SQUEEZE::THE MAIN JOB of central banks is to control inflation which, over time, creates uncertainty and undermines real investment. When economies overheat the central bank must make unpopular decisions, such as raising interest rates to slow down credit-creation and the money supply.
This sometimes causes conflict with governments who take a shorter-term view and would prefer not to remove the punch bowl when the economic party is in full swing. Central bankers, though unelected, are rightly or wrongly part of the system of checks and balances in most western democracies. Many claim to be independent of government but this usually depends on the disposition of the Governor and Board of the Bank in question.
Oddly, the US Fed is something of an outlier in that it has been given a mandate to promote economic growth as well as to control inflation. This dual mandate is difficult to manage and it is now clear that Alan Greenspan would have been much better advised to curb growth and irrational exuberance by keeping interest rates higher than he did for most of his tenure.
An important question is whether or not central banks should take responsibility for asset price inflation. Traditionally, central banks worried only about inflation in the prices of goods and services and not about the prices of assets, such as land, property, equities and other securities. But it is obvious that there is a connection between the two. If asset prices go up, consumers feel wealthier and spend more, forcing up the prices of everyday goods and services. Rising house prices can also set off demands for pay increases which feed into conventional inflation.
During Greenspan’s tenure at the Fed, it was argued by many that central bankers had no special expertise in predicting whether asset prices were excessive or not, and had no business raising interest rates to curb these prices. These arguments seemed far too purist at the time and, in retrospect, it seems clear that the role of central banks – as well as of financial regulators – will have to be re-thought.
In my view, central banks should develop techniques for assessing fundamental value in asset markets and these appraisals should be integrated into the monetary policy frameworks. It is too dangerous to allow massive speculative bubbles to develop unimpeded.
After the recession hit and asset prices collapsed, there was far more concern about deflation. Inflation disappeared from the agenda as central banks lowered interest rates as far as they could, and when they could go no lower they engaged in quantitative easing – a euphemism for directly increasing the money supply. Many argued justifiably that deflation could be even more serious than inflation. Consumers would postpone spending indefinitely, as happened in Japan. It would be extremely difficult for the authorities to get out of a deflationary trap. Falling prices would not necessarily lead to improved competitiveness because workers would not accept cuts in nominal wages.
Ireland is a classic case of “sticky” wages and welfare benefits. There is always a clamour for index-linking when prices go up but not when they go down.
Many mainstream economists believe that an inflation rate of about 2 per cent per annum is healthy, as long as it does not give rise to expectations about higher rates and as long as it is not excessive in relation to inflation in trading countries. But if prices fall by 5 per cent per annum, say, then consumers will wait and wait for further price falls. Domestic demand collapses and, unless this can be compensated for by exports, the entire economy can be placed in jeopardy. For economies which have to service substantial amounts of foreign debt this can be especially burdensome because with falling prices, more real resources must be deployed each year.
The effect of falling prices on the fiscal situation is not entirely clear-cut. The Exchequer will benefit from the lower prices it has to pay for goods and services and from the lower quotes it will receive for capital projects. But on the other hand, there is no scope for taxation by stealth, such as “bracket creep”. Incomes will not be rising that much, if at all, and tax-payers will not be moving into higher income brackets with the same rapidity as they do in an inflationary environment.
We have seen the response of the US to recession and deflation. US president Barack Obama brought in a stimulus fiscal package, the Fed reduced interest rates with unprecedented haste and followed this up with quantitative easing. The Eurozone as a whole has tended to move in the same direction though rather less dramatically.
Are these expansionary policies likely to turn deflationary tendencies into inflationary ones any time soon? A number of investment strategists believe that this is likely because the Fed will find it difficult to neutralise the stimulus and “will do anything to avoid deflation”. They believe that inflation is now the more likely outcome and that this warrants a change in investment strategies in favour of index-linked ones. These advisors would also recommend real estate, since rents can be raised to reflect inflation.
It seems to me that it may be premature to factor in inflation. There is considerable spare capacity on the production side so even if demand picks up it is unlikely to bid up the prices of goods and services for some time. Quantitative easing does not seem to have yet filtered through to the money supply either. The growth in the money supply in the Eurozone and in the US is close enough to zero.
One doesn’t have to be a monetarist to believe that monetary growth is the main factor behind inflation; the evidence is compelling. Since the money supply is not growing we do not have to worry about inflation for several years because of the long lags involved. But with low interest rates and quantitative easing why isn’t the money supply growing?
The main reason is because the banks aren’t lending very much; they are using the injections of liquidity to strengthen their balance sheets rather than on-lend to customers. It is credit which creates deposit money and since there is little fresh credit, there is virtually no monetary growth. Consequently, inflation is not a worry at the present time.
But deflation is still a cause for concern, especially in Ireland. We have not adopted a stimulus package and our banks are more zombified than most. What we have done is precisely the opposite to what the US has done. In the middle of the worst recession in our history we have brought in three of the most deflationary budgets ever conceived. We now realise to our cost that Nama and massive capital injections will not get the banks lending again any time soon. In fact when the banks cash in their IOUs for European Central Bank (ECB) funds they are likely to use them to buy safe Government bonds.
On top of that, the Central Bank is allowing banks to raise their lending interest rates to improve their profit margins without any signal from the ECB. This is the second de facto tightening of monetary policy. The chances are that it will be further tightened by the ECB sometime next year. We are also promised at least two more deflationary budgets, including carbon taxes and property taxes. Because of the massive re-capitalisations of the banks, tax-payers are facing a very bleak long-term future. How can consumer demand recover?
In the middle of the worst depression ever experienced, we are inflicting upon ourselves five deflationary budgets and at least three restrictive monetary policies. In the past, Irish economists have criticised former finance ministers for following pro-cyclical stances of policy. But that was nothing compared to what is happening now.
Admittedly the climate for foreign borrowing is less auspicious today, but it does not appear as if the Government even considered the implications of piling deflation upon deflation. There is a chance that, as a small open economy, the deflationary effects here can be mitigated. But, nevertheless, the Government has taken a huge risk with the economy, without analysing the downside implications.
Ministers keep on saying how the EU is pleased with our economic policies. Of course they are. That is because we have promised to keep to the EU fiscal guidelines. The financial markets are also pleased with us. But none of these institutions cares about the effects on the real Irish economy, on unemployment or emigration. Let us hope and pray that we have not deflated ourselves into the ground to satisfy Brussels mandarins, financial markets and Irish bankers.
Michael Casey is a former chief economist at the Central Bank and board member of the IMF
