The question is now being asked

If you check out some of my selected articles on the left column, you'll see one titled No Inflation. I wrote this back in 2005 as a result of a few years of thinking on the subject. Essentially it is an argument which points out that, since money's worth is only as a means to exchange goods and services, then it functions as a way to determine the worth of something. When an economy is beset by inflation or deflation, then the economy's ability to determine the worth of goods and services is compromised.

My argument is that, by ensuring that the value of money remains neutral - neither inflating in price nor deflating in price - then the economy is best able to use money to its full advantage.

In order to force a situation in which zero inflation exists - absolute price stability - then central banks like the US Federal Reserve or the Australian Reserve Bank need to adjust interest rates accordingly. In this case, interest rates would go up and economic activity would stall for a while as prices adjust to absolute stability.

The current thinking is that the best balance is to have a little inflation. Modern central banks believe that inflation should exist in a band of between 1-3%. Yet even this, I would argue, is dicey.

In the last month we have seen the result of the Subprime Meltdown - a cascading amount of home owners in the United States are unable to afford their mortgages and are foreclosing. A recent article in the New York Times indicates that recent employment statistics, along with bond market statistics, have swung strongly towards a recession.

The housing bubble that caused this subprime meltdown is a classic asset-price bubble. The worrying aspect of asset-price bubbles is that they do not translate into inflation figures until well after they start. Simply put, there is now direct evidence that exposes the limitations of current monetary policy. The Federal Reserve Bank, in hindsight, should have acted earlier to prevent both the housing bubble as well as the Dot-com bubble before it. Yet no mechanism existed to warn the Fed to act - inflation was not high enough to warrant action. But the reason why no mechanism existed was because it was assumed that a little inflation was a good thing.

I'm saying all this because I have just read an article in The Economist about how the current financial crisis is affecting Canada. The final paragraph of this article is telling:

He (the governor of the Bank of Canada) acknowledged that the Bank of Canada may itself have played a role in stoking the excesses by not raising interest rates enough. “One can see in retrospect that we should have been driving those rates harder than we did, because in reality credit conditions were being eased by increased securitisation and movement of stuff off balance [sheet],” he says. That is an admission that most officials would make only when they are safely in retirement. If the failure to tighten was an error, it was surely one committed by many other central banks besides Canada's.

In other words, the question is now being asked - would it have been better for monetary policy to be tighter? Hopefully someone, somewhere, will realise that absolute price stability is probably the best answer.