Inflation in the United States Soaring to it’s highest level in four decades. A lot of great, gifted, economists at the Federal Reserve. No government anymore than anyone of us, likes to take responsibility for bad things.

Look, we need to talk about inflation and specifically about why it seems to be such a mystery to economists and central bankers.

For example, here you see inflation in the Eurozone. And these were the European central bank’s inflation forecasts. As you can see, they consistently expected inflation to subside, while it only got worse.

Similarly, before the pandemic, inflation remained stubbornly low and the same economists kept predicting that inflation would go back up.

And this is by no means unique to Europe.

Recently the chairman of the U.S. Federal Reserve bank, Jerome Powell, shocked the world when he said:

We now understand better how little we understand about inflation”

And since there are plenty of theories about inflation, that got me wondering, why is inflation still a mystery to central bankers?

To answer that question, we first need to understand how the current theory of inflation was forged during a great scientific battle. A battle that saw Monetarist economists such as Milton Friedman first defeat the Keynesians, only to then be defeated by the New-Keynesians, which are now battling new theories such as Modern Monetary Theory, and the Fiscal Theory of the Price level.

Let’s start at the beginning.

Keynesians Love Philips

In the 1970s the world of macroeconomics was basically on fire.

At this time, the world’s advanced economies were plagued by a scourge of inflation combined with super high unemployment.

But, according to the Keynesian economists of the time, this combination should not have been possible. You see, in 1958 an economist called William Philips discovered that historically there was a remarkably stable relationship between unemployment and inflation.

This observation, was then incorporated into a theoretical framework that was inspired by the work of

famous economist John Maynard Keynes.

These Keynesian economists were very much concerned with stabilising unemployment at a very low level.

So, it seems weird to view inflation as a consequence of too much employment opportunities.

However, it does make sense if you view

the rise of all prices simultaneously as a consequence of overall demand outpacing supply.

After all, if almost everybody is already employed, you cannot really make more stuff.

Or, as economists would say, supply is constrained.

At the same time, with so many workers employed, demand is at an all time high.

And, with overall demand higher than overall supply, it makes sense that overall prices will go up.

However, during the oil crisis of the 1970s, the U.S. experienced double digit inflation while unemployment reached all time highs of 7.5%.

This rare combination of stagnation and inflation, came to be known as stagflation.

And, I know that many people think that economists are not real scientists. But, as should be the case in science, the old Keynesian theory not fitting the data meant that the field was wide open for new challengers.

The challengers that initially seemed to come out on top were the monetarists. And their champion was Chicago Professor Milton Friedman.

Friedman Prints A Theory

The charismatic professor seemed to have all the answers. According to him, inflation was a actually a simple problem.

Now the first step to our understanding the cause of inflation is to recognize that it is always and everywhere a monetary phenomenon. It’s always and everywhere a result of too much money. Of a more rapid increase in the quantity of money. Moreover, in the modern era the important next step is to recognize that today governments control the quantity of money. So that today, inflation is made in Washington and nowhere else.”

Like the Philips curve, this theory made intuitive sense.

If all prices rise, that must mean that the value of money is actually going down. The central bank creates money. So, if there is inflation, that must mean that the central bank is simply printing too much money.

Working in favour of this theory was also that it built on a long intellectual tradition.

You see, in the 18th century, famous philosopher and economist David Hume already imagined a simple economy in which money is basically gold.

If the quantity of gold was unexpectedly increased, the only logical consequence is that the value of gold money drops compared to goods.

Most economists believe that this is exactly what happened in Europe right after the Spanish discovered silver and gold in South America,

A sudden increase in the quantity of money naturally meant higher prices in Europe.

What’s more, this theory could also explain the Philips curve relationship between unemployment and inflation. After all, a sudden increase in the quantity of money cannot lead to more production if everyone is already, it would likely just lead to more demand and therefore higher prices.

Finally, the monetarists recognized that if the economy was to grow at a steady rate, then money also needed to increase at a steady rate to keep prices stable.

So, to prevent inflation the solution would simply be to increase the money supply every year at some optimal rate.

And, actually quite a few central bankers were convinced.

For example, in 1979, the Bank of England set itself a target to increase the broad money supply by 7-11%.

There was just one problem.

The UK broad money supply increased by a whopping 22%.

Double the target. That was a bit confusing for the monetarists.

So, why did this happen?

Well, likely because the UK economy of the late 70s wasn’t comparable to a simple gold coin economy.

