Root cause of economic instability

Christopher Lingle , Bangkok | Thu, 07/03/2008 10:38 AM | Opinion

With no end to increases in the price of oil and many other commodities, inflation has begun its stranglehold on economies around the world. In the U.S., consumer confidence is at a 16-year low in June while inflation expectations are at a recent record high.

It was not meant to be this way. Indeed, it did not seem so even yesterday.

As it is, central bankers have been basking in praise for adopting inflation targeting that seemed to offer a mix of high economic growth with low rates of price increases.

These inflation-targeting regimes used monetary policy to hit a publicly-announced target for changes in price levels, usually by manipulating short-term interest rates.

The Bank of England is generally credited with pioneering modern inflation targeting that met with success in holding price level changes within a targeted range. With the specter of inflation unleashed on the global economy, bouquets have quickly been turned into brickbats,

It turns out that none of the source of pride or the cause of the fall is new. Indeed, East Asia up to 1997 and Argentina until 1998 were seen as havens of "good" macroeconomic data before collapsing into deep economic and financial turmoil.

Then as now, loose monetary policies of central banks created localized or regional bubbles. In Argentina, excessive public-sector borrowing driven by low interest rates in Argentina boosted a bond bubble that brought debt to an unsustainable level.

In both instances, macroeconomic stability soon gave way to microeconomic collapse that saw currency values plummet and financial insolvencies soar.

As a prelude to the harsh reality of rising inflation, central bankers conjured up massive amounts of excess global liquidity that most recently spawned commodity bubbles. The inevitable response to out-of-control price increases is ending irresponsibly-loose monetary policies to halt a bogus boom, possibly setting off a deep and widespread recession.

What is now clear is that maintaining a "stable" rate of inflation was a veil behind that masked microeconomic distortions that morphed into macroeconomic instability.

This is especially ironic since support for setting inflation targets comes from a belief that when central banks stabilize price levels, market mechanisms will operate better.

The logic is that an increasing price level is acceptable if it is stable and predictable. As such, price stability does not require central banks to oversee low rates of price increases. What is important for inflation targeting to "work" is that rises or falls in the general price level be anticipated. Yet inflation targeting has been consistent with substantial economic instability.

Besides setting conditions that led to the high inflation rates coursing around us, a predictable and stable rate of price increases create various forms of deadweight losses.

First, consider that the logic of inflation targeting to insure price stabilization assumes that money is "neutral" with respect to effect of the rate of money growth on the real economy. This means that putting more money into the system will only change the price level whereas the relative prices of goods and services remain unaffected.

This is surely wrong. As it is, relative prices of goods and services within market economies are not established independently of some form of money. Monetary prices of goods are determined by the demand and supply of these goods in simultaneous conjunction with the demand and supply of money. Therefore, the notion of monetary "neutrality" as far as relative prices of goods is absurd.

An increase in the money supply does not enter the economy with each person receiving the same amount of money at the same moment. The reality of an uneven inflow of new money changes relative demand for goods so that relative prices will change.

And increasing the money supply causes real wealth to be redistributed away from those that receive the new money later than the others. But earlier recipients have increased real wealth that changes their demand for goods and services that alters the relative prices of goods and services.

Another challenge to the assertion that stable and predictable price increases under inflation targeting are "neutral" with respect to the real economy concerns "bracket creep" in tax liability. As incomes rise to compensate for lost purchasing power from rising price levels, some individuals will move into higher marginal tax rates.

Similarly, "stable" prices that rise predictably and consistently can lead to "phantom" capital gains from rising prices rather than a change in real scarcity. This tends to inspire attempts to avoid higher tax liabilities that will reduce the availability of capital.

Most central bankers think of inflation in the narrow terms of rising consumer prices as measured by an arbitrary indicator like a consumer price index (CPI). But a rising CPI is just one of several possible results of rapid growth in the money supply.

Asset bubbles, an increased trade deficit and a depreciating currency can all be caused by an inflated money supply even with a "stable" CPI.

As such, it must be counted as a failure that inflation targeting did not address asset and commodity bubbles. For their part, inflation targets guide central bankers in deciding how to implement monetary policy to stabilize prices rather than to minimize the effect of price rises on the real economy. this approach tends to introduce extensive distortions into the real economy.

It is hard to resist the logic that inflation targeting and interest manipulations that accompanied it caused most of the ongoing financial instability and various asset and commodity bubbles.

When central banks realize that their cheap-credit policies drive asset bubbles, they may stop meddling with interest rates and put tighter controls on money supply growth and credit growth.

The writer is Research Scholar at the Centre for Civil Society in New Delhi and Visiting Professor of Economics at Universidad Francisco Marroquin in Guatemala. He can be reached at Clingle@ufm.edu

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