Is the bear taking the wheel ?

Economics is a weird discipline practiced by many but mastered by few. In the post war era the convictions were firmly grounded on the general theory authored by in 1936 John Maynard Keynes. The economy was to be kept in check through demand side management with an active government employing fiscal policy to keep the economy from overheating and recessing. In almost thirty years the Keynesian paradigm ruled as the economic mindset of particularly European governments.

In the 1970’s all this came abruptly to the end. Two oil crises in 1973 and 1979 made economists and politicians aware of the supply side of economics. With the devastating effects of stagflation theoretically impossible at the time following the traditional Phillips curve a new economic paradigm, originated from the Chicago School of Economics, began its reign headed by Milton Friedman with central bank inflation bashing, low government involvement, and supply side economics.

Today it is commonly recognized that both demand and supply side politics go hand in hand in the pursuit of a balanced economy. However, any undergraduate economics student knows the tale cited above and the horrible days of stagflation serve as a nightmare to remember.

How does the above fit in with the world economy of today?

In the recent months the discourse of economists has been one of astonishing with a touch of slight concern. The main driver of discussion has been the interest rates and subsequent low bond yields. How have we been able to keep interest rates so low for so long without inflationary pressures? The Economist answered the question by reviving the venerable Keynesian IS/LM model hailing the age of zero inflation due to the exportation of cheap consumer goods from China and India – you can also read this recent survey from the Economist for a presentation of the “shift in thrift” which is supposed to have caused an unbalance between savings and investments in part yielding the low interest rates with the United States as the main driver of world demand.

However, It seems now that inflation is beginning to catch up (see this article) and central bankers are facing a difficult task. In the wake of Rita and Katrina oil prices have increased sharply from an already elevated level and the situation is slowly beginning to resemble a serious supply chock; see article from the Economist here. I also highly recommend Mark Thoma’s blog which has dealt extensively with the state of the world economy in the past week and in particular this article. This is a wonderful place where evy-league scholars are an abundant ressource

Perhaps economists should begin to evoke old spook stories to avoid history to repeat itself?