest heavily in the equity market. If you are really, really poor, you have no financial wealth. So, that did not really impact you. And if you are really, really rich, you have a lot of ways to invest, and particularly, you invest massively in the equity markets. At the end of the day, the more conservative, middle-class people got really screwed.

Bethany: There’s one area we didn’t talk about with him that I do think is interesting and that makes me a little bit less optimistic about inflation coming down. But I am out of my depth here. So, you tell me where I’m wrong. But it does seem to me that the Fed, through QE, and specifically through its purchase of mortgage bonds, a very specifically chosen asset class, that it then made that rate very, very, very low, basically encouraging people to go out and speculate in the housing market. And there’s some data about now this huge percentage of investors in the housing market.

And I’ve heard some people talking about this, that the massive increases in housing and in rents have not filtered through CPI because it comes on a lagging basis. And so, that seems to me like an area potentially in which the Fed deserves more criticism for really targeting, what seems to be targeting dramatic price appreciation in a specific asset class. And it seems like that may have longer-term consequences for the future that have not yet filtered through, if there’s a lag in those huge price increases showing up in inflation.

Luigi: On the one hand, there is no doubt that the Fed encouraged investment in housing with its policy. However, if this investment in housing implies more construction of houses, the effect should be the opposite, because that should lead eventually to lower prices and lower rents.

Now, I think this is very different, whether this is in cities or in noncities where it is easy to build, because then prices lead to higher construction. In cities that are heavily regulated, where new construction is very hard, also thanks to the so-called not in my backyard sort of policies, then you’re right. Then this translates only into higher prices. And that’s the negative.

I think that you might be shocked, but the speculation in housing and your favorite thing, the speculation of private-equity guys that buy out and pay themselves dividends and keep leveraging up, was not a bug, it was a feature. That’s exactly where the Fed wanted to push the economy. It’s not something that you would say is collateral damage. I wanted to achieve A, and . . . No, no, no. Maybe they don’t say so explicitly, but if you read all the documents, they say, “We want to push the economy. Our interest rates are going to push the economy.” They’re going to push the economy exactly in the way you describe.

One question, and actually, I saw Ricardo at the presentation at the conference, and then we chit-chatted about this. And he’s an expert on monetary policy, I’m not. But I was asking him, what is really the objective function, since we know what the policy mandate is? If you think more broadly, what should be the objective function of monetary policy? And to what extent does this continuous manipulation of interest rates, with a goal of maintaining full employment, have some major other sort of side effects?

And this is the part that basically nobody wants to discuss, because everybody likes this framework in which the Fed can control the economy, to some extent. They don’t want to discuss the collateral damage of using and fine-tuning the economy with interest rates.

And for today’s capital-is, capitalisn’t.

Speaker 9: Obtained by The Guardian, the cache of 124,000 documents that’s being dubbed the Uber Files reveals that the tech giant flouted laws, lobbied governments, and even courted politicians to force its services around the globe.

Bethany: For a long time, our very own Luigi Zingales has been talking about the problems with academic research. Among them, not just that people are paid, professors are paid, to do supposedly unbiased research, but also that their need for corporate data makes them willing to enter into these arrangements with corporations. It means that other people who aren’t willing to enter into these arrangements don’t get access to the data.

I think Luigi might have had a different reaction, maybe, to the release of all the Uber data than most of us did. Many people’s reaction was shock, horror. There’s gambling in Casablanca. Oh my goodness. Academic research can sometimes be corrupted by these factors. Whereas Luigi, I think you maybe thought, “Of course, this is what happens.” But you tell me.

Luigi: I don’t want to sound like, “Of course, I knew it.” Honestly, what was most disturbing to me was the level of familiarity and personal relationship with very high officials. So the fact that Emmanuel Macron was reassuring Travis Kalanick, whatever his name is, the former CEO of Uber, that things would go through in France in spite of the fact that half of the government he belonged to was doing something else, was kind of strange and raised the question of why Uber has this level of connection at such a high level.

And then you understand that this is basically the entire Obama campaign machine transferred to Uber because, from David Plouffe to Jim Messina, to even the economist Alan Krueger, who was at the CEA, they all moved from supporting Obama to supporting Uber with the same sort of massive strategy. That’s kind of worrisome.

The fact that some academics might write some papers where they are paid to do some research, I don’t think is the end of the world if they disclose properly. What I find more complicated is whether they are not aware of how their results are used strategically in a marketing campaign. And, in particular, when they write papers with data, and then, all of a sudden, they analyze some things, but not others.

