Article originally published in GoldMoney Analysis, July 21st 2011.
After the oil shocks and severe inflation of the 1970s, the world’s major central banks made a crucial decision to stop creating inflation and instability by tailoring their monetary policies to the financial needs of the state. In the 1990s they adopted specific monetary rules designed to preserve price stability. Yet since then, while inflation has moderated (see chart 2), the price level has risen and continues to rise, despite central bankers’ claims to have been successful at achieving price stability.
Sorry, but there is something wrong here, because central banks do not really target a stable price level but a stable rate of (low) inflation, poorly defined as the change in the prices of a “representative basket” of consumer goods and services. Whatever its measure and definition, they do not stabilise the price level but the inflation rate around a desirable (positive) target. This is not just nitpicking, as inflation (even the low 2% rate per annum we see in most western economies) leads to serious currency depreciation over a few years. This is not merely an academic question, therefore, as its consequences on money and on the economy in general are not negligible, it merits special attention and analysis.
In the 1920s the great Austrian economist F.A. Hayek1 fought vehemently against price stabilisation. Hayek argued that deflations could be the result of increasing productivity in competitive and dynamic markets. In this case, deflation would be the expected and natural outcome of a growing open economy, bringing about many positive effects: innovation, productivity growth, increasing output and a more open economy, leading to more competitive entrepreneurs and thus cheaper goods and services. Nothing new so far for an Economics 101 student. In such a scenario, the central bank could prevent prices from falling by increasing money supply. However, the resulting rise of the general price level would be non-neutral, as it would have a notable impact both on money and the real economy. On the one hand, the value of money would have been set outside the market; in fact, this policy would harm the purchasing power of the currency and its role as a store of value. Excessive money creation distorts consumers and entrepreneurs’ expectations as it adds “noise” in the price level, thus affecting agents’ planning and decision-making processes. In order to avoid such distortions, G. Selgin2 has followed Hayek’s original thesis and thus proposes a mild deflation in the case of growing economies.
Why do central banks intervene to offset any type of deflation? Moreover, why do they adopt an inflation target every year? Don’t they care about the loss of value of their own currency? Well, the fact is that central banks fear deflation much more than inflation, an irrational fear based on the memories of the terrible recessive deflation that hit developed economies in the 1930s. However, not all deflations are the same and, even if it sounds trivial and self-evident, but central banks don’t take this into account when conduct monetary policy.
The need to distinguish between different types of deflation fell into obscurity with the application of the Keynesian paradigm in the post-war years, and we have again suffered the consequences of this fatal error. Adhering to this sort of unsound monetary policy during the last economic boom, which consisted of maintaining a low inflation rate (and even worse, measured just as consumer inflation), has been a major contributory factor towards the recent financial crisis. The massive creation of liquidity in money markets during the last boom has been the result of the application of this inflationary-biased monetary policy.
Let’s take a look at the development of money and prices in the eurozone, especially since 2004 (see chart 1). The European Central Bank defines price stability as the harmonised consumer price index (HCPI) rising at less than 2%, but also adds that it will not permit deflation to take hold. Following the ECB’s own definition of what price stability means, the bank committed to achieving a rate of inflation “below, but close to, 2% over the medium term”. Has this strategy led to monetary stability? Not at all. Money supply boomed at high (unsustainable) rates from 2004 to 2007, double that of eurozone income growth. We now know how this massive creation of liquidity contributed to the serious problems now facing the eurozone. And thus we have more evidence that suggests that adopting even a low inflationary target does not lead to monetary stability, and less still to stable economic growth over the medium and long term.
As a picture is worth a thousand words, let me compare the results of our current inflationary policy rules with those of the classical gold standard in England. With the gold standard, every single paper bank note was redeemable in gold at sight, so the central bank could not expand money supply discretionarily and money growth remained quite steady. Moreover, the central bank did not target inflation; and, as shown in chart 2, there were inflations followed by deflations from 1850 to 1914 and, on average, the price level remained stable for more than half a century. As was the case in England and most gold-standard countries, the price level in 1850 was roughly the same as the one in 1914! The contrast with the evidence from the years following the Second World War is self-evident, where the conduct of (de facto) purely fiat monetary systems has fostered inflation, especially since the 1970s.
It is a fact that, without adopting any price stabilisation rule, the gold standard did preserve the purchasing power of the currency, while current inflationary policy rules do achieve a low positive inflation rate (at best), but at the cost of generating excessive money growth and eroding the purchasing power of money in the medium and long term.
1. Hayek (1928): Monetary Nationalism and International Stability, Augustus M. Kelly Publishers, (1989) Fairfield.
2. Selgin (1997): Less Than Zero. The case for a falling price level in a growing economy, IEA Hobart Paper No. 132, London.