After a long period of lethargy, once again the ghost of inflation is engulfing the world. The old debate on how to improve price stability has revived. Should policymakers act on monetary and fiscal brakes by reducing spending and raising interest rates – that is, from a conservative standpoint? Should they instead move in the opposite direction by lowering interest rates, the route Turkey took under the direction of President Recep Tayyip Erdogan? Or policymakers should perhaps attempt to intervene more directly through price controls or by clamping down on large firms with pricing power, as some economists and historians in the US have argued.
If you want to react to these policies without thinking, think again. Economics is not a science with definite rules. Different situations require different policies. The only valid answer to policy questions in economics is: “It depends.”
Conservative measures for inflation often have costly side effects (such as bankruptcies and rising unemployment) and do not always produce the desired effects quickly. For example, price controls have sometimes worked during times of war.
Furthermore, when high inflation is driven primarily by expectations rather than ‘fundamentals’, temporary wage-price controls can help coordinate price-setters to move to a low-inflation equilibrium. Such ‘heterosexual’ programs were successful in Israel and several Latin American countries during the 1980s.
Even this idea doesn’t necessarily mean that lower interest rates can reduce inflation. There is a school of thought within economics that links inflation to cost-push factors, such as high interest rates, that boost the cost of working capital.
The inflation-producing effects of high interest rates are called the ‘Cavallo effect’ after former Argentine finance minister Domingo Cavallo, who discussed it in his 1977 Harvard doctoral thesis. The theory has also received some empirical support in special cases. This is why it is wrong to scoff at currently non-fashionable views on inflation as “science denial” by some leading economists, as some prominent economists have done.
What might a relevant outlook for inflation mean today?
Current inflation in the US and many other advanced economies is significantly different from the late 1970s. It is neither out of date (as of now), nor driven by pay-price spirals and backward indices.
Inflationary pressures result largely from a transitory set of factors, such as the pandemic-related redistribution of spending from services to goods, and other disruptions in supply-chain and production. While expansionary monetary and fiscal policies have increased income, these policies are also temporary. The alternative would have been a dramatic decline in employment and living standards.
In the present circumstances, policy makers in developed countries should not over-react to the rise in inflation. As historian Adam Tooze has argued, temporary inflation calls for a restrained response, whether through regulation or through the exercise of central bank monetary policy.
The best argument against price controls is not that they are “incompatible with science”, but that there is no need to consider anything so radical for now. The same caution would apply to conservative policy as well.
What about Erdoan’s relentless insistence that higher inflation is a consequence rather than a cause of higher interest rates? The validity of his argument has always been in doubt, given that Turkey’s macroeconomic imbalances are legacy and in fact have been building up for quite some time.
The evidence that has accumulated since policymakers began using Erdoan speaks loud and clear. Notably, market rates have continued to rise, despite Turkey’s central bank’s policy rate lowering. Depositors and savers in Turkey have demanded higher rates, raising the cost of loans for borrowers.
This undermines the argument that lower policy rates can effectively reduce production costs for firms. This indicates that the increase in Turkey’s interest rates reflects more fundamental problems with its economy, uncertainty about the conduct of its economic policy, and higher inflationary expectations for the future.
Sometimes, as is the case with Turkey, the conservative economic logic is actually correct. Using a deviant from a traditional policy can be costly. But this does not mean that there are universal rules or that the prevailing view among economists should determine policy. Otherwise, some of the most important policy innovations in history – think of the New Deal in the Americas or industrial policy in East Asia after World War II – would never have happened.
In fact, inflation targeting, the dominant monetary policy framework today, is a product of the peculiar political and economic conditions in New Zealand during the 1980s. This sat uncomfortably with the theory of monetary policy of the time.
Economists should be polite when they recommend (or reject) various strategies to fight inflation. And while policymakers should heed the evidence and arguments, they should be skeptical when the economists who advise them display excessive confidence. ©2022/Project Syndicate
Dani Roderick is Professor of International Political Economy at Harvard University’s John F. Kennedy School of Government, and author of ‘Straight Talk on Trade: Ideas for a Sensible World Economy’.
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