Hi and welcome to Ones and Twos, FP's economics podcast. Every week we take a couple data points, use them to try to explain the world. I'm Cameron Abadie, FP's deputy editor, with you in Berlin, Germany. Joining us as always is FP's economics columnist and Columbia University professor Adam Tooze in New York. Hi Adam.
So one segment for you all this weekend. It's something of a tradition. The data point specifically is 14.8. That is the rate of inflation in March 1980 in the United States. That's the rate at which consumer prices were going up per year at the time. Today, in contrast, the United States Federal Reserve and the ECB, the Bank of England, they all publish an explicit target of about 2% inflation. And that target tells us more or less in advance where interest rates will be heading. And so between those two numbers, between 1980 and today, between that 14.8 and the 2% that I mentioned, lies a really big shift in modern economic governance, because central banks stopped kind of just, you know, applying interest rates and started talking about interest rates, trying to shape what households and firms expect to happen. And behind that shift lies a development in economic science. And that development was recognized by the Royal Swedish Academy this past week. On Monday, the Nobel Prize for economics was awarded to two Americans, Michael Woodford of Columbia and Robert Hall of Stanford, for, quote, 'microeconomic foundations of macroeconomic stabilization.' So they said that the work of these economists gave us a new theoretical foundation for the models that are used by central banks and governments around the world. Woodford is often cited as the architect of the kind of modern central banking toolkit. Hall also is cited in this context in terms of generally leading this shift to expectations and what's sometimes dubbed New Keynesianism. So as I mentioned, it's something of a tradition for us to discuss the winners of the Nobel Prize for economics. This year is no different. It's a heady set of ideas, and so we're going to take the entire episode to unpack them and what exactly is at stake. And so to start off with, Adam, if you had to explain Woodford's framework and how it changed what central bankers do exactly, what is that exactly? And then when it comes to Hall, he seems also like a potentially odd pairing. As I was reading about his work, it kind of ranges from consumption theory, unemployment, recession dating. More recently wrote about flat tax. But what holds Hall's work and Woodford's work together? Why was this a pairing in the first place as well?
Yeah, this is fascinating stuff. It's very reminiscent of my own days of training as an economist in the 80s. And it's the most technical Nobel Prize in economics we've had in a while. So, you know, may the Lord forgive us for what we're about to do in trying to make sense of this and convey its general import. And part of the problem, in fact, is that Woodford and Hall's theoretizations are themselves very complicated and situated in very sophisticated ways in a literature. And yet they've entered the mainstream to such an extent that it's actually quite difficult to pinpoint, you know, against the backdrop of our just general kitchen sink economics, what the kind of brilliance of their contribution is, because in some sense we live in a world that they... well, the question you're asking is, did they shape it? I think a fairer assessment might be to say that Hall, in his late 70s work, kind of opened the space, a discursive space for thinking about the way in which expectations shape long-term future economic behavior, most fundamentally consumption, which is the largest driver of demand. And in the models that Woodford uses, the very simple models, the entire economy is consumption. And then in the 90s, central bankers, actually driven by their own policy logic, adopted the signature policy that these two converge on, or Woodford in particular converges on, which is inflation targeting. And then in 2003, Woodford published his sort of foundational book, which founded a kind of modeling tradition which rationalized ex post what central bankers were doing. So I think it's that order. So we have the breakthroughs in theory from Hall, we have the shifts in policy as a result of the disappointment with policy frameworks in the 80s, and then interest in prices, Woodford's key contribution of 2003, which anchors all of this and has become the workhorse for standard macroeconomic theorizing ever since and for policy theorizing ever since.
Okay, so that's the setup and the way this works. What are the key intuitions here?
