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economies). Goodhart referred to inflation expectations as the “bootstrap theory of inflation”. The former Bank of England governor Mervyn King (no relation of Stephen) less kindly calls it the “King Canute Theory of Inflation”.
Managing expectations turns out to be as difficult as turning back the tide. After the financial crisis central banks began to issue “forward guidance”, informing the bond markets about where interest rates would be in future. Forward guidance implied, says (Stephen) King, that central bankers were better able to see into the future than anyone else. Since inflation had remained close to target throughout the past decade, they became excessively confident in their ability to control it. Groupthink among the interest-rate setters set in, as evidenced by the unanimous decisions made by the Bank of England’s Monetary Policy Committee (MPC) during the pandemic period – decisions that turned out to be unanimously wrong.
The MPC’s members were also remarkably slow to recognize their mistakes. For instance, between August 2020 and August 2022, as UK inflation climbed from 0.3 per cent to 9.9 per cent, the committee continued to forecast that it would return to target within a couple of years. Its members appeared to be suffering not just from groupthink, but from cognitive dissonance – namely, a failure to absorb information that contradicts one’s established position. Last year both the Federal Reserve and European Central Bank quietly abandoned providing forward guidance.
The issue with attempting to manage inflation expectations goes deeper than the central bankers’ forecasting failure. No one has come up with a decent theory as to how expectations are formed, says King. For his part, Goodhart suggests that expectations are merely an extrapolation of recent experience. In September 2021 the Federal Reserve economist Jeremy Rudd presented a paper provocatively titled “Why do we think inflation expectations matter for inflation? (And should we?)”, which questioned whether expected inflation was a key determinant of inflation. This notion, he suggested, was unnecessary and unsound, and lacked either empirical or theoretical support. Any link between inflation and inflation expectations, Rudd wrote, wasn’t evidence of a causal relationship. Besides, market measures of expected inflation (as provided by the spread between conventional and inflationlinked bonds) hadn’t picked up recent changes in trend inflation. (As if this wasn’t damning enough, Rudd added in a footnote what must be the most curious and sensational comment ever to appear in an official central banking text, expressing a “deeper concern that the primary role of mainstream economics in our society is to provide an apologetics for a criminally oppressive, unsustainable, and unjust social order”.)
Inflation expectations may be unstable, difficult to measure and resilient to central bank control, but history suggests that they have influenced the course of past inflation episodes. When workers expect that price rises will continue to accelerate, un i ons s t a r t t o demand i n f l a t i on - bus t i ng pay increases. When inflation becomes unstable, money becomes a hot potato, passed on rapidly from one hand to another. As the circulation of money accelerates, inflation accelerates: a self-fulfilling prophecy.
During the Weimar hyperinflation the rise in German prices far exceeded the relative increase in the number of paper marks in circulation. After the currency stabilization of November 1923, which restricted future note issuance and put Germany’s finances on a more stable footing, inflation dropped like a stone, even as the amount of money in circulation rose. Only the dramatic collapse in the public’s inflation expectations can explain this outcome.
Central bankers also pay insufficient attention to the relationship between inflation and government debt, says King. After 1945 decades of inflation gradually eroded the vast British and American war debts. “Left to their own devices”, writes King,
“governments cannot help but be tempted by inflation.” The economist John Cochrane of the Hoover Institution at Stanford has revised informal observations about the “fiscal theory” of inflation into a formal theoretical model, which states that inflation occurs when the public debt becomes too large relative to the state’s tax-raising capacity and its ability to pay off its liabilities from future fiscal surpluses.
The actions of monetary policymakers in recent years have increased the l ikelihood of a debtinduced inflation. Zero interest rates and enormous central bank purchases of government debt (often referred to as “quantitative easing”) encouraged governments to embark on an epic spending binge. During the pandemic fiscal deficits on both sides of the Atlantic rose to the highest levels ever seen in peacetime. Since 2007 Britain’s national debt relative to GDP has more than doubled. “Would government debt have risen quite as far without being ‘underwritten’ by central banks?” King asks. Probably not.
Having acquired a large chunk of outstanding government bonds, central banks now pay interest on reserves. (These represent the central bank liabilities accrued through quantitative easing.) Central bank reserves are best seen as short-term government debt. Crucially, their interest cost is determined by overnight lending rates. As King write s , “ i n e f fe c t , the overall shor t i ng o f the maturity structure of public debt – an inevitable consequence of quantitative easing – increases the fiscal sensitivity of monetary policy decisions”. In plain English, government funding costs are set to balloon when the central bank raises rates. This may partly explain why central bankers were so slow to tighten when inflation picked up during the pandemic. Going forward, there is a danger that monetary policymakers will prioritize the stability of government finances over the control of inflation (what economists call “fiscal dominance”).
