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19 December 2005 Inflation Debate Going Off the Rails by Roger Kerr The public debate about inflation
seems at serious risk of going off the rails. Confusion abounds at several levels. First, the Reserve Bank's action
to raise interest rates is widely interpreted as reflecting a desire
to slow the economy after a period of solid growth. But isn't the government's stated
aim to raise the rate of economic growth in order to lift per capita
incomes into the top half of the OECD rankings? Clearly the Bank isn't wanting
to sabotage the government's "top priority" objective.
It has correctly argued many times that low inflation and growth
are not inconsistent - indeed that the best contribution monetary
policy can make to economic growth is to keep prices stable. So shouldn't it and the government
be focusing on what is needed in other policy areas to encourage
sustained non-inflationary growth? Next, the Reserve Bank argued when
increasing interest rates last week that "overall demand continues
to outstrip available capacity". But how can New Zealand demand
outstrip the world's capacity to supply? And even if New Zealand
demand were limited to New Zealand goods and services, the proposition
is tenuous. As David Ranson, a former assistant to the secretary
of the US Treasury, has written, "Skeptics rightly question
how demand could constantly outstrip supply. Surely, demand must
originate from purchasing power, purchasing power from wealth, wealth
from income, and income from the ability to produce (and hence supply)
goods and services." 'Demand pull' and 'cost push' explanations
of inflation have fallen by the wayside in economics. The Philips
Curve was discredited by the stagflation of the 1970s. There is
no consistent relationship between inflation and unemployment, capacity
utilisation and GDP growth. Inflation is not caused by electricity
price rises, the actions of 'monopoly' businesses, union wage claims
or dearer oil. One price or several prices rising is not inflation.
Inflation is a sustained and ongoing increase in the general level
of prices. The Reserve Bank should not be
brow-beating consumers, home owners and banks about irrational behaviour.
Even if it existed it could not cause inflation; commercial banks
are likely to know more about managing their risks than the Reserve
Bank; and the Bank's own reports indicate that the New Zealand financial
system is in good shape. Milton Friedman long ago won the
debate with the demand-pull, cost-push Keynesians. As he famously
said, "Inflation is always and everywhere a monetary phenomenon,
in the sense that it cannot occur without a more rapid increase
in the quantity of money than in output." In other words, the inflation buck
stops with the Reserve Bank, full stop. Recently, US economist Walter Williams
nicely illustrated the point with a simple parable. "Pretend several of us gather
to play a standard Monopoly game that contains $15,140 worth of
money. The player who owns Boardwalk or any other property is free
to sell it for any price he wishes. Given the money supply in the
game, a general price level will emerge for all trades. If some
property prices rise, others will fall, thereby maintaining that
level. Suppose unbeknownst to other players,
I counterfeit $5,000 and introduce it into the game. Initially,
that gives me tremendous purchasing power, whereby I can bid up
property prices. After my $5,000 has circulated through the game,
there will be a general rise in the prices - something that would
have been impossible before I slipped money into the game. My example
is a highly simplistic example of a real economy, but it permits
us to make some basic assessments of inflation." Only the Reserve Bank can print
money. It alone should be held accountable for inflation and inflationary
expectations. Does this mean that monetary policy
can operate satisfactorily regardless of other policies the government
is following? No. Monetary policy needs mates. An anti-inflationary monetary policy
running up against large increases in government spending, high
local government rate increases, cost-increasing employment law
changes, excessive business regulations and the like can produce
severe strains and imbalances (particularly for exporters and those
competing with imports), as we are seeing at the present time. What it does mean, however, is
that the Reserve Bank should not be confusing public debate with
defunct economics and misplaced accusations. In respect of the housing market,
for example, it should be highlighting the cost increases arising
out of misguided 'smart growth' urban planning policies and excessive
and poorly administered building regulations. Talk of direct interventions
in the home lending and foreign exchange markets is worrying. It
could take us back to the days of Muldoonist financial controls
when governments wanted both lower interest rates and slower growth
in lending. Trying to control price and quantity independently is
sheer folly. The problem with bad ideas and bad analysis is that they can give rise to bad policies. Roger Kerr is the executive director of the New Zealand Business Roundtable. For more information, contact: Roger Kerr Web: www.nzbr.org.nz |