And one way of setting this up would be to say it comes out of the radicalization of the neoclassical paradigm in the 1970s towards rational expectations. So towards the idea that in thinking about the economy as operating over time, at any given moment, the conditions of the economy are not just determined by factors that are working at that moment, but crucially in really quite fundamental ways by the horizon of expectation. One would say one was coming from the philosophy of history. Economists call it expectations. And so that is really what shapes decision-making at the current moment. It's the relationship between, I almost said dialectic, it's the relationship between the current conditions and the future outlook. And Hall's fundamental contribution, and a very, as you said, diverse one, was to say, look, we've got two fundamental contributions from the 70s. One is this idea that to model rational action, we have to model rational expectations, because it's no good to just simply say people are making choices in the present. They're not. They're making rational choices over futures they are imagining. And then for Milton Friedman, we have this idea that the Keynesian vision of consumption as just a function of immediate income is inadequate, because in fact what intelligent households do is that they map their long-term income expectation and they smooth their consumption. Ideally, they would kind of smooth it presumably pretty much flat over the course of their lifetimes. And if that's the case, then consumption should take a particular pattern, which Hall, in a complicated backwards kind of logic, theorized was that it would be indeterminate. Actually, it would be random, but it would just be determined by the preferences of households, which were then shaped by their expectations of future income flows. And if you take that as your central anchoring idea about the economy and you do what Woodford does, which is move from individual households who are doing this maximization to making households, which are 70% of demand anyway, into the driver of a whole economy and a simple model, then you arrive at the conclusion, which is the crucial payoff here, that the way in which central bank policy will affect the economy is by way of manipulating interest rate and price expectations, not just the current levels of prices and interest rates, but interest rate and price expectations going forward. And if you model the economy as consisted of households which smooth their consumption over time and firms which are in a Keynesian way stuck in a world in which not everyone gets to adjust their price simultaneously, but are randomly assorted, and you can set the parameter higher or lower, more or less firms at any given moment have the freedom to adjust prices, but not everyone can immediately adjust prices. And all the firms have to make guesses as to the future. And those guesses are about price inflation and interest rates in the future. And then to so-called close the model, you add a central bank which has a policy rule which determines interest rates it sets with regards to the inflation rate and the unemployment rate, or the Phillips curve, the relationship between unemployment, or they call it output gap because we're in a world of neoclassical formulations. Then we have a closed system in which the key variables are price expectations and interest rate expectations, and the job of the central bank is to maximize utility. And in a world of fixed prices, any kind of substantial inflation causes considerable welfare loss because only a fraction of firms can actually do the adjusting. And so others are suddenly out of equilibrium and you get real effects because not all prices can adjust. And so the role of the central bank in a model like this is to stabilize prices, and to do that you stabilize expectations, and to do that you stabilize confidence around policy. And when I say all that and lay all of that out, that is the kitchen sink economics which you and I have used over and over again in the pod for the last however many years it is to make sense of the world. But it is Hall's theorization of long-run consumption as the core of a modern economy with regard to expectations, and then Woodford's generalization of that and the addition of a fixed-price supply curve kind of model for the firm side and a rationalized central bank that has created this, a central bank represented in the model by an equation, some sort of version of what's called the Taylor rule, which also we've discussed on the pod, that creates this sort of, this closed model which has become, as everyone calls it, the workhorse model of modern macro. And so to that extent, it really is a convergence of a variety of different themes, themes from rational expectations economics, themes from neoclassical economics, in that in these models, were it not for price stickiness, we would be in optimal equilibria. And then this idea in Woodford's book is a homage to Wicksell, the great late 19th century monetary theorist who theorized the question of the natural rate of interest, r-star, which has become the guiding policy tool of central banking because it's deviations from r-star, and r-star is the interest rate at which the economy actually stabilizes, that are seen as being, you know, the drivers of either dynamism or deflation. And so the job of the modern central banker, they retrospectively discovered after they'd started already doing it in the 1990s, what Woodford's model tells them is that what you're trying to do is to get r close to r-star such that by means of the manipulation of interest rates and expectations, you stabilize the economy at something like 2% or less inflation. That is the, that's the kind of derivation. But as I say, it's like, it's so, it's so in the mainstream that to realize that this is actually a theoretical construct is itself in some way slightly destabilizing. But it truly is. It's built on this modeling architecture.
Yeah, obviously the technicalities there are complicated, but I wonder if it could be helpful to rewind a bit in time to when these developments were being introduced in theory and then in practice. I, you know, the 1970s were the context for these developments. And I'm curious maybe what were the ideas that were upended by these theoretical developments? Because, you know, we're referring to these thinkers as New Keynesianism. So what were the kind of paleo-Keynesian ideas, so to speak, that were upended? And yeah, what was then the context for introducing these changed ideas of macroeconomics?