If we look at the composition of the money supply target in the UK in 1979, you will see that less than 11% was created by the central bank. A trend that only got worse since then.

In other words, central bankers found out the hard way that, instead of living in Friedman’s simple economy, they lived in an economy that was dominated by credit money.

In modern economies money is issued as credit, not just by central banks, but primarily by private banks and other financial institutions.

And, a crucial difference between credit money and gold is that credit money is typically created by banks to make new production possible.

For example, in the form of a business loan for a new factory.

So, sure, a random gold discovery in Medieval times may have only increase demand in Europe’s economy but not supply.

Causing inflation.

But, a line of credit to build a business will likely lead to more production and demand at the same time. It is therefore less likely to cause all prices to rise.

Now, of course, central bankers could get closer to Friedman’s imagined economy by taking away this power from financial institutions. They even tried this in the US with the Monetary Control Act of 1980.

However that failed because financial institutions soon found clever ways around them by creating new forms of credit money.

In other words, to enact Friedman’s plan, central bankers needed to be willing to basically break the financial system. A system that central banks were created to prevent from collapsing.

So, yeah that didn’t happen.


But, while Friedman’s simple “money printing” theory was not a realistic description of modern economies, he did end up significantly influencing the economists that would come to challenge him.

expecting interest rates

So, 1970s inflation had happened despite high unemployment and despite the central bank not directly controlling the money supply.

In response, many economists, including Friedman, started wondering if it could be true that just expecting inflation could have actually caused inflation.

You see, if workers expect inflation, they might negotiate higher wages at the start of the year. Or if shopkeepers expect higher inflation, they might already adjust their prices for this at the start of the year.

But, then you might ask, how will people get the money to pay these higher prices?

Well, by asking for a bit more credit money at private banks of course.

So, in this case just the expectation of higher inflation, actually causes higher inflation.

Pretty mindboggling stuff, right?

But this then, of course, raises the following question. Why did people expect higher inflation in the 70s?

One hypothesis was that the initial spike in inflation was caused by a huge spike in oil prices. Then, after oil prices had spiked, people just kept expecting high inflation to continue.

Economist call this ‘adaptive expectations’ because people change or adapt their expectations based on what happened in the past.

Alternatively, it could be that people just didn’t believe the central bank wanted to control inflation and therefore they expected higher inflation.

Economists call these types of expectations forward looking expectations.

And this is where a group of economists called the New-Keynesians come in. The New-Keynesians combined the Old-Keynesian Philips curve, with forward looking inflation expectations. Their so-called New-Keynesian Philips curve could obviously explain the Philips curve observation. It could also explain stagflation, by stating that in the 70s the people must have lost trust in the central bank. What’s more, the New-Keynesians required central bankers to control something that they could actually control, the short-term interest rate.

So, in proper scientific fashion, New-Keynesian theory was deemed superior because it was the theory that was the least inconsistent with the data.

The theory implied that, to control inflation, central bankers just needed to concern themselves with two things.

First, they needed to set the precise interest rate that keeps unemployment at a level that is not inflationary. This magical rate also became known as R*

Second, to manage expectations, they needed to be seen as credible inflation AND deflation fighters. Or as central bankers would say, they needed to keep inflation expectations well anchored.

inflation expectations are starting to move down to dangerously low levels. They’ve moved up a bit but are still pretty well anchored”

we stress the importance of having inflation expectations well anchored at 2%”

And for a while, this seemed to work. Wherever central banks adopted this framework, inflation seemed to go down. In fact, it seemed to work so well, that New-Keynesian economics came to dominate the profession. And in their models, the non-inflationary interest rate was not just prevent inflation, it would basically stabilize the entire economy.

Yeah, in 2007, New-Keynesian economists genuinely seemed to believe that they had solved all the great mysteries of macroeconomics.

“I got two guns right here”

But, then, this happened.

Let’s talk about the speed with which we are watching this market deteriorate. We are red everywhere essentially. “


Now, it is true that New-Keynesian theory initially just got into trouble because it didn’t predict the great financial crisis. But, soon inflation would start to act funny as well.

You see, central bankers were communicating that they wanted more inflation

“[inflation is very]( very low, which you think is a good thing, and normally is a good thing. But, we are getting awfully close to the range were prices would actually start falling. Falling prices lead to falling wages, it lets the steam out of the economy, exactly, and you start spiralling downward. Exactly”

What’s more both interest rates and unemployment were low. And so, now it makes sense that central bank economists kept expecting inflation to go up, even though, it didn’t.

