• Sergio Focardi

Inflation is not the key problem


Today there is a lot of discussion about inflation. On the one hand it is thought that inflation destroys the value of capital and reduces the purchasing power of income, on the other hand it is feared that the economy will be pushed towards recession or, worse, towards stagflation, that is, inflation and stagnation. Central banks promise to halt inflation by raising interest rates. Some authors urge central banks to take drastic measures, raising interest rates sharply.


In this post I would like to discuss why I believe that a rise in interest rates is harmful more than beneficial. I will divide the argument into two parts: in the first part I will discuss the actions of central banks from the point of view of the classical concept of inflation, while in the second part I will show that the classical concept of inflation is not applicable to modern economies. The article that I coauthored with Prof Fabozzi Why Should Asset Managers Be Interested In New Economic Thinking?, forthcoming in the Journal Of Portfolio Management, discusses this topic from the point of view of asset management and introduces the concept of Economic Theory Risk as one of the new risks that asset managers face.


The actions of central banks, especially the US Federal Reserve, can be resumed as follows. In order to reduce inflation it is necessary to raise interest rates to reduce demand. The reduction in demand will raise the unemployment rate. A higher unemployment rate will lower inflation. These actions are likely to put the economy into a recession but this is still the lesser evil compared to the risk of runaway inflation.


This reasoning may seem tortuous and perverse. Why raise the unemployment rate to avoid inflation? The answer lies in the Phillips curve. William Phillips was a New Zealand economist who spent most of his academic career at the London School of Economics. In 1958, Phillips published an article arguing for the existence of an empirical relationship between the level of unemployment and inflation which, in his honor, was called the Phillips curve.


The above narrative, however, is at odds with current empirical reality. In fact, over the past three decades, the Phillips curve has become flat. A large increase in interest rates is needed to produce an appreciable effect on inflation. The change in the Phillips curve is likely related to changes in the structure of modern economies and methods of production. Modern economies are segmented into subeconomies that have different dynamics. The employment rate is actually differently distributed in various sectors. In addition, automation makes economies elastic to demand. In fact, for many categories of products and services, thanks to automation, it is possible to produce more with marginal effects on employment.


Academic articles and a recent Federal Reserve working paper, Who killed the Phillips curve?, coauthored by Ratner and Sim, take up the analysis of the Polish economist Michal Kalechi who argued that inflation is essentially a phenomenon linked to the conflict between capitalists and workers. The loss of workers' bargaining power over the past thirty years has given more power to capitalists who have been able to determine prices in order to maximize their profit.


This alternative view suggests that a substantial increase in interest rates, which central banks now want to raise to the level of the natural interest rate, practically close to 2%, will put a heavy price on workers and, more generally, on the economically weaker groups. The economy will enter a recession but the price of the recession will be paid primarily by the workers.


This social narrative suggests that inflation should be seen not as a financial phenomenon but as a symptom of the excessive power that firms now enjoy over workers. Instead of pushing the economy into recession and creating large masses of unemployed, it would be necessary to build very quickly a new social contract that reduces income and wealth inequalities and empowers workers.

Let’s now discuss a more radical view of the inflation problem. The classic concept of inflation is that of the percentage increase in prices. If products and services remain stable over time and all prices change by the same percentage inflation is a well-defined concept. If prices and quantities change in various directions, some prices rise while others decrease, then the concept of inflation becomes partly arbitrary. In fact, it is well known that it is impossible to uniquely define a price index of heterogeneous variables.

But the real problem is that advanced modern economies are complex evolutionary systems in which products and services change qualitatively and are subject to a process of innovation. Due to innovation, some products cease to be marketed and are replaced by new products. Under these conditions the classical concept of inflation is not applicable.

In practice, inflation is measured by calculating the price change index of a basket of goods that are a subset of all products and services. But in this way qualitative changes and innovation are calculated as inflation. Inflation as it is calculated today is a concept that cannot be applied to evolutionary economies.

To get an intuitive idea, America's nominal GDP per capita increased 36-fold in the period 1950-2020. This increase, however, is divided into four-fold real growth and nine-fold inflation. It is intuitive that inflation includes the enormous innovation that took place between 1950 and 2020. A person who today received the salary that a similar job position received in 1950 would literally die of hunger but not simply because of inflation but because of the explosion of products and services available today.


To address the inflation problem , we must first discuss another important point. In the classical macroeconomic treatment it is assumed that the amount of output is a well-defined and measurable concept. But even the concept of quantitative measurement of output does not apply to complex evolutionary economies. We can't aggregate cruises, bananas, laptops, and the thousands of other products and services available today. Lto physical quantity to non-existent output.


However, we can aggregate using prices by calculating the value of output, i.e. nominal GDP. But since prices are relative prices we have the problem of comparing GDP at different times. We need to determine the factor by which to discount nominal GDP at different times to calculate real GDP. In practice, economic output is calculated by discounting nominal GDP with inflation and then calculating real GDP.


The critical point is that today economic decisions are being made, at least in part, using a notion of economic growth based on percentage changes in real GDP. In this way, qualitative changes are completely neglected. Qualitative changes and innovation are not considered real economic growth.


Inflation and real GDP are theoretical terms linked to a process of calculating inflation. The current process of calculating inflation completely ignores innovation and qualitative changes in economic output. By raising rates to the point of causing a recession and creating high unemployment, central banks are depressing innovative processes.


This problem is serious today but it will become much more so when we actually try to implement the decoupling of economic growth from the use of natural resources. As confirmed by COP26 (26th United Nations Climate Change Conference) both governments and the industrial world bet on green growth, that is, on the belief that technology will solve all the problems of the green transition without changing consumption.


At the moment there is no empirical evidence that this is possible. While it is perhaps possible to solve the energy problem with alternative sources, the problem of natural resources remains unsolved. Today we do not have the ability to synthesize from abundant components the materials required by industry. Maybe it will become possible in the future but at the moment we have to use natural resources. The circularity of the economy, in addition to being very expensive from an energy point of view, can only be partial.


To ensure economic growth free from the use of natural resources, it is necessary to review the concept of economic growth and accept that qualitative growth is real growth. To this end, economic theory must change profoundly and economic decision-making must be based on both quantitative and qualitative concepts. The article The Economic Theory of Qualitative Green Growth published in February 2022 by the journal Structural Change and Economic Dynamic, of which I am a co-author, outlines the mathematical theory of qualitative growth. The key point is that economic quantities are conceived as abstract variables linked to observable financial quantities.


Alongside the theoretical changes, however, a profound change in the management of the economy is necessary. The decision-making process must draw inspiration from Abba Lerner's Functional Finance. Economic policy must be concerned with the harmonious development of society where the well-being of citizens must be the fundamental guiding principle.


It is hard to believe that there are forces today that push for such a change. The green transition is the only factor that can truly produce a more just and inclusive society. In fact, the green transition requires a cultural change that pushes towards a less competitive society where the use of goods has more value than their possession.

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