Economic history is rarely taught in universities these days. This is a pity, since it is a better guide to policymaking than Nobel Prize winning theses in economic theory. As a result, every two generations or so we are destined to repeat serious policy mistakes. In Britain the Truss government failed to study the Barber Boom of 1972-73 and arguably the world’s central banks too have failed to learn from the oil price shocks of 1973 and 1980.
Stephen D King’s highly readable and informative book provides a welcome antidote. Its title is spot on. We should talk about inflation, not least because of its arbitrary incidence. It penalises thrift and rewards profligacy. It makes planning difficult. And it enables government through sleight of hand to impose stealth taxes through freezing tax thresholds and real wage cuts on its employees.
King’s canter through 2,000 years of inflationary history — from Emperor Diocletian’s debasement of the coinage through to the Federal Reserve’s decision in 2021 to allow inflation to run at above the 2 per cent “central target” — is instructive. Money matters. Print too much and inflation generally follows. But sadly the quantity of money and inflation is not so correlated as to make monetarism — the strict control of supply — an effective policy guide.
Confidence in a currency matters too. Lose it and trust in institutions diminishes. You only have to look at the experience of Argentina and Brazil. But the history of institutions in mature economies also contains lessons. During the 19th century, the high water mark of the gold standard, the purchasing power of sterling increased by 48 per cent. During the 20th century, when both the gold standard and the post-1945 Bretton Woods system of fixed exchange rate collapsed, sterling’s purchasing power fell by 98 per cent.
When inflation is rising, governments invariably blame external factors. And we should be in no doubt that the supply chain problems arising from the pandemic, and the energy price increases generated by the war in Ukraine, have been a major factor in the recent upsurge in inflation. But the ease with which inflation took root must also reflect the excessively loose monetary policy of recent years.
King concedes in We Need to Talk About Inflation that “the big challenge regarding inflation is to work out which of its many instances are temporary — the Korean war, for example — and which are likely to persist”. The answer, he writes, lies in four tests.
First, have there been institutional changes suggesting an increased bias in favour of inflation? King argues that central banks’ bias against deflation during the past decade may have created a bias in favour of inflation. He adds that by distorting the bond market, quantitative easing removed a key early warning indicator available to central banks to gauge inflationary risks: freely moving prices in government paper. Quantitative easing — the lowering of market interest rates through the large-scale buying of government bonds — also muddied the relationship between finance ministries and central banks, sucking the latter into the corrosive orbit of fiscal decision making.
Second, are there signs of monetary excess that indicate heightened inflationary risk? Here, King points to the rate of US monetary expansion during the pandemic.
Third, are inflationary risks trivialised or excused? It took 2.5 years for the annual rate of UK inflation to rise from 0.3 per cent to 10 per cent: yet, throughout that period, the Bank of England persistently forecast that inflation would return to the 2 per cent target within two years.
Finally, have supply conditions changed for the worse? The supply chain problems of the pandemic may be receding, but trade barriers — often mis-sold as greater national resilience — remain on the increase. And whatever the benefits of Brexit in terms of “taking back control”, all the signs are that it has damaged the British economy’s ability to grow.
Arguably, King’s tests are retrofitted to give one answer: that inflation would rise and persist. But it doesn’t mean he’s wrong. As inflation begins to fall through this year, it will be tempting to think that it will inexorably return to target. That appears to be the view of the central banks and the markets.
But the warning signs are still there. Economies are still close to full employment. Vacancies remain elevated.
Real interest rates remain negative. Quantitative tightening may have begun. But the central banks still own eye-watering quantities of government bonds suggesting monetary conditions remain loose.
King fears that central banks’ missions have become too wide. As he puts it, “financial stability, full employment, green finance, and, in the European Central Bank’s case, preservation of the euro may all have been worthy objectives but there was no guarantee that they could all be met simultaneously.” The resulting trade-offs forced central banks “to make choices that they were politically ill-equipped to carry out”. The recent banking crisis has certainly underlined the very real tension between monetary policy and regulatory responsibilities.
Perhaps, central bankers have spent too much time in the company of politicians: they don’t want to be blamed for higher unemployment. They may be legally independent. But they are no longer the detached philosopher kings of legend, immune to the social consequences of their actions in the inexorable pursuit of low inflation.
In one sense, this is desirable. We want central bankers to care about the society they serve. But it’s a further sign of a bias in favour of inflation. And King’s timely book should be essential reading for economic policymakers everywhere.
We Need to Talk About Inflation: 14 Urgent Lessons from the Last 2,000 Years by Stephen D King, Yale £20, 224 pages
Nicholas Macpherson is a former permanent secretary at the UK Treasury
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