We Need To Talk About Inflation...

My interview with Stephen D. King

Greetings The War on Prices subscribers,

On April 5th I sat down with British HSBC economist Stephen D. King to discuss his excellent new book “We Need To Talk About Inflation: 14 Urgent Lessons from the Last 2,000 Years.” (Buy it!)

In this interview, King and I discussed why policymakers missed the inflation surge, the link between monetary and fiscal policy, the economic costs of inflation, the difficulties of curbing it, and how inflation leads to misguided policy responses—such as wage and price controls.

For the video: click here, or on the picture. Otherwise, you can read the full transcript below or on Substack.

Enjoy!

Ryan

Ryan Bourne (01:27) Now I usually start these sorts of interviews by asking authors: what is your book about? But that seems a bit of a redundant question given both the moment and the title of the book. So perhaps let's kick off with this one instead. When and why did you start becoming concerned that the inflation genie was back out of the bottle?

Stephen King (01:48) Well, that's a very, very good question. I have to admit that over the last two or three decades, I've been mostly worried about deflation or disinflation, mostly worried about a sort of Japanification of the Western developed world. But I suppose I began to think at the beginning of 2021 that things were rather different from expectations. You had the pandemic, there's lots and lots of talk from central bankers about the risks of deflation associated with the pandemic, particularly the impact on demand of these lockdowns that came through. Yet initially, inflation wasn't really falling. And then towards the tail end of 2020, and particularly into the first two or three months of 2021, you first of all had the US inflation rate beginning to move higher, surprising on the upside relative to almost all the forecasts that were out there at the time. But in short order, that was followed by the same kind of story coming through in both the UK and in the eurozone.

And I think it was particularly important that it wasn't so much the US story alone, because a lot of people tried to explain that away through the Biden fiscal stimulus and saying this is a uniquely American event. The problem was, it wasn't  obvious  why a uniquely American event would then lift inflation in the UK and in the eurozone. So it was the kind of transatlantic nature of these inflationary surprises that made me wonder if perhaps things had changed and everything I wrote about inflation thereafter followed from that initial insight I suppose.

Ryan Bourne (03:26) Yeah, and it strikes me that one difficulty of this moment is that there are feasible supply-side and demand-side stories to explain the inflation we've seen. If we go back to Milton Friedman's framing of inflation as always and everywhere a monetary phenomenon in the sense that it can be produced only by, I think he says, a more rapid increase in the quantity of money than in output. Well, on the output side, we have had a pandemic and a war in Ukraine that have conceivably reduced the potential of the economy to produce goods and services. But of course, the we've also had the money supply pumped up by central banks and big demand side stimuluses from governments too. So unpicking what's to blame is more difficult perhaps this time than with some other inflations. So how do you kind of think about that and disentangle the contributions of those different drivers?

Stephen King (04:25) Well, this is admittedly very tricky. And I think it's something that central bankers themselves have struggled with because their initial interpretation was that all of this was “transitory,” to use a word that was very popular back in 2020 and 2021. And of course, Jay Powell, the chair of the Fed has now effectively abolished the use of the word transitory because it turned out that inflation was at least more persistent than had been initially expected.

So the first thing I would say is that over the last 20 or 30 years we've had prices going up, typically offset by other prices going down. Some goods rise in price, some services rise in price, others fall, and they kind of offset each other to such a degree that you end up with relatively stable overall inflation. What's been odd, I would suggest, over the last two or three years is that you've had some prices rising very, very quickly indeed, but very, very few prices, if any, falling over the same period of time. So it's kind of the absence of those disinflationary or deflationary offsets itself I think is a genuine shift from what we've seen over the last 20 or 30 years.

The second factor to go back to Milton Friedman is that I think that there were two policy decisions made in 2020, one of which was right and one of which was probably wrong. The first which was right was the enormous fiscal stimulus. Now this is not fiscal stimulus in the usual way. This was, I would suggest, building a financial bridge between a pre-COVID world and a hoped-for post-COVID world. And the idea was that you would try to preserve your economic infrastructure as much as you possibly could during the lockdown. So trying to avoid mass bankruptcies, trying to avoid mass unemployment. And I think to a large extent, those policies on the fiscal side succeeded. Now, of course, the consequence of that is much higher levels of government debt. But that may well have been a price worth paying given the circumstances of the time.

At the same time, central bankers looked at what appeared to be a catastrophic decline in GDP in terms of economic output,  really on par with what we had seen during the Great Depression in the 1930s. And faced with that decline in GDP or output, I think there was a genuine fear that we could be on the verge of another Great Depression. Everyone knows from the Great Depression that the thing to do in those circumstances is to print lots of money to stop those deflationary forces from really working their way through.

However, what we discovered very quickly was that unlike the Great Depression, there were no mass bankruptcies, there were no serious bank failures, there was no collapse in asset prices, there was no debt deflation. So effectively you had this huge monetary stimulus for really no obvious long-term purpose. And it also suggests that when the inflation did start to rise, I think that central banks were so fixated with the past story of deflation or disinflation that it was almost as if they couldn't intellectually imagine the return of inflation. So, it was partly a story about excessive stimulus, excessive monetary expansion in 2020, but it was also partly almost a refusal to accept that one of the consequences of those actions was a significantly higher inflation than any of the central banks themselves had anticipated.

