Ricardo Reis on the Macroeconomics of Financial Crises and the Recent Inflation Surge

Ricardo Reis is a professor of economics at the London School of Economics and is the co-author of a new book titled, *A Crash Course on Crises: Macroeconomic Concepts for Run-ups, Collapses, and Recoveries.* Ricardo is also a previous guest of Macro Musings and he rejoins the podcast to talk about his new book as well as his overall assessment of the inflation surge of the past few years. David and Ricardo specifically discuss what constitutes a bubble, the Eurozone crisis as a story of capital inflows and misallocation, shadow banking and systemic risk during the 2008 financial crisis, Ricardo’s view of the Phillips curve, and a lot more.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Ricardo, welcome back to the show.

Ricardo Reis: Thank you so much for having me, David.

Beckworth: Well, it's great to have you on, and I was looking back to the last time you were on the show and it was in January 2021. So we were just on the cusp of the great inflation surge, or whatever we're going to call it, historically speaking, but it hadn't begun yet. In fact, it begins in March. So back then we were talking about the currency swap lines, the work you did on that, very fascinating, the evolution and use of it during the pandemic. We also talked about your work on R versus G versus M, and the fiscal sustainability issues, which I think is very timely, still very important.

Beckworth: Maybe we'll get to that later in the show, but very fascinating conversation, and I'll encourage listeners to go back and check out that episode if you haven't already. But today, Ricardo, I want to talk about inflation and your new book. So your new book is co-authored with Markus Brunnermeier, another former guest of the podcast. And the title again is, A Crash Course on Crises: Macroeconomic Concepts for Run-ups, Collapses and Recoveries. So tell us about this book, the motivation, the brief summary of it, and then we'll delve deeper into each chapter.

A Crash Course on Crises: Background and Summary

Reis: Absolutely. So the motivation… this has really been a long gestation of a book, because the motivation arose more than 10 years ago, 12 years ago, with the financial crisis. The great financial crisis was really a very important event in terms of macro history, and in terms of how we think about how macro economies work. And it motivated a lot of work and research at the intersection of macroeconomics with finance. Myself, up until 2008, 10, I had done a lot of work at intersection between macro and behavioral economics and international economics. And I think it's fair to say that after that I've become much more of a macro finance economist working at the intersection of those two, understanding how features of financial markets feed into the macro economy and vice versa. And that was triggered in terms of my own research because I had all these questions that came up from the recession; all of these questions that came up from 2010, ‘11, ‘09, ‘08, ‘07, and trying to make sense of them.

Reis: I was certainly not the only one at that. Many other very, very good researchers were in that. But by 2014, 15, David, it was clear to me that all of that research was really not incorporated in what I was teaching to, say, undergraduates, meaning, we have the macro textbooks with the macro features, which sometimes would play a little bit of lip service to the financial institutional features of the economy. But a lot of these concepts in microfinance about how financial problems feed into the macro economy and the macro economy feeds into financial problems were really not there, even though they were becoming very widely accepted in macro circles, not just from the research the previous two years, but even in so far as research from 20, 30 years ago, was very well established by that.

Reis: And so what started was myself in teaching intermediate macroeconomics at Columbia at first and then here at the LSE, starting to have more and more weeks of the subject where I would talk about macro finance concepts using my own lecture notes and deviating from the textbook, and then talking to Markus who was finding himself with exactly the same experience in teaching money and banking at Princeton. And so we said, "Well, it just seems like there needs to be a book that captures what some of these concepts are, that is not a replacement for the existing textbooks, but rather a complement to that," meaning something where you could go and get three chapters, two chapters or maybe lots of chapters and say, "Look, we really want to talk about this microfinance concept. Let's use this book to get some chapters from it."

Reis: Or if you want to teach a course just on crises, actually a fun course some universities teach, then you could really cover all of them. And so what we did was write this book which has these 10 self-contained chapters so that teachers can really just grab one and put it in their syllabus, and write them in a fairly concise way and have to make really tough choices, we had to make, in terms of keeping it very narrow in terms of each chapter has one concept, develop some theoretical apparatus, explain that concept. And it has two case studies or applications in history of crisis, so that you could easily pick up a chapter and teach it over say a week, over a couple of classes, and include it in your courses. And I think in doing so, really cover this important part of what macroeconomics is today, and which becomes crucial especially when you're trying to make sense of what's a crisis and what's a financial crisis.

Reis: And therefore the title, A Crash Course on Crises, a crash course because here you have these self-contained chapters, each one with an important macro finance theoretical concept and to applications, where all of those applications are to crises, and the financial crises, macro financial crises in that crises that not only come with wild gyrations in asset prices but also with macro consequences, and the two are tightly interlinked. And we cover not just the 2010 crisis, 2008, but we go all the way to Chile in the 1970s, the Japanese bubbles of the 1980s and Argentina in the early 2000s and many others like that. So that was the idea for why this book came. It's a very short book, we really worked very hard from the first draft that was 400 or 500 pages plus to this one that is roughly a hundred pages, I think, in order to keep it... Because we really wanted it to be easy for you to get a chapter and teach it in a week or less. And so it was an enormous effort, especially in synthesizing what we thought were some of the important concepts, but that was the motivation, yeah.

Beckworth: Thanks. So I downloaded the Kindle version, and I was able to read through it relatively quickly, very interesting. I loved your case studies, as you mentioned, some of those countries, those examples. And I liked the way you frame this as macro financial crashes versus plain vanilla financial crises. So you really brought that linkage together. And I want to begin discussing this book. Again, we don't have time to do every chapter, but I want to do a few of them. I want to begin with chapter two, “Bubbles and Beliefs,” and let me just ask a very basic question. What is a bubble? And I ask this because as you know, Ricardo, there are some people in our profession who don't believe in bubbles, efficient market hypothesis folks. I remember as a student, I went to a seminar once and I asked about a bubble and the presenter goes, "Oh, we have a budding young socialist in our midst here today," because I dare question… But I think most people intuitively get this idea, but how do you, as an academic, as an author of this book, outline a bubble, and then is it contested in the profession at all?

What is a Bubble?

Reis: Well, it certainly is because the term, as you rightly put it, is one that has been so used, overused, that it both means too much and nothing at all at this point. It becomes one of these terms that gets a life in itself and then either some people seeing it, as you said, a synonym for socialism or capitalism or whatever other ism you're obsessed about. I've seen so many uses and definitions of that term that by now it means very little or very little to nothing. I think the way we define it or the way we started it is that a bubble is really when a price of an asset exceeds fundamentals. Now without you defining fundamentals again, boy, this definition can really fit anything that you want there. But we add the following, which is that a bubble arises when you are willing to pay a price of the fundamental because you expect to sell it to someone else in the future.

