Heresies of inflation

Economists should be clear when recommending (or rejecting) various anti-inflation strategies. And while policymakers should pay attention to economic evidence and arguments, they should be skeptical when the economists who advise them show overconfidence

The specter of inflation is once again haunting the world, after a long lull during which policymakers were more likely to be preoccupied with the price of deflation. Now, old debates have surfaced over how best to restore price stability.

Should policymakers tighten the monetary and fiscal reins, cutting spending and raising interest rates – traditional approaches to fighting inflation? Should they move in the opposite direction by cutting interest rates, a path taken by Turkey's central bank under President Recep Tayyip Erdogan? Or perhaps policymakers should try to intervene directly, through price controls or by cracking down on large firms with price-setting power, as some economists and historians from the United States have argued.

If you have a knee-jerk reaction to these policies – immediately picking up one tool while inadvertently rejecting others – think again. Economics is not a science with fixed rules. Different conditions require different policies. The only valid answer to policy questions in economics is: "It depends."

The usual remedies for inflation often have costly side effects (such as bankruptcies and rising unemployment) and have not always produced the desired effects quickly enough. Price controls have sometimes worked, for example during wartime.

Moreover, when high inflation is driven primarily by expectations rather than “fundamentals,” temporary wage-price controls can help coordinate price determinants to move to a low-inflation equilibrium. Such "heterodox" programs were successful during the 1980s in Israel and in a number of Latin American countries.

Even the idea that lower interest rates lower inflation is not necessarily strange. There is a school of thought within economics – rejected by most mainstream economists today – that links inflation to cost-push factors such as high interest rates (which increase the costs of working capital).

The inflationary effects of high interest rates are called the “Cavallo effect,” after former Argentine finance minister Domingo Cavallo, who discussed it in his Harvard doctoral thesis in 1877. (Ironically, Cavallo used a very different strategy for fighting inflation – based on a fixed exchange rate and full currency convertibility – when he took office in Argentina with chronically high inflation during the 1990s). The theory has even received empirical support in specific cases.

This is why ridiculing currently unfashionable ideas about inflation as “science denial,” akin to rejecting vaccines for COVID-19, as some prominent economists have done, is so wrong. In fact, when a particular claim about the real world seems inconsistent with existing theories, this is often an invitation for a bright young economist to demonstrate that the claim can indeed be justified, under certain specific conditions. The true science of economics is contextual, not universal.

What might the contextual approach to inflation mean today?

Current inflation in the US and many other advanced economies differs significantly from the inflation of the late 1970s. It is neither chronic (so far), nor driven by wage-price spirals and backward indexation.

Inflationary pressure appears to stem mainly from a set of transitory factors, such as the reallocation of pandemic-related spending from services to goods, supply chain and other disruptions in production. While expansionary monetary and fiscal policies have increased incomes, these policies are also temporary. The alternative would have been a dramatic collapse of employment and living standards.

In these current circumstances, therefore, policymakers in developed countries should not overreact to rising inflation. As historian Adam Tooze has argued, transitory inflation requires a restrained response, whether through adjustment or monetary policy.

The best argument against price controls is not that they are "incompatible with science," but that nothing so radical should be considered for now. The same caution would apply to orthodox policy: central banks should be patient before raising interest rates.

What about Erdogan's continued insistence that high inflation is the result and not the cause of high interest rates? The validity of his argument has always been in doubt, given that Turkey's macroeconomic disparities have been building for quite some time.

Even when an argument cannot be settled in advance, the facts ultimately allow us to distinguish between theories that do and do not make sense in a given place. In Turkey's case, the evidence that has been accumulating since policymakers began the Erdogan experiment speaks loud and clear.

In particular, despite the reduction of the Turkish central bank's policy rate – the interest rate that the monetary authorities directly control – market interest rates have continued to rise. Depositors and savers have demanded higher rates, raising the price of credit for borrowers.

This undermines the argument that low policy rates can effectively reduce production costs for firms. It shows that the increase in interest rates reflects more fundamental problems with the economy, uncertainty about the progress of economic policy and higher inflationary expectations for the future.

Sometimes, as in the case of Turkey, the orthodox economic argument is indeed correct. Experiments that depart from conventional policies can be costly. But this does not mean that there are universal rules in economics or that the prevailing view among mainstream economists should determine policy. Otherwise, some of the most important policy innovations in history – think the New Deal in the US or industrial policy in post-World War II East Asia – would never have happened.

In fact, today's dominant monetary policy framework, inflation targeting, is itself a product of the particular political and economic circumstances that prevailed in New Zealand during the 1980s. It sat awkwardly with the monetary policy theory of the time.

Economists should be clear when recommending (or rejecting) various anti-inflation strategies. And while policymakers should pay attention to economic evidence and arguments, they should be skeptical when the economists who advise them show overconfidence.

(Dani Rodrik, Professor of International Political Economy at the John F. Kennedy School of Government, Harvard University, is president of the International Economic Association and author of Straight Talk on Trade: Ideas for a Sane World Economy, Princeton University Press , 2017. The comment was written for the global journalism network, "Project Syndicate", of which "Koha Ditore" is also a part.)