Stiglitz - "Let's inflate!"

Joseph Stiglitz is one of the world's most pre-eminent economists. He has qualifications and professorships coming out of his ears. He even won the 2001 Nobel Prize for economics. I, on the other hand, am an economic hack who occasionally makes embarrassing mistakes like asserting that GDP figures don't include inflation.

Nevertheless, let me now publicly say that Stiglitz's latest column attacking inflation targeting is dead wrong. Of course no one is likely to listen to me if arguments were based upon respect and qualification alone - but I would say that I have a very good argument against his views, so it would be important to take arguments like mine on the basis of content alone rather than simply saying that Stiglitz must be right because he has a Nobel Prize (though it goes without saying that his achievements in economics probably do deserve such high honours and therefore anything he says about economics is probably worth listening to).

One thing I'm noticing about my travel into the study of inflation is that my examination of the subject seems to differ at a very basic level from many others, including Stiglitz's. It seems to me that when economists look at inflation they view it from a very restricted perspective. Such a perspective results in conclusions that, while based upon hard data and empirical research, fail to take into account certain basic factors, namely a) that money's value is in its ability to quantify costs of goods and services, thus allowing individuals and businesses to use it in exchange for the procurement of these goods and services, and b) that the marketplace's most important function is to accurately and objectively value goods and services - a process that involves the use of a monetary amount.

The reason why I am such a hawk is because I see inflation as seriously harming the reason for money's existence and a way of confusing the market's need for accurate valuation. This, however, does not mean that I am a deflation lover - far from it. Deflation and inflation are two sides of the same coin: both result in imbalances that harm the economy. Price stability - whereby prices neither inflate or deflate over the long term - is where I'm coming from.

Milton Friedman, perhaps the most important economist in the second half of the twentieth century, spoke of inflation this way: Inflation is always and everywhere a monetary phenomenon. I may not agree with most of Friedman's philosophies (I'm reasonably left of centre in politics and economics), but I would argue that this adage of his is of vital importance.

My understanding of inflation may be problematic at this point, but I have always seen inflation or deflation as a result of a change in the supply and/or demand of money. The money supply - whereby money is created via the money multiplier inherent in fractional reserve banking - should "always and everywhere" be treated as a marketable good that is subject to the effects of demand. Thus if the supply of money exceeds its demand, then naturally the "price" of money goes down. When this occurs in reality, it means that the price of goods and services grows in relation to money, which is inflation. Conversely, if the demand for money exceeds its supply, then the price of goods and services in relation to money decreases, showing the growing value of money, which is deflation.

I may be mistaken at this point, but it seems to me that too many people equate an increase in the money supply as inflation, which assumes that any form of deflationary effect must be a result of a contraction in the money supply. This is incorrect because it fails to take into effect the demand curve has upon money supply. When this is taken into account, you can have four different possible scenarios:

• Deflation + An increase in the money supply
• Inflation + An increase in the money supply
• Deflation + A decrease in the money supply
• Inflation + A decrease in the money supply
  

Such phenomena can quite easily be discovered by historical economic research. Although I do not have the facts at hand, I would argue that Japan's deflationary episode in the late 1990s was accompanied by a growth (albeit small) in the money supply. Why was it that Japan managed deflation at a time of monetary growth? Easy - the money supply did not keep up with demand.

Inflation can thus be caused by two factors - the first being money creation over and above what the market requires, the second being the demand for money dropping below what is being created. This is why Friedman's adage is so true - if supply problems, for example, caused prices to rise the result would naturally be inflation, even if money creation isn't out of control.

In terms of evidence, I submit to you the latest graphs from The Economist. First click here to see the latest inflation figures. Then click here to see the latest Broad money supply graph.

What stands out like a sore thumb in the latest broad money graph is that money growth in the Eurozone is substantially greater than in the US. Yet the inflation figures show that Eurozone inflation is lower than the US. Why is it that money growth in the Euro is about 40% greater than in the US, while inflation is around 70 basis points lower? The reason is simple - the demand for money in the EU is much higher than the demand for money in the US.

Another feature of the broad money supply graph is that Japan's money supply is only growing slowly - however, it is still growing. The supply of Yen is not contracting. Yet even back in 2005 Japan was having slight deflation.

Now the reason why I have spent so many paragraphs on this issue is because I believe that Stiglitz and others simply do not understand how money supply and its demand is related to the current inflationary problems developing around the world.

It's time I quoted Stiglitz, so here goes:

Raising interest rates can reduce aggregate demand, which can slow the economy and tame increases in prices of some goods and services, especially non-traded goods and services. But, unless taken to an intolerable level, these measures by themselves cannot bring inflation down to the targeted levels. For example, even if global energy and food prices increase at a more moderate rate than now - for example, 20% per year - and get reflected in domestic prices, bringing the overall inflation rate to, say, 3% would require markedly falling prices elsewhere. That would almost surely entail a marked economic slowdown and high unemployment. The cure would be worse than the disease.

Notice here what Stiglitz is saying - if interest rates were used to keep inflation below a certain amount (say 3%) the result would be "marked economic slowdown and high unemployment". Stiglitz's view seems to be clear - if inflation is due to supply problems (rather than an overheating economy), then the practice of "inflation targeting" will do more harm than good:

Today, inflation targeting is being put to the test - and it will almost certainly fail. Developing countries currently face higher rates of inflation not because of poorer macro-management, but because oil and food prices are soaring, and these items represent a much larger share of the average household budget than in rich countries. In China, for example, inflation is approaching 8% or more. In Vietnam, it is expected to approach 18.2% this year, and in India it is 5.8% . By contrast, US inflation stands at 3%. Does that mean that these developing countries should raise their interest rates far more than the US?

