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The Swedish National Bank Prize in Economic Sciences in Memory of Alfred Nobel this year was shared equally between Robert E. Hall and Michael Woodford for their work on what the committee called the microeconomic foundations of macroeconomic stabilization, which sounds pretty cool. But what does this really mean? Well, for a long time, macroeconomists, when making important decisions about fiscal, monetary, and even social policy, considered the economy to be a kind of amorphous mass of rational households, businesses, and trading partners. They believed that, in aggregate, all else being equal, steps like raising interest rates
from 4% to 5% would have a uniform, predictable impact on things like household spending and therefore inflation. Such ideas worked quite well for a while, until they stopped. Stagflation in America in the 1970s was effectively a failure of the Keynesian economic principles on which the world had been based up to that point. In theory, according to the economic manual, if unemployment is rising, the central bank should lower interest rates to stimulate business activity, but all they achieved was creating inflation while unemployment continued to rise.
This year's laureates actually figured out why this happened and, more importantly, created a system that should prevent it from happening again in the future. They did this by moving in the opposite direction from the individual decisions that all these economic actors make in the context of the said policy. And as it turns out, people are pretty fickle and unpredictable, and they don't exactly follow economic advice as expected. At the time, their models and recommendations were truly revolutionary , and by helping economies navigate recessions with less lasting damage, they probably did more for long-term living standards than most people realize. But it's not flawless either. I'm sure many viewers have noticed that even after
most of the world's major central banks adopted the concepts developed by these people, we are still in a situation of persistent inflation that is well above the desired level. Not to mention that if we had kept the way we measured inflation the same for decades, it could be argued that this decade was even worse than the stagflation of the 1970s. So what are these ideas that earned Hall and Woodford this year's Nobel Prize? How have they changed the way crises are handled? And finally, are these ideas relevant in our modern economies? We've all been to meetings where someone adds their note-taking bot. Some bot joins the call, records everything, and when the meeting ends, sends you a mediocre summary email. But most of the time, names are
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The best part is that this notepad is free for Mac and Windows, and will soon be available on iPhone. You can get a month of WhisperFlow Pro for free with unlimited meetings using the link in the description below. So, the main idea behind Hall and Woodford's research is pretty intuitive once you learn about it. People don't change their behavior based on initial data alone. How they respond to politics depends largely on what they think it will mean for them in the future. As a simple example, imagine someone receiving a $20,000 bonus at the end of the year for good performance at a stable, reliable job. Now imagine someone else receiving the same amount as a lump sum payment as a result of a court case. All other things being
equal, both of these people have an extra $20,000 in their pockets. And even if they had the same marginal propensity to consume-which is just a fancy way of saying how much of each additional dollar they are inclined to spend rather than save-they probably wouldn't treat that money the same way. The first person is more likely to expect similar bonuses in the future, so it will be much easier for them to afford the expenses now. The second person knows that this is a one-time event, so they will most likely save money for a " rainy day." If we scale this to the level of the entire national economy, the same logic holds true for how we collectively respond to economic
policy. And when you add up all these individual decisions on an economy-wide scale, the results can be significantly different from what traditional models would expect. The most striking example of this is the stagflation crisis of the 1970s, which is largely the reason why this approach became popular. The inflation of the 1970s was largely caused by two major oil shocks. First the OPEC embargo in 1973, and then the Iranian Revolution of 1979. Although it is worth noting that inflation began to rise in the mid- 1960s, long before these events. Due to the embargo alone, oil prices almost tripled in a few months, leading to a general increase in the price of all goods and services that depended on oil, and that's
practically everything. At the same time, it slowed economic growth and increased unemployment, which in itself is not the best combination. It is obvious that no matter how skillfully economists who shape fiscal policy or work at the central bank used their levers, they could not create more oil, but they could control people's expectations about how to get out of the crisis. And this is where everything went wrong. Under Arthur Burns' chairmanship, the Fed failed to maintain a consistent anti-inflationary stance. Burns, like many politicians of the time, believed that inflation due to supply shocks was largely beyond the control of the Fed, and often blamed oil crises, crop failures, and
government promises to provide full employment. In addition, the Fed was under serious political pressure from the Nixon White House to keep money cheap before the 1972 election, which we know in detail because Nixon had a habit of recording his conversations. The Fed raised rates, sometimes quite sharply-to almost 13% in 1974-but never held them up long enough to break the cycle. Within a year, rates fell back to 5%, and this cycle of short-term increases, a spike in unemployment, and subsequent easing repeated itself for almost the entire decade. The problem was that when price increases became expected, workers began demanding higher
