Dusting Off the Old Books

The Economist in its 'Economic Focus' column argues that there are at least two arguments for dusting off the old Austrian books when it comes to understanding the fragility of the modern economy.  Financial liberalization has increased the chances of credit induced boom-bust cycles, and changing international conditions have in turn changed the monetary transmission mechanisms and thus made some of the old measurement techniques obsolete as guides for monetary policy.

Economics focus

The weeds of destruction

May 4th 2006
From The Economist print edition

Central banks need to worry about more than just inflation

THREE months after Ben Bernanke took over as chairman of

America

's Federal Reserve, financial markets are struggling to decipher his monetary smoke signals. His testimony to Congress on April 27th and some unguarded remarks to a journalist have left markets confused over whether or not the Fed has nearly finished raising interest rates. Some economists argue that the Fed would find its policy easier to explain if it had an explicit inflation target—something Mr Bernanke is known to favour. That might make it easier for financial markets to guess where interest rates are going, but would it necessarily result in better policy?

If candidates in an economics exam are asked: “What should be the main objective of monetary policy?”, the “correct” answer today is price stability: central banks should single-mindedly reduce inflation and then keep it low; they should also avoid deflation. In that same exam in ten years' time, however, the required answer may be different. Or so implies a new paper by Bill White, the chief economist at the Bank for International Settlements, which asks: “Is price stability enough?”*

Inflation is indeed a curse on economies. High inflation disrupts steady growth, and by blurring movements in relative prices it leads to a misallocation of resources. However, stable prices do not guarantee stable economies. The bursting of

Japan

's bubble in the early 1990s and

East Asia

's economic crisis in 1997-98 were both preceded by periods of low inflation. Furthermore, recent structural changes in the global economy could mean that a low, positive rate of inflation is not always best. Thanks to the re-emergence of

China

and

India

and the productivity gains from information technology, the world is enjoying a terrific positive supply shock, which has reduced the prices of many goods. How should central banks respond?

Current received wisdom holds that if a negative supply shock (higher oil prices, say) causes inflation to rise, central banks should tolerate this so long as it does not increase inflationary expectations and lead to second-round effects on other prices. The logic is that central banks should ignore one-off changes in the price of things they cannot control. So, asks Mr White, shouldn't central banks also ignore the fall in inflation arising from a positive supply shock? To be consistent, they should allow inflation to fall below target. Instead, as the prices of traded goods fall, central banks have been propping up inflation by pursuing looser monetary policies.

Mr Bernanke would argue that back in 2003 when the Fed slashed interest rates to 1%, it was trying to prevent deflation. However, not all deflations are like that of the 1930s, a vicious circle of deficient demand, falling prices and rising real debt burdens, which further depressed demand and hence prices. Historically, most deflations have been benign, caused by technological innovation and associated with robust growth. During the rapid globalisation of the late 19th century, falling average prices went hand in hand with strong growth. Today's world has much in common with that period.

Are central banks targeting too high a rate of inflation now that

China

and

India

have boosted global capacity so dramatically? With hindsight, some of the deflation that the Fed was fretting about in 2003 was in fact benign deflation due to cheaper goods from

China

and the IT revolution. But its determination to prevent inflation falling caused it to push interest rates unusually low. This, argues Mr White, could have long-term costs to the extent that persistently easy money leads to too much borrowing, too little saving and unsustainable asset prices.

Most central banks base their policy analysis on models derived from Keynesian economics. In these, holding interest rates too low creates excessive aggregate demand and hence inflation. But Mr White believes that a model based on the Austrian school of economics, at its height between the world wars, may now be more relevant. In Austrian models, the main result of excessively low interest rates is excess credit and an imbalance between saving and investment—rather like the one in

America

today.

A fresh look at fusty tomes

There are two reasons for dusting off Austrian economics. Financial liberalisation, by allowing bigger increases in credit than in the past, has increased the risk of boom-bust cycles of the Austrian sort. Second, competition from

China

and faster productivity growth may have changed the inflation process and made traditional indicators a less useful guide to monetary policy.

Defenders of today's monetary-policy method, focused on consumer-price inflation, may say that it seems to have delivered the goods, in the form of more stable growth. So why change? One reason, suggests Mr White, is that if monetary policy is concerned solely with price stability, surges in credit will be restrained only if they trigger inflationary pressures. Ever-bigger financial imbalances could thus build up. Even if inflation remains subdued in the short term, low interest rates could either increase the risk of higher inflation in future or pump up borrowing and asset prices. Should these imbalances eventually correct themselves, there will be a sharp slowdown.

Central banks therefore need to watch a wider range of indicators, including the growth in credit, saving rates and asset prices. They should be prepared to raise interest rates in response to clear evidence of financial imbalance even if this leads them to undershoot their targets for inflation.

The snag is that in contrast to a simple inflation target, such a framework will make policy less transparent and a central bank may find it harder to explain its interest-rate decisions. Central bankers will need especially clear heads: what could be better than a brisk hike in the Austrian Alps?

*April 2006: available at www.bis.org/publ/work205.pdf