So yes, there's certainly some stuff you could blame specifically on the pandemic such as increases in semiconductor prices, increases in second-hand car prices. There are also things you can subsequently blame on Vladimir Putin, his invasion of Ukraine, his impact on energy prices and latterly food prices too. But in terms of the overall extent of the surprise and the persistence of the surprise and inflation, I think policy, I’m afraid to say, has also played a role.

Ryan Bourne (08:35) Yeah, I guess it's trivially true that the pandemic is responsible in the sense that we wouldn't have seen the extraordinary policies had the pandemic not hit. But that doesn't really take us very far in terms of dealing with the issue as we see it now.

I do worry about the point that you highlighted about policymakers often trying to fight the last war or fight previous wars when this comes about. And that really brings me to my next question - we kind of jumped ahead a bit to the “what done it?” - but there's another question for policymakers to perhaps consider, which is: why did so many of them, including economists and central banks, miss it?

Because in hindsight, you look back at the conditions that we saw under any of the major kind of macroeconomic schools of thought, and it's clear that there were pretty big upside risks of inflation, right? So you take an old monetarist perspective, the money supply had obviously surged, and there was an expectation that the velocity of money might increase significantly as the economies opened up again post-COVID. From a new Keynesian perspective, you had people pointing out that the stimulus was quite excessive relative to what's described as the output gaps of the economies. And even if you're one of the more heterodox fiscal theory of the price level guys, you might have worried that the pandemic had actually shown governments willingness to really borrow and maintain permanently elevated borrowing coming out of the pandemic, almost without limit.

So you look at all these theories, and they all point towards a big risk of inflation. So why didn't more people than you, Larry Summers, Olivier Blanchard, and a few of the monetarists actually see it coming?

Stephen King (10:10) Well, I think there are a couple of explanations. The first one is that in the initial stages of the pandemic, all the emphasis was on losses of demand rather than losses of supply. I think in hindsight, we now know that the losses of demand were temporary. In many cases, the initial losses were made up through huge gains in wealth in 2020, 2021 through big gains in stock markets and so on. So, coming out of the pandemic, it turned out that people had much greater spending power than perhaps had been anticipated in the middle of the pandemic. So that I think is also important.

But frankly, I think that central bankers themselves may have been caught up by their own propaganda. And this is partly a story about how they think about policy and how it works. Now, in the good old days, and this is maybe not so good, but many years ago, when you think about monetary policy, there was typically a policy instrument, for example interest rates, that you had an intermediate target, say the money supply or the exchange rate, and that ultimately fed through to inflation. The reason why you had that arrangement was so people knew full well that the lag between changes in policy rates and the actual inflation rate was very long and very variable, so the chances of getting it right were not that high.

However, because the relationship between money and inflation wasn't that strong, and because the same was also true of the exchange rate, those intermediate targets were largely abandoned. For many years, central banks focused on this idea of saying: “well, we can forecast where inflation will be in a couple of years time and we'll simply promise the public that's where we will take inflation too and they'll believe us and everything will be absolutely fine.” Well of course that's fine until it stops working. Central banks are behaving almost as if they've got a time machine they can take themselves through to two years from now and say “ah yes, because we are credible, and because the public believes that we’re credible, we are guaranteed to get down to 2% inflation” or whatever the target happens to be.

But in truth, if you get a regime shift, whereby for any given level of activity, inflation ends up being higher, or if you have a sustained period of inflation being higher than target and the public begins to question the ability of the central bank to hit its targets, the idea that you can safely predict where inflation will be in two years’ time begins to fall away. It's quite striking if you look at the forecast from central bankers over the last two or three years. For example, the Bank of England’s two-year-ahead forecast is almost invariably at 2%, no matter what is happening today. And it's almost as if they're saying, “we can't afford to predict an error in terms of policy, so we will always forecast that inflation is at 2%.”

That’s not forecasting at all, that’s an assertion that things will work out and be the best of all possible worlds. And I think we've discovered that it is not just central banks alone that determine what happens with inflation. It is also events in some way or another. It is also the possibility that central bankers are not God-like, that they can actually make mistakes, that they are vulnerable to making mistakes. And also the fact that there's almost a compact between the central banks and the public. If the public begins to believe that the central bank no longer is properly in control, then it's just as important the public's mind changes as the central banks themselves could get it wrong. That really matters in terms of people's perceptions as to whether inflation is going to remain stable in the future.

Ryan Bourne (13:56) Yeah, that's a really important point and I think an underappreciated point when people see these stories in the newspapers about forecasts. Quite often there's just an assumption that things return to normality not just on inflation, but things like the economy fulfilling its potential as well.

Stephen King (14:14) I should just add one thing, if I may, which is, economists outside of central banks are as guilty as the central banks themselves of this, because the easy thing to do as an economist forecasting inflation is to say, well, what has the central bank told me inflation will be in two years' time? What's the inflation target? In other words, do I have a good reason to think the central bank deliberately wants to miss the target? Well, no. Therefore, the safest forecast to make is that they'll hit the target, which seems to ignore all the aspects of uncertainty which ultimately govern how policymakers have to deal with the real world.

