Down with deflation!
The power of central bankers – about which Edward Luttwak wrote in the LRB of 14 November – arises not just from their control over important aspects of economic policy, but also from the acceptance by the rest of us of what they may legitimately do in the exercise of this control. Until recently, our acceptance of the notion that central bankers should be committed to price stability has been entirely uncritical; and price stability (not low, but zero inflation) is what the European Central Bank will be required to maintain. But now that European Monetary Union suddenly looks a real, even an imminent possibility, a skirmish has broken out among economists about whether price stability is what monetary policy should be required to achieve.
There are two reasons to take seriously what might otherwise seem the purely pedantic question of whether governments should aim for zero inflation or a ‘reasonable’ rate of, say, 3 or 4 per cent. One is that, at first sight, several countries provide cautionary tales of what can happen when fear of inflation becomes obsessive. Germany is an obvious example: its recession of the early Nineties (subsequently exported, like so many other German products, to the rest of Europe) was due to the Bundesbank’s failure to understand that the extraordinary event of reunification required a more relaxed attitude to inflation if growth were not to suffer (a more sinister explanation is that the Bundesbank understood perfectly well, but didn’t care). Another worrying case is France, whose unemployment rate remains almost double that of Britain a decade after it adopted German monetary policy by effectively hitching its exchange rate to that of the Deutschmark. (One can multiply examples of countries that tighten monetary policy at severe cost to employment in the expectation that unemployment will fall once inflation is under control, and then find themselves waiting unconscionably long for entry to the Promised Land.) It’s easy – and in France’s case, almost irresistible – to blame arthritic labour markets and a romantic Marxist blindness to the sectional selfishness of trade unions. But Latin labour markets and Germanic monetary policy are an uncomfortable combination (Catholic behaviour plus Protestant conscience); and it’s not obvious that the labour markets are the easier to reform. Persistent mass unemployment – if it really is more likely under tight monetary policy – is by any standards a vast cost to pay for zero inflation. Is the allure of price stability great enough to compensate?
Even if the goal itself is a worthy one, is it right always to err on the side of monetary tightness? In Britain responsible newspapers are currently calling for rises in interest rates, for fear that the Government’s inflation target of 2.5 percent may be breached before the end of this Parliament. They are doing so in spite of the recent large rise in the value of sterling, which is likely both to make inflation slow down of its own accord and stifle the recovery in output and employment. Are there good reasons to think that the dangers of missing the inflation target should count for more than the dangers of an excessive tightening of demand? Is the reference by the Financial Times on 15 November to ‘the battle to slay the beast of rising inflation’ timely and prudent, or ludicrously over the top?
A second reason to find the debate fascinating is what it reveals about the way instinct and evidence confront each other in a profession that likes to pride itself on its technocratic objectivity. There is overwhelming evidence – from both case studies and comparative statistics – that very high rates of inflation are extremely damaging to economic welfare in the present, and to investment and growth in the future. I have visited many factories in the former Soviet Union where money has been largely abandoned as a medium of exchange because of hyperinflation and the collapsing banking system, and where all investment and most of management time and effort are devoted to finding and stocking goods that will be useful in barter exchange – everything from aero-engines to potatoes. But there is no evidence that moderate rates of inflation are damaging. Or rather, there are a few conflicting pieces of evidence, none of them individually compelling, plus a great many theories, hunches and plain assertions. What is fascinating is that the flimsiness of the evidence does not lead to tentativeness or moderation among the debaters: inflation appears to stir some strange and deep passions.
What does the evidence actually show about the effect of a little inflation on growth? National growth rates in the European Union are currently in the range of around 1 to 2.5 per cent per year; inflation rates range from zero to around 2.5 per cent. Annual growth rates in East Asia range currently from 4 per cent in Hong Kong, through 6 per cent in the Philippines and Taiwan, 7 per cent in Korea and Singapore, to 8 or 9 per cent in Indonesia, Thailand and China. All of these countries have inflation rates between 3.5 and 7.5 per cent, with the single exception of Singapore (1.5); they have not been using monetary policy to rein in growth for fear of a little inflation. Again, Poland and the Czech Republic (the star performers of Eastern Europe) are growing at around 4-5 per cent, with inflation rates of 20 and 8 per cent respectively.