So, weirdly, I recently found out that Joseph Stiglitz is married to my old babysitter. Apparently, they are blissfully in love, with the local gossip reporting that they are so happy as to make those who know them madly jealous.
This has absolutely nothing to do with inflation targeting, the actual topic of this post. However, I thought that this fact was too bizarre not to pass on.
Anyway, one of my liberal arch-nemeses who is unfortunately really smart and engaging both in writing and in person, points me to this Joseph Stiglitz column on inflation targeting. It doesn't seem to have garnered much attention in America, which is surprising because it's pretty strong stuff:
The World’s central bankers are a close-knit club, given to fads and fashions. In the early 1980’s, they fell under the spell of monetarism, a simplistic economic theory promoted by Milton Friedman. After monetarism was discredited – at great cost to those countries that succumbed to it – the quest began for a new mantra.The answer came in the form of “inflation targeting,” which says that whenever price growth exceeds a target level, interest rates should be raised. This crude recipe is based on little economic theory or empirical evidence; there is no reason to expect that regardless of the source of inflation , the best response is to increase interest rates. One hopes that most countries will have the good sense not to implement inflation targeting; my sympathies go to the unfortunate citizens of those that do. (Among the list of those who have officially adopted inflation targeting in one form or another are: Israel, the Czech Republic, Poland, Brazil, Chile, Colombia, South Africa, Thailand, Korea, Mexico, Hungary, Peru, the Philippines, Slovakia, Indonesia, Romania, New Zealand, Canada, the United Kingdom, Sweden, Australia, Iceland, and Norway.)
Today, inflation targeting is being put to the test – and it will almost certainly fail. Developing countries currently face higher rates of inflation not because of poorer macro-management, but because oil and food prices are soaring, and these items represent a much larger share of the average household budget than in rich countries. In China, for example, inflation is approaching 8% or more. In Vietnam, it is even higher and is expected to approach 18.2% this year, and in India it is 5.8% . By contrast, US inflation stands at 3%. Does that mean that these developing countries should raise their interest rates far more than the US?
I'm not sure I'd call inflation targeting a fad. Nor would I call monetarism discredited. Targeting money supply growth with a fixed rule has been abandoned--indeed, even Uncle Miltie conceded that it had failed. But the central insight that inflation is always and everywhere a monetary phenomenon still seems to have legs. It seems especially odd to say that inflation is rising because oil and food are a large share of household budgets, because central banks usually pay much less attention to headline inflation than to "core" inflation, which excludes volatile food and energy prices. Increases in the relative price of even important goods that have become scarce is not really what Milton Friedman was talking about; he was referring to an increase in the general price level, which indicates that the money supply is growing faster than demand.
A huge portion of the inflation in China and Vietnam comes from the fact that their financial systems are extraordinarily primitive--better than scratching your accounts into clay tablets, but not all that much.
Asian central banks like to buy dollars and sell their own currency in order to subsidize exports. Some argue that this is a valid way to jump start their economies, others that this is misguided mercantilism, but we valiantly wave those arguments aside. They do buy huge amounts of foreign currency and sell their own, which makes their currencies artificially cheap.
If you do this, you are going to get inflation. There are a couple of ways to look at this. One is that you're releasing more currency on the market; another is that you're keeping exports expensive, which protects inefficient local producers and reduces household purchasing power. Either way, you get inflation.
Central banks often try to "sterilize" these transactions by issuing bonds on the domestic market, which soaks up excess currency. But their domestic financial markets are, as previously mentioned, built out of popsicle sticks and held together by baling twine and rubber bands. The answer to this problem is to force state controlled entities, like banks, to buy your government bonds. The banks cannot absorb an indefinite number of bond. Indeed, it is believed that many of them are technically insolvent thanks to mismanagement and local officials who use them as slush funds, though information on this is hard to come by.
The result is that the currency transactions are, as economists delicately put it, "imperfectly sterilized". Hence, inflation, and also, the interesting (in the chinese proverbial sense) possibility of a spectacular collapse at some unspecified time in the future.