wages to keep up. So businesses raised prices to cover higher wage costs, which provoked even greater inflation, which in turn forced them to demand even higher wages. Many salaries at the time, especially in unionized industries, were automatically pegged to the cost of living, which effectively put this cycle on autopilot. For comparison: in 1970, about a quarter of American workers were union members, while today it is about 10%. And by 1981, over half of workers' basic union contracts had such cost-of-living indexation clauses. This is how a series of supply shocks turned into a decade-long inflationary spiral, and it is precisely the type of dynamic
that Hall and Woodford's work explains. Remember that inflation only measures how much prices change over a period of time. It is possible that an energy price shock will push inflation up by 10% per year, and that will simply become the new price level in the future. What really turned these price shocks into a decade-long problem of stagflation was everyone's expectation that inflation would remain high. To be fair, it wasn't just the Fed's fault. The government also played its role. In an attempt to severely curb price increases, the government chose the most direct solution and introduced price controls, forcing certain companies not to sell certain goods above a fixed price. It didn't
work because everyone expected that as soon as the controls were lifted or the shelves were empty, prices would instantly skyrocket, which, of course, happened. Another mistake of that period was that in an attempt to help households with cost of living pressures, the government handed out one-time tax refunds. But since everyone knew it was a one-time event, it had little impact on long-term confidence. Instead of feeling the support of the government and adjusting spending accordingly, many households simply pocketed the money or used it to pay bills, with only a small portion of the funds being spent immediately.
Ultimately, this period of prolonged inflation was ended by the new Fed Chairman Paul Volcker, who famously "broke the spine" of inflation, which sounds pretty impressive. But in reality, this meant raising interest rates to around 20% and keeping them high for as long as it took to change people's expectations, even if it meant a brutal recession with an unemployment rate of 10.8%. All this only slowed down the pace of price increases, but everything that had already risen in price remained expensive. After all, a dollar in 1980 bought less than half of what it could buy in 1970. So, the approach developed by this year's laureates would recommend that the Fed adopt clear, robust anti-inflation policies much
earlier to tackle this problem before it gets out of hand. Today, the 1970s are an excellent example for studying this dynamic, which became the basis of the laureates' research. But their conclusions can be and have been applied to many other economic events besides inflation. Now, before we get to that, I wanted to tell you about the Economics Explained newsletter. If you're watching this video and think there should be other stories like this, we've created a newsletter for that . Once a week, we send out one economic story about things that quietly shape how the world works but are rarely properly explained.
The newsletter is completely free, you can subscribe using the link in the description or the QR code on the screen right now. However, let 's get back to what happens when the economy goes into recession. Likewise, their work highlighted the need for a strong, convincing signal to households that inflation would be suppressed. It also showed the importance of reassuring households that everything will be okay during economic downturns. Typically, during periods of economic turmoil, people are afraid to make large purchases or start new businesses, which in turn exacerbates these turmoil by cutting costs. So a vicious circle arises where fear of a recession can make it worse than it needs to be.
But if the government takes decisive steps to reassure people that they will have money and businesses will be safe, it could shift expectations in a more optimistic direction, helping the economy recover. This, in fact, is the logic of large-scale fiscal stimulus during recessions. Money is important, of course, but just as important is the signal it sends about the government's willingness to support the economy in difficult times. The same principle works in reverse. If, during inflation, the government demonstrates through its actions a lack of intention to control spending, or if the central bank is unwilling to raise rates, even though it is necessary, people and businesses adjust their expectations. They
start acting as if inflation is here to stay, which, as we saw in the 1970s, can become a self-fulfilling prophecy. In general, economic policy affects people much less predictably than gravity does on a thrown ball. People think about the future, form expectations, and act accordingly, which can either reinforce or undermine the goals of any policy. All of these ideas should be very familiar in the context of what we are currently seeing in the world, especially in Europe and the United States. In the 1970s, we could have excused ourselves for not knowing better methods, but the work of Hall and Woodford is now well known to central bankers and advisers, and the Fed has been openly talking
about the need to contain inflation expectations for years. Yet inflation remains a serious problem. To be fair, by most standard measures, the recent surge has not been as severe as that in the 1970s and early 80s. Peak inflation was lower, lasted less, and overall price increases were much smaller. We mentioned earlier that inflation this decade could have been significantly higher than official data suggests. This follows from an article co-authored by former US Treasury Secretary Larry Summers. Until 1983, official inflation measures included borrowing costs such as mortgage interest, and if we counted them today, inflation at the end of 2022 would have reached about 18%. However, this figure should
