Monetary policy is one of the most difficult topics in economics. But also, I believe, a topic of absolutely crucial importance for our prosperity.
As you all know, last week, the Bank of Canada increased its benchmark rate by a quarter of a percentage point to 0.5%. There had been a lot of speculation in recent weeks about that decision to finally raise rates after keeping them at a record low for more than a year. And as usual there will be a lot of speculation about the bank’s next moves. How far will it go ? How fast ?
All this guessing about setting rates has nothing to do with capitalism and free markets ; it has more to do with central planning and government control of the money supply. In a monetary free market, the interest rate would be determined by the demand for credit and the supply of savings, just like any other price in the economy.
Government control over money has serious consequences that few people seem to be aware of.
One of them is that central banks are continually increasing the quantity of money that is circulating in the economy. In Canada for example, if we use the strictest definition of money supply, it has increased by 6 to 14% annually during the past dozen years. The situation is about the same everywhere.
The effects of constantly creating new money out of thin air have been a debasement of our money and a dramatic increase in prices. The reason why overall prices go up is not because businesses are greedy, or because wages go up, or because the price of oil goes up. Ultimately, only the central bank is responsible for creating the conditions for prices to rise by printing more and more money.
The Bank of Canada has had an inflation rate target of 2% for more than 15 years. A price inflation rate of 2% a year may seem small. But when you add up 2% of depreciation of the monetary unit year after year, you end up with large numbers. Total inflation in Canada from 1990 to today adds up to 45%. This means that your dollar can now buy the equivalent of less than 70 cents if you compare it to 20 years ago.
As even the Federal Reserve chairman Ben Bernanke admitted, inflation is the equivalent of a tax. The most insidious of all taxes, which bears hardest on those least able to bear it. It eats away at our purchasing power, our revenues and our savings. It is true that most of us get salary increases that compensate for the loss of purchasing power. But all those whose income doesn’t increase as fast as prices get poorer.
Many interest groups, including governments, like cheap credit. There is an inherent bias in monetary policy in favour of lower interest rates. But this too has unwelcome consequences.
One of them is that people are encouraged to save less, because the returns on savings are lower. And they are led to carry more debt, because credit is easier to obtain. This is precisely what we have been doing in Canada, in the U.S. and elsewhere in the world for the past 20 years. In 1990, the ratio of total debt to disposable income for Canadian families was 90%. Today, this ratio has gone up to 144%, an all-time high.
It seems that debt has become a way of life. Thankfully, public debt in Canada is at a reasonable level. But as we are seeing around the world, many countries such as Greece are now on the brink of bankruptcy because they became too dependent on cheap money. Monetary inflation creates all kinds of market distortions and is also the cause of the booms and busts that our economy has been going through.
The pattern is becoming sufficiently clear that these are not an inherent failure of the capitalist system as many people believe. They are rather caused by central bank policies, as economists such as Nobel Prize winner Friedrich Hayek explained long ago. Remember : we had the dotcom bubble at the end of the 1990s. When that crashed, Alan Greenspan flooded markets with money. Between 2001 and 2004, the Federal Reserve pushed down interest rates to as low as 1%.
If you factor in the level of inflation, real interest rates were actually negative. This is the same as subsidizing people to encourage them to take loans. But we all know this lesson : you cannot live on a credit card for very long !
We then got another bubble, which was made bigger by the policies of the U.S. government. It encouraged banks to extend risky mortgages to insolvent borrowers ; and it encouraged people to take up these mortgages and buy houses that they could not really afford.
You’ve heard the rest of the story. These mortgage loans were securitized and then sold on the market around the world. And the financial institutions that had bought them got into trouble when home owners started to default and home prices went down.
In 2007, that real estate bubble too began to burst. And since then, central banks have once again sent interest rates down to almost 0%. This means that real interest rates are again negative, since price inflation is higher than that. Central banks have flooded the financial markets with money and allowed governments to pile up gigantic amounts of debt to prevent a recession.
It is true that economic growth seems to be back. But how sustainable is it ? How will governments and households reimburse all this debt, unless they cut back on spending ? Will some countries decide to monetize their debt and thereby provoke high inflation ? Have we created more bubbles in new sectors that will bring another global recession down the road when they burst ? If this happens, what kind of stimulus policies will we be able to adopt if we are drowning in debt ?
Despite all these negative effects of inflation, most economists and commentators seem to think that a little inflation is a good thing. And they tell us that deflation, or a fall in prices, would be a disaster for the economy. But that’s not true.
Let’s start with common sense and what’s happening in our daily lives. Do you, as consumers, prefer to buy stuff that is cheaper or more expensive ? I think we all know the answer to that !