Matt writes:
This certainly sounds logical to me, though as a non-economist, most things proposed by staggeringly brilliant economists tend to sound logical to me. But it sounds intuitively correct that a country that imports all of its gasoline can’t keep gas prices down by shrinking the money supply, or that if it did, that monetary policy would have to be deflationary in every other area, and thus ruinous. And, obviously, gas prices tend to get passed through to the rest of the economy.On the other hand, Vietnam’s inflation problem isn’t driven solely by rising commodity prices, but also by a vast influx of investment currency over the past 2 years which has created tremendous upward pressure on the dong. As the government tries to hold down the dong to safeguard exports from getting more expensive, it has to basically increase the supply of dong, which creates inflation. And this is exacerbated as the dollar is falling against other currencies, as well as against oil, which is still Vietnam’s biggest export. The advice of most economists has been that this is untenable, and they’ll have to let the dong rise against the dollar somewhat to alleviate inflation.
Still, Stiglitz’s point seems very solid, right? The current situation does seem to indicate that inflation isn’t, in the old Friedmanite formulation, always and everywhere a monetary problem. Then again, wouldn’t this have already been discovered in 1974? What was the economists’ position then?
As an aside, I think I have to point out that Vietnam needs to do a number of things to its currency system, first among them changing the name. Otherwise, I predict it will be very hard to reach their goal of becoming a major US trading partner.
On to Matt's questions. The government can keep the price of gasoline down by targeting the money supply, but only, as Mr. Steinglass points out, in a ruinous fashion. Moreover, this would just change the general price level, so the relative share of gas in the household budget wouldn't change. If I double your income and double the cost of the goods you buy, we've accomplished nothing except marginally increase the demand for the ink they use to print paychecks. You cannot make a scarce good more abundant by monetary fiat.
As for the Friedmanite dicta, I'd say it still holds: inflation in the general price level is a result of there being more money than demand for money. Sudden scarcity--which is what higher food and energy prices represent--results in a shift in the relative value of everything in the economy. You now have to give up more of other goods to get the same amount of oil, because there is less oil to go around.
What happens when oil and food become scarce? Either people use less of them, or they sacrifice more other goods in order to consume food and oil. That means demand falls for other goods, which should push the prices of those goods down. The people who consumed a lot of oil will be worse off, while those who consumed relatively little will be better off.
An increase in the price of everything can only come as the result of too much money. This is not the same as noting that household budgets now buy less stuff; they buy less stuff because there is less stuff. Basically, a large increase in the price of oil or food is a one time productivity shock to the economy which reduces GDP from where it otherwise would have been.
Take a look at this graph of America's M2 growth. M2 is a measurement of the money supply which includes cash, checking accounts, savings accounts, and a few other safe-as-houses sorts of accounts. It's grown at a pretty startling clip over the last year, almost 10%. Not super-surprising, then, that we're seeing high inflation.
The reason we're getting this inflation is that the Fed is trying to support aggregate demand in the face of the housing collapse and the oil crunch. Though inflation much above 2% is a bad thing for the economy in the long term, higher inflation can, in the short term, alleviate the pain by making people feel richer so that they don't freak out and stay home guarding the TiVo. Actually, it's a little more complicated than that, but this post is long enough already, so I'll leave you with the pronouncement that no, inflation targeting is not a bad idea.
Who are you going to believe--me, or a Nobel-Prize winning economist?
I will apologize for this comment in advance.
"Bevis, he said, 'upward pressure on the dong.'"
Megan,
Good luck with this endeavor at explaining the origin of inflation, it is sure to fail with 99.9% of human beings.
David beat me to it, but I would not have pointed it out using Bevis and Butthead. Well done.
Hasn't "safe as houses" taken on a inverted meaning in recent months?
Megan,
Isn't it possible that inflation has a variety of causes? If for example, you have an huge influx of wealth like in say the middle east during an oil boom that inflation is not caused by the monetary system but by the increase in demand resulting from the increase in everyone's wealth. Other times, it is a monetary issue where the government has just printed too much money like say Weimar Germany. The quesiton is where is the US in all of this? Since I don't see any great influx of external wealth, I would say we are closer to Weimar Germany than we are to the middle east.
My condolences to your former baby sitter. If this guy's prose is any indication of how he is in person, he sounds like an insufferably arrogant egghead.
