What makes sovereign debt sustainable, and for how long can this situation continue?
Among the most important financial forces in the world are fashions in central bankers’ ideas. The dominant central bank fashion in recent years is the notion that they should create perpetual inflation at the rate of 2% per year—not 2% sometimes, but 2% always. If this indeed should happen, in a lifetime of 80 years, consumer prices on average will nearly quintuple. Current central banks’ rhetoric insists on calling this “price stability,” a striking instance of newspeak. They have converted the journalists, who earnestly report whether inflation is meeting the central bank “target,” simply taking it on faith that this target must be a good idea.
The central banking commitment to 2% inflation forever has become internationally widespread, including of course the Federal Reserve, which is the dollar-issuing central bank to the world, not only to the United States. The Fed adopted this debatable doctrine on its own and simply announced it in 2012, without the approval of the Congress, although Congress has the Constitutional duty to regulate the value of money.
Brendan Brown, London-based senior economist for Mitsubishi UFJ Bank and iconoclastic monetary thinker, attacks the 2% inflation fashion head on, as the title of his new book expresses: The Case Against 2 Per Cent Inflation. He argues instead for a regime of sound money (for his definition of what this means, see below).
This complex book first reviews the 2% inflation doctrine’s place in the history of shifting central banking ideas:
Since the fall of the full international gold standard in 1914, the fiat money ‘system’ has wandered through four successive stages…. The first three all ended in dismal failures…. The fourth [2% inflation] is headed in the same direction.
Following the destruction of the gold standard by the First World War and the related wild inflations, the stages have been, according to Brown:
- The gold exchange standard of the 1920s, meant to restore stability but ending with “the bust of the global credit bubble” of the late 1920s.
- 1930s disorders leading to the stabilization efforts of the Bretton Woods agreement of 1944. This system collapsed in 1971.
- Pure fiat currencies with floating exchange rates among them. This period featured the Great Inflation of the 1970s, but also monetarist doctrines, most notably in Germany and also temporarily in the U.S. It ended “most spectacularly” with “the bubble and bust in Japan” in 1989.
- Then “out of the monetarist retreat,” says Brown, “was born…a new stabilization experiment—the targeting of perpetual inflation at 2% p.a.,” the current theory. Since the Fed first formally adopted this idea in 2012 we have had a spectacular global asset price inflation—will it end with a bang or a whimper?
Surveying this history must prompt us to ask: is there is any eternal central banking truth?
The book quotes the changing central banking ideas over time as described by Stanley Fischer, formerly Vice Chairman of the Fed and Governor of the Bank of Israel:
Emphasis on a single rule as the basis for monetary policy implies that the truth has been found, despite the record over time of major shifts in monetary policy—from the gold standard, to the Bretton Woods fixed but changeable exchange rate rule, to Keynesian approaches, to monetary targeting, to the modern frameworks of inflation targeting….
This led Fischer reasonably to suggest that these matters need appropriate awareness of the “human frailty” and the “considerable uncertainties” involved.
Should we put our faith in the most recent central banking fashion of 2% inflation forever? Or will it also end up, as Brown thinks, in “the dustbin of monetary history” with the others?
The book addresses four key questions about the 2% theory:
- Where did it come from?
- What is its rationale?
- Is the rationale convincing?
- How does it contrast with sound money?
Where Did the 2% Doctrine Come From?
The answer, as the book explains, is that it came from New Zealand; specifically, an act of its Parliament: the Reserve Bank of New Zealand Act of 1989. The whole point of the original project was to get inflation down from its unacceptably high level, then about 5%. In its origin, it had nothing to do with making inflation go up. Very important in this context was that the original goal was not 2% inflation, but a range of zero to 2%, as agreed to between New Zealand’s Minister of Finance the Governor of the Reserve Bank. In subsequent international central banking evolution, the “zero” part seems to have been forgotten.
Similarly, the Humphrey Hawkins Act of 1978 in the United States held out the idea that by 1988 the inflation rate could be reduced to zero. We never hear this statutory provision discussed by the Federal Reserve.
Thus, New Zealand’s creation of what has become the international 2% doctrine began with an act of its legislature, followed by an agreement with the government, not an announcement of the central bank by itself. This is a striking contrast with American developments. Does the Fed have the authority to decide this essential question on its own, without the approval of Congress? I don’t think so, and neither did Alan Greenspan.
At the end of the 1980s, the book relates, then Fed Chairman Greenspan “had no inclination to adopt a formal 2% inflation target—seeing this as potentially irritating relations with Congress (here he feared that some members might question why inflation rather than price stability).” This was before the Federal Reserve rhetoric had redefined “price stability” to mean perpetual inflation.
Further, in a key 1996 discussion of whether there should be a specific inflation target, Greenspan argued that “The question is really whether we as an institution can make the unilateral decision to do that. I think this is a very fundamental question for this society. We can go up to the Hill and testify… but we as unelected officials do not have the right to make that decision.” A very sound point. But in 2012, the Federal Reserve on its own made a formal commitment to perpetual inflation at 2%, anyway.
What Is the Rationale for the 2% Doctrine?
One important argument is from the point of view of central bank power. With 2% inflation, it is easier for central banks to run negative real interest rates when needed, while still keeping nominal interest rates over zero. The argument is focused on how to avoid hitting the “zero lower bound” for nominal interest rates. We all know by now that nominal interest rates can in fact go below zero, but presumably not too far below. With 2% inflation, you just have to get nominal rates below 2% to make them negative in real terms. In the meantime, we are assured that 2% inflation is “low.”
This argument assumes that central banks should be in the business of setting of interest rates by discretion, the very thing that sound money advocates doubt or deny that central banks can successfully do. Do central bankers themselves share this doubt? They should.
