2005-07-18

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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3 comments:

apodeictic said...

Problem Number 1: You have left (Un)employment out of the equation. A zero per cent inflation policy will (ceteris paribus) lead to an increase in unemployment just as a full-employment policy will (ceteris paribus) lead to high inflation.

While it's important that money is stable in value it's also important that people have jobs. It's also important for the ruling class that a sufficient number of the plebeians have jobs so that our patrician politicians don't get booted out of office :-) or even worse have riots/rebellion on their hands. (Of course "bread and circuses" is a tried and true policy open to the patricians. That is whay we have unemployment benefits and "popular entertainment" such as pay-tv, professional sport and women's magazines to keep the masses under control. But bread and circuses are only a supplement. They can never take the place of employment for the majority of the masses)

Governments therefore have to make a trade off, and that is why most Western economies have settled on a 2-3% inflationary band as a compromise between the policy ends of as much employment as possible and as much price stability as possible.

In short we have to live with a bit of inflation if we want people to have jobs.

Problem Number 2: Controlling inflation is not that easy in a deregulated economy. It's not just a matter of tweaking the interest rates. While not advocating the economic policies of the "monetarist" school, it is obvious that the size of the money supply will have a considerable impact on inflation. And even with no government intervention ordinary economic activity in a free economy -- especially lending money at interest -- will tend to increase the money supply which will (ceteris paribus) lead to a decrease in the value of money. So if you're going to allow individuals to make their own economic decisions and encourage all that lending/borrowing of money at interest you're going to have a few problems keeping inflation to zero.

Problem Number 3: You tend to ignore the influence of culture/ habits on people's economic habits. One of the biggest mistakes of much economics is homo (o)economicus. Human beings don't always behave as economists would have them behave.

So while the price of houses and the level of interest rates is obviously going to influence the extent to which people borrow money to invest in houses, I think it's a big mistake to assume that they are the only factors. There is as that great economist Shane Warne said something of an "X factor".

Why is it that countries such as Australia, the UK and the US have these property bubbles and countries such as Germany do not? Well, to a large extent it might have to do with economic factors (such as economic growth and low interest rates).

But there is also a very important human element. There are very important cultural factors at play as well. The prevailing wisdom in Australia is to invest in "bricks and morter" no matter what -- to own your own house with a backyard and (if you are so inclined) a swimming pool. The prevailing wisdom in Germany is to rent a flat. If you don't believe me about the influence of this "prevailing wisdom" just look at the urban landscapes of the two countries. How much unsightly urban sprawl so you see in Berlin or Hamburg or Munich? How many suburbs are there in those cities that are totally car-dependent?

Owning a home (or at least aspiring to home ownership) is part of the Australian/ US/ British national psyche. So the fact that it's unaffordable for 95% of people to buy a house at today's prices doesn't deter 95% of people from buying into the market. People keep taking bigger and longer mortgages for a number of reasons. One is the "security" of having your "own place". Another is the prestige factor (which might not be just based on wanting to show off; there's pressure to demonstrate that you're not an economic failure.) You've achieved something when you've got your "own place" -- you've got something to show for your "economic nouse". Another reason to buy despite high prices is the hope that it will turn out to be a "good investment". Well in a self-fulfilling prophecy it will be a good investment if every subequent generation keeps thinking the same way. But if a future generation decides that the prevailing wisdom is no longer so wise then all those who have bought in to an inflated market thinking it will still turn out to be a "good investment" (because prices will continue to rise) will have more than a few costs to bear.

You could stick interest rates to 20% and have the average price of a house in Urbansprawlsville at $1 million dollars and people would still be buying into the market. Admittedly less people would be buying in at those prices and interest rates -- but plenty of people nevertheless would still be buying even though a "rational" buyer might not buy given those conditions.

In Germany the culture is to rent. 70% of Germans rent. It's a cultural thing more than anything else. That's what everyone does. There's just not the cultural pressure to get a mortgage and "a place of your own" even though housing is on the whole quite affordable to buy.

Australians, Americans, Brits buy houses because that's what they're brought up to do. Germans don't buy houses because they were brought up not to buy houses.

I (an Australian) was brought up to buy houses and at the tender age of 23 I took out a mortgage to buy a house I'm not likely to live in for quite a while. Why? Well I'd been working for a few years , had saved up enough for a deposit on a house in the sticks (which given the property bubble was a bargain at A$285k) and did the done thing.

And now because I have dropped out of the workforce I am on "interest only repayments" because I can't afford to pay back the principal not having an income.

In my case it probably wasn't such a bad move. I didn't buy a delapidated dump of a Dog Box in Pott's Point for $2 million. I bought a place I could afford and a place where the rental payments would cover the interest (if not the principal) of the mortgage. I am temporarily out of the workforce "upgrading my skills" as the politically correct boffins would put it and will return to a job and an income again some day in the not too distant future. I don't think I paid any more for the place than what it was worth. In fact I was surprised at the price given the size of the place (4 bedrooms) the state of the house (1947 house, recently renovated interior including a new kitchen) and the location (walk to the railway station, shops, schools). I could foresee myself living there with a wife and ankle biters if I return to the land down under and have the (mis?)fortune to get married and procreate.