Other times, it is a monetary issue where the government has just printed too much money like say Weimar Germany. The quesiton is where is the US in all of this? Since I don't see any great influx of external wealth, I would say we are closer to Weimar Germany than we are to the middle east.
Bingo!!!!!! You can't state that last part enough. You do understand why the Fed stopped printning the M3, right? Have you read how much the IB's have been hitting up the Fed lately? Contrary to what Paulson says publicly, the credit crunch is far from over.
Who are you going to believe--me, or a Nobel-Prize winning economist?
If the economist is Joe Stiglitz...
My problem with his "popular" writings is that he always seems to start with the assumption that every economic theory except for his own has been discredited.
There's something extremely sad to me about a 41-year-old woman changing her name upon marriage, especially when her "new" groom has divorced his last two wives.
Re: If for example, you have an huge influx of wealth like in say the middle east during an oil boom that inflation is not caused by the monetary system but by the increase in demand resulting from the increase in everyone's wealth.
But isn't that a monetary phenomenon? That huge influx of wealth takes the form of Middle Eastern governments printing more money (how else can that wealth be expressed?), but since there's been no associated increase in the supply of goods the increase in demand sends prices soaring. This is exactly what happened in Europe in the 16th and 17th centuries as American silver and gold poured into the continent, most of it promptly coined into money.
"But isn't that a monetary phenomenon? That huge influx of wealth takes the form of Middle Eastern governments printing more money (how else can that wealth be expressed?), but since there's been no associated increase in the supply of goods the increase in demand sends prices soaring. This is exactly what happened in Europe in the 16th and 17th centuries as American silver and gold poured into the continent, most of it promptly coined into money."
But it seems to me there is a difference between producing more money and producing wealth. Lets say we have an economy where everyone is producing widgets that are valued at $5 a widget. Then one day we invent a way to produce widgets that are worth $10 a widget. That would double everyone's wealth in a real sense. We would be selling twice the value of widgets to the rest of the world than we were before. But everyone having more wealth and more money, means we demand more. In that case, slowing the money supply won't do much good to stop the inflation because the underlying rise in the demand will continue. If you clamp down on the money supply, that just means that the widgets we are making are worth $12 than $10. This to me seems different than just printing money.
Minor, annoyingly pedantic, non-substantive quibble that I can't suppress:
"dicta" is a plural. "dictum" is singular. I don't think this term has yet gone the way of "data."
If for example, you have an huge influx of wealth like in say the middle east during an oil boom that inflation is not caused by the monetary system but by the increase in demand resulting from the increase in everyone's wealth.
Okay, suddenly there's an oil boom. Now the only way there can be an oil boom is if somewhere in the world, people are now spending more money on oil than they were before. Every dollar the Middle East is paid for its oil, must be due to someone somewhere else spending a dollar on oil. That someone, or group of someones, now has a dollar less to spend on something else. So, in world terms, the increase in demand in the Middle East is offset by a decrease in demand elsewhere.
I'm not sure I'd call inflation targeting a fad. Nor would I call monetarism discredited.-MM
This was a very good post by Megan. And she's right that monetarism has not been discredited--not in general.
Certain aspects of monetarism--like the goal of a steadily growing money supply regardless of economic conditions--have indeed been widely rejected. But the most important part of monetarism was the revival of the Quantity Theory of Money (in a somewhat more sophisticated form). This relies on the identity:
While Friedman's famous claim "Inflation is always and everywhere a monetary phenomenon," is a slight exaggeration, he was certainly correct that high and sustained inflation is always or nearly always due to excessively loose monetary policy.
Also, let us remember that Friedman took on the Keynesian establishment over the issue of the Phillips Curve and won. The Keynesians had thought that there was a permanent tradoff between inflation and unemployment, so that the central bank could essentially target whatever unemployment rate it wanted. Friedman (along with Ned Phelps and Robert Lucas) explained why that was wrong. And of course, they turned out to be right. As the Keynesian policies (in conjunction with an oil shock) led to stagflation--with high unemployment and high inflation at the same time. This was something naive Keynesians had thought was impossible.
