Stephen King: Economic ills did not begin with inflation

Although your answer to the question on inflation was, you think, near perfect, the responses to the other questions are filling you with dread. Your teacher, after all, had told you that inflation was the only thing that mattered. Yet, here were the examiners expecting you to answer questions about other things: employment, house prices, the balance of payments, government borrowing, the exchange rate, globalisation. The list was seemingly endless.

You drift home, wondering what's happened. How could things have gone so wrong? After all, wasn't your teacher's advice simply reflecting current policy priorities? Were you not responding to the repeated incantations of the Government and the Bank of England? Had they not claimed that inflation targeting was the solution to most macroeconomic ills? And had they not suggested that strong and sustainable growth was the prize that would "automatically" materialise so long as inflation remained well behaved?

With these observations, you begin to brighten up. You might be in danger of failing your economics A level but this no longer seems to matter so much. If inflation is the only thing of any concern, then much of the A level syllabus is a waste of time. Your only lasting regret is that, by studying economics, you've spent two years filling yourself with ideas from an apparently non-vocational and abstract subject with no real application in the world at large: perhaps, in hindsight, you would have been better off learning Latin or Ancient Greek.

This is an unfair caricature of the Government's and the Bank's approach to economic life. But like any caricature, it contains a kernel of truth. For UK policymakers, success on inflation has been so extraordinary that the inevitable question is: what next?

The charts show two measures of UK inflation expectations. The left-hand chart shows a measure derived from inflation-protected, or index-linked, gilts. The right-hand chart shows the results of the Bank's survey of the public's attitudes towards inflation. Although the absolute numbers differ, the striking thing about the charts is the stability of inflationary expectations.

Since 1997, when the Bank gained independence, financial markets have seldom questioned the Bank's ability to achieve price stability. This stability is all the more extraordinary given the external shocks that have come and gone in recent years. Most macroeconomic models suggest that, when oil prices rise, so does inflation. Yet, despite oil prices rising to $60 a barrel, there is barely a whiff of inflation in the UK or, indeed, almost anywhere else.

The boom in UK house prices might also seem to be a threat to price stability: after all, rising house prices was one of the reasons behind the surge in inflation in the late-Eighties and early-Nineties. Yet, this time, house-price gains have been associated with barely a ripple in inflationary expectations. I can add to this list the late-Nineties equity bubble, the strength of sterling, the global recession. These might have been expected to have influencedexpectations of inflation yet, for the most part, none has.

There are four broad reasons behind this lack of any inflationary response. First, policymakers are unanimous that price stability is a necessary precondition of economic prosperity. This belief is so enshrined that it isdifficult to find an external shock which might give rise to lasting inflationary consequences. Second, the growing independence of central banks has removed the last vestiges of short-term political opportunism and, thereby, has reduced the perceived risk of a pre-election inflationary boom. Third, globalisation, associated with heightened capital mobility and the introduction of cheap labour from China, India and Eastern Europe, has cut the bargaining power of labour in industrialised countries. Fourth, demographics are playing a social role: as the baby boomers age, the last thing they want is a return to the days of pension-destroying high inflation.

Given these circumstances, what should governments and central banks do? They can certainly afford a collective slap on the back, because the commitment made to lowering inflation and inflationary expectations appears to have worked. This, however, is not good enough. Policymakers need to recognise that economic policy problems did not begin with the arrival of inflation in the late-Sixties and early-Seventies. Before then, even if inflation was broadly quiescent, there were policy problems aplenty.

What are the other things policymakers should worry about? For central banks, the obvious things to cause sleepless nights are asset-price bubbles and their consequences for debt levels. Any attempt to pretend asset bubbles can be dealt with through the control of inflation deserves to be treated with contempt: the Twenties came to an end with the Wall Street crash and, for Japan, the Eighties came to an end with their Nikkei crash. Yet in neither case was there a whiff of inflation.

As for governments, fiscal policy remains all-important, yet most countries have difficulty working out where fiscal policy is heading. In the eurozone, the Stability and Growth Pact has evolved so much it is losing all meaning. Elsewhere, deficits have got bigger, yet, with ageing populations, it is not obvious that governments should be borrowing: think of those unfunded future pension liabilities that are off balance sheet.

And nations have to come to terms with globalisation as it is, in part, a windfall event. True, the World Trade Organisation and the Gatt rounds contributed to a removal of trade barriers. But the main factors driving globalisation have been exogenous: new technologies and the opening up of trade and capital flows with previouslyexcluded countries and regions.

Yet the consequences of globalisation appear to be poorly understood and politically charged. Current account imbalances are bigger. Policymakers fret about them. But in a world of mobile capital, current account imbalances can be sustainably bigger. So how big is too big? Inflation targeting may work for individual countries but, if countries are at differing stages of development, nominal exchange rates will have to adjust. If they don't, countries may find it difficult to hit inflation targets - whatever happens, real exchange rates will always adjust, either through nominal exchange rate changes or through inflation differentials. Countries may accuse each other of unfairness, but knowing what is unfair isdifficult. Are cheap imports from China unfair, or are attempts to exclude Chinese workers from the global economy through protectionism the injustice?

These issues should be of interest to A level economics students. And they should also be of interest to policymakers, who have to decide which aspects they can afford to exert control over. None of the issuescan be dealt with through inflation targeting. Perhaps it's time for the policy framework to move on, for policymakers to admit that even if some of our economic problems have been solved, there are plenty of challenges ahead.

Stephen King is managing director of economics at HSBC

stephenking@hsbcib.com

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