Monday, February 22, 2010

Inflation is in the News

There were quite a few articles in the newspapers this morning concerning inflation and how governments should set their policy targets with respect to inflation. This discussion was set off by a paper written by Oliver Blanchard, the top economist at the International Monetary Fund, and examined in this post on February 12, “Doesn’t Anyone Understand Inflation,” The proposal of Mr. Blanchard’s that caught everyone’s eye was the proposal that central banks set their target rate of inflation at 4% rather than 2%.

This morning we see an opinion piece by Wolfgang Münchau in the Financial Times,; an article by Sewell Chan in The New York Times,; and another article by Jon Hilsenrath in the Wall Street Journal, All discuss changing ideas about inflation and how government policy, particularly monetary policy, might be adjusted to reflect what has been “learned” from the recent financial crisis.

The underlying concern in these discussions is what changes need to be made to macroeconomic models that will allow us to be better prepared for the next financial disruption. Münchau concludes that in a globalised world with large financial markets, “Unless and until macroeconomists find a way to integrate concepts such as default and bubbles into their frameworks, it is hard to see them making a useful contribution to the policy debate.”

In other words, unless the models include situations that account for rising debt levels and credit inflation (inflations that can lead to excessively rising prices in subsectors of the economy, like in housing markets) we cannot expect economic policy advice that is of much value in combating the problems of the global economy. Sounds like we need to go back to Irving Fisher rather than Maynard Keynes.

The point is that in the United States, the purchasing power of a dollar bill has declined more than 80% since early 1961. In some sub-sectors we saw greater amounts of inflation up until 2007. During this time, global markets developed to a degree never seen before and inflation could be more easily passed from one country to another so that “sectoral” inflations could take place in different nations throughout the world. Living in an inflationary environment changes things!

It is interesting to see in some of these articles that the control of international capital flows is a rising issue. The concern is with the possibility that a debtor nation could export inflation to other countries. In particular, this exporting of credit inflation is being discussed in the Euro-zone in the talks surrounding the ‘bail out’ of Greece. Capital controls are seen as a possible solution to the problem of free-flowing capital.

The ironic thing is that the last period of world-wide discussion of capital flows began at the Paris Peace Conference in 1919 and ended up as a part of the Bretton Woods agreement that followed World War II. The restraint on capital flows following this period lasted until there was a final breakdown of the Bretton Woods system in August 1971 as President Nixon took the United States off the gold-exchange standard.

Maynard Keynes was very much in favor of restricted international capital flows because this allowed countries to operate economic policies independently of other countries and thereby promote “full employment” strategies. Free international capital flows, of course, eventually exert pressure on governments to operate their budgets on a more disciplined basis.

The real problem of inflation, as Münchau argues, “is that macroeconomists treat inflation as a variable, while most of us do not.” He continues: “Price stability is a critical component of the social contract we call money. We accept money as a means of payment, as a unit of account and, most importantly in this context, as a store of value. We trust that the central bank does not debase it. The problem here is not that a particular rate of inflation would be breached; it is the simple fact that inflation is considered a variable to be messed with in the first place.”

The reason that inflation becomes a variable in macroeconomic models is that unemployment becomes a fixed target. That is, in the late 1910s and early 1920s, economists, like Maynard Keynes, became so fearful of a Bolshevik revolution, that they built their models to focus on achieving high levels of employment. In the United States this got built into law: first in the Full Employment Act of 1946, and then in the Humphrey-Hawkins Full Employment Act of 1978. Of course, the definition of “full employment” is a man-made policy objective.

The problem is that once the “social contract” is violated by political consent, inflation becomes a variable that can be sacrificed at the altar of “full employment.” Even “inflation targeting” on the part of central banks’ assumes that there is a tradeoff between higher levels of employment and inflation.

Once the environment incorporates inflationary expectations, debt becomes the currency of record and more and more the expansion of credit comes to rule the economy. Once credit inflation takes over, manufacturing firms focus less on production and more on financial engineering, higher and higher levels of leverage are accepted, and financial innovation becomes crucial to survival.

Three things then happen: first, financial markets become more efficient in that more and more firms, financial and non-financial, can buy or sell ALL the funds they want at the going market rate. Second, this means that there is no limit on the size that firms, financial and non-financial, can become. Third, the financial sector becomes a larger proportion of the economy and hire relatively more people than before.

The conclusion from this is that debt and debt creation is a major part of economic activity. If this fact is not considered in macroeconomic models, then the models will be blatantly deficient. The decline in the purchasing power of the dollar has resulted from putting almost all the emphasis of economic policy on the level of unemployment. The focus on “full employment” has resulted in almost 50 years of credit inflation, financial innovation, and a decline in financial discipline.

I am not saying that high levels of employment are not important. However, one thing I have seen over the past 50 years is a government full employment policy that “forces” people back into jobs they had lost in the economic downturn and that are declining in importance or menial in nature. As a consequence, underemployment has been increasing over the last 50 years or so. But, education and re-training and such are more important over the longer run than putting people back into all of the jobs they lost.

The one thing that is becoming more and more obvious, however, is that once a person, a family, a business, or a nation, loses their financial discipline that all of the resulting policy options are undesirable. As an alcoholic finds out, the early stages of drinking can be very enjoyable and returned to regularly in pleasure and companionship. However, as the discipline of the alcoholic deteriorates, the drinking becomes less and less enjoyable, becomes more and more solitary, and ends up with no happy choices. As many people, businesses, and governments are finding out, having issued large amounts of debt in the past leave very little room to maneuver when the times get tough.

This is something that must be remembered in the future. But, accepting higher levels of inflation is not the answer. Businesses are criticized for focusing too much on the short run: governments should be as well.

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