Reis: If you expect to sell it, so that that's the first part. A second leg of defining the bubble is to think that the fundamental value is, again, it's a discounted value of payoff streams, but where crucially, when you're trying to discount what these payoff streams are going to be in the future, David, you need to talk about what do you discount them by. If I only have this feature, the second part of the definition, then there it would again be vacuous because of course there's always some interest rate which you discount those payoffs that would justify whatever price you have today. So you really have to rely on the two legs that I just talked about here to say, "Look, there's going to be some interest rate at which you would discount, even if you're willing to hold this forever without wanting to sell, because you only care about the payoff streams."

Reis: And then there is the fact that you're thinking you may be able to sell it to someone else later on at a higher price. So the combination of those two is our attempt to, again... In this book we're really trying to synthesize what we think are part of the lectures, David, so in no way do I want to take credit for either this or anything I say in the next few minutes we talk about, as being really my invention or my definition. But we think that these two features are the two that the modern literature on bubbles highlights, emphasizes, and that brings it beyond the simple, “is there a bubble, is there or not a bubble?” A question that I would reject as ultimately almost futile, very hard to understand, but rather thinking of a bubble as simply but an apparatus to think, why do we sometimes see large runs up in prices that then fall very quickly?

Reis: Why is then the concept of bubble important for this gyration of prices? Because on the one hand, note that if all you had was everything fundamentals, in order to have these wild gyrations, you'd really be wanting to talk about, why did the fundamentals get very good or very bad all of a sudden. But secondly, you would, when talking about selling to someone else, you put more of an emphasis of, why is it that some people are willing to buy even though they think the asset is overvalued, and then all of a sudden they've all changed their mind and are willing to sell?

Reis: And I think those are the two fundamental features that I think capture these gyrations of asset prices that are what matters to me when I'm trying to think about the concept of assets in the macro economy as opposed to just trying to say, "Well, is this price a bubble or not, and would I make money buying it or selling it or not?" Which is much more of a more narrow, if you want, finance concept. The theoretical apparatus we use here is really these models of higher order beliefs and of choosing when is it that you start selling? Here's the basic idea, David. I may know that the price of some asset now is overvalued or I believe it is overvalued, but there's going to be some people, let's say you, who are just thinking, "No, no, no, it's been going up. I think it's going to keep on going up all along." Now I know that if I were to sell, then insofar as you were buying, but I'm selling, if there's enough of me, if I'm big enough selling, the price will start falling, and because you, as soon as it starts falling, will re-update and start thinking, "Well, now I think it starts falling," because you're really just following the fad, then that will lead you potentially to crash. However, the usual argument in economics, and if there's some of you, you would say that, "Well, but insofar as I know that if it's going to crash at some date, then I would want to sell just a little bit earlier."

Reis: But then of course I would write, why not sell it even a little bit earlier, and we'd have that a bubble never emerged in the first place, because we always want to sell earlier. This is a process known as backwards induction. But now think about, and this has been what I think has been well-developed in the last 20, 30 years, experimentally, in theory and others, what happens if I only go one step backwards in this backwards induction and I say, "Well, I think it's going to end this bubble only by December." Whereas you say, "No, no, no, I went a step further and realized, well, if it's December, I should sell in November." And someone else said, "I shall sell in October," and someone else in September. So instead of all of us ending up with, “let's sell now,” we end up with the distribution of us selling at different dates.

Reis: And then what you end up with is, because I don't know that you don't know that I don't know of when exactly this is going to end, we're all allowed to have this diversity of what economists like to call higher beliefs, and we end up with a bubble surviving until it finally hits the point where there's enough of us selling, and then all of us end up selling at once. And so I think it's this concept which many people have linked to John Maynard Keynes and his famous beauty contest he talked about where, it's not so much about whether we're trying to figure out, David, whether this asset has a bubble or not, it's really about how we're trying to figure out when are we going to sell. We may all agree that there's a bubble there, but it's rather, is it going to crash in December, November, October, or September?

Reis: And it's that uncertainty of when exactly it's going to end that leads to these large run-ups and then sudden crashes. And that is the concept that we're trying to highlight. And that's a concept then in that chapter we talk about both the Japanese bubble of the mid 1980s and how you saw these very large increases in stock markets and house prices in the crash, but also the internet bubble in 1998-2000, where you saw this remarkable feature where, sometimes called smart money, the hedge fund money, which was riding the tech bubble all the way until the very end, and then it sold very quickly. This precise kind of behavior where at the same time people were saying, "Well, I know there's a bubble out there, but I'm riding it up until that right point." Nobody knows where that point is and that's where those crashes come. That's the key concept they're trying to try to explain here.

Beckworth: Very eloquent explanation for the bubble and I enjoyed reading the chapter. And I enjoyed the case studies, Japan, the late eighties to early nineties, and then the internet bubble, late nineties. Let me ask this question, because you note in the case of Japan, there was some policy involved as well, right? They lowered rates, the Bank of Japan, because of these trade issues. I want to present this potential explanation for a contributing factor to a bubble, and maybe you can correct me, maybe it's the fundamental, but I'm curious, but you can imagine a story where Bank of Japan lowers rates lower than say the equilibrium rate, and a gap emerges, and that maybe adds a little fuel to the fire. Is that something that plays a part of these stories, or are bubbles independent of developments like that?

Reis: It can absolutely play a bubble. Again, that's something that we don't spend too much time on, because, again, we're trying to really teach a concept, and it's not a book about the Japanese bubble per se. And so what we are highlighting is this uncertainty on the timing of these higher beliefs and why you have that these bubbles can survive for a long period of time. But what caused them to elapse in the first place? Well, it's always some momentum that led the price to get above the fundamental. And it is, very importantly, and again given our emphasis, David, there’s going to have to always be some people that believe this is going to persist, and policymakers can have a very powerful role in shifting prices in a way that allows that belief to be self-fulfilling, at least, for a little while and starts the process going. The mechanism that I was telling you about is very much about why it continues until it crashes, but why does it emerge in the first place, and certainly policy will play an important role at that.

Beckworth: Yeah. So there's many ways this unfolds. Policy is just one possibility among many.

Reis: Yes.

Beckworth: Okay. Fair enough. Well, let's go to your second chapter, “Capital Inflows and Misallocation,” and I want to bring it up because you use the Eurozone crisis there. So walk us through that chapter.

