After a long period of rest, in which the biggest concern of economic policymakers was price deflation, the specter of inflation is once again circling the world. Old debates about how best to protect price stability are being reopened.
Should the monetary and fiscal brakes be applied immediately by cutting spending and raising interest rates - in accordance with the recipe for solving the problem of inflation offered by orthodox economics? Or should it go in the opposite direction and cut interest rates, as the central bank of Turkey is doing under the leadership of President Recep Tayyip Erdoğan? Or we should choose a more direct approach and intervene by introducing price controls and punishing large companies that directly affect their level, as suggested by some economists and historians in the United States.
If you have a ready answer and without much thought you support one and reject the other options - maybe it's time to think again. Economics is not a science with hard and fast rules. Different situations require different solutions. The only valid answer to the question of the best path is: "It depends on many factors."
The solution to the problem of inflation proposed by orthodox economics often produces expensive side effects (bankruptcies and rising unemployment) and does not produce fast enough results. In some situations, the price control regime gives good results, for example during wartime.
Also, in cases where high inflation is primarily a product of inflationary expectations and not the state of "fundamental" economic parameters, temporary control of wages and prices can help the actors that most directly influence the price level to align and accept a new equilibrium at a lower rate. Such "heterodox" programs were successful in the 80s in Israel and several South American countries.
Even the idea that lowering interest rates can contribute to reducing inflation is not entirely unacceptable. There is a school of thought in economics - rejected by much of today's economic establishment - that links inflation to factors that contribute to rising labor and raw material prices, such as high interest rates (which raise the cost of working capital).
The inflationary effect of high interest rates is known as the "Cavallo effect", after the former Argentine finance minister who received his doctorate on the subject at Harvard in 1977. inflation, Cavallo opted for a completely different strategy based on fixing the exchange rate and full convertibility.) This theory has in some cases also received empirical confirmation.
That is why it is pointless to scoff at the currently unpopular ideas about inflation as a form of "science denial", akin to refusing vaccinations for covid-19, although some prominent economists are happy to do so. In fact, the moment our observations of the real world turn out to be inconsistent with accepted theories is the perfect opportunity for young and bright economists to demonstrate that problematic observations can be explained, given certain peculiar conditions. True economic science is always contextual, not universal.
What would a contextual approach to inflation entail today?
Current inflation in the United States and many other advanced economies is significantly different from the inflation we had in the 70s. Today's inflation is neither chronic (at least for now) nor is it generated by price and wage growth spirals and wage indexation.
Inflationary pressure today appears to be the product of a transitory set of circumstances, such as the pandemic-induced shift in spending from services to goods, as well as problems in the functioning of supply chains and other disruptions in production. Earnings are protected by expansive measures of monetary and fiscal policy, but they are also temporary. The alternative was a dramatic collapse of employment and living standards.
Under such circumstances, policymakers in developed countries would have to refrain from rash reactions to rising inflation. As historian Adam Tooze shows, transitory inflation should be responded to in a measured way, either through regulatory measures or monetary policy measures.
The best argument against price controls is not the claim that such measures are "incompatible with science", but the fact that there is no need to consider such radical measures for the time being. The same applies to orthodox economic policies: central banks need to show some patience before they start raising interest rates.
What about Erdoğan's claims that high inflation is a consequence, not a cause, of high interest rates? The validity of such claims has always been questionable, given the multitude of macroeconomic problems that have long been piling up in Turkey.
But even if we cannot resolve a dilemma in advance, time and facts will show which theory made the most sense in a given situation. In the case of Turkey, it is more than clear to what conclusions the knowledge gathered since economic policymakers began the Erdoğan experiment points.
First of all, despite the reduction of the central bank reference rate - the interest rate directly controlled by the monetary authorities - market interest rates have continued to rise. Investors and savers demanded higher interest rates and this raised the cost of credit for borrowers.
This contradicts claims that lower reference rates effectively reduce production costs. It also shows that the rise in interest rates indicates some deeper economic problems, uncertainty about economic policies and rising inflationary expectations in the future.
In some situations, as in the case of Turkey, the arguments of orthodox economics are correct. Experiments that depart from conventional policies can cost us dearly. But this does not mean that there are universal rules in economics or that economic policies should be developed based on the prevailing views of the economic establishment. If so, some of the most important innovations in economic history—for example, the New Deal in the United States or industrial policies in East Asia after World War II—would never have happened.
In fact, targeted inflation itself, as today's dominant framework for conducting monetary policy, is a product of the peculiar political and economic circumstances in New Zealand in the 80s of the 20th century, without foundation in the monetary theories and policies of that time.
Economists should exercise more restraint when recommending (or rejecting) various inflation-fighting strategies. And policymakers, in addition to taking into account all economic evidence and arguments, must show more skepticism towards economists who act with excessive self-confidence.
(Project Syndicate; Peščanik.net; translation: Đ. Tomić)
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