Smelling blood, this is when both new inflation theories starting popping up and old theories started coming back into vogue.

On the one hand, you saw the return of the monetarist spirit.

And some of these economists started arguing that with the central bank creating so much money, there had to be inflation somewhere. Even if it couldn’t be found in the official inflation statistics

So, the government is reporting 7% on headline inflation and you are saying we are at 15%?.

Other monetarists went on to say that inflation hadn’t appeared yet. But, that would soon soon appear.

Fed is really trying to increase inflation from one-and-a-half to two they’re going to overshoot by a landslide”

In the other corner you saw the rise of more government centric theories. For example, Warren Mosler’s Modern Monetary Theory states that prices paid by the government, when it spends, sets the price level. It does so by stabilizing wages through both government spending at current prices and monetary policy.

Another contender is Chicago professor Cochrane’s fiscal theory of the price level. Cochrane argues that the price level is determined by the present value of all future government surpluses. Finally, the New Keynesians are actively updating their theory by also emphasising a larger role for government spending in their models.

This could indeed explain the low inflation levels after the great financial crisis. Since, while central banks were stimulating like crazy, governments were relatively conservative in their spending.

But, then, as if it was a final blow, inflation accelerating rapidly after the pandemic was again not foreseen by the New-Keynesian economists employed by the central banks.

After all, unemployment was not lower than it was before the pandemic, and inflation expectations seemed to be well anchored.

Some things that had changed was that there had simultaneously been big government stimulus in the U.S., several massive blow to supply chains, and a big demand shift from the service sector to the goods sector.

At the same time, while wages remained subdued, corporate profits soared. Therefore it made sense that other economists such as Marxists and post-Keynesians joined the fight with theories ranging from price gauging to pure cost-push inflation.

And so, it seems that we are back to square one.

The next theory of inflation needs to be able to explain the Philips curve of the 60s, 70s stagflation, 90s and 2000s steady inflation, the 2010s lack of inflation, and the post-pandemic inflation spike.

But, which theory will be victorious and give Fed chairman Jerome Powell renewed confidence in his ability to understand inflation?

a modest inflation theory

Well, personally, I don’t expect Friedman’s monetarist to get their revenge just yet. To do so, they would need to explain why inflation remained relatively low in the previous decades while the money supply exploded. They would also need to explain why in regions with very activist central banks, such as Europe and Japan, inflation was relatively low. And finally, they would also need to incorporate private credit money into their framework somehow to explain why the central bank doesn’t control the money supply.

That being said, I also think that the New-Keynesians are genuinely in trouble. Their strict mathematical models can accommodate new assumptions to explain every individual inflation. But, I don’t think they can fit in enough new equations to explain each of these individual inflation episodes while keeping their models simple and elegant.

The theories that focus on corporate profit are an interesting counterweight to the Philips curve focus on unemployment. However, I don’t think these were ever intended to explain inflation in all time periods.

Finally, I am eager to learn more about the government focussed theories and hope to talk to some guests soon about them soon, on my second channel.

But, in the end, I think that all of these theories are basically wrong and I also they think they are all correct.

What if the there are just multiple ways that inflation can come about in our complex economy.

In some cases inflation will be generated by excessive money printing, perhaps in response to outside pressure. In other cases, a big supply side disruption might generate higher prices. This might then lead to higher inflation expectations. In both cases extra credit money creation by private bank then FOLLOWs as a CONSEQUENCE of these higher prices. Or, it could be that because of globalization, there are now more workers, supressing wages, leading to deflation.

In other words, just like political scientists have never come up with a simple theory of war, economists will never be able to come up with a simple theory of inflation.

On the bright side, if you remember government spending, money printing, expectations and supply-side disruptions as possible causes of inflation, you can still make useful predictions as an economist. For example, a war will likely be inflationary due to cost-pressures, government spending, and demand shift. On the other hand, interest rates hikes will likely be deflationary because they kill demand.

These are still useful economic predictions. You can see it a bit as how a doctor can predict that smoking will likely cause cancer. But, cannot tell that if you smoke, you will get definitely get cancer or when it will strike.

But, hey, that is just my take on the matter. Made possible by my awesome Patrons and members. Who do you think has the best theory of inflation? Let me know in the comments. And if you are not sure yet, consider watching this video on the history of credit money in Europe or this video, diving into why central bankers are less in control than you might think.