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Good morning. A slightly unusual newsletter today, as I spent the better part of the day at the Greenwich Economic Forum, limiting my writing time. But I did manage two interviews, one with Nouriel Roubini (at the forum) and one with Larry Summers (over the phone). Both economists are very concerned about inflation, and both objected to an argument against inflation anxiety I presented a few days ago.
Below, edited highlights of the interviews. Email me with your thoughts: firstname.lastname@example.org
Larry Summers: we aren’t in the 1950s any more
The reason that I liked this blog post about inflation by Gabriel Mathy, Skanda Amarnath and Alex Williams was not so much that I agreed with the economic argument (I’m not sure I am qualified to assess it properly) but that it provided a powerful explanation of a puzzling phenomenon: why, over the past three or four decades, lots of people have been very wrong about inflation.
MA&W point out that in the early 1950s, unemployment was very low, economic growth was strong and inflation spiked. But inflation came back down quickly without the need for punitive rate policy from the Federal Reserve, because views of future demand changed. Inflation expectations never formed a self-sustaining upward spiral, as economists hypnotised by the 1970s believe they must. Such a spiral does not even explain the sustained inflation of the ’70s, MA&W argue. Instead, deep economic changes that restrained supplies of goods and labour were the root cause. Punchline: don’t worry about inflation expectations taking off in 2021, policymakers, you can run the economy hot.
Summers, the former Harvard president and US Treasury secretary, emailed me to say he didn’t buy any of this for a second. So I called him up.
His first point was that the ’50s Fed was actually very hawkish indeed:
“The 1950s were a period when we had three recessions, including a quite serious recession in 1958 with the single worst quarter of the postwar period prior to Covid, caused by an aggressive Fed worried about inflation. And it was a period when [then Fed chair] William McChesney Martin was practising, to a very strong extent, the doctrine of removing the punch bowl before the party gets good. By no conceivable stretch did the policy of the 1950s have any resemblance to the current doctrines of no pre-emption [of inflation] and total emphasis on maximising unemployment.”
Next, it makes sense that inflation expectations did not take flight in the 1950s, when the gold standard was a recent memory and fiat monetary policy was in its infancy:
“We were coming off of the gold standard. The first edition of Paul Samuelson’s textbook [Economics from 1948] had a graph of the price level, not the inflation rate. If you think the price level is mean-reverting [as it would be on the gold standard], when you have more inflation, you expect more deflation. In an era when people thought of the variable to be the price level not the inflation rate you would not expect that people to anticipate a price spiral . . . When you move to a fiat money standard, expectations formation is going to be completely different, and we had a five-year experiment with expansionary policy in the Kennedy/Johnson administration to get us off to the races.”
Third, the low rates of the 1950s reflect a difference in policy tools:
“Monetary policy in the 1950s worked mostly through credit rationing. It’s irrelevant to say that rates didn’t move very much when regulation was the main tool of monetary policy. There was direct credit control [bank reserve requirements and the like] and the only people allowed to sell mortgages were savings and loans, and they had a cap on the rates they could charge. When rates went above that level, the housing market simply got crunched. Non-rate policy was important then as now, but then it was inducing credit rationing, not blowing up asset bubbles
“The Fed of the 1950s would have turned over in their graves to hear the current Fed say ‘we are not going to pre-empt inflation, we are not even going to respond to current inflation until it is proven to be permanent, we are going to focus on using monetary policy to reduce the unemployment rate of disadvantaged groups’.”
Summers does not buy the notion that current inflation is the result of temporary bottlenecks. Whenever demand exceeds supply, the inflation that results is made up of a series of bottlenecks, each apparently temporary:
“If you thought demand was running hot relative to supply, you would expect there would be bottlenecks. You’d expect inflation to feed through selectively. And there is every reason to think we are going to see new bottlenecks. I read a story today that there is a bottleneck in Christmas decorations. Toilet paper is back to being a bottleneck. Thanksgiving turkeys. There will be new bottlenecks: the history of the ’60s and ’70s was that there was always a specific structural explanation for price increases.”
For evidence of sticky inflation today, he says, look no further than housing and wages, both of which are experiencing wild price increases that are not yet caught by the official indices:
“The housing market, which is 40 per cent of [the] core consumer price index, is saying that house prices are up 20 per cent, that rentals when you get a new tenant are up 17 per cent, and none of that has shown up yet in the CPI. The Dallas Fed has shown that just looking at house prices, not the CPI indices, has a ton of predictive power with a year lag.
“The largest component of costs is wages, and we have a record high level of quits, a record high level of job vacancies, and every employer in America is complaining how labour short they are, from people looking for cleaners to people looking for analysts in investment banks. Because when you raise wages for new workers you have to raise them for everybody, you don’t do it quickly, but you will do it.”
Nouriel Roubini on the coming stagflationary debt crisis
Roubini thinks that ultra-high debt, ultra-low interest rates and a range of pressures on global supply mean that we are headed directly for another crisis, this one culminating in a combination of low growth and high inflation. Starting with debt:
“Look at the level of debt, both private and public, in the global economy. In 1999 it was 220 per cent of GDP. Today, it is 360 per cent and rising. In advanced countries, 420 per cent and rising. In China 330 per cent and rising. In emerging markets, 250 per cent and rising and most of that in foreign currency.”
The only conceivable way out from under all this debt is suppressing real rates, printing money and inflating the debt away. The other options, such as cutting government spending or taxing the rich, are just not viable:
“I don’t see a situation in which government spending as a share of GDP is going to fall. In fact it is going to rise. There is so much income and wealth inequality that whether it’s the US, Europe or anywhere around the world, you’re spending more on the social safety net, given all the damage that has been done [to low-income workers] by trade, migration, globalisation and technology . . .
“The willingness and ability to raise taxes significantly on the quality of the rich is constrained politically and of course if you raise them too much, there’ll be damage to economic growth. The path of least resistance is to wipe out the burden of debt with fixed interest rates, with gradually higher and unexpected inflation.”
But inflating away the debt is hard to do without sparking a crisis, because inflation increases not just nominal rates but real ones, too:
“To reduce those debt ratios, going from 2 per cent to 3 per cent inflation is not gonna be enough. You need to have significant, unexpected inflation that wipes out some of the real value of long-term fixed-rate debt. And by the way, a lot of the debt is shorter term and has to reprice, or the debt is in foreign currencies so for emerging markets the option of wiping it out with inflation is not there, and you have outright defaults.
“. . . Markets will eventually price in volatile inflation, so inflation risk premia become higher. Therefore real rates rise, and eventually debt service ratios are going to become unsustainable.”
Matters will be made worse, Roubini says, by the reversal of several factors that have kept inflation low in recent decades. We are heading for less globalisation, more balkanised supply chains, less migration, decoupling of the US and Chinese economies, a hotter climate, restrictions on the flow of data, an oil shock driven by environmental policy, ageing populations and more. All of this amounts to a rolling supply shock, which will reduce growth already constrained by the debt crisis, and push prices up.
It is not a pretty picture:
“It’s the worst of the 1970s, when you had stagflation, and the worst of the great financial crisis, when debt levels were unsustainable. It’s a slow motion car wreck. This is not a prediction for what’s going to happen to the market in the next three or six months. But over, say, the next two or three years, that’s what I see.”