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Why Low Inflation in the Global North Should Be No Surprise


No Longer Fresh Over at Project Syndicate: Why Low Inflation in the Global North Should Be No Surprise: Late last summer the thoughtful and very sharp Nouriel Roubini used his space here at Project Syndicate to attribute the stubborn and, by many, unexpected persistence of low inflation in the Global North to "positive" (so-called, even though a number of them are on balance unwelcome) shocks to aggregate supply: Nouriel Roubini: The Mystery of the Missing Inflation:

The recent growth acceleration in the advanced economies would be expected to bring with it a pickup in inflation.... Yet core inflation has fallen.... Developed economies have been experiencing positive supply shocks.... The Fed has justified its decision to start normalizing rates... by arguing that the inflation-weakening supply-side shocks are temporary.... Central banks aren’t willing to give up on their formal 2% inflation target, [but] they are willing to prolong the timeline for achieving it...

This is, I believe, significantly more likely than not to be a faulty diagnosis. It is, I think, based on a fundamental misreading of the historical evidence from the 1970s through the 1990s about what has, historically since World War II, driven inflation in the countries of the Global North. The near-consensus belief since the 1970s has been and remains that the Phillips Curve has a substantial slope—a strong reaction of prices to demand pressure or slack—so that relatively small excursions of aggregate demand above levels consistent with full employment would have substantial impact on inflation, and that expectations of inflation are rapidly adaptive: easy de-anchored via a process in which accelerations of inflation in the recent past get rapidly and substantially incorporated into inflation expectations for the future.

More than twenty years ago I wrote an article, America's Peacetime Inflation: the 1970s challenging this standard near-consensus narrative as it had developed back then. The excursions of aggregate demand above levels consistent with full employment were few, short, and small. The incorporation of past inflation jumps into expectations of future inflation took place not rapidly but slowly. It took three large adverse supply shocks—the Yom Kippur War, the Iranian Revolution, and the 1970s productivity slowdown in the context of an economy in which unions still had substantial pricing power and previously-contracted wage increases. And even then more was required: hesitation on the part of central bankers, chiefly Arthur Burns, to commit to achieving price stability. Burns, rather, tended to (understandably) shrink from the consequence that focusing on price stability would bring deep recession, and to kick the can down the road in the hope that something would turn up. And so the stage was set for 1979, the Volcker Disinflation, and the Near-Great Recession of 1979-1982.

Yet, somehow, this actual history of what had happened was swallowed up by a peculiar and particular narrative. The narrative went and goes something like this:

  • Keynesian economists in the 1960s did not understand the natural rate of unemployment.
  • Hence they convinced central bankers and governments to run overly-expansionary policies that pushed aggregate demand above levels consistent with full employment.
  • And this sin against the Gods of the Market was followed by the natural retribution, in the form of high and persistent inflation.
  • This sin then had to be expunged by the sacrifice of the jobs and incomes of millions of workers via the Volcker Disinflation.
  • We must not allow economists and central bankers to commit this same sin of running overly expansionary policies again.

Why does this—not very true—story of what happened in the 1970s have such a hold on us? Why has it continued to have a hold even though it has been a bad guide to the economy since? Those relying on the 1970s and using their image of it to argue for imminent upward outbreaks of Global North inflation in the 1990s, 2000s, and now 2010s have all been wrong. The idea that the natural rate of unemployment was a stable parameter or, indeed, something that could be effectively estimated was also exploded by Staiger, Stock, and Watson more than twenty years ago. The belief that the Phillips Curve has a substantial slope did not survive Blanchard, Cerutti, and Summers. And the belief that the slope of the Phillips Curve was substantial even in the 1970s depends on one's averting one's eyes from the supply shocks of that decade, and thus attributing to demand events that are more plausibly attributed to supply.

Yet not the memory of what happened in the 1970s but rather the constructed image still has a powerful hold today. Why?

The best—although still inadequate, and highly, highly tentative—explanation of this that I have heard is that this story pattern fits with our cognitive biases. This story pattern is one we expect and like to hear. We appear to be pre-programmed at a deep level to seek for and resonate with stories of sin and retribution, crime and punishment, error and comeuppance. From whence this cognitive bias arises may launch many careers in psychology in the future. But we do not have to be prisoners of our heuristics and biases. And we should not be.