Inflation and the Phillips curve

It must be remembered that the Phillips curve is first and foremost an empirical relationship that was originally meant to relate wage inflation and unemployment (Phillips 1958). Ever since it has been in search of a theoretical justification that has come in different guises and sometimes these have also been radically different. In the context of the threeequations model (or the DSGE) it is meant to represent the behaviour of inflation relative to some measure of the output gap. Stripped of all deeper theoretical foundations, that is its bare purpose. Inevitably, when one examines what lies behind it, one is forced to examine inflation per se. It is in the treatment of this crucial economic variable and the Phillips curve that purports to represent it, that the greatest and deepest discrepancies will be found between the three-equations model and the DSGE. But in order to see this in greater detail, some general questions about inflation will have to be addressed.

In its barest form, inflation just means a positive rate of growth in prices. How it comes about and what justifies it can be done in different ways. In particular a general distinction can be made between demand-pull and cost-push inflation. The first case, in intuitive terms is when demand outstrips supply and prices have to rise. Another way of looking at it is to say that it is a case of excess demand. These instances have already been represented in the diagrams of the first chapter in all the cases where the first shock was one on the IS curve (permanent or temporary) making it true that current output would exceed equilibrium (or otherwise put, the output gap is positive). Consistently with the specification of the Phillips curve, the positive output gap on the right-hand side causes inflation to rise on the left-hand side.

The alternative approach is to consider inflation a supply-side phenomenon whereby a rise in the cost of producing output pushes prices up. Both approaches can justify a relationship such as the Phillips curve but the causal mechanism at play and the underlying vision of the labour market are substantially different.

Accounts of inflation all too often end up quoting Friedman's dictum that “inflation is always and everywhere a monetary phenomenon” (Friedman 1963: 39).

In the last 20–30 years of the twentieth century a peculiar disconnect developed between the kind of economic policy model that was taught in universities and the practice of economic policy and monetary policy in particular. Over time the disconnect widened so that the theoretical and empirical models used to inform and analyse policy actions were equally disconnected from what was still being taught in universities. The issue obviously is that the latter remained the venerable IS-LM first introduced by John Hicks (1937) in the UK and Alvin Hansen in the United States (1938). That model remains the simplest and most intuitive one that many introductory textbooks still use.1 But understandably the disconnect referred to above created many problems because so many contemporary policy decisions could only be represented in that context with convoluted and implausible steps. Understandably the search for a model that could bridge the gap and eliminate the disconnect started in earnest. The bulk of this book is dedicated to – arguably – the most versatile of such replacements: the three-equations model pioneered by Carlin and Soskice (2006, 2009, 2014).

Why is the IS-LM model no longer suitable?

To understand why the IS-LM model has to be abandoned it is useful to distinguish between two separate sets of problems about it. One set was always there from the very beginning and its existence had been known since the 1930s, but the other advantages of the model, in terms of its simplicity and intuitiveness, were enough to compensate. These problems are the following.

First, the IS is in flow terms whereas the LM is in stock terms. That is, one relationship measures the amount of consumption, investment, and net exports per unit of time, while the other is a statement of how much liquid money there is at a specific point in time. This mismatch was essentially unavoidable because the IS-LM model was intended to be a mathematical/diagrammatic translation of what Keynes had written in the General Theory (1936), and such a mismatch was already there.

Second, the IS depends on the real interest rate (r) whereas the LM depends on the nominal interest rate (i).

In understanding how to deal with the financial crisis and how to analyse it, there inevitably is a challenge in that it obviously has complex financial roots, and indeed, one of the issues that arose was precisely the fact that institutions had signed up to financial contracts that were so complex that they themselves could not understand them fully. This was so true that, when the crisis struck, it was difficult to unravel who it was that was eventually liable to pay for these contracts. This complexity, this alphabet soup of derivatives with credit default swaps or collateralized debt obligations, is too cumbersome to be analysed in detail, and accounts of some of these contracts have been written elsewhere, Skidelsky (2018) being one such example but there also are two chapters in Carlin and Soskice (2014) dealing with these details. What is going to be covered here is instead the challenges that the financial crisis posed in terms of macroeconomic policy choices in the first instance, and macroeconomic modelling in the second instance. One of the points that will be returned to at several stages is the extent to which financial considerations had been assumed away as largely irrelevant in most of the models that preceded the financial crisis. The question of finance basically was left as a black box that did not matter much, as largely confined with its own selfreferential dealings, but as far as the macroeconomic modelling was concerned, it was not a primary concern. That obviously became patently false and a major drawback of all models once the crisis struck.

