Tuesday, March 02, 2010

Pre Emptive Economics #3 and some notes on Inflation

I've long been a bit of an inflation dove, and right now I'm quite happy to see Olivier Blanchard at the IMF agreeing with me on the whole subject of dealing with inflation. In particular he's suggesting changing the inflation target from 2% to perhaps 4%. David Smith posts his objections to the idea here. Personally I find this arguments a little weak.

Firstly:
It is wrong because, while I am no inflation nutter, adopting a target that doubles the price level every 15 years seems to me irresponsible. It is wrong because it would endorse every suspicion in the bond market that governments will seek to inflate their debt away, rather than go through the hard job of raising taxes and reining back spending. It would be a surefire way of igniting a huge sell-off in government bond markets.
My problem is not really economic, it's political. My probelm with David's argument is that it approaches the issue with rights of debt holders first and foremost. What I believe we have in this situation is a trade-off  between a government's obligations to it's creditors and it's obligations to it's citizens. Naturally, I believe that in a democracy the latter should come first.

Further to this, I think it's worth considering how outstanding financial contracts will affect economic growth. In the current economic state of affairs the government, corporations and citizens are all heavily indebted. The upshot of this is that we are likely to see low investement and low consumer spending. Debt, as it stands is likely to be a major drag on economic growth, it may even drag the economy back into recessions. The government's creditors might not like losing out to inflation, but it's a damn sight better than the government getting into the situation where it has to default.

...he continues...
Most of all, I think it is technically wrong. Imagine if, over the past 10 years, Britain had had a 4% inflation target. Most of that period, inflation was below 2%. To inflate up to the higher target, interest rates would have needed to have been lower rather than higher. A 4% inflation target might have been associated with a typical Bank rate of 2% or 3%, rather than 7%. The future will be different from the past but perhaps not that much. A higher inflation target would have meant an even bigger boom is asset prices.
I'm not sure about this myself, there are a good few arguments against this. Firstly, it could be argued that low inflation provided an incentive to banks to expand their loan books throught he use of derivatives. The financial crisis was a problem of plentiful money more than one of cheap money. Further to this inflation has the effect of reducing the nominal amount of any liabilities meaning that financial institutions would have had fewer problems with the build up of risk.

At the end of the day, 2% seems a pretty arbitary figure so I don't really see any reason why change would necessarily be a bad thing.

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