Ryan Bourne (14:53) Very good point, well made. There's one issue I want to explore in a bit more detail, and that really is the relationship between fiscal and monetary policy. You know, government's borrowing policy, taxes and spending, and monetary policy. Because I think your book does a really nice job in explaining why these are perhaps interlinked, or perhaps more interlinked than some theories admit.

You know, not long ago, at the back end of 2022, there was a big experiment of fiscal policy in the UK. One of the things that many people pointed to in justify it was that monetary policy controls inflation. With fiscal policy, we can afford to achieve other aims. On the right, that might mean trying to generate the supply-side conditions for growth. On the left, it might mean more redistribution or more social spending. But I think a lesson of that experiment is that these things are more interlinked than perhaps these people might care to admit. And you have a very fun analogy in your book. You call monetary and fiscal policy the economic equivalent of Elizabeth Taylor and Richard Burton. Why don't you tell us what you mean by that and how you see the relationship between the two.

Stephen King (16:03): Elizabeth Taylor and Richard Burton were two of the most famous people in the world back in the 1960s. These two incredibly glamorous Hollywood stars who got married and had a very public relationship and then got divorced and then got married again and then got divorced again. The story goes that just before Richard Burton died, he wrote a final love letter to Elizabeth Taylor, which apparently, she took to her grave when she died.

These two people were sometimes together, sometimes apart, but you could never predict exactly what was going on. Now, what I would suggest in recent years, is that we've assumed that monetary and fiscal policy are like Elizabeth Taylor and Richard Burton during one of their divorce phases rather than one of their married phases. This is partly because central banks themselves have been independent and the independence was partly driven by the idea that you wanted to avoid any risk of central banks being asked to monetize, to finance government borrowing, because that way is the path towards really horrible rates of inflation. But what's interesting about the post global financial crisis period, is that the relationship was rekindled in ways that perhaps people hadn't fully anticipated.

One way you can think about this is through the impact of quantitative easing. Now, there was some criticism, very early on that QE would immediately create inflation. I think that was wrong. It was wrong because during the global financial crisis there was a massive destruction of what I would loosely call private money, assets that were treated to be near money which lost their value rapidly. So there was effectively a shortage of the combination of private and public money. It was important you created public money to offset the loss of private money and that was effectively what QE was doing.

I think QE, rather than being abandoned when the recovery came through, central banks stuck to it because they worried that interest rates were too low, that growth was too weak, that there was too much disinflation and not enough inflation. So they stuck with a policy that was originally supposed to be an emergency policy, and I think this created changes and incentives elsewhere within the public sector. The most obvious of these is the fact that government debt levels have risen rapidly as a share of GDP over the last 10-12 years.

And typically that only really happens during wartime. So this has been unusual, the extent to which government debt has risen as a share of GDP. And you might arguably say that's been partly facilitated by knowing that QE was always there to finance that process.

But in terms of inflation specifically, I think QE has had another impact, which is that if you're trying to spot inflation in advance, wanting to know it's about to appear, in the old fashioned way, you would look at the bond market. You would look at whether the bond market vigilantes were becoming worried that yields were beginning to rise. This would be your early warning system, your radar for telling you that there was something bad about to happen and you could perhaps preempt that. But if you persistently do QE, then effectively you're removing your early warning system, you're getting rid of your radar system. So you have no easy way of anticipating inflation until it hits you right in the face.

I think that QE itself has not only created conditions where monetary and fiscal policy are being tied together again because of its persistence, but also it has actually reduced the ability of central banks to spot precisely the thing they're supposed to be worrying about, which is the presence of inflation.

The final thing I'd note, which actually is consistent with some of the comments from the IMF in April of 2023, so very, very recently, is the idea that some governments are now looking a little healthier in terms of their fiscal positions because their debt GDP ratios have started to come down. The obvious reason for why they started to come down is because the GDP in that ratio is nominal GDP and it's basically because prices are rising so swiftly that this is beginning to happen. Now the importance of that is that it's not as though this is free money, it's the fact that the increase in prices may be beneficial for governments, but it's almost certainly not beneficial for other people. So if you happen to be stuck on a fixed nominal wage and prices are rising swiftly, then the government's gain is your real income loss. I think it's important to stress that although inflation picking up has helped somewhat the government fiscal dynamics, it comes at a significant price in terms of the impact on the rest of the economy.

Ryan Bourne (20:54) Yeah, and I hope governments don't take the lesson that inflation is some sort of easy way out of dealing with the longer term debt challenge because of course a lot of the long-term drivers of debt are things like social spending on healthcare which is real demands on services and also in many countries index-linked retirement age payments whether that's social security or state pensions and the like.

So let's shift gears a bit and think about what's the outlook from here. Going back to those  previous theories that  I mentioned under the Friedman framework, if you look at stuff like the money supply, we had the big burst, but as far as I remember the last time I looked, the money supply growth has fallen back somewhere to normal levels in many countries. We've had those one-off stimuluses, they've been kind of feeding through the economy, and we've had the supply shocks, which should only affect the price level, not the overall inflation dynamics.

