Post-modernists claim that you have to treat “texts” like a puzzle, where the author is making one set of assertions, but the real meaning is hidden beneath the surface. In that spirit, I’d like to deconstruct a recent article on inflation in The Economist:
The inflation of the 1970s had its origins in the 1960s, with economists who believed that a bit more inflation could buy lasting lower unemployment. The natural-rate-of-unemployment hypothesis of Milton Friedman and Edmund Phelps, the rational-expectations revolution and the dismal experience of the 1970s all put paid to that idea. Politicians, aware that high inflation often brought regime change, accepted the idea that central banks should be left to concentrate on inflation. The latest crisis has demonstrated that price stability is no guarantee of financial and economic stability—indeed, a narrow obsession with prices may have led central bankers to neglect asset bubbles and the condition of the banks. Yet in practice price stability has not been dislodged from the centre of central banks’ attention. If anything, some seem anxious to unwind their quantitative easing and normalise interest rates despite the prevalent deflationary pressure.
It seems to me that there are many ways of reading this paragraph. Recall my argument that the Fed should try to generate more inflation in order to boost economic recovery. Is my argument consistent with The Economist’s take on things, or inconsistent? Am I arguing for “price stability” or am I peddling a discredited theory that inflation can reduce unemployment? I think I am arguing for price stability, and simply applying the Friedman/Phelps hypothesis, but I’ll bet most readers of The Economist would reach a different conclusion.
Let’s start with what The Economist means by ‘price stability.’ Do they mean stable prices, or do they mean a steady 2% inflation rate? You might say; “It’s obvious, price stability means price stability, i.e. zero inflation.” But there are two problems with that interpretation. First, when The Economist suggests that price stability didn’t insure economic stability, they are almost certainly referring to the Fed and ECB’s policies, which are better described by a 2% inflation target than a 0% percent inflation target. And second, look at what The Economist has to say about the one developed country that actually did have (CPI) “price stability” in the 5 years leading up to the 2008 crisis:
If anything, the record of quantitative easing in Japan should heighten worries of deflation. As Adam Posen of the Peterson Institute for International Economics notes in our forum, it “did not have a predictable or even large short-term result…We need more humility about what we are capable of doing with monetary policy once deflation begins.”
Japan is treated as an example of failed monetary policy, a country that failed to produce “price stability.” And yet in the 5 years preceding the crisis, the Japanese price level was far more stable than then US or Eurozone price levels. OK, what if I am right that by ‘price stability’ The Economist really means 2% inflation? That would cast an entirely differently light on the first paragraph I quoted. If price stability is actually 2% inflation, then it is not true that price stability failed to produce “economic stability.” Indeed, what happened is that the world economy plunged in late 2008 precisely when central banks diverged from a policy of “price stability.” How do we know? We need look no further than another article from the same issue of The Economist:
Judging by the discussion in a new online forum of more than 50 leading economists from around the world, which The Economist launched this week, deflation is the bigger short-term danger in big, rich economies, whereas inflation is an immediate worry in many emerging economies and, potentially, a longer-term danger in rich ones.
That seems a fair assessment. In America, the euro area and Japan, deflation is either uncomfortably close or a painful reality, despite near-zero interest rates and other efforts by central banks. In the year to April core consumer prices rose by a mere 0.9% in America, the slowest pace in four decades. In the euro area they rose by 0.7%. And in Japan, which has battled falling prices for more than a decade, they fell by 1.5%.
So inflation began falling sharply below the 2% “price stability” range precisely when the world economy went into free fall in late 2008. How might people respond to my argument? I suppose they might argue that I have reversed causation; that inflation fell sharply because of the recession, rather than the fall in inflation causing the recession. As you know, I prefer to focus on NGDP. The sharp fall in NGDP caused both the fall in inflation and the fall in RGDP. This should be the standard view of almost all macroeconomists (excepting those who favor real theories of the cycle.) But for some reason it isn’t. The question is why.
I think The Economist would agree that if monetary policymakers had kept NGDP rising at trend, and inflation no lower than 2%, we would not have had a severe recession. Except for the unusual case of 1974 (a severe supply shock) recessions are almost always associated with lower NGDP growth. If we still had 2% inflation, the recession would almost certainly have been very mild.
