The macro revolution continues

I am increasingly convinced that we are at the cusp of the biggest revolution in macroeconomics in at least 60 years. Over the last decade, the number of studies that have empirically investigated theories developed by neoclassical economists like Milton Friedman or Robert Lucas and rejected them has grown tremendously. Just like evidence-based medicine has led to the demise of previously common treatments, empirical studies of markets will in my view lead to a revolution in macroeconomics over the coming decade that will make many of the things we take for granted today obsolete.

It is by now well-established that trickle-down economics doesn’t work and that cutting taxes does not stimulate the economy (at least not enough to increase welfare). Lower taxes also do not boost investments by companies or the stock market. We by now even know that demand curves aren’t always downward sloping (i.e. higher prices do not necessarily lead to lower demand) and the economy does not trend towards a market-clearing equilibrium in the long run.

Yet, these ideas are still used as the very foundation of policy decisions and market forecasts. In 2021, we are again talking about austerity measures as a necessity to rein in deficits and inflationary fears, though there is no link between deficit spending and inflation. We have seen people argue about central bank ‘money printing’ as a driver of inflation, even though that link has been broken for three decades now.

And now, Jeremy Rudd is challenging the very foundation of monetary policy: That inflation expectations matter for future inflation. Jeremy Rudd is an economist at the Federal Reserve and he has published a paper that has become a sensation amongst economists and is a must-read for every professional investor, in my view.

In that paper, he methodically analyses the theoretical and empirical validation of the assumption that inflation expectations are a major driving force of future inflation. This assumption rests on papers published by Milton Friedman, Robert Lucas, and Ed Phelps in the early 1970s. These theories contain a surprisingly large amount of handwaving and overly general assumptions about how employers and consumers form their inflation expectations. Never mind the unrealistic generalisations of these theories, the runaway inflation of the 1970s looked like a major success and they have become gospel in monetary policy circles ever since. Since the mid-1980s, most central banks in the west have tried to target inflation expectations with their monetary policy measures, arguing that if people expect inflation to rise in the future and thus will demand higher wages and increase prices in order to protect their margins.

You should read the paper by Rudd to get a full grasp of all the ways the theories by Friedman, Phelps, and Lucas fail in practice, but as a starter, let me tell you that these theories assume that workers enter wage negotiations by trying to anticipate future real wages and have no money illusion (that is, higher nominal wages are discounted because workers understand that inflation will reduce these nominal wages). Meanwhile, the theories assume that employers do not base hiring decisions on future real wages or future inflation but on current real wages and current inflation. In this fairy tale world, workers demand higher wages if they anticipate inflation to rise and employers are paying these higher wages since they only look at current wages, not future wages.

Meanwhile, back in the real world, we know that workers and employers both are subject to money illusion and do not correctly account for short-term inflation and we also know that employers care very much about future wages and wage inflation.

Ironically, all the theories of inflation developed by the neoclassical economists depend on short-term inflation expectations as the driving force of wage inflation, while monetary policy today puts all its emphasis on long-term inflation expectations and anchoring these at a certain level. These are two different things and somehow, over the decades, a theory that relied on one thing has morphed into a policy that relies on the other.

But what does drive inflation in the real world? If it’s not expected inflation in the future, what is it? Here the behaviour of real people in the real world can provide some clues. It seems that workers and households form their views on wages and inflation not on future expected inflation, but rather on the recent deviation of inflation from long-term historic averages. If consumers experience a bout of higher than usual inflation, they will ask for higher wages. If inflation calms down again, wage inflation declines because workers ask for fewer wage increases.

Furthermore, the negotiating power of workers has substantially declined. With the demise of unions, workers have now much less negotiating power than in the 1970s and higher inflation is much harder to translate into higher wages than fifty years ago. So even if people demand higher wages, we can thank conservative administrations of the 1980s for their inability to actually get those higher wages by reducing the influence of unions. The low inflation of the last thirty years and rising wage inequality and the demise of the working classes are two sides of the same coin.

But if real people do form their wage demands not on expected inflation but based on the observed deviation of inflation from recent trends, it could be that current monetary policy might lead us into a world of permanently higher inflation, yet again. Last year the Fed announced its strategic shift to allow inflation to surpass its 2% target for an extended period of time as long as long-term inflation expectations remain well-anchored. This is to allow inflation to average 2% over time and make up for periods of low inflation with periods of high inflation. But if people demand higher wages based on their experience of recent inflation trends then letting inflation run above 2% for an extended period of time could leave long-term inflation expectations well-anchored, but still increase wage inflation pressures and create a 1970s-style wage-price spiral simply because every year, recent inflation is above historic averages.

The evidence isn’t strong enough, yet, that this will truly happen, but you can rest assured that if inflation remains high, pundits will blame everything from central bank money printing to fiscal deficits on it. They will run a victory lap even though they have completely misdiagnosed the situation. And journalists will celebrate these people as heroes and theories of monetary policy that have long been refuted will be revived once more. Don’t believe them. Read Rudd’s paper and you will be smarter than these morons who live in a world of fairy tales.