Economic Crises still need price stability

I admit it - I'm not an inflation hawk, I'm an Inflation Mushroom Cloud Layin' (insert crass Oedipal phrase), (insert crass Oedipal phrase)!

I have spent the last few years arguing on this blog of the necessity of controlling inflation over and above what many policy makers would think is reasonable. On my own I developed the theory of Absolute Price Stability, which is the #1 Google search for the phrase, even though others had actually invented the idea long before I did.

To quickly summarise what I have said (in case you haven't been turned off yet by my recent goings-on about it), I believe in the following axioms:

• The value of money is solely due to its ability to determine the cost of goods and services and to be used as a way of exchange. It is a way of measuring the worth of economic activity in a quantifiable manner.
• Over-investment and under-investment bring about economic harm to a society.
• Investment in the wrong place and the failure to invest in the right place also bring economic harm to a society.
• When the value of money changes, the market (as households, businesses, individuals and government) will inevitably make poor decisions in regards to what to buy and sell, and what to invest in and borrow for.
• While the market will always be prone to errors in judgement, ensuring that the value of money remains constant will help minimise this risk.
• In order for the value of money to remain constant, monetary policy should now be focused upon Absolute Price Stability - whereby the value of money is affected neither by inflation nor by deflation.
• In practice, Absolute Price Stability is not about price fixing, but inflation fixing. Monetary policy should always ensure that neither inflation nor deflation permanently affect the value of money over the long term. Short term experiences of inflation and deflation are to be expected, but over the long term, monetary policy should ensure that money's average value remains constant.

At present the economic world is suffering a massive credit crunch. In the past I have argued that inflation will continue to bedevil the world even though a recession takes place. I was wrong. I was predicting a different recession to the one now being experienced. Moreover, the one being experienced now is far more dangerous because it now seems to be an unwinding of the entire financial system that the world has been operating for decades. In this sense, the recession was always going to arrive. Moreover, two of the conditions of the recession that I was predicting (fiscal irresponsibility by the US government and the effects of Peak Oil - see here) are still major threats that need to be taken into consideration.

Absolute Price Stability, however, doesn't just mean no inflation. It also means no deflation. Financial conditions have deteriorated so badly in the last month that the only real result will be deflation.¹ While the stupidity of the Fed between 2002-2005 and the fiscal ineptitude of the White House and Congress between 2001-2008 has allowed inflation to grow, we are now seeing the results of those decisions - essentially what goes up (inflation) must come down (deflation).

If the Consumer Price Index begins to show increased deflation (as I think it will - the September figures are due soon) then the only real solution is for the Fed to begin seigniorage - money creation. This is the emergency solution that Ben Bernanke has written about previously, from which he derives his nickname "Helicopter Ben" - the idea being that deflation can be solved by simply throwing money everywhere.

In theory, a central bank can create and control an infinite amount of money. Bernanke and others in the Fed could, if they choose, create $100 Quadrillion dollars out of thin air. The idea that deflation can't be solved is incorrect.

And this is where Absolute Price Stability comes in. If this sort of policy is introduced, the Fed (and other central banks) could quite easily control deflation by creating money and buying back bonds. This would not be done randomly or stupidly - the last thing we need is a Weimar America - but certainly the sterilizing effect of deflation can be balanced through judicious seigniorage. In fact, some of this money creation could be used in the form of stimulus checks or given to the unemployed - it doesn't have to go towards corporations or financial firms.

I'm saying all this not just to push my idea of Absolute Price Stability (which I think will help solve the current crisis and prevent many from occurring ever again) but also to point out that while I have described myself as the "Inflation Mushroom cloud laying (insert crass Oedipal phrase), (insert crass Oedipal phrase)!", the reality is that I am just as opposed to deflation as inflation. I am not advocating some form of permanent deflation - that would be crazy - but instead the belief that money itself is best used when it retains its value.

Moreover, I believe that such a policy is best practised universally. There is only one country which practices Absolute Price Stability and that is Japan (Mark Thoma confirmed that with me once on a comments thread at Economist's View) - yet Japan is sliding into recession too. The reason is that Japan, despite practising Absolute Price Stability, is strongly connected to the world market - which means that a problem in the world market will also affect Japan. But if all countries practised Absolute Price Stability - and made it into an international treaty - then the world would be far less likely to suffer the sort of upheavals that we are experiencing now.
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1 - Unless the US Dollar crashes of course (see Krugman!). But let's ignore that for a moment.