Commentary on Political Economy

Tuesday 25 April 2023



The Bitterest Pill

An old friend is in the news. Huw Pill, chief economist of the Bank of England, finds himself in the crosshairs of Twitter (as you can see here) after some comments he made in a Columbia Law School podcast, which you can find here. The problem is that he said at one point that Britons “need to accept” that they’re poorer. It’s not long since his boss, Bank of England Governor Andrew Bailey, urged workers not to push for higher wages. Outrage has resulted. Twitter is full of attacks on him, along with wildly differing estimates of his salary. The incident tells us a lot. 

Before going further, I need to declare my interest. I first met Huw almost 40 years ago. We studied economics together, as well as politics, as undergraduates. He’s a thoroughly decent person, and has possibly the strongest instinctive grip of economics of anyone I’ve ever met. I have no clue how he votes. The news in 2021 that he’d been given his current job delighted me (and we haven’t been in touch since). I couldn’t imagine a better candidate.

I was shocked, therefore, to see him quoted as saying anything quite so tone-deaf. He’s always dispassionate and analytical, but this doesn’t sound like him at all. So I listened to the podcast. It’s a fair-minded and practical discussion of inflation, in which he quotes Lemony Snicket on the “series of unfortunate events” that have shocked inflation upward one after another — supply chain disruption, the invasion of Ukraine, avian flu and so on. He explicitly admits that the BOE should have understood supply chains better, and that this might have helped the bank control inflation. 

At first listen, I didn’t hear the offending comments. He was talking about how the economy could absorb the massive shock from natural gas prices. Here is the offending passage:

The UK, which is a big net importer of natural gas, is facing a situation that the price of what you’re buying from the rest of the world has gone up a lot, relative to the price of what you’re selling to the rest of the world, which is mainly services in the case of the UK. You don’t need to be much of an economist to realize that if the cost of what you’re buying has gone up compared to what you’re selling, you’re going to be worse off.

So somehow in the UK, someone needs to accept that they’re worse off and stop trying to maintain their real spending power by bidding up prices, whether higher wages or passing the energy costs through on to customers. And what we’re facing now is that reluctance to accept that, yes, we’re all worse off, and we all have to take our share, to try and pass that cost on to one of our compatriots.

That pass-the-parcel game is generating inflation and that part of inflation can persist. How much bargaining power and pricing power exists for different actors in the value chain in the corporate side and in the labor market?  

Later he returned to make the point that the problem was about the UK economy’s attempts to regain what had been lost, and again said that both wage growth and attempts to push up profits were at issue. As I heard it, he was explaining that after a few external shocks, inflation becomes a collective action problem. Ideally, everyone would take a share of the hit, and then they can move on. Human nature isn’t like that, and as a result economics isn’t like that. Nobody wants to volunteer to take a share of the pain unless they’re confident that everyone else will do the same. These days, that’s a pipe dream.

The danger now is of a process which he accurately describes as self-defeating, in which companies defend their margins and workers push for higher wages, and prices keep rising. He didn’t argue that all the burden should fall on workers, and nothing about what he said struck me as in any way out of touch with the realities that many live. Higher prices hurt people, which is why central banks need to get inflation down. The greatest problem for the UK, as he demonstrated with his examples, is in the attempts by companies to pass on their huge extra electricity costs. 

The 1970s

If there is an argument against what Pill is saying, it may be that he’s drawing the wrong lessons from the 1970s, when an exogenous shock to the western economies led to self-defeating collective action problems as labor and capital both tried and failed to avoid taking the hit. It might  have been better for the Federal Reserve in that case to have accepted that there had been a one-time loss of wealth, rather than attempt to attack the problem with easier money, which it did with rate cuts from 1974 through to 1977. 

The following is a quote from Allan Meltzer’s A History of the Federal Reserve, covering the Fed’s miserable experiences in the 1970s. It was pointed out to me by Chris Watling of Longview Economics in London:

The FOMC made several errors and had some bad luck. The oil price increase was non-monetary and did not require a monetary response. Error or misinterpretation caused them to treat the (subsequent) decline in output as a recession instead of a ‘permanent loss of wealth’ and output, in effect a response to a tax paid to foreign oil producers that transferred wealth. Ignoring the difference between the temporary and persistent rate of price change or responding to the loss of output (with stimulus) contributed to inflation. Countries that did not make this error, notably Germany and Switzerland, had much lower inflation rates. The different inflationary responses suggest that policy responses to the decline in output following the increase in the relative price of oil was an important determinant of the size of subsequent inflation.

