David Warsh: Knowledge and skepticism about the causes of inflation

SOMERVILLE, Mass.

In their introduction to the conference volume Knowledge and Skepticism, its editors wrote that there are two main questions worth asking in epistemology.  What is knowledge? And, do we have any of it?  Their formulation has often come to mind these days in connection with Russia’s invasion of Ukraine, but it has also welled-up in my thinking in connection with a very different matter, the phenomenon of inflation.

Charles Goodhart is a central banker’s expert on central banking.  Having completed his PhD at Harvard University, in 1963, he worked for seventeen years as an adviser to the Bank of England on domestic monetary policy, during the tumultuous but ultimately successful battles in Britain and the United States against global inflation, all the while pursuing a thorough examination of the rationale for bank regulation in the first place.

In The Evolution of Central Banking (1988), he traced the history of the most important and least understood regulatory institution of modern government, and for the next thirty years remained in the forefront of the discussion of supervision of the world banking system.

Then, in 2020, with Manoj Pradhan, the 84-year-old Goodhart published The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival, arguing that that, owing to declining fertility rates in China and the West, the coronavirus pandemic has marked a watershed between the deflationary forces of the last thirty or forty years and a coming twenty years or so of rising prices.  A headline of a recent story on the front page of The Wall Street Journal conveyed the story:

Will Inflation Stay High for Decades? One Influential Economist Says Yes

Charles Goodhart sees an era of inexpensive labor giving way to years of worker shortages—and higher prices. Central bankers around the world are listening.

Goodhart predicts that inflation in advanced economies will settle at 3 percent to 4 percent around the end of 2022 and remain at that level for decades, wrote WSJ reporter Tom Fairless, as opposed to about 1.5 percent in the decade before the pandemic, with interest rates correspondingly higher. The Black Death, a 14th Century pandemic, had triggered a similar quarter-century of soaring wages and rising prices, he observed. You can read Fairless’s story yourself, thanks to this free link.

The question is, if Goodhart is right, what should central bankers do about it? Ever since he first presented his findings to a meeting of central bankers in 2016, monetary policy specialists representing various interests and points of view have been arguing about it. “Lower for Longer, ‘‘the latest report of the technical advisory committee of the European Systemic Risk Boars, takes Goodhart’s argument into account and differs sharply.

Among the experts exists a 400- year-old difference of opinion, known by different names at different times, of which Keynesian and Monetarist or Freshwater Saltwater are only the most recent. Some conclude that making appropriate policy is relatively easy: Simply require the central bank to control the supply of money. Others say central bankers’ job is difficult. John Greenwood and Steve H. Hanke, of Johns Hopkins University, put it this way in a recent Journal of Corporate Finance,

There have always been two types of explanations for inflation: ad hoc explanations and monetary explanations. Historically, the ad hoc explanations have been in terms of special factors present on particular occasions: commodity price increases due to bad harvests, supply disruptions due to restrictions on international trade, profiteers or monopolists holding back scarce goods, or trades unions pushing up wages leading to a wage-price spiral or cost-push pressures, and so on in great variety. Even the widely used aggregate demand-aggregate supply model is a species of ad hoc explanation in the sense that it relies on idiosyncratic factors driving estimates of the output gap or special factors affecting the supply of labor or productivity.

The monetary explanations for inflation have focused on increases in the quantity of money: either new discoveries of gold and silver in centuries past, or fiat money creation by the banking system or by the central bank in modern times.

I am an economic journalist, not an economist, and to my mind, there has always seemed something a circular about the shorthand explanation of rising prices, to the effect that “inflation is a matter of too much money chasing too few goods.” By making “rising prices” of goods synonymous with “inflation” of the quantity of money, the language of the shorthand assumes its own truth, and gives short shrift to the changing nature of “goods.” What about the declining fertility rate in China and the West?

As a journalist, I’ve come to think that a more revealing formulation of the difference of opinion about rising (or falling) prices is to be found in Joseph Schumpeter’s History of Economic Analysis (1954), where the economist distinguished between real and monetary analysis. Real analysis, Schumpeter wrote, is old as Aristotle. It “proceeds from the principle that all the essential phenomena of economic life are capable of being described in terms of goods and services, of decisions about them, and relations between them.  Money enters the picture only in the modest role of a technical device that had been adopted in order to facilitate transactions,” and, occasionally, in the central role of what are described as “monetary disorders.”

Monetary analysis, Schumpeter continued, denies that money is of secondary importance in economic affairs., “We need only observe the course of events during and after the California gold discoveries to solidify ourselves that these discoveries were responsible for a great deal more than a change in the unit with which values are expressed,” he added, observing that money serves as a store of value as well as a means of transacting business.

Nor have we any difficulty in realizing – as A. Smith did – that the development of an efficient banking system may make a lot of difference in the development of a country’s wealth.

Schumpeter did not have an especially  high opinion of Adam Smith!

As it happens, I wrote a book about all this forty years ago. As a magazine writer in New York, I had come across a 700-year index of the cost of living in a certain fashion in England. It showed two decades-long periods of steadily rising prices, one in the 16th Century, another in the 18th, both of which eventually leveled off, never returning to their prior levels. So I wrote in 1975 that the rising prices of the ‘50s, ‘60s and ‘70s, too, would probably level off one day, though I didn’t venture why or when, much less mention Paul Volcker, the Federal Reserve Board chairman in 1979-1987.

My interest piqued, I spent a year in the New York Public Library unburdening myself of (some of) my ignorance, before turning back to the task of earning a living, this time as a newspaperman in Boston.  By then I was more interested in the history of technology and government.  Money and banking? Yawn!  The Idea of Economic Complexity finally emerged in 1984, with nothing more to unify those ad hoc accounts of rising prices than the word complexity; intuitively appealing, perhaps, but analytically empty. It was a shaggy little book, in James Fallows’s apt description, politely received and quickly forgotten.

But before it was, Charles P. Kindleberger replied to a note I had written to say that I was entirely right that complexity does not communicate itself to economists, “at least not to this economist.” Kindleberger and I gradually became friends, and  gradually I learned how little I understood how about the languages in which economist wrote for one another. Since then my knowledge of economics has increased to include, for example, the distinction between real and monetary analysis, and so has my admiration for what professional economist have achieved in the 250 years they have been doing business together.  But then so have my doubts that economists have yet learned all there is to know about the understanding their science can produce.  And, suddenly, primers on “inflation” are back in the news for the first time since in forty years.

So I plan to write a few pieces, half a dozen in all, one after another, about what I have learned about what I was trying to say forty years ago, anchoring each in a particular book or article that opened my eyes. I am not a true skeptic in the philosophers’ senses; don’t think that nobody knows anything: I think that economists know a lot. But I believe that they are still learning, that there are things that economists don’t yet know how to say, and that journalists can contribute to the conversation.

If you are looking for state-of-the-art knowledge, read Charles Goodhart. If you are interested in informed speculation, keep reading here.  Better yet, do both. A lot of adventure lies ahead.

David Warsh, a veteran columnist and an economic historian, is proprietor of Somerville-based economicprincipals.com, where this column first appeared.