be treated with caution, as taking into account the cost of borrowing means that the higher interest rates that central banks use to combat inflation are ultimately reflected as higher inflation. But in any case, the fact that this happened raises interesting questions about the limitations of such models. First, their ideas about how people respond to future expectations have been widely questioned over the years. Yes, theoretically, people who receive a lump sum should manage this money more carefully than those who receive it as regular income, but this is often not the case. Athletes, actors, and lottery winners should certainly know that their high incomes won't last forever, but their reputation for
reckless spending is well-founded. In addition to real-life stories, there are well-documented statistics about how quickly people spend unexpected fortunes. Even with Covid checks, households, especially those with low incomes and little savings, spent a quarter to a third of their money over 10 days at a time when they probably should have been preparing for economic instability. To be fair, households with high savings hardly changed their spending, which is much more in line with theory, and Hall's own work acknowledged that financially distressed households would behave differently than the theory predicts, which is what we actually observed. But overall, spending patterns turned out to be much more chaotic than
theories predicted. Much of their work, especially Woodford's, also revolves around the idea of price "stickiness." This is the idea that businesses are often slow to change prices due to things like the inconvenience of reprinting price tags, customer relationships, uncertainty about competitors' actions, and the difficulty of determining the correct new price. This is of great importance for predicting the next steps of the business. Now the physical costs of changing prices have fallen significantly since Hall and Woodford began working on these ideas. Today, there are online companies and even physical retailers that dynamically change prices for each customer. More than a decade ago, Amazon
was already changing its prices over 2.5 million times a day, a far cry from waiting months for a catalog reprint. But other factors that make prices inflexible in practice, such as the risk of losing customers or inciting a price war with competitors, have not disappeared. So, if we were a little cynical, we could say that they proposed structures that don't always work perfectly in practice, don't fully take into account people's behavior, and haven't been able to prevent the cost of living pressures we are currently experiencing. And if we really wanted to look closely, we could see that their ideas about the structure of spending over the life course drew heavily on earlier work, including
Milton Friedman's permanent income hypothesis of 1957 and Franco Modigliani's related life-cycle hypothesis of a few years earlier. So what exactly did they do to deserve the highest award in the industry? Economists like Milton Friedman, Robert Lucas, and Edmund Phelps were talking about expectations long before Hall and Woodford appeared. But Hall and Woodford created rigorous microeconomic models that turned these ideas into practical tools that central banks and governments could actually use to overcome crises. It's like the difference between understanding that a bridge needs to withstand wind and actually having the engineering calculations to build a bridge that won't collapse. Hall has done a lot of
groundwork on how households actually spend money. In his 1978 paper, he took Friedman's permanent income hypothesis and turned it into a tool that could be tested on real data, giving policymakers a much more realistic picture of who they were dealing with. Woodford built his own model on this. His model of how central banks should set interest rates, and especially the idea that a central bank's statements about the future can carry as much weight as its actions today, has become the basis of modern central bank communication. Of course, their models were not perfect from the start, and they will likely need to be constantly adjusted, adapting to new technologies and cultural realities. And so, on top of everything, their work
built on a foundation laid by other economists over decades. But combining all of this into a holistic application toolkit that, when properly configured, can solve a wide range of economic problems-that's why they definitely deserve this award. This understanding has changed approaches to economic management, and ultimately, no one gets credit for crises that didn't happen. We have no idea how many recessions have been shorter or how many inflationary spirals have been avoided because central bankers have used models based on the work of these two economists. But the fact that the global economy has, generally speaking, been more stable in recent decades than before their work became influential is probably no coincidence. On
the other hand, you can give someone the best tools in the world, but that doesn't mean they know how to use them. Today, while we understand the importance of setting expectations and maintaining trust, it is easier said than done. From a political perspective, it is very difficult for governments to contain things like public debt and long-term unsustainable liabilities that undermine people's long-term expectations for the future. At the same time, central bankers are under increasing pressure to do what is politically popular rather than what is prudent, which again undermines their authority and, as a result, people's faith that they will actually get inflation under control.
Hall and Woodford gave the world one of the most useful economic manuals in history. Now it's up to us to decide whether we will make good use of it. We review the Nobel Prize in Economics every year. So if you are interested in the works of previous laureates, you can click on the playlist that appears on the screen. Thanks for watching, friend. Goodbye