Obviously, the policy challenges also need to be examined once a suitable model to analyse them is put together. But one of these challenges can be looked at without any changes to the existing model, and it is the problem of deflation. The first question to be looked at is, why is it that deflation is such a problem? The second one, related to it, is the fact that there is a zero lower bound to the level of the (nominal) interest rate that central banks can set.

Two further questions will need addressing later on in the chapter: how can the mechanics of the banking sector not be ignored? How can the unconventional policies that have been adopted to deal with the crisis in its aftermath be understood?

Having seen the immediate and not so immediate policy responses to the financial crisis it is time to address a deeper and – potentially – more disturbing question. In November 2008 Her Majesty the Queen was visiting the London School of Economics and reportedly asked a question that has since become famous and very, very relevant: “How come you didn't see it coming?” Where obviously she was addressing professional economists and financial experts at that institution. This question has given rise to several answers. Some economists (Besley & Hennessy 2009) put together a written response to Her Majesty, explaining what had happened and why it was not seen coming. This can be summarized as everybody doing the right thing, but the crisis was a one-off shock or an unforeseen and unforeseeable event. Any such answer appears obviously to have the aim of absolving both the policymakers in charge at the time and the theoretical models on which policies were formulated.

Other people, including prominent economists who have been at the very centre of policymaking, have taken a very different view, by claiming there had been something wrong about the policies being pursued and also about the economic models that were used to justify those policies. A prime example is Buiter, at one stage a member of the monetary policy committee at the Bank of England, who has famously written a very scathing article (Buiter 2009) about the uselessness of a particular type of macro and how it had engendered a sense that a crisis could not happen in the way that instead it did. Another such example would be Krugman who has been a very vocal critic of some macro models and hence the policies predicated on those models being very wrong.

A third set of answers asked the question: can it be that by pursuing the policies typical of the great moderation, an environment that actually fostered financial instability was put in place that eventually erupted in the financial crisis? Otherwise put, could it be that there is a trade-off between inflation targeting and financial stability? It is this kind of argument to which this chapter is dedicated with the first example being an adaptation of a diagram developed by De Grauwe (2012: 201) in his textbook on the economics of monetary union.

Until now hints have been given that fiscal policy needed to be looked into, but nothing has been done about it. The reason for not doing so until now is that, to an extent, Carlin and Soskice (2006, 2014) and other textbooks have followed what was an established consensus, and what has been described as a consensus assignment that applied before the financial crisis. This consensus assignment rested on two propositions: (a) stabilization of inflation and output was the task of monetary policy, and it was for the central bank to deal with such matters in the way described in the preceding chapters, whereas fiscal policy could not be used as a countercyclical tool, in order to stabilize output over the cycle; (b) the purpose of fiscal policy was instead to stabilize the ratio of government debt to GDP, for reasons that will be detailed below. A number of arguments were used to justify the preference for monetary policy as a stabilization tool. In the first instance, there was the undeniable fact that fiscal policy acts with longer lags, and it takes a much longer period of time to be implemented, because legislation will have to be passed for new taxation rates, and new levels of expenditure. All this takes time and the implementation thereof will take longer still, whereas changing the interest rate, which is the main tool of monetary policy, as it was before the financial crisis, takes very little. It may take time to feed through and have the desired effect on output and inflation as detailed before, but in terms of the actual policy change the delay can be deemed to be much shorter than it is the case with fiscal policy. The second obvious reason that could be deemed to be relevant in the context of a small open economy, is the fact that assuming a Mundell-Fleming model, or a variation thereof, provided that the exchange rate regime be a flexible one, it is only monetary policy that is effective at changing output, whereas fiscal policy should be completely ineffective.

