Earlier this week I suggested “Why Positive Money is Wrong” (read here). Prof John Weeks wrote this post in response, looking at the issue of the 2% inflation target. It was first published on Brave New Europe. John Weeks is Professor Emeritus at SOAS, University of London, and associate of Prime Economics.
The recent article by Richard Murphy clearly and succinctly demonstrated the fallacies of monetary arguments set forward by Positive Money. I write to elaborate one of his five points, the critique of policy seeking to attain and maintain a specific inflation rate, “inflation targeting”. Murphy explained the basic flaw, that inflation targeting is dysfunctional and politically reactionary. My focus is more narrow, that the 2% target of both the Bank of England and the European Central Bank is bad policy because technically unsound.
The European Central Bank aims for a target rate less than 2% of a measure named the Harmonized Index of Consumer Prices, while the Bank of England uses the so-called CPIH measure. Both measures share the flaw of including of internationally traded commodities, over which neither the ECB nor the Bank of England has any substantial influence.
By definition the rate of inflation equals the sum of price changes for internationally traded goods and services, price changes in constrained markets, and changes of domestic (“non-traded”) goods and services in unregulated prices. The first category includes all those goods and services whose domestic price is determined in international markets. The most obvious example is petroleum, as well as almost all producer inputs. Airline fares and shipping charges are services whose domestic prices closely follow international petroleum prices.
The second category includes all prices set by contract or public sector regulation. The importance of this category will vary across countries. Examples are public utility pricing (water and gas), public services and some modes of transport (e.g. railroad and bus fares). In the third category fall all goods and services relatively unaffected by international markets, public regulation or private contracts.
The inflation target rule requires the sum of the price changes for these three categories be close to w 2%. A rise in internationally determined prices above 2%, for example an oil price increase, is beyond the control of the ECB or the Bank of England. Therefore, the prices in one or both of the other categories must rise less than 2% in order to meet the inflation target. However, many goods and services in the second category have prices relatively inflexible in the short run because of public regulation and private contracts.
As a result all the greatest adjustment must occur for domestic goods and services in unregulated markets. The lowest-paid workers tend to find their employment in these markets precisely because they are unregulated — employees not in trade unions and many self-employed such as care workers. The nature of the three types of markets implies that meeting an inflation target tends to reinforce and increase inequalities.
The market structure of every economy also undermines the effectiveness of targeting as an example shows. If half of all goods and services fall into the first two categories and these prices rise by 3%, then prices in unregulated domestic markets can only rise 1% to meet the ‘less than 2%' target. It is likely that the first two categories take a considerably larger share than half in Britain and most continental countries, which means no increase or even deflation in unregulated markets. Even if international prices transfer only slowly into domestic prices, the principle remains, that the unregulated markets must bear the weight of adjustment.
More serious is that ‘less than 2%' is an unsound target, for an even more fundamental reason. Twenty years ago the Boskin Commission in the US estimated that new products and quality change account for between 0.8 and 1.6 percentage points in the US cost of living index, taking 1.1 as “best estimate”. In a world of globalized markets and production, the British and EU estimate is unlikely to be very different. Therefore, an inflation target below 2% de facto aims for an effective rate of less than 1%.
The benefits of a capitalist economy come from its dynamism, the continuous reallocation of resources in response to technical change and shifts in consumer preferences. This allocation occurs through price adjustment. For example, workers move between sectors in response to wage changes. Some wage inflation and therefore price inflation are inherent in the efficient operation of a market economy. The (less than) 2% inflation target is in theory and practice deflationary, achieved by suppressing the price adjustments essential to economic growth.
Inflation targeting is dysfunctional in principle. Assigning this dysfunctional rule a target of 2% is absurd and technically unsound.
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Good piece. JW makes the interesting point that a 2% target may suppress economic activity, and indeed the historical evidence is that growth is higher when inflation is higher.
There are, I believe, even more important points, such as how an inflation target drives up wealth inequality, and is a deliberate policy by the owners of capital to empower and enrich themselves at the expense of workers, in order to suppress the fact that it is really the workers who are the foundation stones of the economy and the real drivers of growth.
It is worth reading Adam Ferguson’s ‘When money dies’ about Germany’s hyperinflation, if only for the anecdote about a plumber who does not suffer because he can raise his prices everyday and trade his skills for the essentials of life.
Working people with real skills has nothing to fear from a bit of inflation because their human capital is what really counts, not the artificial metric of money (people without the capability to work need to be protected by their community, i.e. the state).
Still I think that we need some kind of feedback loop to prevent hyperinflation. My preferred measure would include asset price inflation so it would not be possible to merrily go along constraining wages at less than 2% while house and share price increase at 10%. Taxing capital assets would be one to constrain asset price inflation and maintain an dynamic equilibrium in the income and wealth distributions.
Agree with all that last para Charles
On which subject (can’t think where else to put this) perhaps we should be keeping a weather eye here http://thecorner.eu/news-europe/vollgeld-a-referendum-about-money-in-switzerland/72808/
because they’re having an interesting referendum:
“1) That the Swiss central bank is the only organisation authorised to create money. Not just notes and coins as it currently does, but also the electronic or digital money which appears in current accounts.
2) That creating money is a separate activity from granting loans. The banks will continue to offer services they currently supply for private and corporate clients (banks accounts, payment services, loans etc.). But they would not be able to create money via the concession of a loan, which is the case at the moment. To be able to grant a loan, they would have to borrow the money from someone who already has it.
If the monetary reform proposal is approved, 100% of the money — physical or digital Swiss francs — would be exclusively created by the Swiss State via its central bank. So the creation of money which is currently 90% privatised would become 100% public. That’s where the name sovereign money comes from”
And Positive Money would destroy the Swiss economy
This is economic madness, I have to say
I believe in MMT – but not this
Very interesting, Bill.
The Swiss referendum proposal fully recognises the role of endogenous money, assumes that most people are aware of it (?) and then seeks to be rid of it.
What they are proposing there is reminiscent of the old, pre-deregulation idea of “asset management” (as opposed to the post-deregulation “liability management”). Under “asset management” rules a bank could lend no more than it held in deposits, or that was the basic idea as I recall. This suggestion takes the whole idea a step further and suggests that they can’t even do that. They would have to borrow (everything) short and lend long.
I notice the the article you linked didn’t mention what would happen to interest rates under this proposal. If the proponents are like the Positive Money mob interest rates would be “left to the market”.
This looks like a return to the old Friedmanite monetarism (‘verticalism’) with the new addition of a ban on endogenous money (Hmmm.). As such it seeks to enforce the (even older) Quantity Theory of Money (oh dear).
At any rate it seems as if a Positive Money style “NGO” managed to use the law to get a referendum without much chance of winning it. As an attention-seeking publicity stunt its probably a good one from their point of view.
We just have to hope they lose
For the sake of the Swiss that is
I find it quite odd to say that
The MMTer Rodger Mitchell recently attempted to get to grips in an article on the causes of inflation the takeaway from his article would appear to be that the comparison graphing of inflation trends with suspected causes is always worth the effort.
https://mythfighter.com/2018/03/17/what-is-the-complex-relationship-among-inflation-deficits-interest-rates-oil-prices-tax-cuts-and-gdp/
However, this is not infallible given suspected causes of deflation or moderation are rarely identified and certainly as a few economists recognise China’s deployment of currency rigging and subsidisation of its exporting industries has played a large role in moderating inflation in many countries.
Totally agree re last paragraph Schofield but beware of Rodger Mitchell. he can be a real blowhard at times (often). He has little discipline and a lot of what of he says seems to come straight off the top of his head.
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