Stephen King: Memo to Gordon... think radical and dump the Bank's inflation target
Monday 20 October 2008
Whisper it quietly, but it's just possible that the Bank of England's inflation target contains a fatal flaw.
Inflation targeting was designed to put the UK economy on the straight and narrow after years of excess. Introduced in the early-1990s by the Conservatives, the credibility of inflation targeting was bolstered by Gordon Brown's decision to grant the Bank of England operational independence in 1997. Back then, it suited the Government's purpose. New Labour claimed to have abolished "boom and bust". This, of course, was a foolish boast.
My point, though, is more subtle. Rather than providing a path out of the current mess, credible inflation targeting may be making things worse. To understand why, think about what's been happening over the last year. House prices have plunged. Credit markets have imploded. Equity markets have crashed. Commodity prices are in freefall. Banks won't lend to each other. Iceland offers a frozen financial tundra. Cash is being stuffed under the mattress. Companies can't get credit from banks.
These events mark a crisis of confidence in financial system not seen since the Thirties' Depression. They also reflect a desire to hold money at any cost. Cash is king, queen, emperor; all-powerful. Financial panics are about fear. Fear others will sell their shares, or their bonds, or their houses before we do. Fear others will keep their jobs while we lose ours. Fear the friendly bank manager will turn their backs on us. So, we hoard what should hold its value come what may. Cash. It does this well if the central bank, through its inflation target, is guaranteeing the value of cash.
While the blame for the crisis is passed from bankers to regulators to governments to hedge funds and on to Iceland in a grotesque game of musical chairs, the biggest current problem is a huge collapse in confidence which is leading to cash hoarding.
What does a sudden increase in demand for cash do to an economy? The more cash is stuffed under the mattress, the lower demand. That means falling prices, falling wages and deflation. Deflation increases the real value of debts. They're forced to spend less to deal with these debts and it's only a matter of time before the economy is facing an Irving Fisher-style debt deflation. If we all hoard cash, the economy will collapse.
It's the madness of crowds. Hoarding cash is what you do if economic uncertainty increases. But it is the road to ruin. The economy implodes and life is never the same again.
An inflation target makes things worse for two reasons. First, a credible inflation target provides certainty for the value of cash. So the credibility of the central bank can be self-defeating during times of financial fear. Second, inflation targeting supposedly lets bygones be bygones. If prices fell last year, or over the last few years, this supposedly makes no difference to the inflation target in the years ahead. But, as prices fall, real debt levels go up. Letting bygones be bygones alongside deflation increases the need to pay off debt quickly. If everyone does this, demand slumps and prices fall more.
So cash becomes a one-way bet. A government's or central bank's promise not to create inflation makes cash enormously attractive. If, in a world of fear, people want to liquidate their risky assets, they're sensible to want to hold cash. Inflation is supposed to be neither too high nor too low. But that approach assumes the Bank of England is able to control the economy through interest rates. If, though, the banking system is under severe stress, it's not at all obvious the Bank's actions will be taken seriously. After all, even with the handful of rate cuts we've seen, the true cost of credit has gone up and its availability has gone down.
So, what is to be done? First, the Government shouldn't just borrow to bail out banks. Even if the capital injections work, banks won't be able to deliver the loan volumes we're used to. A credit shortage will remain. In the absence of private demand, public demand will have to go up. Reports suggest that this is what the Chancellor of the Exchequer intends to deliver in his pre-Budget report. Second, the Government and the Bank need to redefine the monetary objective.
Rather than an inflation target, we need a price level target. This creates extra symmetry which reduces monetary hoarding. If prices fall, as a result of the deflationary consequences of cash hoarding, the Government and the Bank must push prices back up. Put another way, a price level target provides a greater degree of stability for real debt levels and reduces the chances of Irving Fisher-style debt deflation.
A price level target, though, requires the co-operation of both the monetary and fiscal authorities. In the absence of a banking system, another mechanism is needed to pump money into the economy to counter cash hoarding. Thankfully, John Maynard Keynes provided the answer in the 1930s. The Government sells gilts directly to the Bank of England and the Bank creates cash for the Government to use for tax cuts or spending increases. By threatening to create inflation, the incentive to hoard cash dissolves and deflationary threat recedes.
There are some problems with this approach. Might the fear of money creation lead to higher gilt yields or a fall in sterling? Perhaps so, thought the policymakers of the 1930s as they contemplated a shift away from the gold standard. Their resistance was wrong then and it's in danger of being wrong again. When markets implode, sticking to conventional wisdom will surely throw the economy to the dogs.
Stephen King is managing director of economics at HSBC firstname.lastname@example.org
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