Zero Inflation Monetary Policy

Money is an innovative solution to the problem of determining the worth of a particular good or service. In less civilised times, bartering goods and services against one another was one way people could trade them. Certainly in the Old Testament, a person's wealth was often determined by how many sheep or cows or goats one owned (eg Job 1.1-3). Money was invented as a means of exchange, allowing far greater freedom in buying and selling goods and services.

But in order for money to be useful in exchange, it needs value. There is no point in having money if it does not have value. Each nation's central bank controls the value of money to ensure that prices remain viable.

In the past, money was fixed to the price of Gold, ensuring that money had some form of "real value". But Gold is not valuable in and of itself - it is valuable because humans have made it valuable. The same can be said for money - which is why, these days, Gold is not used as the basis of wealth, nor is it tied to the value of money.

But because money has been given value, and because it is only useful in exchange for goods and services, the value of money is very important in an economy. If money is no longer valuable, people will exchange it for goods and services far more readily. If money becomes too valuable, people will no longer buy goods and services, preferring to keep it locked up in a bank account or stored under the bed.

When money loses value, the price of goods and services goes up in response. Things become more expensive because money is no longer as valuable as it once was. The technical term for this is inflation. During the 1920s in Weimar Germany, as all you who remember their High School History, the Government chose to pay off its debts by money printing. So much money was printed that the nation was awash with the stuff. The result was hyperinflation - where money was losing value day by day and where a loaf of bread may be $3.00 tomorrow but $30.00 by the end of the month.

When money gains value, the price of goods and services goes down in response. Things become less expensive because the value of money has increased in relation to the goods and services on offer. The technical term for this is deflation. During the 1930s depression, money was so valuable that people simply refused to spend it. Every penny was squirreled away for a rainy day, and people's possessions dropped in value. People stopped buying goods and services, which meant that many people lost their jobs.

It may surprise many of you to know that it is only recently that price stability seems to have been achieved by many economies. It took the inflation of the 1970s to teach governments the importance of Monetary Policy. This policy ensured that the price of money remained relatively stable. If inflation begun to be a problem, the central bank would raise interest rates, thus creating demand for money. If deflation begun to be a problem, central banks would lower interest rates and print money to pay off outstanding debts, thus creating an increase in the supply of money.

So price stability is essential. Too much inflation or too much deflation leads economies into recession. Moreover, price stability ensures that the market has an accurate sense of worth for goods and services. Once prices go up too much, or go down too much, the market is apt to make mistakes in buying, selling, borrowing and investing.

Current monetary policy around the world today is focused upon the maintenance of price stability. This is achieved by setting an "inflation target". Essentially there are two systems in operation. One system, which is used by the US Federal Reserve, is to have an upper inflation target of around 3%, with any drop below 1% requiring a loosening of policy. The other system, used by Canada and the ECB, has an upper limit of 2% and a "floor" of 0%, and is regarded as a stricter system.

It is my belief that monetary policy should be even stricter. In the long term, I believe that price stability be defined as no inflation or deflation whatsoever. In this sense, I think that the upper limit should be 1%, with the floor set at -1%.

The reason for this is based upon the natural balance between investment and borrowing, and production and consumption. Supply and demand, therefore, is the basis for this.

When money decreases in value, the natural result is inflation. Even the relatively low levels of inflation seen in many Western nations are indicative of a situation in which money is decreasing in value (albeit slowly).

When inflation is present in an economy, conditions exist which decreases the value of money. Money is therefore not as valuable as goods and services, and should be used relatively quickly in order to exchange it for goods and services. Inflation therefore stimulates consumption.

Inflation also stimulates borrowing. Since the inflationary environment lowers the value of money, the cost of borrowing money decreases as well. Therefore all sectors of the economy feel more "relaxed" about borrowing money, since its value is continually dropping, thus making repayments easier over time. Moreover, because money is getting cheaper, it is not wise for any sector to invest in cash deposits. Money is then used to invest in capital, including shares and property.

Of course, there is nothing intrinsically wrong with consumption and borrowing. The problem occurs when an economy over consumes and over invests - eventually a "bubble" forms and the economy is unable to sustain itself.

When deflation is present in an economy, conditions exist which increases the value of money. Because money is getting more valuable, its use to purchase goods and services is diminished. Deflation therefore discourages consumption.

Deflation also discourages borrowing. Since money is rising in value, the cost of borrowing increases more. Deflation hits borrowers hard, as the value of their debt climbs.

My argument is that the best situation to be in is to aim for zero inflation. This will ensure a balance between under consumption and over consumption, between under borrowing and over borrowing. A zero inflation economy is much less likely to be subject to invetsment bubbles, and more likely to invest in areas that promise real growth rather than "paper" growth.

As part of the proof of my assertion I submit to you the economies of Britain, Australia and the United States. All three of these countries have a reasonably loose monetary policy which allows inflation between 2-3%. In all three nations we have seen, in the last 5 years, a growth in the value of housing that has outstripped GDP. In other words, housing has become a "bubble" in these three countries. Economists all over the world are warning people about the coming housing "crash", which is a likely scenario given historic trends. In all three countries, economic growth is being driven by spending based on this housing market, as people extend and upgrade their properties, and borrow against the equity. Once the housing market pops, the spending will also stop, and recession will be on its way.

Canada and the EU, however, do not have such a comparable problem. Of course housing has increased in value in the EU as well, but only in selected pockets. Contrast the growth in Spain to the lack of growth in Germany and you will see what I mean.

The only way to prevent the market from popping is, sadly, to pop it now. The earlier it pops the better. The way to do this would be to increase interest rates - but the loose monetary policies of Australia, Britain and America do not allow for this. The stricter monetary policy in the EU and Canada has made the housing market less of a problem.

If economies do adopt a zero inflation target (as I am suggesting here), then things like the balance of payments, the current account and the national debt will also be affected. Nations like Australia and America have large current account deficits. With an increase in interest rates, domestic consumption will be more constrained, leading to less imports (based upon lower output). You may also have heard people on the news lamenting about Australia's low savings rate - well, a zero-inflation policy will increase personal savings.

This suggestion, of course, goes against prevailing trends, and who am I to doubt the wisdom of such learned men? After all, what I am suggesting is essentially a higher level of interest rates over the long term in order to reduce inflation to zero. Such an action would undoubtedly lead to an economic downturn and higher levels of unemployment - so why suggest it? It is because I believe that, over the long term, it will work, and produce growth and increase employment.



From the Osotrian School Department



© 2005 Neil McKenzie Cameron, http://one-salient-oversight.blogspot.com/
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