From the July 2011 issue of Research Magazine • Subscribe!

July 1, 2011

Inflated Science

Economists don’t understand the economy.

In 1968, the Swedish central bank donated money to the Nobel Foundation to establish a Nobel Prize in economics. It became the sixth category in which the world’s most prestigious accolade was awarded, joining physics, chemistry, medicine, literature and peace. Economics, which when the other five prizes were created in the late 19th century had been in its infancy, now was legitimized. Indeed, a solid conceptual framework seemed to have been developed to analyze relationships between economic players and, equally important, to use the laws of economics to forecast the future, formulate policy and create stable and prosperous societies.

All that is now out the window. Recent economic history shows that both academic economists and economic and monetary policymakers do not know the first thing about inflation, which has far-reaching implications for economic science in general.

Unproven Theories

Concerns about the laws of economics, at least as far as analyzing inflation was concerned, began to emerge a decade after the first Nobel Prize was awarded in 1969. The close correlation between economic growth and price increases had been well-understood both on the intuitive and theoretical level. Faster economic growth has to produce a higher rate of inflation and, in turn, slower growth also slows price increases. A recession can give rise to deflation, a situation when the prices of goods and services fall. Moreover, once inflation takes hold, inflationary expectations perpetuate price increases. Market players rush to buy goods and services to beat the next round of price increases, thus pushing prices higher. In deflation, the same spiral works in reverse. As consumers wait to buy, prices fall.

However, in the late 1970s a wholly unexpected and unexplained phenomenon occurred — stagflation, when double-digit inflation was accompanied by stagnant economic growth. Soon, however, any concerns were allayed when inflation was defeated by the application of conventional economic policies. The Federal Reserve under Paul Volcker jacked up interest rates, whereupon prices began to moderate.

After the experiences of the 1970s and early 1980s, inflation was seen as public enemy No. 1 and the Fed raised rates every time economic growth accelerated and the economy seemed in danger of overheating. But inflation continued to moderate, and stayed very low even through the 1990s economic boom, when the unemployment rate fell well below what had previously been considered a full-employment rate of unemployment — which by definition couldn’t get any lower without triggering inflation. That too was inconsistent with economic theory — because strong demand for labor was supposed to stoke labor costs and unleash inflation. But since the economy was enjoying a period of strong noninflationary growth, this problem was ignored or pooh-poohed by economists.

An Amazing Millennium

But the really crazy stuff began to happen after the year 2000. The U.S. economy went through an extraordinary economic boom while riding roughshod over all economic prescriptions and disregarding flashing warning signs of imminent inflation. Throughout the first decade of the new century, inflation remained a dog that stubbornly refused to bark.

Back in the 1970s, when I first began studying economics, the origins of the inflationary spiral that we were living through at the time were clear. Lyndon Johnson had made a political choice to pursue his War on Poverty at home while fighting a real war abroad. The government began running a budget deficit and by the early 1970s it resulted in a burst of inflation. After 1973, higher oil and other commodity prices contributed to the already mounting inflationary pressures.

A very similar scenario played out starting in 2001 — except for a repeat of inflation. Great Society programs now took the form of massive tax cuts, whereas the United States soon found itself entangled in two costly wars at the same time. Oil prices moved very much as they did in the 1970s, rising for a full decade and stabilizing at a far higher plateau than had previously been the case. But price increases, at least as measured by the consumer price index, remained extremely moderate and inflation was never a major problem facing the monetary authorities.

After the 2008 global financial crisis, matters became even more perplexing. David A. Stockman, the Director of the Office of Management and Budget during Ronald Reagan’s first term, has become an implacable critic of Fed Chairman Ben Bernanke. He believes that the Fed has no idea what it is doing and into what kind of uncharted waters recent monetary and fiscal policies have taken the ship of the U.S. economy.

He is most likely right. Nothing in past economic practice allows us to understand where the economy is headed, and economic theory is no guide, either. If Prof. Bernanke, while teaching economics in Princeton, had a dream in which he as a Fed chairman were keeping U.S. interest rates at zero for more than two-and-a-half years while printing some $3 trillion in additional money and watching the federal government run up a string of $1 trillion-plus deficits, he would have asked to be awakened from this horrible nightmare. Any sane economist would have told you only five years ago that maintaining such policies even for a few short months would trigger a burst of inflation, undermine worldwide confidence in the dollar and irreversibly shred confidence in paper money.

Need for a New Model

Bernanke is like a cardiologist who puts a patient diagnosed with hypertension, high cholesterol and clogged arteries on a high salt, meat-and-butter diet only to observe in amazement that instead of having a heart attack or a stroke, his patient begins to show clear signs of improvement.

There have been attempts to explain why inflation has not occurred yet, or why it will happen later and what has kept consumer prices from rising. Nevertheless, there is enough evidence to suggest that there is something wrong with the underlying theory and that the origins of inflation are not sufficiently grasped by economic science. Previous experiences with inflation — hyperinflation in Germany in the early 1920s and a general acceleration of prices in the world economy in the 1970s — were probably not enough to study the phenomenon in depth.

There are two implications that follow from this statement. First, if we don’t understand inflation, it means that we do not fully understand money and its role in the economy. Since money is the lifeblood of the modern economy, this means, more broadly, that our existing economic models do not provide a useful framework for analyzing economic processes and relationships.

Second, without a clear understanding of the origins of inflation, it will be far more difficult for monetary authorities to combat it if and when it rears its ugly head again. Since the advent of the global financial crisis in 2008, central bankers around the world have been insisting that the economic slump and deflation are far more dangerous than inflation. Their priority is to counteract the economic crisis and prevent deflation, even at the risk of unleashing inflation — because we know how to combat inflation. Such confidence may be dangerously misplaced.

Physicists have a very good principle. They observe natural phenomena and every now and again they stumble against something that is not adequately explained by the existing theory. They try to amend the theory in the hope that it could offer an explanation, but if those attempts fail, they junk the theory and go back to the drawing board.

Fortunately, some such attempts are being made in economics. A number of economists are working to develop new theories and new branches of economic science, such as behavioral economics. They are trying to build bridges to other social sciences, including psychology and anthropology, and to develop new mathematical models of economic behavior. Valuable insights have started to emerge, and new theories may be forthcoming. As Yale professor Robert Shiller told me a few years ago in an interview, these are early days as yet.

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