Inflation Fighters Need To Define Their Target
Listener: 4 March 1995
Keywords: Macroeconomics & Money;
The debate about whether inflation is the appropriate target of monetary policy is bedeviled by there being no rigorous definition of inflation. When most prices are increasing at 20 percent a year, there is no trouble at saying that there is inflation. But when some prices are increasing at 2 percent, some at 4 percent, and some are declining, the issue of whether the economy is inflating is much more equivocal. A price change index can be defined to be the rate of inflation for practical purposes, but that is not the same thing as a rigorous definition. If one practical purpose differs from another, the index becomes less relevant.
But what if it is in the interests of the economy for some prices to move sharply relative to others. At the moment, the Reserve Bank is of the view that interest rates should rise faster than other prices. The Reserve Bank then refers to two different measures of (consumer) inflation, one of which includes interest rates and the other excludes it, adding to the community confusion. There is none if we recall there is no rigorous definition of inflation.
But it may be necessary to change other important price relatives. That was the message of Bryan Gould in a recent article in The New Zealand Herald. It argued that our current anti-inflationary policy prohibited a major depreciation of the exchange rate, which was necessary for sustainable economic growth.
Bryan Gould perhaps needs some introduction. He is currently the Vice-chancellor at Waikato University, but before that he was a leading British Labour politician. This may not seem promising credentials for the senior academic of a university, but born in New Zealand, Gould was a Rhodes Scholar, obtained an outstanding degree at Oxford, and is author or co-author of four books.
One, Monetarism or Prosperity?, is an economics book well within the traditions of the orthodox British economics debate. Written in 1980 it is a criticism of the monetarist economic doctrines which were just being implemented by Margaret Thatcher. It argues that for much of the post-war era the British economy was managed in the interests of its financial sector, at the expense of the real (productive) economy. In particular the maintenance of a high exchange rate for financial stability meant that the British manufacturing sector was disadvantaged when competing against the rest of the world. Since manufacturing’s ability to export and compete against imports is central to the performance of the real economy, British economic growth suffered.
This thesis was not very relevant to the New Zealand economy in 1962 when Gould left. Then 90 percent of exports were pastoral products. But he would recognize the parallels when he returned. The economy has markedly diversified in the 30 years, and today the manufacturing sector is our largest exporter. The statistics are often presented to make agriculture seem bigger, by ignoring the importance of post-farmgate processing. For the Gould argument the sectoral balance hardly matters. What matters is that today exporting and import competing are more price responsive in the short run. Consider the logs which get processed overseas when the exchange rate is high..
Since the book was written over a decade ago, subsequent events might be used as a test of the rightness of its propositions, especially its forecasts of dire consequences if Thatcher’s policies were pursued. Looking up the record I was surprised to find that from 1979 to 1994 (i.e. under the monetarist regime Gould’s book was criticizing), Britain grew on average 1.8 percent a year, while the OECD rich countries averaged 2.5 percent. I had expected Britain to grow about the same, and was going to explain this by the advantages of North Sea oil. Certainly in the mid-1980s Britain grew faster. When the black gold ran out so did Mrs Thatcher’s luck. But even ignoring the advantages of the oil, the poor British growth record is consistent with the book’s theory.
We can but conjecture what would have been the economic growth rate if Britain had devalued as Gould recommended. Some monetarists argue that inflation would have been higher, but there would have been no growth boost. This is probably the position of the Reserve Bank, for they argue this for New Zealand.
Yet the Bank’s own data shows quite clearly that it is possible for the relativity between the exchange rate and consumer prices to diverge for long periods. Moreover when it did, the economy performed exactly as the Gould book predicted. When the exchange rate was relatively overvalued, as in the mid-to-late 1980s, the economy stagnated. When it was undervalued and falling, as in the period before, New Zealand had a growth boom.
Unfortunately the various responses I saw to Gould’s Herald article failed to deal with his analysis except by denying that relative prices mattered to economic performance (interest rates excepted, of course). Perhaps any justification of current policies depends on the pretence there is a rigorous definition of inflation.