We are all consumers, and we all benefit when prices go down. If we pay less for one good, it means we have some money left to buy other goods.
Economic activity does not stop. It simply means we can buy more with the same amount of dollars. And more purchasing power means a higher standard of living for everyone.
In fact, there is nothing mysterious about the effects of lower prices. Think about computers. Fifteen years ago, they were big, not very powerful, had few gadgets, and cost a lot more than today. Prices in the computer business have been going down all the time since then.
Have people stopped buying computers or waited years before buying a new one to benefit from even lower prices ? Absolutely not. On the contrary, more computers are being sold as their prices go down.
Imagine a situation where central banks don’t manipulate the money supply anymore. And instead of continually rising at a rate of between 6 and 14% per year, as we’ve seen in Canada in recent years, the quantity of money in the economy remains stable.
Every year however, we become a little bit more productive. We create new goods and services. We find new methods to produce them more efficiently. Technology gets better. And if there is population growth, there are also more people working.
So there are always more and more goods and services available in the economy, but we have the same quantity of money to buy them. Prices will obviously have to adjust by going down. If the economy grows, let’s say, by 3% a year, while the money supply grows by 0%, then we will necessarily get price deflation.
Note that in this context, businesses are still able to make profits, because their costs also go down.
This is not just theory. It is what happened several times in the 19th century, in an era of rapid economic development. At a time when there were no central banks and when money was calculated as a certain quantity of gold or silver.
Deflation is not a threat to our prosperity. On the contrary, in a situation where the money supply is stable, it is the manifestation of prosperity !
Prosperity has nothing to do with the quantity of money that we have in our pockets, but rather with the quantity of goods that we can buy. And if we can buy more goods with the same amount of money because prices are lower, then we are more prosperous.
This is why there is no reason to fear a drop in prices. And why the interventions by central banks to prevent prices from going down causes more harm than good to the economy.
Now, given all this, what should we do ? I believe that within a few years, we will need to hold a serious debate about returning to the gold standard.
Until then however, there are more immediate measures to discuss, such as the inflation target of the Bank of Canada. The agreement on the price inflation target between the Bank and the minister of Finance is set for five years and has to be renewed next year, in 2011. The Bank is studying different alternatives to the current 2% target.
I’m very happy that the Bank has already rejected a suggestion made in a report by the International Monetary Fund last winter, to increase the target rate to 4%. The IMF logic is entirely based on the idea that central banks should have more flexibility in trying to manipulate interest rates and the amount of money in circulation. According to this view, higher inflation and borrowing costs at the outset of a crisis would allow central banks to slash interest rates more aggressively and keep them at lower levels longer if needed to encourage spending.
That’s like trying to cure a drug addict with larger drug injections. The problem is precisely that there is already too much inflation and too much manipulation of the money by central banks. The solution has to be to reduce them, not increase them. Another one of the proposed alternatives is to target a price level over a longer period instead of an inflation rate every year. This means that if one year for example, the inflation rate is 1%, then the next year the Bank would try to increase prices by 3%, instead of trying to simply go back to its goal of 2%. It would target an average rate of inflation over time and compensate for past deviations by deviations in the opposite direction.
Let me rephrase this differently from my own perspective. The inflation rate was only 1% last year. We should have debased the currency by 2% to reach our targeted price level. So this year, let’s create even more money out of thin air so that it loses 3% of its value. This will compensate for last year’s insufficient debasement of our dollar. Sounds absurd ? I think it is too.
If we have to have an inflation target, I believe the best and most realistic alternative at this point would be to set it at 0%. It is true that this would diminish the ability of the Bank of Canada to artificially stimulate the economy. There could not be negative real interest rates as we have now, since the Bank’s official interest rate cannot go below 0%. But as I said, I think that too much monetary manipulation is the problem, not the solution.
The Bank would need to have a much more prudent and sound monetary policy to keep price inflation at 0%. That would really preserve our purchasing power. That would help prevent the cycles of booms and busts that we have experienced. It would reduce the price distortions that inflation causes throughout the economy. It would facilitate the financial planning of individuals and businesses and increase the efficiency of our economy.
Last August, the governor of the Bank of Canada Mr. Mark Carney said : “The single most direct contribution that monetary policy can make to sound economic performance is to provide our citizens with confidence that their money will retain its purchasing power.”
A 0% inflation target would achieve precisely this and send a powerful message that inflation in itself is wrong. That debasing the currency may bring some short-term gain but always brings long-term pain.
This would be a big step in the right direction.
I may be a dreamer, but I think monetary economics should be a hot topic ! The current review of the Bank’s inflation target is a great time to have this kind of debate. I hope that more Canadians will become interested in in how the inflation rate target affects our purchasing power, our standard of living and therefore our life.