Aren't there reasons then to think that even though team transitory was kind of wrong about how how quickly this would pass through, there are some reasons to hope that a lot of this might still be transitory? I get the sense from the book that you think this is going to be a lot more of a problem to get rid of than looking at those headline theories might suggest. So why don't you just explain that a bit and explain your four tests for whether inflation is likely to be more persistent

Stephen King (22:32) Sure. So first of all, on the issue of money and actually what is now a shrinking money supply in some countries, I think it's important to stress here that it's not just the monetary growth that matters, it's also what you do with the money once you've got it. And there's no doubt that if you look at the overall stock of money relative to GDP as opposed to the growth rate or the direction of travel currently, the stock rose incredibly quickly in 2020 and 2021. If you translate that through into real economic calculations, it basically means that a lot of households saw significant increases in financial wealth, which they still have, and they're therefore still able to spend, even if the money supply itself shrinks further. Under those circumstances, the risk is that the velocity of circulation of money picks up, in other words, the number of times it changes hands during the course of a year accelerates. So it’s not just the volume of money that exists that matters, but it's also what we do with it as the public.

Now related to that is a big debate about interest rates because everyone's talking about the fact that nominal interest rates have risen a long way. As far as the ECB is concerned, the European Central Bank, this is the fastest pace of tightening we've seen from them, although of course the history there is not that long. It's a very rapid pace of tightening from the Federal Reserve as well. So people will look at the direction of change and the speed of change, and say “well look, it shows that monetary policy is tight.”

I think the difficulty there is that we were starting off with remarkably low nominal interest rates, and secondly, in many cases, inflation rates are still higher than the policy rates. This is another way of saying that people are being paid to borrow, that real interest rates are still negative. So for those who can still access credit, these are actually still quite attractive conditions. I think there’s a debate to be had about not just the speed of change and the level that interest rates reach, but also what they have to reach in real terms. And one striking historical comparison here is that if you look at the defeat of inflation in the 1980s under Volcker in the US, it was mostly achieved with positive real policy rates. In other words, the policy rates were higher than the inflation rate. Whereas under Arthur F. Burns in the 1970s, although nominal interest rates went up quite a long way, for the most part, real policy rates adjusted for inflation were negative. So it's not just the case of normal rates going up, it is also the fact that do they go up high enough relative to the inflation rate.

Now as for the four tests, the reason why I came up with these four tests was that I felt that standard economic models were not capturing the risks that we were facing. They were models of complacency almost, that they effectively gave you the right answer to the question you were asking, so inflation would always come back to target within a year or two. So my four tests were designed to sort of think, well, can we be quite so confident about that?

The first of those tests was to ask whether you're creating a change in your institutional arrangements that perhaps unintentionally itself creates an inflationary bias. We've covered some of this already. The fact that you adopt QE and stick to it for a very long period of time might suggest that you're so focused on deflation and you're so certain that deflation is your only risk, that you're unable to spot inflation arising until it's far too late. Lags matter here, speed of action also matters, and it may be that once you've allowed these institutional changes to come through, you're simply less credible in your attempts to try and deal with inflation.

The second test is actually about the money supply. I find it extraordinary, actually, that most central banks ignore monetary factors altogether. They got to a point of, it was almost like a sort of religious commitment to price stability based on the public's faith in the central banks themselves behaving in a certain way and having the skill to achieve the right kinds of outcomes. One barometer to test for that is to look at things like monetary growth and say, well are these numbers consistent with your ambition? And I think it was pretty clear in 2020 that those numbers were not consistent with that ambition. I'm not advocating a return to monetary targeting. I think that's a desire that might reflect people's monetarist instincts, but I don't think it works terribly well because the world is not as precise as some monetarists might have suggested. But I do think that money absolutely matters.

The third test is, are you in danger of being seduced by what I would describe as “time machine” arguments? In other words, are you guilty of assuming the answer to your question.  I think central banks generally have been using time machines, basically saying: “we'll take a time machine, we'll take it forward two years, and if in two years’ time our forecasts tell us that inflation is at 2%, then we're absolutely fine in the here and now.” And the problem with that is that you are totally unable to spot these regime shifts. In other words, you become complacent, which I think is a possible mistake.

And the final test is more of a longer-term structural test, which is, have you got effectively a  supply-side headwind or tailwind regarding inflation? Now for much of the last few decades we've had a tremendous tailwind in reducing inflation, which has been the story of hyper-globalisation, that the West has been able to import cheaper and cheaper goods, which would be made by cheaper workforces in China or India or elsewhere. And this has been great news in one sense because it's lowered goods price inflation, its allowed central banks to keep interest rates very low. And in many cases, they boosted service sector inflation to offset the goods price deflation. It's been associated sometimes with asset price bubbles, but it's never really created that much in the way of inflation. But even before the pandemic, this kind of hyper-globalization story was in trouble. And most obviously, because of the deteriorating relationship between China and the US, and the fact that it's becoming increasingly difficult to come up with what you might describe as global rules of the game for economic engagement.