Capital Inflows and Misallocation and the Eurozone Crisis

Reis: Yeah, so I think there was a bit of a puzzle when the Eurozone crisis came, especially as you looked at the periphery countries like Portugal, Ireland, Greece, Italy, or Spain. And the puzzle was that starting in 2000, David, what we had was that with the joining of the Euro and the emergence of the European Capital Union, as imperfect as it might be, you saw these very large inflows of capital into these periphery countries, and they came with very large, therefore, investment booms. And so you had a period from 2000 to 2008 where you had this very large investment boom, which then of course ends abruptly with the big crash. But as we think about these large investment booms, what happened at the same time is, and very related to the crash that came later, is that these investment booms did not come with increases in productivity.

Reis: Actually, Ireland which had had remarkable productivity growth in the nineties and the eighties, essentially stagnates in terms of productivity growth in the 2000s, and the same could be said of Italy, Greece, and Portugal. So why is it that when we have these very large capital flows, which you would think are chasing the very productive opportunities, if anything, again, standard classical views of capital flows is precisely that the capital's flowing because there's such high productivity in these periphery countries, why is it that we see that they actually end up with very low productivity? And I think that the models that economists have developed in the last 20 years to make sense of this, are models that often go under the big heading of misallocation. And the idea being that the capital can flow from the core to the periphery, but when it reaches the periphery, it doesn't get allocated to the most efficient sectors or even within sectors, it doesn't get allocated to the more efficient firms.

Reis: Why is that? Well, a very catchall phrase would be to say that the financial markets understood broadly, as the markets that allocate capital, are not very efficient. But that could be either because those financial markets are indeed problems, and then some examples of that are local bankers that favor companies that are of the same conglomerate or a friend, or in the case of Spain and Portugal was very noticeable, was that a financial sector that was somewhat underdeveloped, valued a lot in making credit collateral, that immediately made it biased towards the construction, the housing sector, because those have very large physical collateral, which was then combined with construction companies often being important shareholder stakes in banks. But there's also a political component. Because of course politicians love to protect some sectors as opposed to others; again, construction being one of them. But also within sectors, politicians will often want to protect some existing incumbents from competition, create a barrier to entries, and those are all things that we saw very much, for instance, in the European periphery.

Reis: What happens then if you have that, David, is that as the money comes in, as the capital comes in, it both gets allocated to some less efficient sectors, [and] very often these are the non-tradable sectors. Why? Precisely because those are less subject to competition, so it becomes possible to have this misallocation. And within those, to firms that are less efficient, which, depending on the country, sometimes are the large firms that capture the politicians or actually very often they are the micro firms that are always very politically noticeable because they account for a lot of employment, even if for very little of sales.  Either way, what this means is that the capital comes in and it comes with an increase in misallocation, and with that a big fall in productivity, that means that output barely increases and at the same time, this puts the seeds to when there's a sharp reversal of that capital, that has happened with the financial crisis, all you're left [is] with a lower productivity and therefore end up with a big crash in GDP. So we try to teach this concept of misallocation, simple models to make sense of it, and we talked about how this was both useful in the European crisis, as well as to make sense of what happened in Chile in the late 1970s, early 80s, when it had a liberalization of capital that again led to large capital flow, large growth at first, but very quickly then a big crash as productivity had not grown at all.

Beckworth: Okay, so let me go back to your point about misallocation. So somehow there's misallocation in this story you're telling here. And let me throw out another possibility, and again I'm going to sound like a broken record, but policy, okay? So I know there's idiosyncratic features in each country, but I've looked at studies that have constructed Taylor rules for each of the European countries, and if you look at them say pre 2008, 2007, the actual ECB policy rate is pretty close to a Taylor rule for, say, Germany. So the ECB tend to be more in sync with what would be appropriate for Germany. But if you look at the Taylor rules for these periphery countries, man, the rates are way below... That boom's going on and policy should have been much tighter. And then after the Eurozone crisis you see the opposite. The policy's too tight for the periphery, relative to the core. So could it be part of the story is simply you have this one size fits all monetary policy, It's not an optimal currency area, all that stuff that contributes to the misallocation of capital?

Reis: I think that could be part of the story, David, but that will always be a very incomplete part, and you really need some story on the misallocation to make sense of what happened in Europe. First of all, you need to explain the fact I told you of the very large inflow of capital from the core to the periphery that doesn't lead to growth in the periphery. And so this is a comparison, even for a given interest rate, whether it's high or low, why did you see such a large flow coinciding with such a large stagnation or even decline in productivity? So you have to get that micro fact, why is it that that happened? And know that this is independent of whether there would have been a crash or what monetary policy was doing or not.

Reis: You have to go back, David, and when I was in school we would talk about the Lucas paradox ,out of the famous and great economist Robert Lucas, [and he] would say, “well, look, if Portugal is poorer than Spain, then, well, productivity, the marginal product of capital, should be higher in Portugal than... I'm sorry, not Spain, than Germany,” because there's diminishing returns to capital, Germany has already built all of its rows, they already have all of the ideas, therefore now they have very little return to the extra unit of capital. Portugal's still very big because there's all these things to do. Therefore, a lot of money should be flowing from Germany to Portugal, and if it does, we'll get convergence, we'll get massive convergence and Portugal will get richer. Note, David, that this was very much a story of why we did observe convergence in Europe in the 1960s, 70s, 80s and 90s.

Reis: Why does it stop in the 2000s? That's a big fact beyond the crash, why does convergence stop? Why do you see these periphery countries not growing as much? Especially when the Euro, David, even if it was a one size fits all, note that my emphasis is not on the common monetary policy, it's on the fact that we had capital union. People forget that the Euro was not just about the monetary union, it was about lowering a lot of barriers to the movement of capital within Europe. That lowering of barriers meant that capital flew from Germany to Portugal, as it should. Lucas would have told me, "Aha, we're going to have a golden age of convergence. Portugal's going to grow much faster than Germany." And yet we observe exactly the opposite; so much so that the stagnation sows the seeds to what's then a crash 10 years later. That's, I think, where we try and explain, and you really need to make sense of that. And this is a big question especially as we're thinking about why Africa doesn't grow as much, why doesn't capital flow to India more? And this misallocation concept is one that is very powerful beyond just the fact that you were mentioning.

Beckworth: Yeah. And maybe even, I could say something stronger, maybe the Taylor rule analysis is a symptom of this misallocated capital flow, leading to different dynamics across the regions.

