According to Reserve Bank deputy governor Andrew Hauser last week, we’ve entered a world characterised not just by volatility, complexity and uncertainty, but also by “ambiguity” – a world where “you don’t know the model”, meaning that “judgment and instinct are as important as formal analysis”.
At last, someone is talking sense.
Academic economists may be locked into their maths and econometric models, but practising economists know it ain’t that simple. Economics is as much an art as a science.
Economics would be much easier if only human consumers and businesspeople behaved like rational automatons, reacting automatically and mechanically to known incentives, as you implicitly assume they do when you use a set of equations to guide you through the inevitable uncertainty caused by the lamentable truth than the humans who constitute the economy are . . . human.
Keynes reminded his fellow academics of the need to take account of people’s “animal spirits”. Anyone familiar with markets knows they tend to alternate between periods of optimism and pessimism. I prefer to say that maths without psychology will usually get it wrong.
Contrary to the assumption of the simple model that dominates the thinking of almost all economists, humans are not rugged individualists who decide for themselves the best thing to do, then do it without regard to what anyone else is doing.
In reality, consumers and businesspeople are heavily influenced by what other people are doing. We’re susceptible to herd behaviour, fads and fashions. And we live in a permanent state of uncertainty.
In their landmark book, Radical Uncertainty: Decision-making Beyond the Numbers, John Kay and Mervyn King say it’s not true, as economists assume, that businesses are “profit maximising”. That’s not because they wouldn’t like maximum profits, but because they don’t know the magic price to charge that would do the trick.
As the punters often forget, when a firm raises its price, it’s taking a risk. It’s taking a bet that what it gains in higher revenue won’t be cancelled out by the sales it loses from customers unwilling to pay the higher price.
In the real world, firms feel their way with price increases, hoping to avoid going over the top and ending up worse off. But get this: they feel a lot more comfortable putting up their prices when everyone else is putting up theirs. You know, like our firms were doing a year or two ago.
Hauser says that, at present, “we don’t know the model” but, in fact, the Reserve and everyone else are using the same orthodox, mainstream model to explain why, after staying low for almost 30 years, the annual rate of inflation took off in late 2021 and reached a peak of 7.8 per cent by the end of 2022.
As I’ve written incessantly, this first inflation surge in three decades was caused by the COVID-19 pandemic (with a little help from Russia’s attack on Ukraine). The pandemic caused worldwide disruptions to supply, in turn causing the prices of many goods to leap. The second factor was the massive monetary and budgetary stimulus the authorities let loose to keep the economy alive during the lockdowns.
This conventional wisdom is easily accepted because it blames most of the problem on the government. Inflation surged because the authorities cut interest rates and increased government spending by far more than proved necessary. All of us borrowed more and spent more, causing demand to run ahead of supply and prices to rise.
But I’ve long suspected this isn’t the whole story, or even the main story. So, since even the Reserve Bank isn’t sure we’ve got the right model to explain what’s happening in the economy, let me show you my model, which puts most emphasis on psychological factors.
When people in many countries were confined to their homes, they could still use the internet to buy goods, but they couldn’t spend on personally delivered services. So spending on goods surged to levels far greater than businesses were used to supplying. And, since most manufactured goods are imported, we got shortages of ships and shipping containers to go with shortages of cars, silicon chips, building materials and much else.
When Russia’s invasion of Ukraine caused oil and gas prices to soar as well, the media went for weeks with stories of how much prices would be rising. Reporters would go to industry lobby groups, whose shills would regretfully affirm that, yes, prices would be rising hugely. The ABC gave much publicity to some wiseguy claiming the price of a cup of coffee would jump to $8. Great story; pity it was BS.
I could see what was happening at the time. Businesses were using the media to soften up their customers for big price rises. They were setting up a self-fulfilling prophecy.
Only in recent times have academic economists begun to understand the important role played in the economy by “signalling” – a role not captured by their equations. Not only were firms signalling to customers that, due to causes entirely beyond their control, big price rises were unavoidable, they were signalling to all their mates that now would be a great time to whack up their own prices.
But my alternative explanation doesn’t start there. Remember that, for seven whole years before this latest price surge, the inflation rate was stuck below the bottom of the 2 to 3 per cent target range, despite the Reserve’s efforts to get it up.
Why was inflation unacceptably low? My theory is it was another self-fulfilling prophecy. Businesses weren’t game to raise their prices because no other businesses were raising theirs. Everyone was waiting for some inflationary event to give them some cover, but nothing turned up.
Until the pandemic’s supply disruptions and the Russia-induced jump in oil and gas prices turned up. As soon as it did, everyone breathed a sigh of relief and began wondering how big an increase they could get away with.
The irony is that the pandemic-induced supply disruptions – and even, to an extent, the oil and gas price rises – proved temporary and were reversed. Leaving all the unrelated price rises to stand.
