19 December 2005
Inflation Debate Going Off the Rails
The public debate about inflation seems at serious risk of going off the rails. Confusion abounds at several levels.
First, the Reserve Bank’s action to raise interest rates is widely interpreted as reflecting a desire to slow the
economy after a period of solid growth.
But isn’t the government’s stated aim to raise the rate of economic growth in order to lift per capita incomes into the
top half of the OECD rankings?
Clearly the Bank isn’t wanting to sabotage the government’s “top priority” objective. It has correctly argued many
times that low inflation and growth are not inconsistent – indeed that the best contribution monetary policy can make to
economic growth is to keep prices stable. So shouldn’t it and the government be focusing on what is needed in other
policy areas to encourage sustained non-inflationary growth? Next, the Reserve Bank argued when increasing interest
rates last week that “overall demand continues to outstrip available capacity”.
But how can New Zealand demand outstrip the world’s capacity to supply? And even if New Zealand demand were limited to
New Zealand goods and services, the proposition is tenuous. As David Ranson, a former assistant to the secretary of the
US Treasury, has written, “Skeptics rightly question how demand could constantly outstrip supply. Surely, demand must
originate from purchasing power, purchasing power from wealth, wealth from income, and income from the ability to
produce (and hence supply) goods and services.”
‘Demand pull’ and ‘cost push’ explanations of inflation have fallen by the wayside in economics. The Philips Curve was
discredited by the stagflation of the 1970s. There is no consistent relationship between inflation and unemployment,
capacity utilisation and GDP growth.
Inflation is not caused by electricity price rises, the actions of ‘monopoly’ businesses, union wage claims or dearer
oil. One price or several prices rising is not inflation. Inflation is a sustained and ongoing increase in the general
level of prices.
The Reserve Bank should not be brow-beating consumers, home owners and banks about irrational behaviour. Even if it
existed it could not cause inflation; commercial banks are likely to know more about managing their risks than the
Reserve Bank; and the Bank’s own reports indicate that the New Zealand financial system is in good shape.
Milton Friedman long ago won the debate with the demand-pull, cost-push Keynesians. As he famously said, “Inflation is
always and everywhere a monetary phenomenon, in the sense that it cannot occur without a more rapid increase in the
quantity of money than in output.” In other words, the inflation buck stops with the Reserve Bank, full stop.
Recently, US economist Walter Williams nicely illustrated the point with a simple parable.
“Pretend several of us gather to play a standard Monopoly game that contains $15,140 worth of money. The player who
owns Boardwalk or any other property is free to sell it for any price he wishes. Given the money supply in the game, a
general price level will emerge for all trades. If some property prices rise, others will fall, thereby maintaining that
level. Suppose unbeknownst to other players, I counterfeit $5,000 and introduce it into the game. Initially, that gives
me tremendous purchasing power, whereby I can bid up property prices. After my $5,000 has circulated through the game,
there will be a general rise in the prices – something that would have been impossible before I slipped money into the
game. My example is a highly simplistic example of a real economy, but it permits us to make some basic assessments of
inflation.” Only the Reserve Bank can print money. It alone should be held accountable for inflation and inflationary
expectations.
Does this mean that monetary policy can operate satisfactorily regardless of other policies the government is following?
No. Monetary policy needs mates.
An anti-inflationary monetary policy running up against large increases in government spending, high local government
rate increases, costincreasing employment law changes, excessive business regulations and the like can produce severe
strains and imbalances (particularly for exporters and those competing with imports), as we are seeing at the present
time.
What it does mean, however, is that the Reserve Bank should not be confusing public debate with defunct economics and
misplaced accusations.
In respect of the housing market, for example, it should be highlighting the cost increases arising out of misguided
‘smart growth’ urban planning policies and excessive and poorly administered building regulations. Talk of direct
interventions in the home lending and foreign exchange markets is worrying. It could take us back to the days of
Muldoonist financial controls when governments wanted both lower interest rates and slower growth in lending. Trying to
control price and quantity independently is sheer folly.
The problem with bad ideas and bad analysis is that they can give rise to bad policies.
Roger Kerr is the executive director of the New Zealand Business Roundtable