Reis: So when it comes to the Taylor rule, David, that's absolutely… and so let me now make that link now. Look, the Taylor rule is always conditional on, or subject to, how should you set interest rates subject to a neutral rate? And R star is the name of the neutral in the long run. In the short run, just the neutral rate is often sometimes called the Wicksellian rate. Anyway, a neutral interest rate, a real interest rate, is a reference point, right? The Taylor rule is how do you set the nominal interest rate in deviation from that? Well, in an integrated capital market, David, there's only one neutral rate, because, if the interest rate in Germany was different from the Portuguese one, then capital will exactly flow. In a world of misallocation, capital flows, but there's these different interest rates precisely because the return in different areas, in different sectors, even in the economy, forget different countries, across different firms, those interest rates are different, they don't get equalized precisely because of misallocation. After all, David, another way to talk about misallocation is why doesn't the capital go to the high interest rate, high return company as opposed to the low return company to which it's misallocated. It's understanding those frictions. Well, once you understand those frictions exist, how they work, you understand in the Taylor rule, when we talk about one neutral rate, that is a gross simplification.

Reis: Even within an economy there's many interest rates. Even across borders there's many interest rates. And then you start getting to the question that you are raising, which is, "Okay, how do I aggregate all of these? How do I reconcile the fact that I have many? How do I build some weighted average with what weights of all of these interest rates so then I can use my Taylor rule logic and apparatus to make sense of it?” And so in that sense, the misallocation, yes, it makes it more likely that if you want, the monetary policy may not have been right or wrong, but it also makes it more constructive in the sense of saying, what you need to think about is how do you build neutral rates in a world with many, many rates.

Beckworth: Okay, well let's move on to your next two chapters. You have one on banking and shadow banking, and the important role that shadow banking's playing. And you also have a chapter called, “Systemic Risk: Amplification and Contagion.” I want to tie those together, if I may, because I think these two chapters particularly point back to 2008 when the money market fund run took place, when Lehman collapsed, and how it went from… I think, arguably, it was as a mild recession, in second half of 2008, something very fierce, very different. And I bring this up because there's been debates. What really caused the Great Recession or the great financial crisis? Was it the housing market and household balance sheets going down or was it a run on the markets? Was it a run on shadow money? And like Ben Bernanke tends to come down on the side of, it's the shadow money story, but there's other researchers who say, "Oh, it's household balance sheets." Use that as a case study to maybe flesh out these two chapters for us.

Shadow Banking, Systemic Risk, and the 2008 Financial Crisis

Reis: You're right that they're very related, and you're right in saying that they can really help us understand what happened in 2008 and make progress in the debate that you're mentioning in the following sense. I think what we first emphasize is that when you think about modern banks, and we really call them modern, David, as opposed to shadow, insofar as just to talk about that this is a change in the structure of the bank, not on whether it's regulated or not, which is where shadow often comes up. And when we look at modern banks, and I'm using your banks as a broad sense, because financial institutions may be more accurate. I think the two large changes are, first, that on the liabilities you have a lot more reliance on wholesale funding in different types. That is less on just depositors and more on loans by other financial institutions.

Reis: That was a very big part of Bear Stearns, if you remember what surprised us in 2007 was how quickly that bank failed. Why? Because most of its lenders were other large banks that withdraw very quickly. We were used to a world in which bank runs came with people queuing at the door of agencies, and as a result took forever to... Took a long time and allowed time for the authorities to intervene by the time they withdrew. And so you have a lot of this wholesale funding. And this wholesale funding often comes with contracts like repos and others that rely on collateral. That brings me to the asset side of the banks.

Reis:. On the asset side, what we have is that banks, as opposed to having illiquid loans that are specific, and your mortgage is different from my mortgage, and my house is different from your house, what you had is more and more securities or securitized assets, meaning both, say, simple, one, there are stocks and government bonds, securities, things that have market prices that move every day, but also as a result of the change in the 90s and 2000s, that even the mortgages were now securitized, they were packaged, the so-called mortgage-backed securities, and again they had prices every day. Why do these two interact? Because that meant that all of a sudden you had a lot of assets that had a market price that you could give, pledge as collateral in a repo transaction in order to get more wholesale funding, in order to get more loans from other financial corporations. As a result, banks could grow much faster. They would also become riskier, though, because changes in the prices of those assets could trigger not just that you would suffer losses on your asset side, but also some of your funders would now no longer want to roll over their funding because of the collateral that you had being less valuable.

Reis: But as they take away your funding, that means that you have to now sell some of the assets you had before, but in doing so, you put downward pressure on the asset prices. These are precisely what we then talk [about] in the following chapter, which is, these cycles, that meant that now whenever you had a fall in asset prices, let's say house prices, whether that fall in house prices was bigger or smaller relative to historical experience or not, is that that fall in house prices, because it led to a fall in now the securitized assets of banks, that led to them having some of their funding cut, that led them to have to sell some of the assets they had, some of the mortgages, or not extend new mortgages, which in turn led to a further fall in house prices. And this is what economists sometimes call strategic complementaries.

Reis: If your bank, David, gets in trouble and you start giving less mortgages, selling houses, house prices fall. In a typical market when you're in trouble, that's good news for me, that's strategic substitutes; meaning, if you start selling, if your podcast gets worse, someone else has a better podcast and they'll gain market share at your expense, and so your bad news is good news for me. But in a world in which banks are all lending to each other, and they're taking the assets, the securitized assets with market prices as collateral, what that means is that when you get in trouble, and you, all of a sudden, stop holding mortgages that at leads to a fall in house prices, well that fall in house prices makes me in trouble, makes me also want to do the same thing. And that leads to this very large amplification, the creation of systemic risk, what's sometimes called contagion, in creating a crisis.

Reis: And therefore, it's understanding this concept, David, where again, and you see now, hopefully it makes more sense, also, the introduction to my book, more than getting to the debate of was it the house prices, was it the financial sector, at the heart of it, what we try to explain is these important, I think, concepts that students should learn, more people should learn, that why is it that whether it's one or the other is, why do they amplify? Why is it that they become so big? Why do they become so systemic, and in doing so create a big macro crash? Because, otherwise, David, boy, prices fall all of the time, whether it's houses or others. And we are saying that it's really more about these dynamics of amplification.

Beckworth: Okay. So listeners, there are more chapters, but for the sake of time, I'm going to move on. I do want to ask a few follow-up questions. And again, the name of the book, you need to get your copy, it is, A Crash Course on Crises: Macroeconomic Concepts for Run-ups, Collapses, and Recoveries. Ricardo, I just want to piggyback off of this discussion, this macro financial crash discussion, and follow up to the great financial crisis. There was a big push for macroprudential policy as a response. And that includes things such as countercyclical capital buffers in banking, or we have the FSOC in the US. We designate systematically important institutions that have to hold extra capital. But something else that emerged out of this period was state contingent debt contracts, at least the notion of it, or income contingent debt contracts. So for example, a mortgage, how much you would pay would be contingent upon your income, or student loans. There's a lot of talk about this but nothing ever materialized. I guess my sense is, even the macroprudential tools we have haven't been fully embraced or used, maybe it's politics. But why haven't things like income contingent debt contracts taken off since that crisis? Because there was lot of talk about it when it first happened.