So the old Keynesianism was largely discredited and most of what was once called "Monetarism" or "Monetarism" was basically absorbed into orthodox theory. That's why Andrei Schleifer (of Harvard) has called this "The Age of Friedman" and Larry Summers--a Democrat and a nephew of two of Friedman's great antagonists--has written:
And of course inflation targeting is not a fad. The European Central Bank (and its predecessor, the Bundesnbank), has been using inflation targeting for a long time, and with great success. Indeed, inflation targeting is but another incarnation of Friedman's (and Lucas's) monetary ideas, which rightly emphasized both the crucial role of expectations and the destructive effects of high rates of inflation over time.
Megan, I have a question:
You say that "An increase in the price of everything can only come as the result of too much money". But to me this begs the question "What if the price of everything hinged on one product? Say...oil?" If the price of oil spikes, doesn't that increase the cost of everything else? All the consumer goods that are shipped by freight? All the produce that is harvested by a diesel powered machine? So it isn't only that consumers have less disposable income due to oil prices and consumption drops, ergo prices drop. But rather prices must also rise or at least not drop because margins disappeared when overhead inflated, due to oil prices. Isn't this a valid fear, that stifling oil prices will reduce the economy to stagflation no matter the interest rates do? Or to put it another way, didn't the stagflation of the 70's have an end that coincided rather well with a drop in the price of oil?
Aw come on, young lady - he only got one third of the prize, and anyway it's the quasi-Nobel that economists fabricated for themselves, not one of the real ones. Sounds like a fair fight to me.
Quite right, dearieme.
The Nobel Prize for economics lies somewhere between the real ones (physics, chemistry, medicine and physiology) and the joke ones (literature and peace, aka the starter Nobel Prizes).
I went to middle school with his son, Michael, and daughter Siobhan (sp?). Michael once tried to bleach his hair with straight Clorox. It didn't work out so well.
Sigh. What is it with these crank theories? Here we go again:
Or how about this from that well-known hot-bed of liberalism, The National Review:
Yes, before someone else points it out, there's quite a bit of weasel room in the claim to allow one to wriggle away from it. To which I will reply that the Germans printed an insane quantity of bank-notes to devalue the reparations they had to pay the French. This was pointed out by Keynes in his "Economic Consequences of the Peace". Is Keynes now a Monetarist as well? Iow, the idea that Friedman coined the idea of excessive money supply as the originator of inflation is nonsense - this fact was well understood since at least, oh, the eighteenth century? The seventeenth? Or even earlier?
MZM, money of zero maturity, is said, cf. Spengler, to be growing at 28% per annum. Thanks for the M2 figure; is it better?
"Vietnam needs to do a number of things to its currency system, first among them changing the name."(?)
Ha! Ha! Ha! I get it it. We're never going to get over original sin if we trade in "dong"s.
There's an even easier example, freddiemac. Imagine that for some reason the number of people able to do any useful work drops to one percent of the current value. The price of _everything_ goes up, way up. For the simple reason that labor becomes way, way more expensive. Of course, the price of some things would go up more than others.
Some here seem to be confused about temporary bouts of inflation caused by negative supply shocks and the more lasting bouts caused by loose monetary policy over a period of time. An oil price rise can indeed push other prices up for a time, but is unlikely to lead to high and sustained inflation without accomodative monetary policy. Hence, in his Macro text (which is pretty standard) David Romer flatly states:
And he shows a graph showing an extremely high degree of correlation between the two...
Anyway, those who are interested will find good comments on inflation targeting here
and here. Stiglitz has certainly made important contributions to economic theory, but his claim that inflation targeting is a "fad" that is "based on little economic theory" is clearly false, as those links show.
Some might also be interested in criticism of Joeseph Stiglitz's policy advice by an economist of equal repute:
Ouch.
I propose adding "The Question of The Dong" to the Doha round.
Within the Stigliz "framework", once you are off the orthodoxy, isn't the question how high is too high?
At some point, 'tolerating inflation' simply leads to gross distortions of the incentives to save and invest, to the point that "the disease is worse than the cure" seems to fall back on itself ...
Re: But it seems to me there is a difference between producing more money and producing wealth.