Now while Aussies, Sepos and Brits buy because that's what their society tells them, Germans on the whole rent because that's what's the done thing in that culture. Very people see the need to buy. It's not uncommon to have tenants in a flat or house for 10 or 20 years. That is almost unthinkable in Australia. (Not having any figures to go by) I think the average tenancy would probably be less than two years. Now that I'm living in Germany I feel no pressure to buy here. (Hypothetically speaking) if I were to spend the rest of my life here in Germany I probably wouldn't buy a house or a flat. It's just not the done thing. Renting in affordable and you can rent a place long term.

So in short, don't ignore the impact of cultural difference and other human elements in your analysis of housing bubbles. This Aussie (now living in Germany) bought in Straya to a large extent because of cultural factors and probably wouldn't buy in Germany because of cultural factors. So there :-)

Now coming back to your point about inflation. I don't know of any country that has a long-term goal of 0% inflation. You just can't do it without having all kinds of undesirable outcomes.

One Salient Oversight said...

Hah - your Deutschocentricity has revealed your secret identity. How are you going David?

I see you're a fan of the Phillips curve. There is some truth in your point that zero interest inflation will lead to higher unemployment. However you need to see the economic model as being dynamic rather than static. If it were simply a matter of low inflation = high unemployment then, logically, we should aim for high inflation in order to bring about low unemployment. The fact that we don't means that there is something wrong with the model itself. The 1970s showed us that Inflation and Unemployment can co-exist.

The reason why we don't have high inflation rates to boost unemployment is because it has been shown that, while it has a short-term boost, over the long term the economy can't sustain such levels and a "boom and bust" situation leads to higher unemployment.

I don't know if you know much about Monetarism but I'm certainly sold on a number of their positions.

When the Reserve Bank (or Fed or ECB) raises interest rates it actually physically intervenes in the economy. It approaches the marketplace and says "We want to borrow x amount of money". Because the Central bank is backed by the state, it is considered a very "safe" investment, and investors will rush to invest. Money is then lent to the Central bank - which then doesn't do anything with it. Money is therefore taken out of the economy and stored away - this has the effect of raising the value of money and thus reducing inflation. This is the way that modern central banks maintain price stability - it is a giant intervention in the marketplace.

Empirical evidence for this can be found by examining the role of the US Federal Reserve under Paul Volcker in the early 1980s. He raised interest rates, choked off the money supply, lowered inflation to 3%, and caused a very large world recession. Keeping monetary policy tight in the 1980s allowed the economy to grow and for employment to be increased without any huge increase in inflation. See http://en.wikipedia.org/wiki/Paul_Volcker

Historical information (from the depression and from the 1970s) gives us the proof that while there is a causal relationship between inflation/deflation and employment/unemployment, that whenever prices begin to be unstable (either increasing or decreasing quickly) then the economy is in danger.

My solution here is simple - keep prices level (zero inflation) and the economy will be able to look after itself... eventually.

As to your third point I myself am very aware of the propensity of economists to ramble on. the fact is that the marketplace often makes stupid decisions, which is why I am all in favour of some form of government intervention in important areas (such as health, education and so on). Cultural differences are certainly important here.

But even cultural differences can be affected by restrictions in the money supply. Yes we Aussies like to buy our homes but increasingly we Aussies want investment properties as well - but this is not due to some cultural thing but because the market has allowed this to happen. If interest rates were higher, house prices would actually be lower and there wouldn't be all this speculation or borrowing against the equity.

But whether you are in Sydney or Berlin, when interest rates increase, people like to put their money into savings accounts rather than pay off mortgages or spend it on Kraftwerk or Rammstein CDs.

Germany does not have a property bubble - obviously because cultural reasons affect it. But is there any investment bubble at all in Germany at present? No. Australia and the US and the UK have property bubbles now - and back in 2001, America had a stock market bubble that popped.

The idea is that the economy moves along in peaks and troughs. Monetary policy helps to flatten the curves by preventing both unsustainable highs and horrible, horrible lows. My assertion is that current monetary policy has not been doing enough to prevent the highs, and that by allowing inflation of 2-3% it is, over the long term, causing investment bubbles.

Every now and then in Australia someone bemoans our national savings rate, which has plummeted over the past decade. Every now and then, someone starts worrying about the housing bubble. the solution to both is a rise in interest rates. the more expensive money becomes, the more likely people are to save, and the less likely they are to invest in something that might not be sustainable (like a housing bubble). But the current doctrine prevents a rise in interest rates until inflation hits a certain point. So if raising rates to increase savings and prevent bubbles is to be justified, then a whole change in thinking must occur whereby Central banks set their inflation targets lower.

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The measured inflation rate at any point in time will be made up of an array of individual price changes. But the amount of inflation in the economy is about more than just the sum of all individual price changes. Something more fundamental determines the amount of inflation in the economy - whether it is 1%, 10% or 100%.