We Need to Talk About Inflation is a damning critique both of central bank actions over recent years and of the economics profession’s shaky grasp of inflation. King writes lucidly, avoiding the jargon that makes economics impenetrable to the lay reader. This short volume brims with common sense, and its “fourteen lessons” – from “Money matters” and “Public attitudes matter” to “Democratically elected governments cannot help but be tempted by inflation” – are laid out clearly and accessibly. Despite its claim to present inflation lessons from 2,000 years of inflation, however, the historical analysis is skimpy. There is no mention, for example, of the great Chinese monetary convulsions of the twelfth and thirteenth centuries – the first recorded paper money inflations.
King also overlooks the sociological aspects of inflation – an approach that gained popularity in the 1970s. In The Rise and Decline of Nations (1982) the American economist Mancur Olson argued that inflation occurs when powerful groups within society – what he calls “distributional coalitions” (such as employees vs companies, public sector workers vs taxpayers or the young vs retirees) – become engaged in a fierce struggle for a greater slice of the economic pie. Inflation increases the size of the pie, even if each share is worth less in real terms. Given rising levels of inequality and societal conflict in the West, this bodes ill.
Inflation is an extremely complex phenomenon that isn’t captured fully by any single economic model. It should also be considered that the various c ompet i n g t h e o r i e s – monet a r i s t , Keyne s i a n , expectations-driven, fiscal and sociological – are not mutually exclusive. Each contains an important insight without telling the whole story. If the dogmatic tribes of economists had the courtesy to listen to each others’ views, their understanding might improve. There is certainly plenty of room for improvement. As the chairman of the Federal Reserve, Jerome Powell, confessed last summer, with a modest y and contr i t i on uncommon in central banking circles, “I think we now understand better how little we understand about inflation”.
Justice for all? The curious political legacy of
John Rawls’s masterwork
FREE AND EQUAL What would a fair society look like?
DANIEL CHANDLER 416pp. Allen Lane. £25.
The President: OK, Professor. Justice. Hit me! John Rawls: The first principle of a just society is that everyone should have equal and extensive basic liberties. Freedom of association, freedom of religion ... all that sort of thing. The President: Got it. Next! John Rawls: Fair equality of opportunity. Not just anti-discrimination laws, but high-quality education for all, so everyone can develop their potential if they have the motivation. The President: Great. What else? John Rawls: Finally, we make sure the worst off a re made a s we l l o f f a s po s s i b l e . Make s u re economic life works to the greatest benefit of the least advantaged, even if corporate profits fall. The President: (Doubtfully) So how do we do all this? John Rawls: You work it out. I’m only telling you what to aim for. The President: And that took you 560 pages?
TH I S , I N A N (admittedly fictional) nutshell, is the story of a fifty-year frustration following the publication of John Rawls’s A Theory of Justice (1971). The book is often regarded as the greatest work of political philosophy written in English since the nineteenth century. But, even though Rawls presents an inspiring vision, it has, among those who wield real political power, largely failed to inspire. While Robert Nozick’s sparkling Anarchy, State, and Utopia, published just two years later in response to Rawls, has been heating the blood of libertarian-leaning policymakers ever since, no progressive politician has ever been seen waving a copy of A Theory of Justice at their political opponents. The economist and philosopher Daniel Chandler regards this as a badly missed opportunity and, in his attractively written and strongly argued Free and Equal, he attempts to show how to be a Rawlsian in policy right here, right now.
It is slightly ironic, though, that Chandler has chosen to embark on this project at a time when Rawls is coming under intense waves of critical pressure in the academy. Raymond Geuss has led a crusade accusing Rawls of a type of indulgent and destructive abstraction; Charles Mills has probed Rawls’s worrying lack of attention to questions of race; and Katrina Forrester has been one of several authors to have explored Rawls as a landmark in the history of ideas – chastening for those of us who read A Theory of Justice as an undergraduate when it was considered hot and new. Yet of the countless scholarly books and articles written on Rawls, few have attended to Chandler’s task of working out how to create a Rawlsian policy world.
The author sets out, then, to convince us that a Rawlsian approach to policy is both desirable and feasible. To accomplish the first leg he provides a clear and helpful summary of A Theory of Justice, its significance and, just as important, Rawls’s argument for it. The theory itself was introduced in the dialogue above. Essentially it has three principles. The first two – the basic liberty principle and the fair
MAY 19, 2023