As John Maynard Keynes noted, we are all beholden to the ideas of “some defunct economist”. But central bankers more than most. For all the talk of data-dependent decision making, monetary policy operates with a lag, forcing its practitioners to rely on theory to guide them on how to act in the here and now to quash inflation or protect jobs. One of the dominant theories central bankers rely on is that a credible commitment to control inflation will itself be enough to dampen it. Paul Volcker became an iconic Federal Reserve chair for his aggressive interest rate increases, which in the classical interpretation tamed inflation and led to the Great Moderation. But how powerful an influence do the actions of central banks actually have on inflation? A new paper — straight out of the radical confines of the Fed — suggests that the impact of the “Volcker shock” has been vastly overplayed, and that the inflation of the 1970s was solved through de facto class war and the degradation of the union movement rather than monetary policy. The paper itself — catchily titled Who Killed the Phillips curve? A Murder Mystery — can be found here, but its central point is this:. . . the assumed change in bargaining power, and the resulting flattening of the Phillips curve, reduces inflation volatility by 87 per cent without any changes in the monetary policy regime. This result casts doubt on the dominant view that the disinflation since the 1980s was due to Volcker’s monetary policy.Coming from deep inside the Fed this is near heresy. After all, central banks have naturally long been in thrall to theories that made them the heroes of the story. Central to this well-known tale is the idea that monetary authorities have kept inflation at bay through a credible pre-commitment that they will anchor the general price level. Knowing this, individuals have consistently behaved in a way so as to keep prices from spiralling upwards — in a kind of self-fulfilling prophecy.It’s from these ideas — which originate from economists such as Milton Friedman and Robert Lucas — that we can trace the current view that central banks need to talk tough and signal through aggressive interest rate increases that they are “serious about inflation”. Only then will individuals adjust their own behaviour in such a way so as to bring inflation back under control. And if inflation keeps going higher, then expect even more chatter about how central banks have “moved too slowly” and therefore lost the credibility on price stability. The paper by David Ratner and Jae Sim, two Fed economists, in practice tries to torch this argument. To be fair, the ideas that the authors have formalised into a model from which they draw their conclusions aren’t new. They are from two other economists who arguably represent the main competition to Lucas for the hearts and minds of central banks (though don’t expect anybody to admit it): Michael Kalecki and Joan Robinson.Both Kalecki and Robinson are founding members of “Post Keynesian economics”. (To give Kalecki his due, he is also a pre-Keynesian economist, having developed ideas contained in the General Theory before or at the same time as Keynes). Both explored the idea of class as a driving force in determining economic outcomes. On their understanding, inflation isn’t due to a lack of credible commitment from central banks to control inflation, but a power struggle between capital and labour. The spark for inflation may be hard to locate between commodity shocks and general economic malaise, but its engine is likely to be a battle between capital — who seeks to maintain its share of national income via mark-ups — and labour, who try and do the same through higher wages. In their paper, Ratner and Sim construct what they call a “Kaleckian Phillips curve”, to replace the traditional one and incorporate the bargaining power of workers. Here is what they find: The pre-Pandemic data since the 1990s suggests that the Phillips curve relationship, a central tenet of New Keynesian monetary economics, appears to have broken down. This paper develops a “Kaleckian Phillips curve”, the slope of which positively depends on the strength of worker bargaining power under the assumption that workers bargain with firms not only over match surplus (as in the standard search and matching literature) but also over production rents. Our comparative static and dynamic analyses show that the origin of the break down of the Phillips curve relationship may be found in the collapse of worker bargaining power since 1980s. The econometric evidence based on both time series and cross-sectional data renders robust support for this theoretical analysis.What does this mean for central banks? If sustained inflation derives from class war, then the chances of the current bout becoming entrenched again are extremely low. The working class as a cohesive social force no longer exists. Businesses can safely protect their margins and the burden of inflation will fall on labour as real wages fall. Sustained price rises will eventually subside as supply shocks from the pandemic and war fade and real spending power is eroded. Nobody in authority will be citing Kalecki or Robinson any time soon, but this theory may have some purchase with central bankers. Most remain obsessed with wages — the Bank of England’s Andrew Bailey has even called for pay restraint — and none are contemplating something on the scale of a Volcker shock. It may be that what central banks are counting on the most to guide their actions is a class-based theory of inflation, which tells them that ‘capital won and labour ain’t coming back’. In other words, inflation will subside, not because it’s necessarily transitory, but because workers don’t have the power to make it stick around. More