If you haven't got those global rules of the game, then the risk is that your hyper-globalization doesn't have to reverse completely, but it doesn't grow as quickly as it was. And I think that is manifestly true over the last few years. So all those benefits you had begin to go into reverse. Now, this was originally part of what was called the Great Moderation, which the original authors described as a series of lucky breaks, effectively, for western policymakers, but I think the term was hijacked by central bankers. I think Ben Bernanke was partly guilty of hijacking this term because they began to say that the Great Moderation, which is effectively a story of sustained reasonable growth and low and stable inflation, was a direct product of the central bank’s own wisdom. It was their own wise decisions that gave rise to this sort of series of good outcomes.

But if the original idea of the Great Moderation is correct, then of course the lucky breaks can turn to unlucky breaks and I think that’s been true now for a number of years. I think the supply side conditions have been deteriorating anyway. If you continue to behave as if your supply conditions are identical to where they were in the past and you promote demand to a certain level, then you might discover that you actually have too much demand relative to this more constrained supply.

As night follows day, you're going to end up with more inflation. And there is a similarity here between what has happened recently and what happened in the 1970s, because there were a series of negative supply side shocks that most people ignored, or thought of them as being demand shocks rather than supply shocks. There were differences in terms of what central bankers did in response to this, but those that really failed were the ones who said, this is all demand, and then when inflation started to rise, it was all temporary, and when it didn't go away, there was still a reluctance to accept that they had to do something painful to get rid of it.

It took years and years and years for a new consensus to emerge which finally said, “if we don't tackle inflation, we're going to end up with enormous problems tackling everything else.” This has to be a necessary condition of success, but you know that wasn't there in the early 70s, it was the late 70s or the early 80s that you finally got to that belief system.

Ryan Bourne (31:18) I think that brings us quite nicely to kind of the next segment of questions really, which is I think there's a bit of confusion out there about why actually inflation is a problem that we should take seriously. Now as we've discussed, there are different causes of inflation at various times, and if you have a supply shock, a negative supply shock, that represents a real fall in the standard of living.

But many inflationary periods through history, and your book does  write extensively about previous episodes as well, are demand side driven, should we say? Monetary phenomenon on the demand side. But if all prices are going up, including wages, the actual real effects on the economy might not be as big as we think. Maybe you could talk to us a bit about what you see as the problem of having high and variable kinds of inflation. Because it's not just really about the cost of living, it's not synonymous with the cost of living, is it?

Stephen King (32:27) No, it's not. And I think that when people think of inflation, they think of prices rising relative to their own wages. But actually, inflation, in its most broad definition, is not so much about the rising price of this good or this service, it's actually about the falling value of money, the pound in your pocket. The dollar in your pocket just doesn't give you as much spending power as would have been the case earlier.

So the problems with inflation are partly distortionary. If you're not quite sure whether your wage will rise as quickly as the price level, you might hold off from doing things you otherwise would have done. There's uncertainty created because although it may be that eventually all prices and wages rise at the same rate, they tend to move in discrete intervals. Sometimes prices are rising relative to wages, and if you're a wage owner, you can feel as though you've been left behind.

The second issue is that inflation is a profoundly undemocratic process. People often forget about this, that it is redistributiional. So, if you happen to be working in a company that has tremendous pricing power, and this has been a big debate, frankly, over the course of the last year or two, it may well be the case you've got the ability to pass on higher costs in the form of higher prices, and possibly more than just pass on the costs. Equally, if you're a member of a powerful union, you can threaten to withdraw your labor. It might be a gain that you can actually demand an inflation-busting wage increase.

On the other hand, if you are a pensioner with no indexation on your pension, then inflation is a disaster for you because you're going to be made poorer and poorer over time. And the same might well be true of someone who's self-employed, who's supplying goods to the oligopoly, which is in a dominant position. Actually, you haven't got the ability to pass on price increases or cost increases quite so easily.

So you create these winners and losers. But it's not just about incomes. It's also about wealth and assets. Generally speaking, inflation is the debtor's friend and the creditor's enemy. This is very, very simplistic, perhaps, but if you're a saver and your savings are mostly in the form of cash, inflation is a very destructive process. It doesn't have to be perhaps if interest rates rise fast enough, but as we've already discussed, interest rates so far have not risen fast enough. So, people with cash savings in particular are in some degree of trouble.

At the same time, if you're a debtor, the great thing about inflation is it reduces the real value of those debts over time because prices and wages are rising simultaneously. So your debts are continuously falling, which is great news for first-time buyers of houses with big mortgages because the mortgages will become smaller and smaller over time. So long as those people keep their jobs and see the big inflationary wage gains. It's also of course great news for governments because governments typically are very highly indebted.

And this comes back to the Richard Burton, Elizabeth Taylor argument because governments have a very powerful incentive to create inflation if the alternatives are politically unacceptable. If a government has an unsustainable fiscal position, then yes, it can raise taxes, it can cut government spending, it could default at the extreme. But if none of those things are politically palatable, then the other way of doing it is just to create some inflation, because effectively, the inflation acts as a tax on people who have a certain level of wealth in the form of cash savings. It's a pretty brutal process, but I think what tends to happen in the short term is it is easier to pretend that the inflation is just a series of external shocks that will go away. It is easier on that basis to avoid the recession or the hard land that might be required to bring inflation back under control.

