It looks increasingly like inflation is here to stay. The Federal Reserve economists admit this one day and deny it the next. In the hallowed halls of monetary orthodoxy – from New York to San Francisco to DC – confusion is setting in.
Until now, orthodox monetary theory has had an easy time of it. Since the articulation of inflation targeting in the 1980s and 1990s, rates have been tending in one direction: down. They fall, fall, fall, then rise a little – only to fall some more.
During this time a cosy relationship formed between the FOMC and the markets. As my co-author James Montier and I showed in a paper written in 2016, on days when the FOMC held their meetings stock markets would rally hard – and it did not matter what the results of those meetings were; rates could go up, down or sideways and markets would rally. Now the Fed is in a position where they might have to upset the markets if they want to be seen to be doing their job. As this tension builds, perhaps it is time to dust off some of the heterodox monetary theories to see if they have anything to tell us.
A Tale of Two Theories
Orthodox monetary theory effectively rests on two premises. The first is that there exists a natural rate of interest at which the economy operates at a high employment and low inflation equilibrium. The second is that the central bank interest rate – in the US, the Fed funds rate – can be manipulated to hit this natural rate, albeit by approximation. The Fed economists are smart guys. They have PhDs in economics. They can figure it out, they tell us.
The two main heterodox monetary theories might be termed ‘Austrian’ and ‘Post-Keynesian’. The Austrian theory – originally championed by Friedrich Von Hayek and Ludwig Von Mises – is effectively characterised by the denial of the second premise. Austrians claim that no matter how clever the Fed economists are they are nowhere near as clever as the free market. If the market was left to itself, the banking system and the entrepreneurs would grope their way toward the natural rate. When the boffins grab the reigns, however, things go awry.
Anecdotally, the Austrian theory seems confirmed by Fed behaviour. Austrians never tire of pointing out that the Fed are in bed with Wall Street. “If the Fed is really searching for the best interest rate for the real economy, to balance savings and investment at a high employment, low inflation equilibrium then why do they seem so concerned with the impact they are having on the stock and corporate bond markets?” the Austrian will ask rhetorically. As the Fed moves into increasingly exotic territory – such as the market for Mortgage-Backed Securities and now even junk bonds – the Austrian’s cri de coeur is amplified so that ever less sensitive listeners start to hear it.
The Post-Keynesian theory is more radical than the Austrian one. Post-Keynesians deny the first premise: they deny the existence of the natural rate of interest altogether. There are a few ways of looking at this. One is the ‘classic’ interpretation, found in Keynes’ General Theory of Employment, Money, and Interest. This interpretation emphasises the theoretical side; Post-Keynesians point out that the economy has no single natural equilibrium. Equilibrium between savings and investment is determined, they argue, by the volume of employment and therefore of aggregate demand. There are as many equilibria as there are constellations in the sky; and for every equilibrium there is a unique equilibrium rate of interest.
Then there is the ‘distributionary’ interpretation championed by the likes of Luigi Pasinetti. Some Post-Keynesians take this observation further and point out that it entails that the rate of interest should actually be seen as a distributionary variable. The rate of profit determines the income of capitalists; the rate of wage growth determines the income of workers; and the rate of interest determines the income of rentiers.
Finally, there is the more psychological or ‘practical’ interpretation that I tend to promote, which was first articulated by GLS Shackle. The practical interpretation emphasises the psychological side of asset and capital markets. In a few words: interest rates do not drive behaviour, behaviour drives interest rates. Investment in both financial markets and real capital markets is primarily driven by the feelings or animal spirits of those doing the investing – and these spirits are subject to extremely violent swings.
The Austrian theory and the Post-Keynesian challenge the orthodox monetary economists in different ways. The Austrian theory ultimately counsels that central banks should be abolished. They argue that markets should set the rate of interest and markets alone. Some advocate a return to gold standard – although I find this confusing as the natural rate theory rejects quantity theory of money arguments – but others do not. Some even call for a free market in money itself – let a thousand currencies bloom.
The Post-Keynesian theory is more forgiving of the centralised system – but not of the orthodox pretensions. Like the Austrians they tend to look at central bankers and smirk slightly as the bend themselves into pretzels trying to control an uncontrollable system. But since there is for them no natural rate, if the central bankers were not bending themselves into pretzels the market participants would be doing it anyway. Post-Keynesians view central banks as effective backstops on the excesses of human psychology and so view their lender of last resort mandate as a stabilising force. But their monetary policy operations are, to Post-Keynesians, misguided and they say that the central banks would be better off parking the interest rate at a rate that is fair for savers – typically either mirroring the rate of wage or productivity growth.
Notes on the Current Crisis
Today the Fed is stuck. They are in a position where if they follow their mandate through and raise interest rates to counter the surging inflation, they risk spooking the markets that they have stroked to ever higher valuations for decades. I recently ran some back of the envelope estimates of the current natural rate of interest – using data from the New York Fed which in turn uses the Laubach-Williams estimation model – and I found that in order to raise nominal rates back toward the natural rate, the Fed would have to engage in another ‘Volcker Shock’ type event. One need not be an expert on financial markets to be fairly sure that this would cause a complete meltdown across multiple markets, from bonds, to stocks, to the market for housing.
Austrians would do well to highlight the cul-de-sac that the Fed has driven itself into. If the present inflation continues, expect a lot of turmoil at the Fed. Expect a lot of disconnect between what the Fed economists talk about in private and what they say at their FOMC meetings. Expect, in a word, a lot of hypocrisy. Some Austrians will probably leverage this to argue against the existence of the Fed. But I expect that many will join the growing number of inflation hawks that will inevitably start to proliferate.
Post-Keynesians, on the other hand, should probably emphasise the uncertainty inherent in any policy moving forward. Post-Keynesians do not view inflation as always and everywhere a monetary phenomenon. In my view, the present inflation is almost certainly not that. The response to the pandemic has been to wreak havoc on supply chains across the world. It is possible that higher interest rates could help to alleviate this – say, by creating slack demand through a recession and giving the supply side the time it needs to heal. But it is equally possible that raising rates and generating a recession will not Impact the inflation. It looks to me like unwinding the interventions of the past two years could take a decade.
In a sense, then, the position of the Post-Keynesian should be a studied, but resigned nihilism. The reality of the situation is that we have created a huge economic mess from our pandemic response. The tools that we have built in our economic institutions were poorly suited to the economy in normal times – now there is a chance that they could be wholly redundant. But just as easily, the inflation may evaporate. The supply chains may be more resilient than they currently appear. We simply do not know. That said, I would not bet my house on inflation subsiding peacefully.
In the meantime, the economics profession needs a shake – a strong shake. After the crisis of 2008, many of us thought that the profession was reforming itself, becoming less dogmatic in its theories and less inflexible in its solutions. Instead, what we have got is a strong tilt toward demand-side policies and, frankly, left-wing politics.
This is not inspiring. At all. The profession remains cloistered and insular. Debate remains stifled and dreary. That said, the challenge posed by 2008 to the profession will likely be small in comparison to the challenge posed by sustained inflation. The upside of this is that the profession could be offered, once again, an opportunity to reform. The question is whether they will take it. As I remain resigned about the prospects for the Fed to stop the inflation, I remain resigned on this question too. Hey, its not my credibility on the line!
