CAMBRIDGE – After a long period of inactivity when policymakers preoccupied with deflation, the specter of inflation is once again looming over the world. Now, old debates about how best to restore price stability are resurfacing.
Should policymakers apply the monetary and fiscal brakes by cutting spending and raising interest rates – traditional ways of fighting inflation? Should they do the opposite by cutting interest rates, which is the path taken by Turkey’s central bank under President Recep Tayyip Erdogan? Or should they intervene more directly by imposing price controls or cracking down on big firms that can set prices, as some American economists and historians have suggested.
If you are quick and spontaneous in the face of these policies — rushing to agree to one treatment but rejecting the other — think again. Economics is not a science based on fixed rules. Different situations require different policies. The only correct answer to a political question in economics is: “It depends on many factors.” Conventional inflation treatments often have costly side effects (such as bankruptcy and high unemployment), which are not always sufficient to produce the desired effect quickly. Price controls sometimes work, as in wartime. Moreover, when inflation is primarily driven by expectations rather than “fundamentals,” temporary price and wage controls can help coordinate the transition of price makers to a low inflation equilibrium.
In fact, this “heretic” program was successful in Israel and many Latin American countries in the eighties. Even the idea of lowering interest rates out of inflation is not necessarily unnatural or outlandish. An economic idea – rejected by most mainstream economists today – links inflation to cost factors, such as higher interest rates (which increase the cost of working capital).
The effects of inflation are known as the “Cavallo effect,” named after Domingo Cavallo, the former Argentine finance minister who discussed these issues in his Harvard doctoral thesis in 1977. (Ironically, Cavallo adopted an entirely different strategy for fighting inflation – based on fixed exchange rates and the possibility of full currency conversion – when he took office in the 1990s amid chronically high inflation). In some cases, the theory has some empirical support.
That is why it would be a mistake to scoff at current outdated thinking about inflation as a “denial of science,” along the lines of rejecting the COVID-19 vaccine, as some prominent economists have done. Indeed, when a particular claim about the real world appears to conflict with current theories, it often takes a young and bright economist to justify the claim in certain circumstances. The real economy is contextual, not global. What might a contextual approach to inflation mean today?
Current inflation in the United States and many other advanced economies is very different from the inflation of the late 1970s. It is neither long-term (for now) nor driven by price and wage cycles and price regression schemes. Inflationary pressures appear to be largely driven by a combination of transitional factors, such as the reallocation of pandemic-related spending from services to goods, as well as supply chain and other production disruptions. While expansionary monetary and fiscal policies have boosted incomes, they are also temporary. Another option is a sharp decline in working and living standards.
Therefore, under the present conditions, policy makers in developed countries should not overreact to high rates of inflation. As historian Adam Toze has argued, short-lived inflation requires a restrained response, whether through regulation or monetary policy. The best argument against price setting is not that it is “incompatible with science”, but that there is no need to consider any fundamental issues now. The same caution applies to conventional policy: Central banks must be patient before raising interest rates.
So what if Erdogan continues to insist that high inflation is the result, not the cause, of high interest rates? The validity of his argument is questionable, given the severity and accumulation of macroeconomic imbalances in Turkey over time. Even if the arguments cannot be resolved in advance, the facts ultimately allow us to distinguish between logical and non-local theories. In the case of Turkey, the evidence that has accumulated since policymakers began learning from Erdogan’s experience is crystal clear. In particular, market interest rates continued to rise despite the decrease in the central bank’s official interest rate (the rate directly controlled by the monetary authority). Depositors and depositors demand higher interest rates, which causes the rate of credit to the borrowers to rise. This would undermine the argument that low official interest rates can actually reduce firms’ production costs. This indicates that higher rates reflect more fundamental problems in the economy, as well as uncertainty about economic policy behavior and rising inflation expectations in the future.
Sometimes, as in the case of Turkey, traditional economic arguments seem valid. Experiments that decouple from traditional politics can be costly. But this does not mean that economics has universal rules, or that the prevailing opinions of mainstream economists should dictate policy. Otherwise, some of the most important policy innovations in history — such as the New Deal in the United States or industrial policy in East Asia after World War II — would never happen.
In fact, the dominant monetary policy framework or inflation targeting today is itself a product of certain political and economic conditions that prevailed in New Zealand in the 1980s. It was at odds with monetary policy theory at the time. Economists should be modest in recommending (or rejecting) various strategies to combat inflation. While policy makers should heed economic evidence and arguments, when the economists they advise are feeling overconfident, they should remain skeptical.