So what then happens is that you begin to accommodate the inflationary process, and then that feeds through into society in a much more untrusting fashion because once the process starts, there's always one group who's going to have a big wage increase before others, which then creates a going rate for others to demand a similar wage increase. The same is true of pricing. So once the process is established, once you've allowed it to be established, stopping it then becomes incredibly difficult. And as a very good example of this from the 1970s,  all countries had a similar oil shock.

In other words, oil prices went up a long way. If you look at the responses to the oil shock, the Germans basically said we're not going to have any inflation associated with this, so they kept monetary policy tight. And the British said we're absolutely not going to have any unemployment associated with it, so they kept policy loose. And the outcome was ultimately very good for Germany because it kept on top of inflation. And by doing that, growth rates were better and unemployment was lower. And it was very bad news for the UK because the moral sense was we must tackle unemployment, we must boost economic growth, but economic reality itself had changed and there was an unwillingness to come to terms with that new economic reality. As a consequence, far too much inflation was accommodated at that particular point in time.

Ryan Bourne (37:45) Yeah, and I think during a lot of the debates that we've had between different schools of thought on how to deal with inflation, people are actually talking past each other. In the sense that there are some people that do want to minimize the volatility of output rather than prices. So, if you're framing this as, “we should try and keep to the trend of nominal GDP growth over time,” really what you're saying is, when these supply shocks hit, we should tolerate higher inflation and suffer the lower real growth just to keep the nominal GDP on target. Whereas a lot of people that are much more exercised about inflation are obviously coming at this from a price stability perspective. So quite often it's the aims, what they think the aims of monetary policy should actually be, which are the underlying reasons why people are kind of disagreeing about what the policy response should be today.

Stephen King (38:37) I think that’s absolutely right. I think it's understandable that people are worried that effectively hitting the economy with a sledgehammer to try and get rid of inflation, which isn't always necessarily your fault, is an extremely painful process. But on the other hand, if you don't act on inflation at all, the way in which it becomes ingrained into society and to people's behaviors and to people's expectations makes it that much more difficult to remove. I think it was Paul Volcker himself who said the one lesson he learned from this whole process of inflation was to act early and act quickly and act aggressively because if you don’t, the costs of acting much later tend to be much greater.

Ryan Bourne (39:16) Well, let's talk about one of those costs that you kind of didn't mention. When people perceive that an inflation tax is arbitrary and unfair, we start getting  demands for policy change. We've had a whole outbreak of different narratives, a lot of things that we  thought we'd learned were not true, but the narratives have come back out.: we can blame trade unions for inflation, we can blame corporate greed for inflation, we can blame corporate concentration for causing inflation--not just being a symbol of the inflation problem, but actually causing inflation. Even the ECB last week had a tweet where they asked: what drives inflation, wages or profits? To which one might have replied: neither, you. But it's that sort of thinking  which leads to the demand for wage and price controls. And that's been something that we've seen throughout history and you have lots of fun examples of the misguided use of price controls through time. So why don't you tell us a couple of those stories.

Stephen King (40:25) An early one is the price edicts of Diocletian who was the Roman emperor at the beginning of 300s AD and he was one of a long tradition of Roman emperors who'd been debasing the coinage, basically diluting the amount of silver in silver coins. As a consequence, the value of those coins had steadily dropped overtime.

The reason why he'd done this, of course, was that there were tremendous fiscal pressures on the empire because they were fighting wars on virtually all fronts and they had to find a way of paying the soldiers. So they thought, well, we just mint more and more of these coins with less and less silver in them and hope that no one spots it, which of course, funnily enough, people did spot it.

And one reaction to this was his price edict, which was a command across the Roman Empire to effectively impose price ceilings on the range of goods, one of which I was new to discover which was the price ceiling for a male lion. But anyway, what's interesting is that, of course, none of this worked. It didn't work because the economic reality was that inflation was already high and out of control. And what happened was that people who, in normal circumstances, would sell their goods for money began to choose not to. They hoarded because they were better off having the goods rather than the money. And although there was a capital punishment for this kind of speculation, the reality was that it was worth taking the risk rather than losing your fortune by being given a bunch of what would prove to be worthless coins. So this was not a good example because effectively the monetary policy, if you like, at the time was moving in exactly the opposite direction of what the price controls themselves were supposed to achieve.

You can go through to the Nixon era in the US in the 1970s, coming off the Smithsonian agreement, the collapse of Bretton Woods, and the floating of the US dollar. There was an attempt by a young Donald Rumsfeld, funny enough, to try to limit the extent of the price increases associated with the sudden devaluation and dollar printing that was taking place. Did it work? No, it just created the series of distortions that certainly didn't eradicate inflation. It might have reduced inflation for a short period of time, but again it was really still the story of too much money chasing too few goods.