As stated before, the three-equations model synthetically presented in the previous chapter, is intended to be many things with the obvious aim of being a less obsolete framework to represent modern policy choices than the venerable IS-LM. That is, however, not the only aim, because the other obvious one is to be a pedagogically accessible, diagrammatic representation of the model most central banks and treasury departments use for their forecasting. This model is known as the dynamic stochastic general equilibrium one (DSGE), but also sometimes as the “consensus model” because it represents a way in which the great disagreement in macroeconomic modelling originating from the 1980s came to a consensus representation in that the main structure of the real business cycle agenda (also known as fresh-water economics as it is mainly associated with the universities on the great lakes of the United States) was paired with key insights originating from New Keynesian economics (also known as salt-water economics as it is mainly associated with the universities on the two coasts of the United States). There are many versions of the DSGE and therefore any generalization on this is bound to be easily disproven, but very superficially the model is often summarized into three basic equations. These are:

• 1. An interest rate rule (or Taylor rule) that describes the behaviour of the policymaker which is obviously the equivalent of the monetary rule of the previous chapter.

• 2. A demand-side equation sometimes described as a New Keynesian IS curve (which is obviously meant to match the IS curve of the previous chapter).

• 3. A supply-side equation of different and varied specification that may take the form of the New Keynesian Phillips curve whose function is performed by the inertiaaugmented Phillips curve of the previous chapter.

Again very superficially, because there are three equations matched by another three, it would be easy to claim that the two models must be pretty much interchangeable. That is, however, not true the moment one digs deeper into how the three relationships are justified in the two models. The task of the present and following chapter is therefore to explore what lies behind the three equations presented in the previous one, and understand the extent to which they actually depart from the corresponding ones of the DSGE they so superficially match.

Until now expectations on inflation have been formed with a mechanical rule whereby the past realized inflation rate is used as the best prediction of the next period one so that in symbols: πte= πt−1. The reasons for adopting such a simple rule are primarily empirical. As Carlin and Soskice (2006, 2014) argue, it is a specification that fits the data well over the period of the great moderation and it captures the empirical observation of a certain inertia in inflation, whereby the current rate of inflation in any one period has a bearing on what the next period's rate of inflation can be. Assuming that households and firms operate under such a rule has a certain plausibility, provided that the general context in which expectations are formed be a relatively stable one. These conditions are obviously matched in the sample period of the great moderation and it is therefore plausible to imagine that many economic agents would resort to such a simple mechanical rule, or collectively act as if they had adopted such a rule, when the actual oscillations of the inflation rate around the target rate are too minimal to warrant more informed and more costly assessments of what is to be expected. Nonetheless there is no denying that the adoption of such a mechanical rule has serious theoretical drawbacks that largely match what prompted the abandonment of the adaptive expectations mechanism in the 1970s. In practice, there is in fact little way of discriminating between the inertial specification of the Phillips curve and the one adopted by Friedman (1968) with an adaptive expectations mechanism, whereby expectations are formed on the basis of some update or correction on past forecasting errors. A degree of observational equivalence is inevitable and therefore the theoretical criticisms apply equally. These in particular are the following.

In the first instance, there is a degree of undesirable asymmetry whereby the central bank is forward-looking or is able to predict what is going to happen, in particular the future period inertia-augmented Phillips curve, whereas firms and households are entirely backward-looking and are reacting to past events rather than looking forward to forthcoming ones.

The legacy of the Mundell-Fleming model

Until now an assumption has been made that the economy under consideration is a closed one, and is therefore not open to international trade and international flows of finance. This is deeply implausible especially when the actual economy being considered is that of the UK, or of any individual country in Europe. In practice, the choice of maintaining the economy closed in its modelling is dictated by the fact that abandoning the LM curve has very awkward implications for an open economy model, which has to replicate the results of the venerable Mundell-Fleming one. The latter can be described as the open economy extension of the IS-LM, but translating it into a diagram that would dispense with an LM curve that represents changes in the domestic money supply has proven a challenge. In their 2006 book, Carlin and Soskice shied away from such a challenge and reverted to the Mundell-Fleming in their open economy chapters, thereby reinstating the implausible LM curve. This was altered in the 2014 book (Carlin & Soskice 2014) but, as it will be argued below, the result is not altogether satisfactory. The unavoidable challenge is given by the fact that the Mundell-Fleming diagram is invariably simpler and more intuitive than any of its replacements. So, it comes to a choice: textbooks (e.g., Gärtner 2014) which place the treatment of the open economy at their centre, opt to retain that older model at the price of an implausibly obsolete diagrammatic representation of the conduct of monetary policy. Textbooks instead that place greater weight on a plausible and accurate description of the latter, have to compromise with awkward diagrams in their open economy settings. This is the route taken by Carlin and Soskice (2014) and so will it be the case in what follows here, in the hope of doing something marginally less awkward. But it has to be understood that the aim is to replicate the results of the Mundell-Fleming which have to be kept in mind, and a thoroughly clear rendition of which can be found in Gärtner (2014).