What Stiglitz's article doesn't mention is a solution to the problems he poses. If, as he argues, inflation targeting will do more harm than good, then what is his solution? There's no doubt that he thinks that inflation targeting should be abolished... but that is not a solution, just the removal of a certain policy. What should replace it? What should central banks do to ensure price stability?

Stiglitz is essentially arguing that inflation should be let loose, that central banks and governments should just sit back and let prices rise. The justification for this argument is that price stability should only be maintained by central banks when inflation is not the result of supply problems.

And that, of course, is where he is dead wrong on inflation.

Let's go back to the reasons why money is so important. The first reason is that money is unique in that is the only commodity that exists solely as a means of exchange. Money's raison d'être is that individuals and businesses can buy and sell goods and services. When money loses its value, the inflation that follows causes price rises, money's usefulness begins to be lost, which then affects the second reason why money exists - as the sole way the market is able to value and compare the importance of goods and services. Inflation of any amount will confuse the marketplace's ability to buy, sell and invest.

When the market is confused, it will inevitably make wrong decisions. Whenever price stability is not maintained (either as inflation or as deflation) the market's ability to make mistakes increases. Investment bubbles are always likely to occur during inflationary periods, as will long periods of "noninvestment" during periods of deflation (as witnessed during the depression).

I can just imagine having this argument with Joseph Stiglitz. "Mr Cameron", he says, "are you therefore proposing that countries raise interest rates at the moment, knowing the economic damage it will cause?". Yes Mr Stiglitz, that is exactly what I am saying.

The problem is that Stiglitz can't see beyond the current inflation/interest rate issue. Food and oil, not to mention other commodities, are causing a massive increase in world inflation. Chances are these twin problems are caused not by speculators but by real supply issues. I have argued elsewhere, for example, that oil supplies are facing a worldwide decline due to supply peaks being reached (Peak Oil). The inflation caused by oil prices is due mainly to supply problems.

If economies are going to go into recession, it will be due to the effect of oil and food supply problems. All things being equal, any reduction in vital commodities will cause a worldwide drop in the standard of living (a drop that can be measured in terms of GDP and GDP per capita). Inflation and the money supply just doesn't come into it.

What is important is not whether economic contraction can be avoided in the face of such severe supply shocks (it can't), but whether or not an economy can weather such a downturn in such a way as to prevent secondary issues from making things worse.

The problem with Stiglitz's "solution" (lets inflate!) is that it can do nothing to prevent an economic contraction from occurring, while messing things up for the economy as it tries to recover. High levels of inflation will cause the market to inaccurately respond to price signals while at the same time punishing those who choose to save money.

Of course, those who advocate inflation targeting (or those very few who advocate absolute price stability like myself) cannot prevent the economic contraction from occurring either. That's because the nature of the contraction has nothing to do with the money supply (it is not cyclical) and cannot be avoided by either increasing or decreasing interest rates. Nevertheless I would argue that by enforcing price stability - even through an economic contraction - would result in a better outcome for the economy as it recovers. Keeping prices low and ensuring that interest rates exceed inflation will reward those who have chosen to save money through the contraction, while at the same time keeping money's raison d'être intact. This will ensure that when the economy recovers from the contraction, individuals and businesses will be able to properly and accurately value the prices of goods, services and investment opportunities - a process that becomes increasingly unmanageable during high inflation.

Stiglitz argues that "inflation targeting" has no empirical basis to back it up:

This crude recipe is based on little economic theory or empirical evidence; there is no reason to expect that regardless of the source of inflation, the best response is to increase interest rates.

Yet I would point out that the solution he proposes (let's inflate!) results in shorter boom/bust cycles that increase long-term unemployment while eroding the purchasing power of the currency, a situation that impoverishes everyone. I use as the basis of my evidence the experience of the US and the world during the late 1960s to early 1980s, a period of time that saw three recessions, high unemployment and high inflation, much of it caused by supply problems.

It disturbs me that not only figures like Joseph Stiglitz can forcefully argue that price stability is no longer to be maintained under certain circumstances, but that such ideas can be seriously put forward during a period when inflation is beginning to bite. Stiglitz and others who argue for the "lets inflate" model argue that, well, Milton Friedman was evil and things will change and the economy these days is different and can handle bursts of inflation. The problem with such an attitude is not that it is somehow a new critique of an "out of date" monetary model, but that it is in actual fact a return to a pre-monetarist mindset that brought us long term stagflation.

Those who argue against inflation targeting are essentially wanting a return to the 1970s, where double digit inflation was common, where recessions were plentiful, and where unemployment blighted the social landscape. Their "solution" is not workable either in good times or in the bad times that we are entering. Moreover, they have assumed that inflation is not solely a monetary phenomenon, and that it is possible to keep an economy "growing" in the midst of a serious supply shortage through the use of inflation, thus giving money both a value it does not have (the ability to "cure" a recession) and reducing the value it does have (its power to exchange and value goods, services and investments).

I will say this - those economies which have central banks which judiciously maintain price stability will be the ones who will successfully endure the current downturn. Conversely, economies whose central banks are less judicious (including Bernanke's Fed) will only make things worse over the long term.