As the economic outlook darkens, comparisons with the past are becoming increasingly frantic: are we seeing a return to the 1970s, or even the 1980s or 1990s? We are all familiar with the idea that ‘history doesn’t repeat itself, but it often rhymes’. And if we don’t learn from the past, are we doomed to repeat it? Not so fast: in difficult times, economics has a habit of transforming itself to come up with new answers. It looks as though 2022 will be no different.
On the surface, today’s parallels with the 1970s feel almost irresistible: industrial action, double-digit inflation forecasts and fears of a wage-price spiral. Added to this is stock market misery – the S&P 500 has just seen its biggest drop since 1970. But don’t be swayed by eye-catching headline figures. There are many more profound (and more boring) differences between that decade and today. Research from Oxford Economics stresses that while comparisons with the period feel ‘natural’, a 1970s redux is unlikely.
"If you dig below the surface, we think the current situation is very different," argues Andrew Goodwin, Oxford's chief UK economist. Firstly, the link between inflation and pay growth is much weaker than it was 50 years ago – despite high-profile industrial action. This makes the risk of a wage-price spiral much lower.
On top of this, monetary policy is now independent of government. In the 1970s, governments prioritised full employment and pro-cyclical policies, meaning inflation was not the primary consideration for much of the decade. The Bank of England's modern role means it is focused on fighting inflation, giving it the remit to stamp down on price growth via a series of interest rate hikes. And while factors outside its control – such as supply chain issues and energy prices – may mean inflation persists for longer, this may ultimately prove to be at a lower level than in the 1970s, and to have a different impact. "The 1970s represented a crisis for profits, not living standards," Oxford Economics says. It predicts the opposite this time around.
But wait: this is where comparisons with the 1980s come in. If central banks are raising interest rates, does an economic slowdown beckon? In the early 1980s, the US economy tipped into recession twice as Fed chair Paul Volcker wrestled with high inflation rates. Volcker believed that fighting inflation was the Fed’s primary concern and that the only way to bring it down was to convince the public that the Fed was getting tough. And it got very tough indeed – US interest rates rose to almost 20 per cent in 1981.
It is tempting to draw parallels with today’s stern central bank rhetoric: the UK’s monetary policy committee (MPC) said in June that "the committee will be particularly alert to indications of more persistent inflationary pressures, and will if necessary act forcefully in response". But inflation targeting has become the norm since the 1980s, meaning that central banks should need to do less to convince the public of their tough stance. After all, the last time UK inflation was this high was in 1982, when interest rates were at 13 per cent, as the chart shows. Interest rates sit at 1.25 per cent today, and are not expected to exceed 3.5 per cent at any point during this rate hike cycle.
Volcker-era rate hikes also came at a heavy price, leaving US unemployment soaring to 11 per cent. For all the pressures on living standards, a repeat is not likely today. Labour markets in advanced economies remain remarkably resilient – at 3.8 per cent, UK unemployment is still below pre-pandemic levels.
The UK entered recession in the early 1990s: interest rates had hit the teens again and, as the second chart shows, house prices started to tumble as homeowners struggled to keep up with high mortgage payments. Many homeowners found themselves in negative equity, with the value of their property falling below the outstanding balance of their mortgage. Is history about to repeat itself?
Probably not. Until 1992, monetary policy was built to maintain the value of the pound: sky-high rates were sometimes required to defend the value of sterling. Today’s rate hikes are expected to be far more modest, meaning the impact on monthly mortgage repayments should be less severe. Gloomy consumer and business confidence should also be offset to a degree by lower unemployment – rates in the 1990s were almost twice as high as today.
The past rhymes
There may be no perfect reflections, but each of these decades gives us a glimpse of something that feels familiar to us today. It is very tempting to latch onto these sentiments. After all, by looking back we might decipher where the economy will move next. Even better, perhaps we can tell where policy is heading: will policymakers try to emulate their forebears, hammering inflation as Volcker did in the 1980s? Will they look to avoid the mistakes of the past by pouncing at the first sign of a wage-price spiral?
