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Why So Many Predictions About Inflation Were Wrong
Knowing the history of economic thought can lead to more accurate inflation forecasts and better monetary and fiscal policy
By Patrick Horan and M. Scott King
In March, the Consumer Price Index was 8.5% higher than the same time last year—the highest inflation the U.S. has seen since 1981. Many observers, including one of us, underestimated how severe inflation would be. More importantly, many central bankers, including those at the Federal Reserve, were too sanguine about rising prices. Recently in Vox, economics journalist Dylan Matthews issued a mea culpa for arguing in 2021 that inflation would not be a serious problem. Summing up his miscalculation, he wrote, “I unfairly dismissed the most boring, Econ 101 explanation for why inflation happens: that there was too much money sloshing around for the amount of stuff the economy was able to produce.”
Matthews’ acknowledgement is commendable and refreshing to see in a media environment where most commentators are loath to admit error. His article contains many good insights, including his conclusion that too much total spending in the economy is the principal cause of inflation. However, there is another reason why policymakers got inflation wrong: failure to appreciate economic history and the history of economic ideas.
‘Last War’ Bias
Economist Scott Sumner has said that the Fed is like a “general fighting the last war[;] it has traditionally pivoted too slowly when one problem is addressed and the opposite problem moves to the forefront.” Monetary history suggests Sumner is right. In their famous book “A Monetary History of the United States,” Milton Friedman and Anna J. Schwartz showed that the Fed had allowed the U.S. money supply to collapse in the 1930s, which turned a recession into the Great Depression. This was clearly a case where monetary policy was too tight. Later, in the 1960s and 1970s, the Fed committed the opposite error: It caused the money supply to grow excessively, leading to the Great Inflation. Under then-Chair Paul Volcker, the Fed eventually quelled the high inflation by tightening policy in the early 1980s.
The Fed then became very focused on keeping inflation low—in fact, too low. Throughout most of 2008, out of a misguided concern over rising prices, the Fed was reluctant to provide an accommodative monetary policy to an ailing economy. Only after the financial crisis intensified that fall did the Fed go to great lengths to stave off economic contraction. Even then, the Fed failed to prevent a fall in total spending, which deeply exacerbated the Great Recession and hindered economic recovery.
During the 2010s, inflation was generally below the Fed’s 2% target. Some policymakers wondered whether the central bank could even raise inflation to 2%—as if the lessons from the 1970s no longer applied. Then in 2020, seeking to avoid the errors of 2008 and 2009, the Fed pursued a very expansionary monetary policy to mitigate the economic fallout from the COVID-19 pandemic. Although this accommodative policy likely supported the swift economic recovery from that year’s recession, the Fed was too slow to recognize when enough was enough. Now the Fed faces the challenge of achieving a “soft landing,” where it brings down inflation without sparking a recession, something it has accomplished only a few times in history.
“Last war” bias is a form of recency bias. People—including intelligent policymakers and well-meaning informed commentators—are more likely to exaggerate the importance of recent events than earlier events. But we often do not have the luxury of ignoring history from the more distant past. As the saying goes, “The past is never dead. It’s not even past.”
Why Study the History of Economic Thought?
Knowing history does not just mean economic history, as in the study of historical economic developments using contemporary economic theory and statistical or econometric techniques. Although that is crucial, another key element is the history of intellectual debates in economics, that is, the history of economic thought. Most economists recognize the importance of economic theory (such as the workhorse model of supply and demand), but unfortunately, they do not care very much about the history of thought.
One reason many economists don’t learn the history of economic thought is that the incentives for work in this area are not strong. A perusal of the top economics journals reveals some articles focusing on economic history, but history of thought is largely absent. Nobel laureates George Stigler and Paul Samuelson have both argued that economists had good reason to move away from the history of thought: Stigler thought economists would find more success researching other topics, and Samuelson postulated that modern economics had already absorbed the best ideas from the past. Economic history, though faring relatively better, also found itself on the back foot. As Deirdre McCloskey persuasively argued, scholars eschewed historical topics in favor of more modern techniques in macroeconomics and econometrics.
But these attitudes about the history of economic thought should not prevail. Economists Peter Boettke, Christopher Coyne and Peter Leeson provide a useful corrective, arguing that the trajectory of economic thinking is not linear. Rather, the scientific process is “lumpy,” and important ideas can be ignored due to political pressures, philosophical trends and simple human fallibility. And when leading lights such as Stigler and Samuelson signal that history of thought is a less valuable intellectual pursuit, promising young scholars will likely ignore it. If this is the situation in academia, it is unsurprising to see a similar deemphasis among public intellectuals.
Economic history and history of thought can help us craft better economic theory and policy. As McCloskey puts it, applying economics to the past has resulted in new theories to help answer novel questions. For example, Avner Greif’s work on 11th century trading coalitions encouraged economists to think more deeply about how nonmarket factors such as reputation could support economic exchange.
A misunderstanding of the economic past can also lead to the pursuit of suboptimal policies. Many industrializing countries subsidized domestic rail in the 20th century, in large part because they believed rail had been necessary for the industrialization of developed countries in the 19th century. However, as economic historian Robert Fogel showed, railways were not as important to the Industrial Revolution in the U.S. as many believe. And viewing economic thought as a straight line of progress can lead to the discarding of “older” ideas that still have much explanatory merit.
The parallels to today’s policy debates should be evident. With no intention to lambast or single him out, an early quote from Dylan Matthews’ article is illustrative:
When prices began ticking up a little faster than normal early last year, I wasn’t overly concerned. I’d been covering economic policy since 2008, and in that whole time . . . the US had never had a problem with excess inflation.
Inflation had not been a problem for the past 14 years, and Matthews provides a respectable argument as to why he and others were reasonably unconcerned about it. To his credit, Matthews’ article gives a very brief history of debates on inflation. Nevertheless, he clearly thought of inflation in terms of the experience since 2008, and the window separating 2008 from the present is a small one. The Great Inflation, after all, only ended in 1982. While we should not let the 1970s experience overly influence our approach to monetary policy today, a prominent place for economic history in policymakers’ discussions may have at least kept the possibility of high inflation in the public consciousness.
Monetary policy over the past two years has indeed been extraordinary, perhaps with good reason in light of the pandemic. Yet when it comes to excessive inflation, the theories of the past—be they Austrian, Keynesian or otherwise—point to monetary policy as the culprit. A greater appreciation of the history of thought—notably, who has argued what in the past, and for what reasons—is important for intellectuals and policymakers, lest we find ourselves repeating past errors.
Troublingly, there may already be signs of such errors on the part of policymakers. Sumner has raised the alarm, indicating that some parts of the Fed have blamed fiscal policy (policy pertaining to government spending and taxation) rather than monetary policy (policy that affects the money supply) for inflationary woes, and that the Fed itself has been too slow on the draw when it comes to tightening monetary policy. Thinkers of yesteryear, such as Friedman and Schwartz, have already pointed out these dangers. What is old may tragically become new again.
Knowledge of the history of thought or economic history does not necessarily have the final word. One can certainly be well-versed in both disciplines while maintaining that this time truly is different. But unless policymakers and economists fully understand why this time is different, an unfamiliarity with the economic events and ideas of the past opens the risk of being blindsided by the present. Being aware of the work of our intellectual predecessors is necessary to help public servants and pundits perform their duties effectively. And if intellectual and political leaders learn this history, it could lead to better economic policies and more accurate inflation predictions.