And then very recently, the debate we've seen over the last two or three years really connected with the idea that the profit share in US GDP has been rising rapidly, and therefore this must be a consequence of the abuse of pricing power. Well, it's certainly true that the profit share has gone up a long way, but what's striking is that the profits that we've seen the biggest increases in have typically been those which have seen the smallest price increases rather than the largest price increases. Perhaps more importantly, of course, the profit share didn't start rising in 2020. It started rising about 20 years earlier, if not 30 years earlier. And most of that period, of course, has been associated with deflation or disinflation rather than inflation.

It may well be that people can have a debate about the share of capital in GDP and the share of labor, but I don't think inflation itself is the obvious explanation for it. Nor do I think that using price and wage controls is the answer to it. Because so many times all they do is they create distortions, they stop the market itself working properly and you're likely to find that inflation is still relatively high, but your economy itself performs less well, less productively than it would have done in the absence of the price and wage controls.

Ryan Bourne (44:15) Would you make an exception with that in terms of European energy prices? How would you have gone about if you were advising the House of Lords committee to develop the ideal policy for dealing with that unexpected shock?

Stephen King (44:30) Well, this is slightly trickier because obviously with the energy price shock this has huge distributional consequences and huge political consequences.  I think there was a case for trying to protect people from the full extent of the energy price shock, partly because you didn't know for how long the energy price shock would last for. And to be fair, energy prices have come down very swiftly over the last three or four months.

But it could never have been an open-ended commitment because if we had an energy price shock of the kind that we saw in the 1970s and 1980s, the fiscal consequences of offering that kind of support would have been absolutely vast, with massive increases in government debt that take you back to Elizabeth Taylor and Richard Burton and the possible printing of money associated with it. So that itself would have been rather difficult. And moreover, if prices really are changing, you can't just protect people from it. You eventually have to accept that people must adjust to the new economic reality. And they do eventually, but the idea that fiscal policy should be there to cushion everyone for every eventuality is easier said than done.

Ryan Bourne (46:44) Yeah, and I think it might be one of the unfortunate long-term consequences of the pandemic, those embedded expectations [of the role of the state]. But the sense I get bringing all this together is that you don't think there's any easier way of ridding an economy of persistent inflation than tightening policy. Of course, you know, you have a lot of wishful thinking. People say, well, we should raise the growth potential of the economy, both on the supply side, right but also on the modern monetary theory left with big state investments. But that's all long term, it's not going to change much in the immediate future. And it's not even clear looking across countries and across time how much the growth potential of an economy can be altered by government policy.

So given where we are and given what I think you're saying needs to be done, do you think now that we have independent central banks, this is an easier task than it was in the past? Or are there reasons to expect that this relationship might have made instances like this where you have persistent, quite modest inflation, say four or five percent over a number of years, more difficult to rid ourselves of now?

Stephen King (47:00) I think this is a tricky one. I try to tackle this in the book. I'm not sure if I've been that successful, but what I'm thinking about is that when inflation is sort of dead and buried as it has been over the last 20 or 30 years, the central bank's life is relatively easy. It has plenty of public support. It appears that the technocratic people in charge are doing a good job. Everyone's happy with them. And actually you can see this through Bank of England's own surveys that they conduct asking the public their perception of if the bank is doing a good job a bad job. For the most part, the Bank has been doing a good job in the sense that it's had a positive net rating from the public. Funny enough, that's all changed over the course of the last few months which is obviously a reflection in part of the fact that inflation has been much higher than the bank itself had indicated.

But I think what is unclear is whether independent central banks are so easily able to tackle an inflation problem when it's already established. And this, I think, depends partly on politics. One example of this is: imagine that the Bank of England was made independent not in 1997 as it was, but rather let's say in 1980, when inflation was incredibly high, when unemployment was already high, but was going to become a lot, lot higher over the next two or three years. Could an independent central bank run by technocrats deliver the kind of reduction in inflation that actually was delivered?

Now the argument in favour of this is to say, well, because they're independent, they have more credibility and therefore the costs of reducing inflation are likely to be less. But in truth, the Thatcher government got away with it because she won an election in 1979, they won another election in 1983, and a further election in 1987. So she could point to, if you like, her own political credibility. She could say, look, I've won elections, I've done these tough policies, but I've been supported in this, I’ve got some political legitimacy. The problem with a central bank is that when life is difficult, when you have to make tough choices (and sometimes I'm afraid policymakers do have to make tough choices), it's not obvious what kind of democratic legitimacy a central bank on its own would be able to muster in those circumstances. So in other words, could a central bank deliver the kind of increase in unemployment that happened in the 1980s? I suspect probably not. Either it wouldn’t do the job, or it would end up being taken back over by the government to do the job that as technocrats would not be possible.

Now the other point I'd make is that the Federal Reserve nominally was an independent central bank through the 1970s and 1980s, but of course the experience under Volcker was fundamentally different from the experience under Arthur F. Burns. But Volcker himself gave a speech just after he stepped down from the Fed, suggesting, that although he was seen to be the great all conquering hero with regard to inflation, that in one sense he was lucky with his timing.