I mean, first of all, just, I mean, it's, first of all, let's just get our terminology sorted out because it's, it's, it's bewildering. But so these aren't post-Keynesians. Post-Keynesians are left 1970s Keynesians who are the sort of people that want to do more interventionist policy, corporatist price controls, modern monetary theory, functional finance are kind of post-Keynesian positions in the 70s and the 80s. These are New Keynesians, and New Keynesians are the school of Keynesianism that came out of the synthesis between Keynesian and the macro picture that Keynes painted and its domestication, the post-Keynesians will say, its domestication by the conformist, the conformist tendencies essentially of MIT macroeconomics. It's the Samuelsons, the Solos, people like this. We've talked about them on the show, that people like Joan Robinson, who's a post-Keynesian, oppose. And what the New Keynesians are doing are trying to make Keynesianism respectable in terms of neoclassical economics, right? So New Keynesians are married with neoclassical economics, and post-Keynesians oppose the two of them. That's a bad marriage, right? This is bastard Keynesianism, is what somebody like Robinson would have called this. It's Keynesian at all because it says that neoclassical economics has to reckon with the fact that in the actual world there are price rigidities, which we are going to model in the most minimal way imaginable so as to make it tractable for new neoclassical models by introducing this limit on price adjustment on the corporate side, and that's the way we're going to do this. And once you do that, a bunch of other things follow, it turns out, and you get to conclusions which are a little bit like Keynesianism. So that's how this works. It's a little bit cosplay, really, because you're pretending to do Keynesianism because you want to take things like unemployment seriously, but you're doing it within a framework defined by neoclassical economics, which, as the ideologically sensitive people like Robinson would insist, basically gives the game away from the beginning, right? Which is where then criticisms by Huw Dixon and people like that come in more recently, because they're saying, look, you've just evacuated everything that was actually Keynesian. Let's set this apart and go back to the 70s and why this is happening. So what's happening in the 70s is that a more widely inflected Keynesianism, which had a bunch of different currents, comes under huge pressure because of the familiar story about the breakdown of the framework of policymaking from the late 60s. The fact that the trade-off between unemployment and inflation embodied in the Phillips curve no longer appears very good. It doesn't appear very good because it seems that if you aim for a balance between unemployment and inflation, you think, great, okay, this is an acceptable compromise. Unfortunately, what starts happening is the inflation rate starts drifting upwards. Why? Because of wage-price spirals, because workers begin to realize you're targeting that inflation rate and this unemployment rate. And in that case, we would like to reconsider the bargain and keep driving this up. So there's a collapse in the confidence in the first-generation Keynesian-neoclassical synthesis, and so it's replaced by more or less radical answers. And the New Keynesians at MIT, of which these are key exponents, are trying somehow in a rearguard action to save Keynesianism from this massive onrush. And the massive onrush initially says, right, you know what we're going to do is we're basically going to take the central bank and we're going to target inflation by targeting the money supply, first-generation monetarism. So it's this logic that we're seeing with this Nobel Prize is actually the product not of one disappointment, that is the disappointment of classic Keynesianism in the 70s, but a disappointment secondly with monetary targeting in the 1980s. And what's interesting is that Hall actually in the 80s published pieces, and I remember this discussion very vividly, where they said, right, we can't really target money supply creation, so let's target nominal GDP, which is inflation and real economic growth in a single blob. That is something maybe the central bank can set. It's a little bit like what the Chinese will call social credit creation. So we're going to focus on the entire aggregate of nominal demand, like the whole flow of demand through the economy. And that is not the strategy that won out, because that potentially would widen the central bank's remit to all sorts of types of credit creation. No, what they did was they backed away in the 90s towards saying, you know, no, no, no, the thing we should focus on is prices, just the output, and then we'll use the interest rate to do the adjusting, and we won't take a view on credit creation and money supply. We'll just use the interest rate to target the price level. That'll be more parsimonious and more straightforward, and we'll close the door to any nasty post-Keynesian lefty kind of ideas. And it's that which then in the early 2000s is pivotal to rationalizing. So that's the kind of story through two failures: the 70s failure of old Keynesianism, so-called, the so-called failure, the manifest failure of monetarism to actually deliver a reasonable policy framework, the search for a new policy framework, which actually goes down a narrowing path, leads to price stability mandates with interest rates as the key policy variable. And Woodford delivers by far and away the most sophisticated sort of synthetic argument for that framework.
