Keynes, monetarism and now inflation targeting failed.
So let's dial back and try all three...!
ONCE UPON a time, the world was split
into 'free' and 'Communist'. It made spotting the bad guys real easy, writes
Adrian Ash at BullionVault.
A nice variant applied closer to home, dividing the UK
between 'Labour' and 'Tory'. And for teenage schoolkids, this mapped onto
economics as 'Keynesians' versus 'monetarists'.
The first group said governments could boost growth by
spending more and taxing less...or vice versa. But there was never much
versa, as the monetarists noted, and that lower tax thing never came off. Keynesianism proved itself false – deadly in fact – with
the long inflation crisis of the 1970s.
No, what counted now was the money supply. Hence the name.
Monetarism said growth rose and fell with the amount of money and credit
supplied to an economy. So central banking, not government spending, was in
fact the answer. The authorities could boost GDP by cutting interest rates to
encourage new debt. But first they needed to tame inflation by setting rates
higher than any time outside pre-modern wars.
It worked, or seemed to, in the way that all cargo cults take hold at first. So by the time I was
subjected to a high school education, monetarism ruled, moving from academic
theory to a radical policy to the way things simply were inside two decades.
At least, that's what we were told.
But monetarism, as in the life-cycle of all such ideas,
had already gone a step further. The final step, in fact.
Yes, its key insight – the so-called 'M' aggregates of
money supply – still appeared nightly on the TV news. It's still reported by
many central banks today each month as well. But long before economics
disturbed my adolescence, monetarism had already started to fail, and was
being replaced a new model of how the world should work.
See, in the early-to-mid 1980s, the money supply numbers
stopped doing what they were supposed to. Central bankers still trimmed interest
rates here, nudged them up there, and messed about with reserve ratio
requirements. But the M2, M3 and M4 aggregates – counting notes and coin in
circulation, plus various measures of cash on deposit, short-term bills and
other 'near-money' assets – no longer responded, running wild as if with a
mind of their own.
Inflation sort of went down and growth kinda went up, as
hoped. But while the policy decisions seemed to be working, the money-supply
numbers supposed to inform them just didn't fit. And if the model
doesn't fit reality (or vice versa), it needed replacing. A new theory and
practice was needed. Academics delivered it right on cue.
Inflation targeting was what counted. Because hey, low
inflation allowed strong growth, just so long as inflation didn't slip too
low into the dreaded "deflation". So a target of, say, 2.0% per
year for rises in the Consumer Price Index meant central bankers could keep
everything rosy for Goldilocks – not too hot, not too cold, but just right –
again by trimming rates here, or nudging them there. Only now, central
bankers really understood how their actions affected the world, and the
mechanism was much easier for the public to understand too.
The 'long boom' of the 1990s and early 2000s proved this
new idea of inflation targeting to be perfect. Right up until it wasn't.
"Keeping inflation stable at a moderately low level
is important," said Fed chair Janet Yellen earlier this fall in a lecture at the University of Massachusetts,
"because inflation that is high, excessively low, or unstable imposes
significant costs on households and businesses.
"[But] the Federal Reserve has not always been
successful in fulfilling the price stability element of its mandate."
No fooling. Inflation overshot going into the financial
crisis. Zero rates and QE money creation has since failed to stem its slide
towards the dread zero. Twiddling the dials and pulling the levers is no
longer working...if indeed it ever did. Maybe, just maybe, the central
bankers aren't in fact in control.
The US Fed today targets 2.0% annual inflation. So
does the Bank of England, the European Central Bank, and pretty much every
other 'monetary authority' you can name. They judge that level as the sweet
spot for price rises – too low to hurt anyone with 1970s-style price hikes,
but a safe distance from letting shop prices fall, destroying profit margins,
delaying consumer spending, and making debt ever-more expensive in real
terms.
Inflation since the financial crash however has gone AWOL,
despite interest rates at the lowest levels in history. The Fed met this
month with headline US inflation running
at zero from 12 months before. So-called 'volatile' fuel and food aside
(not part of anyone's cost of living, right?) it may as well have raised
rates, instead of staying put for the 83rd month in succession. Because
holding rates at zero ain't working.
Some academics spotted the problem soon as the Lehman's crash hit.
Indeed, the Bank of England's philosopher chief Mervyn King – governor during
financial crisis part 1 – had warned about the worsening wrinkle in monetary
theory and policy as far back as 2002.
"Acceptance of the idea that inflation is a monetary phenomenon
has been accompanied by the lack of references to money in the conduct of
monetary policy during its most successful period. The disappearance of money
[supply aggregates] from the models used by economists is...more apparent
than real...[But] nevertheless, there are real dangers in relegating money to
this behind-the-scenes role."
Ignore the self-praise. Monetary policy's "most
successful period" in fact accompanied the most fertile credit bubble in
history. And when it burst, the Bank of England – like the Fed, European
Central Bank, Swiss National Bank and most notably the Bank of Japan –
quickly ran straight back to monetarism, applying the biggest dose of
money-supply medicine in history.
Slashing rates to try and boost credit, they also pumped
new money straight into the banking system in the hope of avoiding deflation.
Just like King's former academic colleague at Princeton Ben Bernanke had
theorized, also in 2002, when he told Japanese policymakers that fixing their
soft, slow deflation would take but a moment's work through the magic of ink and
paper.
"The US government has a technology, called a
printing press (or, today, its electronic equivalent), that allows it to
produce as many US dollars as it wishes at essentially no cost. The
government can [thus] reduce the value of a Dollar in terms of goods and
services, which is equivalent to raising the prices in dollars of those goods
and services...Under a paper-money system, a determined government can always
generate higher spending and hence positive inflation."
Yet reviving the old, discredited model of monetary policy
by running a trillion volts of electronic cash through it failed to revive
inflation in the US either when its turn came. Still price levels stay static
today. Inflation targeting is broken, and frantic monetarism hasn't worked
either.
Central bankers need a new idea. Academics are happy to
oblige.
Stumble into the senior common room today, in fact, and
you'd think you ate the wrong mushrooms for lunch...
"Martin and I are in agreement...the merits of
money-financed cash transfers (helicopter drops) overwhelm the alternatives
[of abolishing cash and setting negative interest rates]..."
Doesn't the food taste strange to you?
That last soundbite isn't so academic. It's actually
Citigroup economist Steven Englander, a managing director at US bank
Citigroup's research division. And the idea of Helicopter Money...showering
cash onto private households as a gift they can spend at will...is breaking out
of the lecture hall just as Keynesianism, monetarism, and inflation targeting
did before it.
You might fear this ends badly, or simply find it insane
to begin with. Because the world is not short of money today.
"Of course," said Ben Bernanke back in his famous 2002 speech about how easy it was to defeat
deflation, "the US government is not going to print money and distribute
it willy-nilly."
Not even Ben Bernanke could see the pretty pass through
which monetary academia is about to push us.