Macroprudential Policy Tools: Income Contingent Debt Contracts

Reis: So I don't know I why they haven't taken off, but let me tell you an argument in the book for why they may not be such a good idea.

Beckworth: Okay.

Reis: Because again, it reflects one important concept in macro finance of the last couple of decades, and that is the concept of a safe asset. A safe asset is what? Well, it is an asset that, on the one hand, means that in a world in which we can trade on every characteristic, and so you said, "Well, Ricardo, maybe we could start trading on a few more." but even if you trade on a few more, there'll be many others on which we can't trade. There's lots of contingencies to which no legal contract could be written on. We'd like to have an asset that allows us to trade throughout good and bad times that is available there, and in particular that I can put money aside on, knowing that it will always be there, and will be state contingent, in a sense that it will be there no matter what the weather is, no matter whether contingencies are. That asset will be useful because for all the ways in which you can say, “well, my cashflow, your cashflow, my returns, your returns,” depend on some features that maybe we'd like to contract on.

Reis: It's also the case that there'll be many in which we can't contract on, and both of us would like to have a little bit of that safe harbor, that safe asset, in order to deal with all the ones that we can’t contract on. A safe asset, therefore, if you want, is… an analogy, is a good friend to everyone in risky times. Not only when... Because the assets you were saying, they'll be bad for me and good for you, depending on the realization of the world, it is important to have an asset that's a good asset, a good friend for everyone there. Moreover, this asset is easily tradable, is one that one can sell and buy exactly at all times, not that an asset with a lot of the features that you described would always be an asset, that in some circumstances, would often find itself having to deal with the legal difficulties of verifying, did a contingency arise or not, and would be therefore delayed, and therefore would not be something they would trade very easily and very liquid all the time.

Reis: That is, you want an asset that, in some sense, and this is a concept developed by Gary Gorton and [inaudible] and others. You want an asset that's somewhat information insensitive, that does not depend on everything that happens, allows it to be tradable. And that asset then becomes the safe asset in which we want to deposit our savings on the side to ensure against all of the other risks we have. What this means though, David, as well is that this asset has the following feature, and the following self-fulfilling feature, which is that precisely because when we enter a crash, a crisis, it becomes both harder to produce these assets, but also we will want to hold some more of these assets. At those times, these assets go up in price. And as they go up in price, in a crisis, a safe asset is also the really good return, because everyone is fleeing towards them, they're being more available then.

Reis: That makes them fantastic insurance, because note, as opposed to the contingencies that you were proposing, you would have that this asset is automatically going up in price because whenever we enter a crash, as everyone wants to flee to the good friend, the price of the asset is going up. Therefore, by having some of these assets, these safe assets, we have, if you want, the provision of some of the insurance that overcomes the difficulties in contracting across them. However, and here comes the crash side of it, because it is a self-fulfilling safe asset, what you have is that some assets, and let's go back, why not, to the Euro crisis of 2010s. What you have is that an asset like, say, a Spanish bond, can be perceived as being safe but when you get a succession of shocks that mean that now I don't know if it's going to default or not as opposed to it's never going to default. As it becomes more safe contingent, it depends on what some summit in Brussels will happen. Take into account all the conditions that you wanted, David. It'll be a good idea to pay more to pay less.

Reis: Because of all of that, it starts becoming less safe, let's say contingent, and you're having a flow away from it. And you have these flight to safety episodes that end up being very dangerous. Note, David, going then to the other application we talk about, which is 2020, the pandemic flight to safety. What we had was that we had, with the Covid pandemic, there was a lot of fear that the Treasury market, because of some of its instability, had stopped being a safe asset, and it was the very strong intervention by the Federal Reserve and others to keep the Treasury market working, that made sure that it told all investors, “you don't have to worry about it, there's no contingencies here. A Treasury is always going to be your safe friend. It will continue to be safe.” And in doing so, in some ways, [it] prevented a financial crisis over the last two years, keeping the safety of the Treasury. And that, of course, leads us, David, into much tougher discussions, which is, if you kept on having debt ceiling debates, are we not exactly undermining this kind of safety that is so crucial in stopping a financial crisis?

Beckworth: Well, I love safe assets, as you know, and I can spend a whole show on that, but the points you make are very interesting. There were arguments... I believe Robert Shiller called for a GDP linked bond for countries. But how do you actually implement those? Who would verify the GDP? I think it's also the reason we don't see a whole lot of TIPS. People prefer these fixed nominal debt contracts, regular Treasuries over TIPS. TIPS aren't as abundant and as liquid, and I think it goes back to these points you're making. Alright, let's segue from your interesting book to your interesting work on inflation. And again, I mentioned last time you were on the show, it was the beginning of 2021, right before everything unfolded, and you had a lot of to say, articles.

Beckworth: I was at the Hoover Monetary policy conference. You presented there, really interesting work on CPI swaps that provided probabilities, worst case scenarios. But what we've been through, as you know Ricardo, is we’ve had this inflation surge, starts in the spring of ‘21, it peaks in the summer of 2022, at least in the US, and it's been coming down quite dramatically. And there's big debate today over, why is it coming down? Is it just one-off supply side? Is it good luck or did the central banks have a role to play in it? But I want to get your sense. What is your… kind of stepping away, taking the 30,000-foot perspective, what happened? What caused inflation to go up and why is it going down now?

Breaking Down the Recent Inflation Rollercoaster and What’s to Come

Reis: Absolutely. So let me give you a very broad and necessarily imprecise view of what happened and what's about to happen. What happened is that in 2021, all the way into the beginning of 2022, we had four large shocks that pushed inflation up. Shock number one, the economy recovered much faster from the pandemic than what we had anticipated. And with that excess demand, that pushes prices up. Second shock, and interacting with the first, we have these very large supply bottlenecks in 2021. So even as demand is racing ahead, much more than we thought, we have supply contracting much more than had been anticipated before. And so then demand met shrinking supply, and led to a jump up of prices in 2021. But at the same time, what we had in the second half of 2021 is that inflation expectations, that is whether people thought that this blip up in prices would just be a month or two or whether it would persist, also started shifting to the right.