Earlier this year, Hannah Rose Woods published a book on nostalgia, Rule, Nostalgia, which argues that the British have been harking back to the ‘good old days’ since the 1500s. As unwelcome as a return to certain economic pasts might prove, the narrative itself can feel comforting. Woods explains that “nostalgia offers us protection from our anxieties: the chance to escape our worries about what the future holds and recall a story that might tell us who we are and where it is that we are going. And yet we know that real life is always too complex to fold the truth into the comforting structure of a storybook”.
Taking a broad and dispassionate look back at the past is sensible. But when we try to convince ourselves that one of these decades perfectly reflects our own, we can easily tip into something more unhelpful. Have we really seen it all before? What’s more, can we look back at the past with the easy confidence that we now have the tools to solve our economic problems?
Macroeconomics as we recognise it today came about after World War Two. This period saw the advent of Keynesianism, and its now-familiar emphasis on government spending. Keynes argued that the economy was not self-correcting, and could find itself stuck in undesirable states – and no state was more sticky and undesirable than the Great Depression.
Keynes pioneered countercyclical macroeconomic policies, arguing that the government had the power to influence the state of the economy. Even in the darkest days of the Great Depression, faith in the doctrine of the balanced budget had made the idea of the government spending more than it took in taxes unthinkable. Keynes argued that the government could, and should, use its might to fight recessions and ensure unemployment is kept as low as possible.
And for a time, it seemed to work. Keynesian policies were widely adopted, and – while the immediate post-war years saw supply chain shortages that are another partial parallel with the current day – the decades following WWII saw faster growth, greater productivity and generous social security benefits.
But the high unemployment and high inflation of the 1970s began to persuade governments that spending alone could no longer fix a recession. By 1975, inflation stood at 24.4 per cent, and unemployment at 5.4 per cent. “We used to think that you could spend your way out of a recession, and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists,” said prime minister James Callaghan in 1976.
Enter neoliberalism. Neoliberalism held that economic transformation could be achieved by increasing competition and reducing the role of the state. At a macroeconomic level, the 1980s saw the birth of neoliberal ‘trickle-down’ economics (the idea that as the rich become richer, they spend more, creating more jobs and income for everyone). We also saw the emergence of ‘monetarism’ – the idea that inflation could be constrained by changing the money supply.
It was in this climate that Volcker hiked US interest rates. This might seem like a standard policy prescription to us today, but at the time it was an economic electric shock – running against the Keynesian ideal of the government steering an economy towards full employment.
But by the 1990s, economics had again evolved, taking a softer, more hybrid approach to macroeconomics: this was the era of ‘flexible inflation targeting’. The UK adopted an inflation target in 1992, and would go on to delegate monetary policy to the Bank of England in 1997. The MPC’s primary mandate was to keep inflation low, but there was a dash of Keynesianism in there too. The then governor, Mervyn King, memorably announced that central bankers were not "inflation nutters", and the Bank of England would balance the objectives of growth and employment with keeping inflation to target.
Don’t look backwards, but forwards
Economics hasn’t always had the right answers, but it has reinvented itself to try to come up with them. When we look back to the past, we can’t confidently assume that we now have the economic tools to deal with whatever lies ahead.
It would be wrong to forget that the 1970s, 1980s and 1990s were tipping points, where our understanding of economics evolved significantly. It would be even worse to assume that the discipline as we know it is equipped to deal with the challenges of the 2020s. And it would be a serious mistake to assume that economics has reached its final form today. But what shape might it take next?
At a macroeconomic level, it looks as though the big state is back. In an IMF report James Manyika, chairman of the McKinsey Global Institute, argues for something that looks a little like post-Covid Keynesianism: "Over the past two decades, in advanced economies, responsibility has generally shifted from institutions to individuals. Yet health systems are being tested and often found wanting, while benefits from paid sick leave to universal basic income are getting a second look. There is potential for a long-term shift in how institutions support people, through safety nets and a more inclusive social contract."