Well, I guess I should apologize for getting the post-Keynesian and New Keynesian distinction... I mean, honestly, I was going to say that almost sounds intentionally obfuscating to sort of have them mean opposite or opposing ideas captured in that distinction between neo and new. So, you know, I guess I'll also pin the blame on the terminology itself.
There's also post-Keynesian, by the way, which brings out some... there's also post-Keynesian, which takes the neo one step further.
But I do find it interesting that there is a kind of, it seems to me, almost a democratic idea in sort of introducing the sense that, like, people's cognitive understanding of the economy is itself a factor, or it's like the sort of the foundational then factor in determining then how the economy may develop, and that it's sort of that, and that there is something in that idea that is almost, you know, from a political perspective, seems actually interestingly democratizing. Sort of you need to sort of that people understand the economy, and that understanding then needs to be taken into account by policymakers and can't be ignored, I guess.
I think that's, I think that's a key idea, and it's very much of the 1970s moment, right? This is the moment of reflexive modernization, of risk society, all Beck's work we've talked about on the pod at various points on the show. It's definitely a move beyond the simple hydraulic technocratic view of the economy that says the economy is best basically modeled as a series of, you know, flows of demand which we technocrats standing outside that world can manipulate using the following variables. And this framework pushes back fundamentally at that by saying actually policy can only really work because the economy cannot adjust as quickly as it would like to adjust, and so the best thing for policy to do is actually to aim for a certain sort of stabilization, and that stabilization exactly as you say acts on and through the rationality of the agents. Whereas if you think about Keynes in the General Theory, consumers don't have any agency, they're just behavioral functions of their income, and business people who do the investing are, you know, the victims of beauty contests and animal spirits. So there's no rationality anywhere except in the head of the Mandarin bureaucrat who's going to do the stabilizing. And as a first cut, it's not a bad model, and it reflects the politics of the interwar period, and in many ways is quite sympathetic, because where we head in the 70s is the reverse, which is the, you know, the celebration, the deification almost of market logic and the logic of investors of different types. But it is certainly, this is the level at which to read this. This is absolutely a moment in the backlash against mid-century modernism, if you like, or mid-century technocracy. And it's saying, no, no, no, no, it's like so much more complicated. If you let the smart, cynical, manipulative actors in civil society know what's on your technocratic mind, don't be surprised if they exploit that knowledge because they're playing poker with you. They're not like a dumb, you know, fruit machine where you just keep pressing the button. They're playing poker with you. So look them in the eyes and they will start reading your eyes, which is where then all of the issues of credibility come from, of central bank communication, all these kind of things. So it's a, it, in many ways, you know, the post-Keynesian and post-Keynesian critiques coming from the left, you know, are quite on point in various ways, but they do underestimate this shift in the tone of policy, which is quite important in practice. Of course, in the end, it's not really the consumers that are the drivers here, though they are the big aggregate of demand. Of course, the main sounding board of central bank policy in this model are financial markets, and particularly bond markets, which is why we talk about them all the time on the show, because that's where the interest rate moves by policy and where expectations of inflation do most of the work.
Yeah, it's interesting. I mean, it's, I guess it's almost maybe a new conception of technocracy in terms of the role that central banks then assume.
It's more Hayekian. I mean, there's a Burkean feel to this, like, you know, don't scare the horses. It's all about just creating a kind of settlement in which, and this is where, you know, you have these meta definitions of price stability. Price stability isn't just when prices are stable. Price stability is the situation in which no one's ever thought about prices because they are stable. As soon as anyone starts thinking about prices, you're in trouble, and that it's, you know, it's a fragile situation at that moment. So it really has a, and the BIS and people like that will actually even rationalize these cycles where, like, preemptive aggressive policy is valid because it will take prices off the salient agenda. So there's a lot of quite subtle and interesting politics embedded in this. You know, the exponents themselves aren't interested in that really. They're interested in the formal modeling, which is impressive. But for the rest of us, I think that's another way of approaching this and understanding what they're trying to do. They really, it is not, you know, it's not wrong to think of this in the context of the so-called Great Moderation, which is kind of the macroeconomic equivalent of the end of history kind of thesis. You know, with the end of history, it's not just when history's stopped happening, it's like when you can't even remember there was history, and that's a little bit like what the ideal of this kind of policy would just actually remove nominal price movement, because with sticky prices, you don't want nominal price movement.