Reis: And as people start expecting higher inflation, they start wanting to set their prices, in the case of firms, higher, or in the case of consumers, to buy faster before prices rise even more. And that third shock of expected inflation was a third shock to prices. And then a fourth shock was, of course, the energy price, which was both the shock, the expectations, re-enhanced the expectation shock of 2022 because oil prices have a very large impact on people's expectations, and led to some persistence that verify their belief, and also because that led to a further contraction in supply. But starting with these shocks, David, and that is I think the very important lesson that can never be forgotten is that, ultimately, policy responds to those shocks, and especially monetary policy, could always have responded to those shocks and kept inflation lower. But here we have that, those shocks, that sequence of shocks in 2021, all the way to the beginning of 2022, was met with very loose monetary policy.

Reis: Central banks, in 2020, provided a lot of stimulus, not anticipating the racing recovery from the pandemic. Central banks misinterpreted the supply bottlenecks as being very temporary. And central banks were, for a while, too overconfident in the ability to anchor expectations, and in the credibility that they would've earned in the last 20 years. And there was a combination of those that meant that we were very slow to act in raising interest rates. We were somewhere between six and nine months too late. And I can say this, without just being a Monday morning quarterback, I was talking about raising rates as early as April of 2021.

Reis: And I think if we had to raised those, we would still have had inflation going up, but nothing like what we have right now, and so it was loose monetary policy partly contributing to it. Why was that monetary policy loose? Oh, and by the way, David, I left out, though, a mix of a shock in a policy, which is of course the large fiscal stimulus. A large fiscal stimulus, both was a shock pushing forward, but as well, is also a policy. But that ends then with why was monetary policy so loose? And I think the issue there really goes back to, if you look at the documents around the flexible average inflation targeting or the ECB review, and they go back to what I have called, because I think it really captures more of the common feature, was the low R star view of the world. There was a view of the world that the problem was that R star was too low, meaning that we had a glut of savings, and as a result, equilibrium real returns were going to be low for a very long time, permanently, even.

Reis: What that meant is that policymakers were especially focused on the dangers of hitting zero nominal rates, and how monetary policy would be too tight at that point. If the dangers of entering the deflation traps that Keynes had written about, and being stuck in a very low deflation problem, and thirdly, they were very much focused on inflation expectations being anchored too low, and this leading to insufficient aggregate demand. When in fact what happened in 2021 is that the world turned upside down, and what you had instead is that the problem was not the zero lower bound. The problem was rather to raise rates fast enough. The problem was not to be stuck in deflation, but instead of avoiding a high inflation. The problem was not demand, but rather supply. The problem was that inflation expectations were too unanchored, not too anchored.

Reis: And I think it was that low R star view of the world that the mission reviews that really solidified, that took nine months to pivot away. To end in a more rosy note, it's remarkable how quickly the Fed did pivot away from it, and it's now been more than 18 months that it pivoted away, and the ECB, 12 months. And in pivoting away by raising interest rates very aggressively, it has managed to, in my view, stop this inflation disaster. What could have been arguably 18 months ago, a repetition of the 70s, I think has been stopped in its tracks by the very, very decisive actions of the Fed and ECB. And lo and behold, 18 months after they started tightening, as often happens, here is inflation coming down, decisively coming down, the expectations looking very re-anchored now relative to before, and all kinds of indicators from credit indicators, money indicators and others, all moving in the direction that points to inflation coming down swiftly over the next 12 months.

Reis:. And whether that comes more or less swiftly now depends on how much tougher or softer the central banks want to be. But I think the shift in… I don't know if ideologies, in mission of the central banks [inaudible] 18 months ago, the humility to do that pivot is why inflation is now coming down. And to my eyes, although this is certainly something that's going to be debated for many decades, why is inflation coming down, you ask? Because the central banks changed course 12, 18 months ago. Ultimately, because monetary policy, David, that's what determines inflation. It was loose monetary policy that allowed those shocks to lead to high inflation earlier. It's been tight monetary policy that has allowed us to pivot, that has allowed inflation to start falling. And if the Fed and ECB continue on track, I am quite optimistic that inflation is going to be coming down quite swiftly over the next 18 months, and they will reach the end of 2024, beginning of 2025 with inflation fairly close to 2% simply by doing what they've been doing for the last 12 months.

Beckworth: So to the extent that the central banks are responsible for the low inflation, and I think you would acknowledge there are some supply disturbances that have cleared up as well, like oil prices coming down and such. But to the extent the central banks did play a role, what is the mechanism? Is it through inflation expectations? They reasserted credibility? People became confident, so people changed their spending patterns through the expectations term?

Reis: David, they're always shocks, but if you sail, some people sail… I do a little bit of sailing with my teenage son. There's always wind, there's always sun, there's always currents. But ultimately if you are a competent enough sailor, you should be adjusting the rudder, the sails and whatnot, and sail in the direction where you want to go. I always get worried when I hear central banks blame too much, the shocks. The shocks may mean that you can get a little slower to where you want to go, but you still get there. And so shocks are reasons why inflation, this year, may not be two, but be four or five. But if inflation is eight for two or three years in a row, it's your fault you didn't get there.

Reis: You could have done something about it, because you have a very powerful… to do something about it. You are the monopoly supplier of the currency. You set the nominal interest rate which determines the relative attractiveness of investing in nominal investments versus in the real economy. And you have this overwhelming power over inflation. What is the levers to that power? The main one, David, is certainly the interest rate in how it changes the attractiveness of nominal versus real investments, in the way in which it changes the cost of credit, in the way in which it changes the return to saving. But moreover, as you rightly noted, there's also the fact that announcements of credibility affect people's inflation expectations. And that is, likewise, an extremely powerful tool and an extremely powerful mechanism. What you have, David, 18 months ago, is a combination of, because of an inflation spurt that went too high for too long, the only way to use your credibility is to use your lever to raise the interest rates.

Reis: You can do a lot of forward guidance and credibility only when you have a lot of credibility, and then you don't have to do much in terms of the interest rates. Once inflation got out of hand, and it did get out of hand, then what you need to do is raise interest rates aggressively as central banks did. And at that point everything goes your way, in that you're both working through the channels, direct channels of more expensive credit and difference between nominal and real, as well as the credibility, because you're regaining the credibility by doing so. And so at that point, all of the channels start working in the same direction, and I think that's what's happened in the last 12 months.

Beckworth: Well let's talk about the future of interest rates, because you brought up the point that the Fed reassessed their very rosy views of R star or their very low views of R star. And if you look at their projections, if you look at their long run federal funds rate, it's two and a half percent. You take out their 2% inflation target, it's around half a percent. If I look at the Laubach-Williams R star, it's also low, it's a little bit above that. But if I go to the market forecast… And I'm trying to make a fair comparison, so this is long run, so I'm going to do five-year forward TIPS. They're between one and 1.5% depending on how you adjust for liquidity premiums. So markets are actually pricing in a higher real medium to long run rate relative to where central banks and some of these R star measures are. What do you think is going on there?