I agree. But oil is not wealth. The oil-producing countries are producing oil-- not wealth. They are exactly analogous to the Spanish in the 1500s extracting lots of gold and silver out of the New World, with the one difference being that the Spanish could turn the stuff into money directly via a mint, while the oil-producers must exchange their oil for dollars and euros. But neither the old Spanish nor the modern OPEC nations are adding wealth to their economies-- they are just adding money.
Amicus et al.
The name 'Dung' in Vietnamese is pronouced 'Thung;' QED 'dong' is, is ....
"The current [oil] situation does seem to indicate that inflation isn’t, in the old Friedmanite formulation, always and everywhere a monetary problem. Then again, wouldn’t this have already been discovered in 1974? "
Friedman's formulation was exactly confirmed during the '74-period "oil inflation".
I.e.: Oil "inflation" occurred only in the US, where the Fed pursued an easy money policy to offset the impact of the price rises. No increase in inflation occurred in Germany where the Bundesbank always pursued a strong stable-money policy after the Weimar episode. And inflation fell in Japan where the BoJ had begun a disinflation program before the oil price rises and continued it through them.
So the same oil price effect was felt in all three countries (actually, a bigger effect was felt in Germany and Japan because the US had significant low-cost domestic oil supplies and they didn't).
But the countries followed three different monetary policies and got three different price-level results, exactly as per Friedman (and as, IIRC, he points out with nice charts and graphs in his book Money Mischief).
This in fact was the episode that pretty much buried the old-style Keynsianism, and moved Friedman from being an outside critic of the mainstream to being the guy who more than anyone else directed the future mainstream of central banking policy.
Sigh. Jim, it's been known for a long time that printing money in just that fashion will have exactly that effect. In fact, the standard explanation seems to be that Nixon instituted an easy money policy for political reasons, over the objections of people who pointed out just exactly what would happen. Ah, here we go:
As far as I know, Friedman's main claim to fame was predicting that the Phillips curve(employment vs inflation) would fail, given certain circumstances. This prediction was born out in the 70's. Perhaps this is what you were thinking of.
This "monetarism is discredited" absurdity from Stiglitz -- defining monetarism as "targeting growth of the money supply" -- is a hobby horse of some leftish economists who really, really long in their hearts for the old-style Keyensianism to return to them, but know it can never be.
Krugman actually went so far as to claim that Friedman himself had conceded that "monetarism was a rather naive doctrine that has not stood the test of time" -- again ridiculously identifying it as targeting money supply growth.
Yet Friedman once listed 11 principles of monetarism for all to see. Guess what is not one of them. Bernanke provides them so you can see for yourself. How many of them haven't stood the test of time, according to Ben and the guys at the world's central banks?
You'd think someone presenting himself as a professional economist refuting monetarism would bother to know what the 11 principles of monetarism are, eh? For a smart guy Krugman sometimes beggars belief.
(Krugman's following words were that Friedman is "not ... on a level with Keynes, who transformed the way we see the world". ~sigh~ Oh, John Maynard ... ~sigh~.)
"Sigh. Jim, it's been known for a long time that printing money in just that fashion..."
It was known in 1974 that "cost push inflation" was bogus? I did my econ grad school work after that and they were still teaching it then, it's still sitting there on my shelf in my old textbooks.
If everyone knew that cost push inflation was bogus even way back then, why are so many people still pushing the idea right now in this very thread?
Of course everybody's always known that "printing money" by the gobs will cause inflation, Weimar was before 1974 and so was ancient Rome.
What many people didn't believe was that a huge spike in the price of a basic commodity like oil was consistent with steady disinflation if a central bank like Japan's so wanted -- instead of, Oh my God, how can a tripling of the price of oil not cause inflation???
As to Friedman's Phillips curve analysis, yes that's right, and there was his permanent income theory of consumption, his natural rate hypothesis, his Monetary History ... he had enough claims to fame for several first-tier economists.
You might want to read this by Krugman, now that you've got your knickers in a twist:
and:
and from the follow-up:
Jim, your two posts seem to be making two separate points now. What I was responding to in your first post was this:
And as I said, this was a well-known consequence that the administration knew about; tinkering with the money was always a political stratagem, not an economic one.
You appear to be talking about something completely different in your next post.
Hey! My wife's name is Dong, you insensitive clod! :)