The West German Bundesbank did a much better job of controlling inflation in the 1970s than the Fed (and Pill worked for many years at its successor, the European Central Bank). West Germany and Switzerland also at that point had much more cohesive societies that were easier to persuade than most western countries to share the pain than would be the case now.

A wildcat strike over inflation in 1973 by garbage collectors in West Germany. Photographer: Klaus Rose/Ullstein Bild/Getty

The main lesson for today might be that central banks should not have been anything like as generous in 2020 and 2021. It also, according to Watling, suggests that the risk now is from the current attempts to reduce the money supply. He said:

If the effect of ‘too much money creation’ in the pandemic led to too much inflation (boosted by supply side shocks) and growth, then the corollary is that ‘too little money creation’ (or indeed money destruction) should lead to not enough inflation (i.e. deflation) and negative growth. That has certainly been the history of large spikes in money creation and subsequent phases of contraction. Indeed under the gold standard, designed to keep prices stable over time (i.e. zero average inflation), bouts of inflation were typically followed by periods of deflation (and negative money growth).

If he’s correct that central bankers, including the BOE, are now overtightening, Watling suggests that profit margins should soon come under pressure as companies have to cope with falling prices in many areas of the economy. At present, they’re using rising prices to expand operating margins, inflation should turn to deflation, and bonds should outperform equities significantly (as one rallies, and the other declines). 

Earnings Season

Evidence in support of Watling’s line is appearing day by day in earnings announcements. The risk of a deflationary shock from last month’s banking failures looks much more serious after First Republic Bank’s first quarter earnings announcement, in which executives revealed that its deposits had fallen 40% since the beginning of the year. This is despite March’s big coordinated rescue when large banks agreed to put $30 billion into First Republic’s deposits. Its share price was stable for a month after that rescue, but dropped 49% after earnings came out.

The bank is now considering disposing of assets worth $100 billion. Forced sales like this would add to negative pressures on broader markets, which helps to explain a very poor day for stocks.

Meanwhile, the day’s strongest gainer in the S&P 500, PepsiCo Inc., demonstrated an inflationary force. The company’s value is now at an all-time record, thanks to surprisingly strong profits that rested on its ability to persuade customers to pay a higher price for its products. The company candidly admitted that “most of the revenue increase is price mix.” Pepsi has pricing power and is using it — which is what its shareholders want, but might be unpopular with central bankers, and very unpopular with the public at large. Higher inflation makes it easier to raise prices — which implies, as Watling cautions, that profits could be harder to sustain if prices in the wider economy start to fall. 

What lessons should we learn from this? At a practical level, the abuse Pill has taken demonstrates the ever-present danger of mistaking your audience. What is reasonable to people who want to listen to a podcast about economics produced by a law school may land very differently when taken out of context and broadcast to a wider audience. It’s one thing for a central bank official to explain the risks of a collective action problem; it’s quite another for a central banker to tell people they shouldn’t ask for more money.

In terms of how debates about policy can be conducted in the social media age, the read-through is rather sad. Newsletters (like this one) and podcasts have opened up the opportunity for long-form public discourse. People can explain themselves at length in a public forum. That’s healthy. But there are dangers in speaking honestly, even in the rather bland economic terms that Pill did, if your words will then be refracted through media designed for much shorter-form discourse. If we want central bankers to be more accountable, and we do, that’s a problem. 

The furious reaction does, rather sadly, illustrate just how dangerous the “pass-the-parcel” dynamic could become. Levels of trust in society are low, and we communicate with each other through brief and often abusive insults on social media. And as trust in the “elite” grows ever lower, I fear I’m going to be accused of closing ranks with that elite. Suspicion of others’ motives makes it harder to get anything done. That’s certainly true of controlling inflation. 

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