The Future Path of Interest Rates and R Star

Reis: So let me give you an answer in two parts. We want to have a clear view, it's crucial for monetary policy, of where the long-run nominal interest rate is going to be. And then what I'm going to show is the sum of two bits, R star, that is the real return, plus expected inflation. Now when it comes to expected inflation, and tying back to the previous discussion we were having, it's crucial, therefore, to anchor it near the inflation target, both because of the self-fulfilling nature of that anchoring, but also so that we have that number being a clear 2%, given that that's the target, as opposed to 2% plus a large inflation risk premium creeping into that. I've been spending a lot of time in my research in the last two, three years, in trying to use survey measures, market measures from swaps, from TIPS and others, because we have indicators and all of those measures are very imperfect signals of where that long-run, let me call it pi star is, long run inflation, pi, the Greek letter for inflation usually used by economists.

Reis: And on that, I think some of what comes out of that work is that on the one hand, central banks over the last 12 months, have been able to re-anchor that. It's very important here not to look just at means, but at distributions, probabilities of disasters, liquidity effects in these markets. And so I've done  quite a bit of work on this. And my conclusion on that is that central banks have, for the most part, succeeded to bring it down to 2%. But there is an inflation risk premium that is still very uncertain in that you're going to have to add that 2% something, having to do with how much investors got burned in the last two and three months by the very high inflation eroding their nominal returns. And on that one it's much harder, but it does seem that there's an increase of maybe 20, 30 basis points relative to before, with the inflation risk premia, 2.1, 2.2., maybe that's gone up to 2.4, but that seems to be entirely because of the inflation risk premium.

Reis: And that David is a great conquest because if you asked me 12 months ago, I would say that pi star would've been as high as 3% because you're already seeing also a lot of not even believing that we'd go back to two percent. So that's on the pi star. Now let's move to the R star, the real part. I think the real difficulty there is that we have measures like Laubach-Williams that you mentioned, that are entirely based on the return on government bonds, but the one that in part matters for the transmission of monetary policy for the real economy is the return on private capital investment. And in the last 20 years, what they had seen was a very large wedge between those two measures.

Reis: Some measures, like some of the ones you mentioned, relied only on government bonds, which had fallen a lot. But most measures of the return on private investment had shown almost no fall at all, and therefore a very large increase in the wedge between them. So it's really, when you're trying to think about what's going to happen now in the future, I think you really have to start telling me stories, accounts, theories, data on what's going to happen to that wedge. Because that wedge is what accounts for all of the decline in the government bond R star the last 20 years. And if I think about those stories, David, some of those stories were, one, well the reason why the R star and government bonds fell was because you have the savings glut, all of these Asian countries saving a lot. They didn't really want to invest in the real economy in the US or Europe or to a limited extent because they weren't really quite sure, they wouldn't be [inaudible].

Reis: So they bought a lot of treasuries instead. And that's what brought down the R star and government bonds. David, what's the big change in geopolitics today is how Asian countries are getting very skeptical of saving abroad. You're already seeing it in the Chinese data, way less on the flows of buying Treasuries. What you're seeing is these serial trade wars, conflicts and others. I still keep on seeing lots of Chinese T-shirts in the shops where I shop in. But capital flows of Chinese buying even more Treasuries or European securities, that you're already seeing a decline, and therefore you are seeing a force towards, again, that wedge, this appetite for Treasuries to decline, which would push for an R star to go up. Second, David, the other force for the wedge was that we had 10 years, 20 years where investment, which is very stagnant in the US and Euro area, savers wanted to buy government bonds but weren't really putting this into real investment in the economy, perhaps because of the financial crisis and some of the topics in the book, perhaps for problems in the financial sector in channeling investment.

Reis: But what we had was both a lot of saving and not a lot of private investment. Well what do we have right now, David? We have very large public investment programs in the US with the IRA, in the Euro area, doing very large amounts of physical investment, and at the same time, issuing a lot of Treasuries, by the way, but especially with a lot of private investment, which will again push towards compressing the wedge that had increased so much, and therefore again, pushing for a higher R star moving forward. And then finally, the last effect is, of course, the effect that my good friend and colleague Charles Goodhart has been talking about, which is the demographics which have pushed the R star down, is now slowly turning towards raising R star.

Reis: So once you combine with the fact that pi star, I think when… although it may increase a little bit, 20 basis points. When you have the insatiable appetite of Asian economies for Treasuries is becoming satiable and satiated. And three, the fact that we're now diverting investment towards... We're diverting savings towards actual saving. All of those tell me that R star, the government bond R star, is going up. Is it 1.5% or 2%? I don't know. But starting from a view where I thought was very plausible five years ago to say that R star was 0.5%. The view then now is it’s more like one and a half or two going forward. I'm certainly in that camp. Although with the huge humility of trying to forecast where these things will go, but I'm certainly the camp of the one and a half percent, of it increasing to at least one and a half. Because all of the same factors that led it to fall in the previous 20 years, if I bought all of your factors for why it fell, I look at those same factors and they are all pointing towards it increasing. So I find it hard to see people then arguing, "No, no, it's going to stay low," for the same reasons I've been telling for 10 years why it fell.

Beckworth: Well let me push back on one of those factors, I guess, take a different interpretation. I completely buy your point about the investment boom, it's clearly everywhere, so the return on capital should go up. But on the demographic question, so Charles Goodhart has that famous book out, and he argues the aging population will begin to spend out all of their savings, there won't be as much. But there's another view that goes something like this: the world's demographics are getting worse, we're living longer, getting older, therefore we need to save more. We also are more risk averse in our portfolios as we get older. And so there's two countervailing forces there. I mean how certain are you that the Charles Goodhart story is going to dominate the other one?

The Countervailing Savings Stories

Reis: Well, I don't want to be here defending Charles. He can defend himself for that point, but I will do it a little bit. I think Charles's point was not that the world is not aging, David, it was that what creates the excess in savings is when we are aging but not aged. That is that, when we have a bulk of the world population in that forties, fifties where you're saving a lot towards retirement, at least to a savings boom. But as those 50 year olds become 60 year olds and 70 year olds, they start dissaving. And so his point was not that the population… we aren't living longer, actually, the living longer goes in his direction, David. It means that you have more time in the seventies, eighties and nineties in which you are dissaving. It was that we were caught over the last 20 years in that transition phase when a bulk of the rich economies and others were in a saving stage and they're about to enter the dissaving stage, and that's what will trigger the change.