Let me be very concrete. There is a paper that shows that women, when they drive for Uber, they make 7 percent less than men. And this is not on tips. This is actually because men drive faster. A very interesting paper. However, any economist worth his name or her name would say, “Wait a minute! Are men driving faster and equally safely, and then it’s efficient that they get paid more, because they’re better? Or are they driving faster and recklessly and killing people, and that would be a disaster?” And, to be honest, this to me is so much more interesting than a 7 percent difference in wages that it is not even funny. So, if you write a paper about this topic, and you work on this, why don’t you analyze this fact?

Now, I think it’s an insult to the intelligence of the authors to think that this did not occur to them. My presumption—and I admit, I don’t have any information—but my presumption is that Uber said, “You don’t have access to the data on accidents, but you have access to all the other data.” And then, if Uber chooses what data you have access to and whatnot, they probably have preanalyzed the data so that they give you only the data where you are going to independently reach the conclusion that is supporting what Uber wants. Then, the question of the difference between PR and academic research is really, really nonexistent.

One thing that we might add in this is when it comes to themselves, economists turn into sociologists. As economists, you think that money creates incentives. But when it comes to themselves, most economists think that money does not create incentives. That is the most ironic of them all.

Bethany: That actually is pretty awesome. And there you have human nature at work in a nutshell, this idea of access. And it’s one that pervades journalism as well, the compromises you have to make in order to get access. And I think it’s hugely problematic. I think this corporate control of important data, which they can, I guess, legitimately argue is theirs, but then allows them to only have research done that they want to be done is really problematic. And I’m not sure of an easy answer to that. You may have one.

Luigi: No. I think that the big difference between journalists and academia in general is not necessarily that sources are important. It’s that journalists get trained in how to deal with sources, and academics do not. Maybe I have a comparative advantage because, having written for a long time in Italian newspapers, I get a little bit more of the tension that exists in the journalism world.

And I think this should be important in general in academia, but particularly in economics and particularly now, because in the old days, many of the most remarkable datasets were public. And so, this issue did not arise. At the University of Chicago, Jim Lorie and others created the Center for Research in Security Prices that has all the stock prices of all the companies publicly listed. And everybody uses that data. And people find mistakes in the data, they fix it. But it’s fair game. There is no unique access.

Today, it is really, really valuable to have unique access to a company dataset, to the point that you can easily get tenure at a top university if you are the only guy who has access to a valuable dataset. And that’s too much. And, by the way, there are ways to regulate, in principle, because I’ve gone through that. The universities have some procedures. And, for example, you cannot analyze some data in which somebody else has a final judgment on whether the publication is released or not, except for confidentiality.

They might have a final judgment to say, “I don’t want any data to reveal the individuality of a person.” For example, when you work with the Census data, the Census has a review to make sure that you don’t work with such refined data that I can identify the company you’re working with. But if I say that, for your preferred topic, Bethany, private equity is good or private equity is bad, the Census cannot say anything about whether you release it or not.

Now, ironically, this is not true with the Federal Reserve. The Federal Reserve has an army of PhDs, but it also has a kind of—it’s not called this, but a censorship office. It has an officer who is in charge of reviewing all the studies that will be released for distribution. And sometimes, they’re not released.

And a member of a research department of the Fed once told me, “Oh! But this almost never happens.” And I said, “You are an economist. You understand in an equilibrium that you don’t write a paper if you expect a paper not to be published. So, that’s exactly the problem. And the fact that you don’t even understand that, that’s the scary part.”

Bethany: But I was thinking, the question that interests me most about this whole thing, and unfortunately, I don’t think there’s an answer to it, but the modern incarnation of Uber says, “That’s all in the past. We didn’t do any of this. All of those people are gone. Don’t look at us.” And what I wonder is, OK, yes, that’s true. But is it true in the larger sense, in that would Uber be where it is as a company if it were not for those actions in the past? In other words, how much of what Uber has today and what they’re building on is a direct result of these actions that now everybody says, “That was so reprehensible”?

It’s a little bit to me like Catholic confession. You do terrible things, and you go in and tell the priest that you’ve done terrible things. And then you say, “But that was old me. Now there’s new me. And I’m free of all my sins.” And I hate that in every aspect of life. I hate it with personal things, and I hate it with corporate America where companies say, “But now we’ve gotten rid of that bad CEO, and those bad seeds. And look at us. Aren’t we great?”

But the truth of the matter is, you would never be where you are, and you would never have what you have to build with, if it hadn’t been for all those horrible actions that you’re now disavowing. And, again, I don’t know the answer, how much of where Uber is today can be chalked up to that behavior. But I think a fair amount of it.