Why mainstream economics got inflation wrong

In his November 7 2023 New York Times newsletter, economist Paul Krugman asks a good, albeit belated, question: Why did so many economists get the inflation outlook wrong? After all, the near-consensus among mainstream economists in recent years was that inflation would persist – and even accelerate – and that this justified substantial interest-rate hikes by the US Federal Reserve. 

Yet the quasi-inflation of 2021-22 proved transitory.

Krugman poses his question with impeccable diplomacy, professing "respect" for three authors of a September 2022 paper published by the Brookings Institution (which was then promoted by Harvard University's Jason Furman) projecting that it would take at least two years of unemployment at 6.5% to bring inflation back to the Fed's self-imposed 2% target. But inflation had already peaked before the Brookings paper appeared, and long before the Fed's rate hikes might have been felt. Over the next year, inflation petered out, even as unemployment remained below 4%. "Team Transitory" – which once briefly included US Secretary of the Treasury Janet L Yellen – endured two years of derision, but it was correct all along.

Krugman rightly focuses on the illogic of certain inflation "pessimists," who "came up with new, completely unrelated justifications" for their contention that inflation would "remain stubbornly high" long after the 2021 fiscal stimulus packages had been absorbed. Since these pessimists encountered very little mainstream dissent, their doomsaying continued to dominate the discourse well into 2023.

Krugman tactfully avoids naming Lawrence H Summers, whose "justifications" for inflation pessimism included supposedly excessive "savings," the Fed's "debt purchases" and forecasts of "essentially zero interest rates," and "soaring stock and real estate prices." Yet, aside from his worries about fiscal stimulus, this was all nonsense. As I pointed out at the time, savings cannot cause inflation, and a technical forecast has no causal power.

Adopting the persona of a naïf, Krugman then suggests that it was "almost as if economists were looking for reasons to be pessimistic." A paragon of politesse, he declines to tell us what those reasons might have been. But two always stood out. The first was fear: if American workers retained a financial cushion from the COVID-19 aid packages, they might be "harder to boss around." The second reason concerned power: high interest rates tend to support the dollar internationally.

Since then, various Fed officials have acknowledged both motives many times. For example, an obsession with wages permeates all of Fed Chair Jerome Powell's speeches, and he has openly stated his commitment to maintaining a strong dollar. It is no surprise that mainstream economists endorse – indeed, craft – the same arguments.

But I, too, was being polite, because I omitted a third possibility: namely, that some mainstream economists might call for high interest rates to curry favor with bankers, who enjoy larger profit margins when rates are high (especially now that the Fed pays interest on bank reserves directly). A strong public stance on the matter could generate hefty speaking fees, consulting contracts, or a path to high public office. As Krugman concludes, "I'd like to see some hard thinking about how so many of my colleagues got this story so wrong and maybe even a bit of introspection about their motivations."

That would be nice, but let's not hold our breath. Instead, let's turn to a larger issue. Krugman notes that all the economists he mentions "are very much part of the economics profession's mainstream." He means this as a compliment; yet, as Hamlet says, "there's the rub." Consider just how often mainstream economists get things wrong – not only small things, but very big ones. Remember their famous failure to foresee the 2007-09 financial crisis, or the woefully ill-advised turn to austerity in 2010? What about the predictably perverse effect of sanctions on Russia? The misdiagnosis of inflation in 2021-22 was merely the latest episode in a long-running series of failures.

The question we should be asking, then, is whether there is something wrong with mainstream economics. Mainstream economists should perhaps re-examine their core beliefs, or maybe we need a new "mainstream" altogether.

To be sure, Krugman notes that "one strand of argument involved parallels with the inflation of the 1970s." But this only grazes the problem. The real issue is that most of today's leading mainstream economists were trained in the 1970s, and their worldview – not just the facts, but the theory – was fixed back then. On macroeconomic issues such as inflation, the influences of general equilibrium theory, inflation-unemployment trade-offs, and monetarism remain strong. The legacies of Kenneth Arrow, Paul Samuelson, Robert Solow, and Milton Friedman live on.

That earlier generation's project was partly scientific, partly political. As "social scientists," they believed in the power of mathematics, which they borrowed from the celestial mechanics of previous centuries. Politically, they sought to defend capitalism against the Soviet challenge during the Cold War. By uniting these objectives, they fashioned the market-oriented mathematical straitjacket in which today's mainstream economists were raised – and from which they cannot escape. Yesterday's Wunderkinder – including Summers and Krugman – are today's tired old men.

Notably, Krugman's reflection on disinflation makes no mention of the economists who did not misdiagnose things, including Isabella M Weber of the University of Massachusetts Amherst, and L. Randall Wray and Yeva Nersisyan of the Levy Institute. They correctly predicted the disinflation back in March 2022.

But economists with better ideas never get citations by name, let alone job offers from so-called top departments, mainly because so many members of the old guard want to preserve the academic, political, and media monopolies they have held since the 1970s. That means purging new ideas and belittling the people who advance them. By offering such a polite, gentle critique of his "colleagues" after their latest failure, Krugman is being diplomatic to a fault. 

James K Galbraith, Professor at the Lyndon B Johnson School of Public Affairs at the University of Texas at Austin, is a former executive director of the Joint Economic Committee of the US Congress and the co-author (with Jing Chen) of the forthcoming Entropy Economics: The Biophysical Basis of Value and Production.

Disclaimer: This article first appeared on Project Syndicate, and is published by special syndication arrangement.