So why does The Economist imply that a policy of “price stability” failed to ensure economic stability? I think there are two reasons. First, they think the financial crisis (not falling inflation) caused the recession. And second, they don’t think monetary policy could have done much to prevent the fall in inflation. I plan to do another post soon using data from the IMF, which I believe shows pretty conclusively that the financial crisis was almost entirely due to falling NGDP, and only a small part was due to foolish lending that would have gone bad even with briskly growing NGDP. But for now let me focus on the second point, which I think is the sine qua non of The Economist’s assertion. At the end of the first article I linked to, they made this claim:
With the exception of Japan, there have been few instances of governments pressing central banks for more expansionary policies. To be sure, there’s not much more they could do. But perhaps politicians, like central bankers, are not yet ready to discard orthodoxy.
Not much more they could do? What in the world would make The Economist think that monetary stimulus could not easily boost inflation right now? Here’s what. Go back to the second quotation, when Adam Posen expresses skepticism about the ability of monetary policy to arrest inflation. And why does he express skepticism? Because of what The Economist calls “the record of quantitative easing in Japan.” This is where I start to feel like Paul Krugman, wanting to grab the world by the shoulders and scream “wake-up people.” For the 100th time, inflation targeting in Japan didn’t fail because IT WAS NEVER TRIED. The evidence is absolutely overwhelming that the BOJ didn’t want even 2% inflation. The BOJ behaved exactly like a central bank who wanted to keep CPI inflation at 0% or slightly below, and they have succeeded in that objective better than almost any other central bank in the world. Here’s the evidence:
1. They twice tightened monetary policy (in 2000 and 2006) when Japan did not have any inflation. They did this by raising interest rates. What does that tell you?
2. The monetary injections of 2002-03 were temporary, and withdrawn in 2006, despite the fact that there was no inflation. Temporary currency injections are not stimulative.
3. They let the yen appreciate sharply from about 115 to 85 to the dollar, despite falling prices in Japan.
4. They continually refuse to set a positive inflation target, as the Fed and ECB have either implicitly or explicitly done.
5. They refuse to do level targeting, which is known to be very helpful during deflation. This would force them to make up for past deflationary mistakes.
When will people stop talking about the BOJ as some sort of helpless victim of deflation who did all they could, and recognize that they are an extremely reactionary central bank, much more so that the Fed or ECB?
Why is this important? Because if you recognize that a regime of level targeting can prevent deflation, even during a financial crisis, then you also recognize that it can prevent a severe demand-side recession in the wake of a financial crisis. And you will also see the current fall in inflation to levels far below “price stability” as a failure of monetary policy, not some sort of inevitable side-effect of a recession that was caused by financial distress.
To summarize, The Economist should have written the following; “Price stability worked well up until 2008. When central banks switched to a more deflationary policy we got the severe recession predicted by the Friedman/Phelps Natural Rate model. Monetary policy can prevent this from occurring with level targeting of prices, or better yet, NGDP. Oh, and the tight money also made the financial crisis much worse.”
While we are deconstructing The Economist, think about this. The article focuses almost entirely on monetary policy, with almost no discussion of fiscal policy. Now I don’t have a big problem with that, as I believe monetary policy drives inflation, and fiscal policy has only a minor effect. But here is what I object to. When mainstream publications like The Economist talk about ideas for stimulating the real economy to boost growth and lower unemployment, they almost always spend a lot of time on fiscal policy. I don’t see any theoretical justification for this dichotomy in any of the mainstream macro models that journalists rely on. Those models say that both fiscal and monetary stimulus boost both prices and output. The tendency of journalists to talk about inflation in the context of monetary policy and real growth in the context of fiscal stimulus is very revealing. They have some non-mainstream model in their minds, but for the life of me I can’t figure out what that model could possibly be.
To end on a more positive note, I really like the first paragraph of the first article I cited in The Economist:
IN THE short run inflation is an economic phenomenon. In the long run it is a political one. This week The Economist asked a group of leading economists whether they reckoned inflation or deflation was the greater threat; this was our inaugural question in “Economics by invitation”, an online forum of more than 50 eminent economists. The rough consensus was that in the near term, as Western economies struggle to recover, the bigger worry there is deflation. But as the time horizon lengthened, more experts cited inflation, because it seems the most plausible exit strategy for governments trying to deal with crushing debts.
I feel bad being so critical of a magazine that invited me to join 49 other much more esteemed economists. Think of it this way. I subscribe to the paper edition of The Economist because it is the best magazine/newspaper in the world. That’s where I found the article. Similar perspectives can be found in any other serious publication. So don’t take it personally Mr. and Ms. Anonymous Journalists at The Economist—I still love your work.