Copernicus Predicted Today’s Inflation
In 1543, the great Polish polymath and astronomer, Nicholas Copernicus, published De Revolutionibus Orbium Coelestium (On the Revolutions of the Heavenly Spheres). Although widely ignored for fifty years, his theory that the earth revolves around the sun instigated a revolution in astronomy and marked the start of a paradigm shift in scientific method. The idea of progress through periodic revolutions can also be found in the field of economics, but unlike in the natural sciences, economic theory still struggles to understand many phenomena. Inflation is one of them, as recent events reveal.
Inflation, but not Everywhere
In the depths of the 2008 Financial Crisis, Queen Elizabeth II prompted red faces on a visit to the London School of Economics when she enquired why nobody had seen it coming. Her Majesty later received a letter blaming a “failure of the collective imagination." A similar embarrassment happened in June 2022, when US consumer price inflation (CPI) rocketed to 9% – the fastest pace since 1981. The surge in prices came as a great surprise to almost all economic forecasters, including the 400 PhD economists employed by the Federal Reserve who only last year published an official projection that inflation would remain stable at 2.1%.
The US is not alone. CPI recently hit 10.1% in the UK, and a startling 78.6% in Turkey. Bank of England governor, Andrew Bailey, has tried to shift the blame onto global cost pressures from COVID and the war in Ukraine, but the jump in global commodity prices is a relative price shift and leaves an important fact unexplained: in certain countries the behaviour of the overall price level has been benign. In Switzerland, for example, inflation in July was only 3.4%, while in Japan it was 2.4%.
This divergence between high and low inflation countries is revealing because Switzerland and Japan are open economies subject to the same global cost pressures as the US, UK, and Turkey. What really separates these two groups of countries are the different magnitudes of money supply growth engineered by Central Banks during the pandemic. Taking the period from February 2020 to September 2021, broad money increased by 36.4% and 18.9% respectively in the US and UK, while in Turkey it exceeded 80%. By contrast, money supply growth over that period was only 11.3% and 7.6% respectively in low inflation Japan and Switzerland.
Most mainstream economists nowadays ignore the money supply, but this was not always so. One of the first recorded analyses of the connection between money and prices was set out by none other than Copernicus in his Monetae Cudendae Ratio (‘Treatise on Money’) published 1517. The ruling Teutonic Order had debased the coinage, leading to inflation. Copernicus advised the King that “the dearness of everything is a result of the cheapness of money...An excessive quantity of money should be avoided.” Over the centuries, rapid monetary expansion has always been associated with inflation. During the pandemic, there were few voices warning of inflation. The exception was the monetarists, such as John Greenwood, who last year predicted inflation “as high as 9.” These warnings were ignored. Indeed, Jay Powell, Chair of the Federal Reserve, dismissed the role of money supply when he reassured Congress that M2, a calculation of the money supply, “does not really have important implications.”
Economic Revolutions and Counterrevolutions
How has the economics profession come to this? Classical economists such as Irving Fisher took as axiomatic the quantity theory of money (QTM), which proposes that changes in the stock of money reliably affect the general price level. In the classical view, unemployment was mostly voluntary, hence by definition there was little spare capacity to complicate the link between rising money balances and higher prices. Money was seen as a veil that did not affect the real economy. However, the terrible experience of deflation and depression during the 1930s led to a “Keynesian Revolution” in economic theory.
The QTM was replaced by an emphasis on cost factors as the main determinant of prices, with money supply reduced to a secondary role. The new orthodoxy prevailed for forty years until the unprecedented shock of stagflation. Driven by accelerating money supply, US inflation soared from an average of 2.45% in the 1960s to 7.25% in the 1970s, coincident with high unemployment.
The Keynesian model could not explain this phenomenon, and so gave way to a monetarist counterrevolution led by Milton Friedman. The QTM returned to the forefront of economic theory, and for a time it underpinned the policy framework of the Bank of England. Gradually, however, the pendulum has swung back to the current orthodoxy – as expressed by Jay Powell above – with money supply once more reduced to a minor role.
Two features of this cycle of revolutions and counterrevolutions are worth noting. Firstly, theoretical orthodoxy develops in response to new data. As older theories accumulate more anomalous and unexplained facts, the burden of necessary modifications becomes overwhelming and the theory breaks down. Secondly, economics often struggles to reach a settled conclusion. It is a social not a natural science.
The LSE professor of Logic and Scientific Method, Karl Popper, famously stressed a key difference between categories of science: that of falsifiability. In true science (as opposed to pseudoscience), theory should be able to make falsifiable predictions. The assertion that “all swans are white” cannot be proved by observing millions of white swans, whereas the discovery of one black swan will immediately refute it.
In natural science, the possibility of conducting controlled experiments makes it relatively easy to refute theories. Unfortunately, social science involves the hard-to-measure interactions of millions of humans with indiscernible motivations. This makes controlled experiments very difficult. Occasionally, extreme occurrences can cut through the noise to reveal underlying relationships between certain variables, which provides opportunities for falsification or confirmation. This provokes debate. The monetarists’ forecasts of the latest inflation shock prompted the new UK prime minister Liz Truss to admonish, “we have not been tough enough on money supply.”
Economic & Astronomic Revolutions
The relatively short-lived impact of Keynesian and Monetarist revolutions can be contrasted with the sixteenth century Copernican Revolution in astronomy. Over a period of 150 years, astronomer-mathematicians such as Nicolas Copernicus and Galileo Galilei convinced a sceptical establishment that the earth was not at the centre of the universe, but rather it rotated around the sun. The status quo was stubbornly resistant to change even as more data was presented by astronomers using more accurate instruments. First developed by the ancient Greek astronomer, Ptolemaeus, the geocentric theory had proved very successful in explaining astronomical observations. Only the retrograde movements of the five known planets caused difficulties. Furthermore, the powerful Catholic church held that, according to the Bible, God had placed the earth at the centre of the universe.
Indeed, Copernicus’ new theory still did not adequately explain planetary motions. Then, in his 1609 work Astronomia Nova, the German astronomer Johannes Kepler proposed a radical new theory that the orbit of Mars was not circular, but elliptical. This ‘First Law of Planetary Motion’ would not have been possible without the very precise observational data collected by his mentor Tycho Brahe. Kepler’s new theory supported heliocentrism. It also yielded testable predictions, which other astronomers could not refute (or ‘falsify’). Hence a new scientific method was born.
For their entire lives Copernicus, Kepler and Galileo were deeply religious men who were trying to explain what they saw as God’s universe, but their works were banned by the Catholic church. Indeed, Galileo was sentenced to lifetime house arrest for heresy.
A parallel can be drawn between the discovery of Mars’s elliptical orbit and the stagflation of the 1970s. Both sets of observations obliged a reluctant established orthodoxy to accept a new theoretical model. The present conjuncture, with divergent inflation rates in otherwise similar countries should prompt another re-think of mainstream theories about inflation. Moreover, US money supply growth has just turned negative, a historically rare occurrence. Inflation could thus at some point turn to deflation, a potential disaster which should lend some urgency to the debate.
If we are now on the precipice of another counterrevolution in economics, Milton Friedman’s experience may be illuminating. He outlined three stages of how a revolutionary’s ideas gain acceptance: “The first reaction is to ignore the interloper [...] The second reaction is to ridicule him. Finally, you put on his clothes [...] you adopt for your own his views, and then attribute to him a caricature of those views. He’s an extremist [...] of course money does matter, but...”.
Thankfully, in the modern era no one is likely to face house arrest.