A deeper economic argument for inflation (though not necessarily perpetual inflation) is that it allows real wages to fall while nominal wages do not, and thus enables required adjustment in real prices to take place, even though wages are “sticky.” This was the key argument that Janet Yellen made to the Fed’s Open Market Committee in the opening 2% target debate in 1996, and it will be recognized as a classic Keynesian idea. It does depend, however, as then-Governor Yellen herself said at the time, on people believing in nominal dollars rather than inflation-adjusted ones—in other words, in “money illusion,” though she did not use that term.
Making sure inflation is 2% runs another important theme, we will make sure that we will never have price deflation, assumed to be always bad. But is moderate deflation always and necessarily bad? Brown doesn’t think so, as explained below. Constant inflation with low or negative real rates also makes sure that debt is favored, strengthening its tendency to induce financial bubbles.
A clear and firm repetitive communication of the 2% target, it is further argued, will manage market and popular expectations of future inflation or deflation, “anchoring” them at about 2%. “I don’t see anything magical about targeting 2% inflation,” former Fed Chairman Ben Bernanke said later, “my advocacy…was based much more on the transparency and communication advantages.” Of course, central bankers can neither bind their successors, nor know that 2% is the perfect number now, let alone forever.
An additional argument is that standard government measures overstate the rate of inflation, so you have to make your inflation target high enough to offset this mistake.
Is the Rationale Convincing?
In a word, according to Brown: No. I agree. Celebrated central banker Paul Volcker has recently added his distinguished No to this discussion, as noted below.
Underlying Brown’s rejection of all perpetual inflation targets, including 2%, is his fundamental insight about the natural course of average prices in a free market, entrepreneurial economy. The natural course, he says, is not forever upwards, nor always stable. “In a well-functioning capitalist economy, sound money goes along with prices on average for goods and services which fluctuate upwards and downwards over considerable periods, with some tendency to revert to a mean over the long run.” [italics added] A natural rhythm of prices makes them sometimes go down, notably in periods of “spurts in productivity growth, resource abundance, or perhaps a change in product and labor market structure.” This kind of deflation is not a disaster to be fought at all costs by central banks because it shows that productivity is making real incomes rise. Combined with alternating periods of rising prices, in this currently non-existing scenario, prices on average tend to go sideways in the long term.
Instead, modern central banks keep attempting to manipulate prices to a different and “better” outcome—to rise constantly at the same 2% rate forever. But, Brown asks rhetorically (and convincingly to me), “Why should we believe these super claims about central bank wisdom and insight when the record suggests otherwise?” Why indeed?
Further, “Attempts of central banks to drive up prices when the natural rhythm is downwards end up with likely virulent asset price inflation (and eventual bust),” Brown argues. With modern central bank policies, asset price booms and busts are certainly what we experienced, followed by another remarkable asset price inflation.
“You will not find in the advocacy literature for monetarism or for the 2% inflation standard,” the book observes, “any mention of asset price inflation.” I recently read two presentations made at the Brookings Institution discussing whether the 2% doctrine should be changed. Neither mentioned asset price inflation. Certainly, no monetary theory or policy makes sense which does not address the issue of asset price inflation.
Concerning other defenses of 2% inflation forever, we may ponder: How much of central bank actions should be based on trying to fool the people with money illusion? And if your position is that you don’t believe the government’s inflation statistics, wouldn’t it be a superior approach to state, as Greenspan reasonably suggested, that the right inflation goal is “zero, if inflation is properly measured”?
Finally in this context, we note that Paul Volcker, in his new book, Keeping At It: The Quest for Sound Money and Good Government, provides these thoughts about the 2% theory: “I know of no theoretical justification,” and “All these arguments [for it] seem to me to have little empirical support.”
How Does 2% Forever Contrast with a Sound Money Regime?
Brown’s fundamental recommendation is for “a journey away from the 2% inflation standard to a sound money alternative.” What does he mean by “sound money”? Not, as we have seen, that price levels should be always the same, instead of price levels rising forever at 2% per year. His definition of sound money is rather this:
The guiding features of sound money are market determination of short- and long-term interest rates free of any official manipulation; the quality of money and consumer satisfaction with it are the lead objectives of the money suppliers; persistent moves of money prices of goods and services in one direction should not be expected; over the long run, there should be some tendency for prices to revert to the mean, but in no precise or assured manner; money must not be a tool of the sovereign usable towards funding expenditures without legislating tax rises or floating loans on the free market at non-manipulated rates; [or of] bailing out cronies including the banks.
This is a radically market-based doctrine. It retains no role for the central bank serving as the national price fixing committee to manipulate interest rates or prices generally. Although an amazing number of people naively accept the idea that central banks can successfully fix prices, Brown shows why we should reject that pretense. The book also rejects central bank policies of financial repression “levying inflation tax on the small and the weak” to finance the government’s deficits. It certainly does not flatter the ambitions of central bankers to “manage the economy” or the desire of governments for monetization of their debts and collection of inflation taxes. In short, it is not a doctrine to appeal to political elites.
How then shall you get some country to try it? Ay, there’s the rub. Perhaps some small country or countries might play the New Zealand of a new sound money monetary doctrine? Brown speculates about this possibility, but it does not seem too hopeful. Still, as has been wisely observed, “Many things which had once been unimaginable nevertheless came to pass.” Is it possible that the fashion in central bankers’ ideas will turn to sound money after the next crisis?
In sum, Brown has written an interesting history, thorough analysis, and penetrating criticism of the 2% inflation forever doctrine, and provided provocative food for thought about what in contrast a sound money regime would be like.