And his point was that the sort of economic narrative of the 1970s was that inflation was a series of unfortunate events, and that the central bank's job was to try to maximize activity and employment and maybe you could use incomes policies or prices policies to temper the inflationary consequences. And he points out that by the end of the 1970s, that cozy consensus had been abandoned, that there was now slowly a recognition that unless you tackle inflation first, you are not going to be able to achieve the other objectives in terms of activity and employment. So effectively he arrived at the right time that the political consensus had shifted, therefore it was easier for him to carry out those policies. Or put another way, if Volcker had been in charge in the early 70s, maybe he'd have found it as difficult as Arthur Burns found it because the political circumstances were fundamentally different.

Ryan Bourne (51:03) Yeah, I think that's right. And I think it will be very interesting given the changing political winds, whether we're still talking about inflation in the buildup to the 2024 election and the start of the presidential debates. Now one big problem with dealing with inflation is that trying to eradicate it itself can bring costs, downstream costs. And I think it's fair to say at the moment, rising interest rates have exposed financial problems at some bank and non-bank institutions.

A couple of things spring to mind. In the UK, we saw a lot of pension funds that were very exposed to interest rate risk. And when Liz Truss's short government brought both uncertainty and rising borrowing costs as a reaction to huge borrowing in her budget, that caused a kind of self-reinforcing dynamic that actually put whole pension funds at risk as bond yields rose. We’ve seen the problems more recently at Silicon Valley Bank.

Do you foresee other skeletons in the closet? And do you worry that these are going to make central banks’ job of dealing with inflation more difficult? Because obviously a lot of these things can then have depressive consequences on broader economic activity. So how should we think about managing those and how much do you worry about that?

Stephen King (52:18) Well, I definitely worry, because we've already had some instances of this. And it's worth stressing that those instances are partly a consequence of central banks’ own policies—effectively persuading people that deflation was the only risk out there, that interest rates were going to be at zero forever more, and that QE was always available. So when inflation comes along and changes all those metrics, it begins to have obviously knock on effects into the financial system and it can be deeply unsettling.

The tricky thing for central banks, is trying to work out the persistence of these kinds of shocks. If you have something like the global financial crisis, it's a game changer because the global financial crisis wasn't just a failure of a few banks. It was a sort of collapse of the credit system, which did point to disinflationary and deflationary problems. If you have that sort of story, it's a huge game changer.

But there are plenty of other examples in the past of financial difficulties associated with rising interest rates or tightening monetary policy, which have completely different consequences. You can go back to the long-term capital management crisis of 1998 and the Russian debt default that was associated with it. You can look back to the October 1987 stock market crash, and in both of those cases, the Federal Reserve cut rates or had to respond differently to what it was planning to do.

But what's striking about both those examples is that within the space of a year or 18 months, they were back to tightening policy. They'd been effectively sort of pushed to one side, diverted from what they should have been doing in terms of controlling inflation because they had to because there was financial instability. But ultimately once they resolve the financial instability, they were back to fighting the original problem, which is inflation.

The same is broadly true, I suppose, of the savings and loans crisis through the 1980s. It was a huge problem, but it wasn't something that necessarily had a lasting influence in terms of monetary policy. And then from my perspective in the UK, we have what was called the secondary banking crisis in the beginning of the 1970s where many of the secondary banks had assumed that interest rates remained lower than they proved to be, ended up in terrible trouble, partly because of inflation being a bigger difficulty than people had expected. And there had to be a launch of so-called lifeboats to rescue some of them, not all of them, but some of them. Nevertheless, the sort of desire to fight against the problems of the secondary banks may well have contributed to inflation being more persistent than would otherwise have been the case.

The problem here I think is that sometimes the financial shock and the inflationary shock could move in the same direction Which is certainly true during the global financial crisis. But on other occasions, the financial shock can try to steer monetary policy in a completely different direction than where it should be going to deal with the inflation shock. Under those circumstances, the risk of making policy error or at least making trade-offs that don't work so well into the future becomes that much greater.

Ryan Bourne (55:15) Yes, one suspects that the story of this episode has got legs yet. I think one thing that your book really exposes, and that current events expose, is that the potential for inflation is always around the corner and we haven't defeated it, it wasn't eradicated and part of the problem that we face now is a result of too many people in prominent positions thinking that it had been vanquished. So just before we go Stephen, you've been so generous with your time, we really appreciate you being here. Perhaps just tell our viewers when is the book out? How can they get a hold of it? And what are your next projects? Are you taking a well-earned rest as you do this book tour?

Stephen King (55:57) Well, it's out in the UK later this month. My publisher, I think, is putting it out a little later in the US. I apologize to US viewers for that. But I think it's coming out around about the third week of May. It's already available to pre-order on all good online retailers. I won't mention any by name, but the obvious ones are there. And yeah, so the sort of promotion's going to continue through April and May, probably into June as well, but I think that people will be talking about inflation for still quite some time from where we are currently.

Ryan Bourne (56:32) I would just urge everybody, do read this book. There's lots of great insights, some great stories of inflationary episodes across 2000 years, as the book cover suggests, and it's well worth your time. So Stephen, thank you so much for joining us today.

Stephen King (56:48) Thank you.