Capital Economics agrees that the size and role of the state is unlikely to return to pre-virus conditions, but also notes that this raises "lasting and challenging questions about how governments fund themselves". And there is no denying that a big state comes with big costs. The OBR’s recent Fiscal Risks and Sustainability report found that public debt was on track to reach 267 per cent of GDP by 2052 – in the absence of any policy changes, at least.
Tightening fiscal policy could be a hard sell. Fiscal support over the pandemic was unprecedented in its scale, reaching 10.4 per cent of GDP. The OBR reports that the government has already spent as much this year (1.25 per cent of GDP) helping households cope with the soaring cost of living as it did supporting the economy through the financial crisis. The report suggests that high levels of support "may have raised expectations regarding the role of government in future crises". If the big state is here to stay, so are big questions about funding it.
Green economics is an area that may be subject to more radical change. Today’s burgeoning environmental economic policies try to price economic resources, and leave the market to work out the rest. This is as abstract as it sounds: examples like carbon taxes, and calculations to put a monetary value on biodiversity, have so far met with limited success
One future may lie instead in ‘ecological economics’, which argues that the economy is really a subsystem of the wider ecosystem. In Doughnut Economics, for example, Kate Raworth argues that the capacity of the planet is the ultimate constraint on economic progress. Instead of trying to get the environment to fall in line with our established economic models, economics might have to start working around the environment.
A Doughnut Economics approach has implications for firms, too. Under this model, firms become growth ‘agnostic’, rather than growth ‘addicted’. They also switch from becoming ‘extractive’ (thinking about how much financial value can be extracted from an enterprise), to becoming ‘generative’ (thinking about how many benefits can be generated from an enterprise). While this might seem antithetical to the capitalist model of development, it is akin to the mindset adopted by a growing number of environmental, social, and governance (ESG)-focused investors.
As energy security issues and movements in commodity prices are currently underlining, 2022 will not see a wholesale change in our understanding of the nature of the firm. But emphasis on sustainability and social responsibility could well become more widespread – and more sincere, too.
At a more theoretical level, this could be the era of ‘complexity economics’. Complexity economics argues that growth, development, technological change and inequality are the outcomes of hidden interactions. While traditional economics is happy to analyse these outcomes, it pays less attention to the forces that drive them. Complexity economics demands that we take a closer look.
Its first move could be to bring about an economic data revolution. Traditionally, macroeconomics deals in aggregates: summing up firm, household and customs data to estimate big picture figures like GDP and net exports. But where mainstream economics adds up, complexity economics networks, using so-called ‘spectral analysis’ instead.
According to a traditional production function, output is determined by a place's labour and capital. But a 2019 working paper by Harvard’s Bustos and Yildirim argued that production is shaped by the sophistication of the products being made and the availability of the right production capabilities. High income locations don’t just get more from their capital and labour inputs – they produce more complex products using a more complex means of production. More often than not, this means more technology: as Arthur Sants outlined in 'Labour strikes will accelerate digital transformation', IC 15 July 2022, digitisation is dematerialising the world. This also makes measuring output harder and more abstract, with knock-on effects for how we understand questions of productivity, income and growth. Could network models give us a firmer footing?
Complexity economics can also help us to explain the impact of technology at a firm level. An April 2022 journal article on ‘The new paradigm of economic complexity’ applies complexity economics to Google’s market share. Under this framework, growth is the outcome of a self-reinforcing feedback loop: Google’s labour and capital allow its search engine to make marginally better predictions. This attracts more users, which, in turn, provides better data, leading to better predictions. This has a ‘snowball effect’ which promotes exponential growth in the use of Google products – a dynamic process that traditional economics would struggle to foresee.
As a framework, complexity economics is firmly embedded in new technology itself: its models rely heavily on machine learning and big data. But the picture isn’t entirely rosy. Complex economies require complex regulation, and creates complex challenges, many of which are familiar concerns: think tackling monopolies, inequality and the physical concentration or isolation of certain industries and jobs.
It looks as though the next evolution of economics could be messy. Will we move away from our neat models to embrace more complexity, or non-economic factors? It is hard to say. In the face of these untidy new ideas, it is tempting to turn instead to a more certain past. But we shouldn’t: looking back can teach us a little, but looking forwards could teach us so much more.