To start, we need to understand why and how the Soviet Union collapsed and how the trauma of collapse shaped how Putin, his allies and millions of Russians came to view the world. Putin described Soviet collapse as “the greatest geopolitical catastrophe of the century”. “Tens of millions of our fellow citizens and countrymen found themselves beyond the fringes of Russian territory”. An “epidemic of collapse” as he called it, spilled into Russia, threatening its very existence. The 1990s are remembered as a traumatic time for most Russians in which quality of life and rule of law fell apart. Savings and job security evaporated. Rates of poverty, alcoholism and mortality increased. Average life expectancy fell by nearly five years. Russia's population declined. Putin came to power as prime minister at the end of that turbulent decade in 1999 and became president the following year. His presidency was defined by that backdrop; Putinism was all about reversing that catastrophe and restoring Russian pride by rebuilding the state to its former glory. What that meant exactly evolved over time, but Putinism always held Russia of the 1990s as its antithesis. Humiliation, decay, poverty and death are indelibly connected to state weakness, liberalism, democracy, and all things “Western” in the Putinist view of politics.

The collapse of communism sparked violent conflict and Russia used war, and proxies, to protect its interests. The collapse of the USSR unleashed powerful centrifugal forces that Moscow struggled to contain. Even then, Soviet and then Russian governments exhibited an interest in holding onto as much of the USSR as possible, especially those areas where Russians, Russian-speakers, and Russian allies lived, under Moscow's influence. They used force where they could, force moderated principally not by morality or political intent but by crippling incapacity. A will to fight unmatched by the capacity to do so was a recurrent theme, which stretched from Lithuania to the failed August 1991 coup, to Chechnya. Only against the unarmed, the very lightly armed, or other elements of its own enormous military institution did the Soviet and then Russian armies enjoy much success in the 1990s. But it was not for want of trying.

The moment of Putin's failure was caught on a phone's camera. It was Friday 25 February 2022. The phone belonged to Volodymyr Zelensky, president of Ukraine. Rumours that he and his government had fled Kyiv were swirling, fanned by Russian propaganda and trolls, but standing in the lamp-lit street outside his presidential office, Zelensky issued a simple message of defiance. “The PM is here, the Party leader is here, the President is here. We are all here”. He continued, “our military is here. Citizens in society are here. We’re all here defending our country, our independence, and it will stay that way”.

In that moment it was evident that Putin had failed to topple Ukraine's government and replace it with one more subservient to Moscow. In the months and years that followed, Russia also failed to win a decisive military victory capable of coercing Kyiv back into the Eurasian sphere. Russia's naked aggression and Ukraine's heroic defence finally spurred an appalled West into action. Ukrainian forces pushed the Russian army back from Kyiv, Mykolaiv and Kharkiv. The war continues but as I write, Ukraine has conducted a successful counter-offensive in Kharkiv, has retaken the one major city Russian forces did manage to take in its initial advance, Kherson, and has fought Russia's much vaunted spring offensive to a bloody standstill in Bakhmut. Russian losses are colossal. The US estimates that Russia has sustained more than 200,000 casualties. It has lost thousands of tanks, APCs and drones, dozens of helicopters and aircraft. Things have got so bad that in September 2022, Putin was forced to order a general mobilization of men of fighting age, pouring badly trained civilians into the grinder to replace the professional troops eliminated by Ukraine's defenders. Wagner recruited prisoners to send to the front and provided the vanguard for the assault on Bakhmut in spring 2023, its cavalier attitude to the welfare of its soldiers resulting in appalling losses. When Ukraine started to turn the tide there too, Prigozhin launched an excoriating public tirade against Putin and the Russian army, who he blamed for the failure – a telling sign that the Putinist alliance is fracturing under the weight of its own war.