From the comments: inflation, monetary and economic stability and central banks
Larry Motuz, Paul Davidson and Don John weigh in on this post about central banks, different inflation metrics and monetary stability. What can we learn from them? Below, the comments. Below these, some remarks from me. First, however, the fact that a broader metric of inflation like domestic demand inflation (graph, source: Eurostat) shows a dramatically different development than consumer price inflation. ‘Dramatically’ as the differences add up. The total increase of the consumer price level in Germany between 1999 and 2009 was about 22%, the total increase in the domestic demand price level (which includes consumer prices!) was about 12%. Looking at one of the other does make a difference (and small wonder German households are so inflation averse!)! The comments:
- Motuz totally agrees with the idea that central banks should not target (only) the price level but ‘monetary stability’ which includes sustainable (private) debts.
- Paul Davidson is however quite critical:
Central banks should not look at the price level rate of change as a target at all. To do so is to implicitly accept the neutral money axiom– which Keynes rejected. This neutral money presumption simply stated is that changes in the money supply have no effect on employment and output — but have a major effect on the price level. The neutral money presumption is the basis of all classical economic theories– and especially Milton Friedman’s quantity of money theory.
The central bank should concentrate on maintaining all the liquidity the public desires and assure that financial markets maintain liquidity by providing the market maker in each financial market sufficient liquidity to assure that all financial market price changes are ORDERLY! ORDERLINESS is necessary to maintain liquidity in any financial asset market!
Instead the central bank has taken upon itself the function of creating an incomes policy that keeps labor wage demands closely attuned to increases in labor productivity over time. If labor demand for wage increases rises to more than 2% above productivity increases, then the price level of domestic producible goods and services will be inflated by more than 2 %.
In that case, the central bank will introduce a tight money policy to weaken labor power to demand inflationary wage increases– and in doing so, the central bank is using the level of unemployment as the lever in a disguised incomes policy! Why? because orthodox mainstream classical economists do not want the government to interfere directly into controlling labor wage demands that entrepreneurs will give into — as long as there is full employment and firms can sell at any price all that the full employment of labor can produce…
Some decades ago Sidney Weintraub had introduced TIP — a Tax based Incomes Policy– as a direct government control for constraining wage demands without having to create unemployment to limit workers power in the market!
- Don John states:
If CBs have set policy as Paul describes, it is a failure: wages in most developed countries are growing more slowly than inflation+productivity. Labour power has been weakened to the point that the labour share of the economic surplus is declining and inequality increasing. It is hard to believe that central bankers can have run these policies with these effects for thirty five years and not done so deliberately
My remarks: I make two different arguments. The first: central banks have, at this moment, inflation targets which focus on the consumer price index. There is an ideological side to this: it is consistent with ‘new classical’ economic models. A case can however be made – when you look at inflation at all! – that using another, more broadly based metric would be better. New classical models treat government consumption as wasteful which is stupid already (coastal defences have no direct financial return but my country would not even exist without them) but which in the Eurozone of course also problematic as some services which in one country are provided by the government are, in another country, provided by the private sector. Non private consumption data should, therefore, be included too. Comparable arguments can be made for exports and investments. Also, substantial differences between the long term development of indices exist – we should really have a discussion about this. Inflation targeting is a flawed policy but even then focusing on the right metric matters. The GDP deflator is however not fit for this task as it is influenced by the terms of trade (i.e. the exchange rate of the Euro). I stick to this argument and add that – when we look at German data – that Germany has, by focusing on consumer prices, been strangling consumer demand while the real interest rate in Germany has been quite a bit higher than indicated by consumer price inflation. These data totally comply with the prolonged stagnation of Germany up to 2006. The ECB really suffocated the Germans. Not now. But between 1999 and 2006. Fortunately, German fiscal policy was, at the time, pretty loose.
Is it, however, wise of central banks to define lowe and stable inflation as the overriding goal of a central bank? Of course it is not. I totally agree with Paul Davidson: money is not neutral. Not in the short run and not in the long run (and even less so in the Eurozone). When I (and David) state this, we have a credit centered idea about money in the back and front of our head. Banks provide credit to customers (households, companies, the government) and create (together with their customers) money in the process. The government is pivotal in this system, as the government stipulates and guarantees that money created by, say, Deutsche Bank can be used to pay down a debt at Credit Agricole. This requires that banks are liquid at all times – and the central bank has the responsibility to make this happen (in Greece, Ireland and Cyprus the ECB reneged this role, with dire consequences). Which already indicates that money is not neutral. It matters, for one thing, who is borrowing. For those not yet convinced: in the Eurozone the main organizations borrowing from the banks are, at this moment, the governments of individual Eurozone states. And it makes a difference if the government borrows to pay for coastal defences (badly needed in the UK!) or if a company borrows the production of rubber boats. And not just now. But also in the future. A very large financial problem in the Eurozone are bad debts. Debts which are not paid back in time – a situation which threatens the entire financial system. Many of these debts are related to mortgages – one big change of the last decades has been that banks increasingly became vehicles to provide mortgages, two thirds or so of total assets on their balance sheets are at this moment mortgage related. Many of these mortgages can’t be paid back or refinanced because wages and pensions were cut, (long term) unemployment is higher than ever, households are ‘under water’ etcetera.
Now, I do think that the central bank has a role to ensure that mortgages can be refinanced (even when families are under water) and to prevent slumps and high unemployment by providing liquidity. Indeed: this is needed for the orderly functioning of markets! But I also am of the opinion that they have to ‘lean against the wind’ in the case of real estate booms. They did not do so – the ECB even made the fundamental mistake (which has been corrected about four years ago) to assume, in its monetary statistics, that securitizing mortgages not only led to the (optical) disappearance of these mortgages of the balance sheets of banks but also to a decline in the stock of money and debt… Shadow banks were in a sense no creation of the banks – but of the Central Banks! This was not a case of ideological blindness but an outright blunder. But it underscores my point that central banks should look at (not the same thing as: target) a whole array of indicators, not just of prices but also of household debt and income and the relation between such variables. Including debt and credit – two of the very aspects of ‘money’ which make this ‘social contrivance’ non neutral.
Don John in essence argues that wage moderation policies of central banks have ‘undershooted’ their target. Which is true: even central bankers are, at this moment, arguing for higher wage increases and one reason why interest rates are not raised is the very fact that wage increases are low and, in the Eurozone, becoming ever lower. Which Yellen and Draghi consider very troublesome.