Reis: So I think that's Charles's point, not that we're not aging more, is that we're in the process of aging. We're going from the saving stage to the dissaving stage. Now, at the same time, that is of course a slow process, and one that will work slowly. But you bring in something that moves faster, which is risk aversion and a desire to save, precautionary savings, which also, by the way, is covered in my book on the crash course on crises, which is that that precautionary savings was, well, after the financial crisis, we all got more afraid, we started saving more, we started seeking more of those safe assets. And you saw that also in 2020 and 2021, we saw people saving more during the pandemic. But what have you seen in the last two years, David? You've seen a lot of dissaving, a lot of unwinding of that precautionary savings motive.

Reis: You've seen a lot of people going back to our discussion of why we had such a run-up of inflation and such a quick recovery. People have been very, very quick to spend. So that precautionary saving argument, which would have been a level argument on why we want to save more, has faced a wall in 2020, that when faced with having more savings, people did not say, “let me keep this higher stock of savings,” but actually saved down to their old stock as we are approaching now. So the theory that precautionary savings, that more risk aversion leads to save more, hit a big test in 2020. And I'm sorry to say the data show that that doesn't seem to have a huge quantitative bite, at least to judge by the last 18 months of dissaving, of converging back to pre-pandemic savings.

Beckworth: Okay, one last question and then I'll let you go, but the Phillips curve, it's a key part of modern macro, and at least in the US, it's come under a lot of criticism because we've had low inflation, low unemployment, all of the predictions of some of the big names that we would have to have this huge amount of unemployment to get to the inflation we've gotten to, it hasn't happened. What is your thoughts on the Phillips curve? And maybe we should begin with, how do you view the Phillips curve? Do you view it as a reduced form relationship or a deep structural one? And then from there I guess it's maybe easier to think about its future.

Ricardo’s View of the Phillips Curve

Reis: David, let me start by saying that I'm the Phillips professor at the LSE, so I have to defend the Phillips curve.

Beckworth: Okay.

Reis: I can never say it's obsolete otherwise I would fall on the floor since my chair would become obsolete. So it's definitely present. But with that account, let me make three observations. The first one is that, the way I understand monetary policy is, whereby tightening monetary policy, a central bank is able to bring inflation down. In the same way that when I go to the doctor with an infection with a bacteria of some kind, antibiotics are the way to kill the bacteria and cure me from that. However, a side effect, and I emphasize, let me say it slowly, a side effect of raising interest rates is that you also cause a recession. You also lead to an increase in unemployment. In the same way that a side effect of taking antibiotics is that they tend to wreak havoc with your gastrointestinal, digestive system.

Reis: Note that it is not a channel. It's not by taking antibiotics and screwing up my intestines that I therefore kill the bacteria. No, no, it’s a side effect. Likewise, raising interest rates lowers inflation and has a side effect of unemployment, but it may not lower unemployment the same way that you may go through a course of antibiotics and be perfectly fine with your gastrointestinal system. So the fact that unemployment has not gone up, does not in any way discredit the way in which monetary policy works, does not pose a puzzle of any kind, because an increase in unemployment following a tightening of monetary policy is not something that has to happen for inflation to fall. It's something that often happens as a side effect. So I make that point first. Second, the Phillips curve is, I think, still one of the most important concepts for any monetary policymaker precisely because if you were to say that raising interest rates brings down inflation, and you are to ignore the side effects, you would go crazy on raising and lowering interest rates in sharp ways, focusing solely on inflation.

Reis: It's understanding that side effect, and that side effect is the Phillips curve, that when you raise interest rates, you're going to bring down inflation, but you may also increase unemployment. That side effect is there. That makes central banking hard, monetary policy hard. That leads you to be cautious. That leads you to not destroy economies in your obsession with controlling inflation. So understanding the Phillips curve as a trade-off, as a structural trade-off, as a side effect of what happens after you raise interest rates and lower down inflation, is, I think, essential. And any central bank that told me it does not understand the Phillips curve [inaudible] in the central bank, is one that should resign immediately because it would be a very dangerous central bank in that sense.

Reis: However, and third answer now here, the Phillips curve, however, and as it is, as indeed it was written by Bill Phillips originally, my predecessor here at the LSE many decades ago, as an empirical relation that says that you have a correlation between inflation and employment, or even as a causal relation, that it's through raising unemployment, they lower inflation, is a deeply flawed empirical as well as theoretical claim, precisely because it is a side effect. And when that happens sometimes, but not always, precisely because it's not the causal mechanism, it very often happens that you have inflation going up and down with unemployment not going up and down in that way. That is why when you look at a correlation between inflation and employment, you end up with relatively low values.

Reis: It is also why when Bill Phillips did those correlations, under some circumstances, having to do with monetary-fiscal regimes, he found very nice Phillips curves, but under other circumstances you wouldn't find them. Just like, David, under some circumstances, antibiotics mess up your stomach and some others, it doesn't. So that Phillips curve is seen as an ironclad law of what happens when employment and inflation moves, seen as a causal part of the mechanism when inflation goes down. That, indeed, is, I think, something that does not receive a lot of support in theory or in the data. But the Phillips curve has a very important trade off as what you can do, is why you have to be careful in controlling inflation, that is absolutely essential for any central bank.

Beckworth: Well, let me tell you how I think about it, and correct my understanding here. I view it more as a reduced form relationship. It's reflecting some other third variable, which is aggregate demand, which is being shaped by monetary policy. So aggregate demand can affect inflation, it can affect unemployment, and so policy is moving aggregate demand towards some goal and maybe it affects unemployment, maybe it affects inflation. Is that too simple of an understanding?

Reis: That's a perfectly acceptable complementary view to the ones I was saying. It goes back a little bit to my, as a side effect, meaning you want to be monitoring employment to understand this correlation exists, because it is reflecting something going on in your body, right? You're trying to diagnose the body of the patient. You're trying to kill the bacteria. You know that when you do the antibiotics, it's going to have an effect on a bunch of other things, and you want to be monitoring them, and focusing on your digestion is a very useful one, sometimes even if you're really as triggering is whether the antibiotics are creating problems in other parts of the body, absolutely.

Beckworth: Okay. Well, with that, our time is up. Our guest today has been Ricardo Reis. His book is, A Crash Course on Crises: Macroeconomic Concepts for Run-ups, Collapses, and Recoveries. Be sure to get a copy. Ricardo, thank you once again for coming on the show.

Reis: Thanks for having me.

Photo by Spencer Platt via Getty Images