So, weirdly, I recently found out that Joseph Stiglitz is married to my old babysitter. Apparently, they are blissfully in love, with the local gossip reporting that they are so happy as to make those who know them madly jealous.

This has absolutely nothing to do with inflation targeting, the actual topic of this post. However, I thought that this fact was too bizarre not to pass on.

Anyway, one of my liberal arch-nemeses who is unfortunately really smart and engaging both in writing and in person, points me to this Joseph Stiglitz column on inflation targeting. It doesn't seem to have garnered much attention in America, which is surprising because it's pretty strong stuff:


The World’s central bankers are a close-knit club, given to fads and fashions. In the early 1980’s, they fell under the spell of monetarism, a simplistic economic theory promoted by Milton Friedman. After monetarism was discredited – at great cost to those countries that succumbed to it – the quest began for a new mantra.

The answer came in the form of “inflation targeting,” which says that whenever price growth exceeds a target level, interest rates should be raised. This crude recipe is based on little economic theory or empirical evidence; there is no reason to expect that regardless of the source of inflation , the best response is to increase interest rates. One hopes that most countries will have the good sense not to implement inflation targeting; my sympathies go to the unfortunate citizens of those that do. (Among the list of those who have officially adopted inflation targeting in one form or another are: Israel, the Czech Republic, Poland, Brazil, Chile, Colombia, South Africa, Thailand, Korea, Mexico, Hungary, Peru, the Philippines, Slovakia, Indonesia, Romania, New Zealand, Canada, the United Kingdom, Sweden, Australia, Iceland, and Norway.)

Today, inflation targeting is being put to the test – and it will almost certainly fail. Developing countries currently face higher rates of inflation not because of poorer macro-management, but because oil and food prices are soaring, and these items represent a much larger share of the average household budget than in rich countries. In China, for example, inflation is approaching 8% or more. In Vietnam, it is even higher and is expected to approach 18.2% this year, and in India it is 5.8% . By contrast, US inflation stands at 3%. Does that mean that these developing countries should raise their interest rates far more than the US?



I'm not sure I'd call inflation targeting a fad. Nor would I call monetarism discredited. Targeting money supply growth with a fixed rule has been abandoned--indeed, even Uncle Miltie conceded that it had failed. But the central insight that inflation is always and everywhere a monetary phenomenon still seems to have legs. It seems especially odd to say that inflation is rising because oil and food are a large share of household budgets, because central banks usually pay much less attention to headline inflation than to "core" inflation, which excludes volatile food and energy prices. Increases in the relative price of even important goods that have become scarce is not really what Milton Friedman was talking about; he was referring to an increase in the general price level, which indicates that the money supply is growing faster than demand.

A huge portion of the inflation in China and Vietnam comes from the fact that their financial systems are extraordinarily primitive--better than scratching your accounts into clay tablets, but not all that much.

Asian central banks like to buy dollars and sell their own currency in order to subsidize exports. Some argue that this is a valid way to jump start their economies, others that this is misguided mercantilism, but we valiantly wave those arguments aside. They do buy huge amounts of foreign currency and sell their own, which makes their currencies artificially cheap.

If you do this, you are going to get inflation. There are a couple of ways to look at this. One is that you're releasing more currency on the market; another is that you're keeping exports expensive, which protects inefficient local producers and reduces household purchasing power. Either way, you get inflation.

Central banks often try to "sterilize" these transactions by issuing bonds on the domestic market, which soaks up excess currency. But their domestic financial markets are, as previously mentioned, built out of popsicle sticks and held together by baling twine and rubber bands. The answer to this problem is to force state controlled entities, like banks, to buy your government bonds. The banks cannot absorb an indefinite number of bond. Indeed, it is believed that many of them are technically insolvent thanks to mismanagement and local officials who use them as slush funds, though information on this is hard to come by.

The result is that the currency transactions are, as economists delicately put it, "imperfectly sterilized". Hence, inflation, and also, the interesting (in the chinese proverbial sense) possibility of a spectacular collapse at some unspecified time in the future.

Matt writes:

This certainly sounds logical to me, though as a non-economist, most things proposed by staggeringly brilliant economists tend to sound logical to me. But it sounds intuitively correct that a country that imports all of its gasoline can’t keep gas prices down by shrinking the money supply, or that if it did, that monetary policy would have to be deflationary in every other area, and thus ruinous. And, obviously, gas prices tend to get passed through to the rest of the economy.

On the other hand, Vietnam’s inflation problem isn’t driven solely by rising commodity prices, but also by a vast influx of investment currency over the past 2 years which has created tremendous upward pressure on the dong. As the government tries to hold down the dong to safeguard exports from getting more expensive, it has to basically increase the supply of dong, which creates inflation. And this is exacerbated as the dollar is falling against other currencies, as well as against oil, which is still Vietnam’s biggest export. The advice of most economists has been that this is untenable, and they’ll have to let the dong rise against the dollar somewhat to alleviate inflation.

Still, Stiglitz’s point seems very solid, right? The current situation does seem to indicate that inflation isn’t, in the old Friedmanite formulation, always and everywhere a monetary problem. Then again, wouldn’t this have already been discovered in 1974? What was the economists’ position then?



As an aside, I think I have to point out that Vietnam needs to do a number of things to its currency system, first among them changing the name. Otherwise, I predict it will be very hard to reach their goal of becoming a major US trading partner.

On to Matt's questions. The government can keep the price of gasoline down by targeting the money supply, but only, as Mr. Steinglass points out, in a ruinous fashion. Moreover, this would just change the general price level, so the relative share of gas in the household budget wouldn't change. If I double your income and double the cost of the goods you buy, we've accomplished nothing except marginally increase the demand for the ink they use to print paychecks. You cannot make a scarce good more abundant by monetary fiat.

As for the Friedmanite dicta, I'd say it still holds: inflation in the general price level is a result of there being more money than demand for money. Sudden scarcity--which is what higher food and energy prices represent--results in a shift in the relative value of everything in the economy. You now have to give up more of other goods to get the same amount of oil, because there is less oil to go around.

What happens when oil and food become scarce? Either people use less of them, or they sacrifice more other goods in order to consume food and oil. That means demand falls for other goods, which should push the prices of those goods down. The people who consumed a lot of oil will be worse off, while those who consumed relatively little will be better off.

An increase in the price of everything can only come as the result of too much money. This is not the same as noting that household budgets now buy less stuff; they buy less stuff because there is less stuff. Basically, a large increase in the price of oil or food is a one time productivity shock to the economy which reduces GDP from where it otherwise would have been.

Take a look at this graph of America's M2 growth. M2 is a measurement of the money supply which includes cash, checking accounts, savings accounts, and a few other safe-as-houses sorts of accounts. It's grown at a pretty startling clip over the last year, almost 10%. Not super-surprising, then, that we're seeing high inflation.

The reason we're getting this inflation is that the Fed is trying to support aggregate demand in the face of the housing collapse and the oil crunch. Though inflation much above 2% is a bad thing for the economy in the long term, higher inflation can, in the short term, alleviate the pain by making people feel richer so that they don't freak out and stay home guarding the TiVo. Actually, it's a little more complicated than that, but this post is long enough already, so I'll leave you with the pronouncement that no, inflation targeting is not a bad idea.

Who are you going to believe--me, or a Nobel-Prize winning economist?

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