The Great Moderation
For the past 27 years UK governments of all political persuasions have targeted a rate of inflation of 2 per cent as the principal objective of monetary policy. The Bank of England is charged with the implementation of policy and, to ensure its freedom to take tough decisions, it was granted operational independence from the Treasury in 1997. The result has been the Great Moderation: low and stable inflation averaging 2.8 per cent annually, falling unemployment (with the exception of a few years after the 2008 financial crisis) which has recently been at 4 per cent (effectively full employment) and a growth of those employed in the working population from 69 to 75 per cent. Alan Blinder, a Princeton economist, described price stability as “ when ordinary people stop talking about and worrying about inflation”. This is precisely what happened.
Inflation targeting was introduced in the early 1990s, after the experience of living through two decades of high and volatile inflation. Throughout the 1970s and early 80s, inflation averaged 15 per cent annually. However, it was not just inflation that was a problem. Inflation was accompanied by rising unemployment, so-called “ stagflation ”, labour disputes, strikes and relatively low productivity growth, which became known internationally as “ the British disease”.
The success of inflation targeting has been due to the freedom of the Bank of England to raise or lower interest rates without political interference, so controlling the growth of monetary aggregates and consequently anchoring expectations of future inflation at 2 per cent. Similar success in controlling inflation has occurred in the US, Japan and the Euro zone. In each case their central banks have enjoyed operational independence.
The Sudden Return of Inflation
Recently inflation has, once again, become a topic of conversation. The combination of the global pandemic, lockdowns in one country after another and a more troubled global economy will, according to the Chancellor of the Exchequer, land the UK in a recession “ the likes of which we have not seen”. The OECD and the Office for Budget Responsibility estimate that the crisis will lead to a UK unemployment rate of 11.7 per cent, or 4 million people. If a second wave of Covid-19 were to occur, this rate could rise to 15 per cent, or nearly 5 million. The response of economists, commentators, central bankers and politicians has been that extraordinary times demand extraordinary measures. Hence the staggering increase in public spending and the monetary authorities ’ rapid credit expansion have both met with general approval as an appropriate response to the crisis. The question is: might these measures not lead to inflation?
The UK money supply (M4) has been growing at an annualised rate of 20 per cent since February. Last year it was closer to 4 per cent. In addition, the Bank of England has reduced the amount of capital that banks and building societies need to set against their lending. Some commentators have weighed in, recommending that printing money is a valid response to the crisis because “deflation is a bigger fear than hyperinflation” (FT, 28 April). This has been the view of reputable US economists, such as Olivier Blanchard and Lawrence Summers, who fear we face secular deflation. They propose doubling the current inflation target to 4 per cent. Others have suggested that inflation should be allowed to rise to a “moderate rate”, which can only imply a higher rate (New Statesman, 26 June). Adam Tooze, the Princeton historian, who is British, has argued that in times of crisis the rate of inflation should be allowed to rise — even, if necessary, to levels last seen in the UK in the 1970s (BBC News, 28 June).
Meanwhile, the former Chancellor Sajid Javid, plus the economists Gerard Lyons and Jim O ’ Neill , have proposed the more radical option of dropping inflation as a target. They would replace it by a money income growth target, an aggregation of real income growth and the rate of inflation, which would mean that inflation could rise significantly. “ Growth must be the target, not inflation.” (O ’ Neill).
The actions of the Bank and the Treasury and the views of the commentariat have not been lost on investors. The demand for government securities (gilts) index-linked to inflation has been increasing, even when they offer negative yields. The prices of gold and silver are at their highest for nine years. The increase in global trade has resulted in price rises of industrial metals and oil. Auction prices for such diverse items as Michael Jordan ’ s old shoes, fine wines and contemporary art are soaring.
Against this background we must take the prospect of inflation seriously. I say this, not because I am unconcerned about the costs and pain of rising unemployment. The inability to find paid employment after repeated attempts to do so is depressing, demoralising and spiritually impoverishing. As the 1930s and early 1980s showed, unemployment is indeed a “ social evil ”. The 1970s also demonstrated, however, that this is true of high and volatile inflation.
At that time, I was a member of the economics department of the London School of Economics, teaching and conducting research in the field of monetary economics. That inflation reached 25 per cent in 1975 is a matter of record. Inflation seems a more abstract concept than unemployment, but it can have just as devastating an impact. Living through that period and witnessing at first hand the corrosive effects it had on economic life and the life of society I saw another aspect of the story and one which I would never wish to see repeated. Carefully managed savings were eroded; reckless borrowing was rewarded. It is interesting that most members of the present Cabinet had not reached their teens when inflation took off in the 1970s and so have little experience of living with it.
Lessons of the 1970s and 1980s
The immediate priority for the Government must be to tackle rising unemployment, but not at the risk of letting inflation take off again. To allow inflation to rise would be a failure to learn the lessons of history.
One lesson is that inflation is ultimately and invariably a monetary phenomenon, something recognised by great British economic thinkers such as Hume, Smith, Ricardo, Mill, Marshall and Keynes. It is typically slow to take off, volatile when it does and extremely costly to root out. When the monetary taps are turned on, the immediate impact is on rising asset prices, then increasing aggregate demand, a short term boost to output and finally rising prices of goods and services. This was true of the early 70s, the “ Barber boom ” (Tony Barber was Chancellor of the Exchequer 1970-74), and the late 80s following the then Chancellor Nigel Lawson ’ s instructions to the Bank of England to shadow the Deutschmark, with the result that the money supply grew more rapidly. Over these years the change in the rate of inflation from year to year was high at times, with large annual increases of 3 to 8.5 per cent, but low at others, with equally significant decreases of 3 to 9 per cent.
Controlling inflation is painful. It requires the central bank to raise interest rates. In the mid-1970s, the Bank rate was raised to 15 per cent, in 1979 under the new Thatcher government to 17 per cent and again in the late 1980s to 15 per cent. Each time interest rates have been raised, inflation has been brought down, but only at the cost of increased unemployment.
The evidence since the 1960s suggests that it is an illusion to think that there is a trade-off between inflation and unemployment or between inflation and the rate of economic growth, other than in the very short term. The factors which make for growth are the skills of the labour force and the productivity of capital investment, which cannot easily be changed in the short term. Increased growth resulting from a sudden rise in public expenditure will prove unsustainable in the longer term.
While historically inflation is a monetary phenomenon, it would be wrong to be dogmatic and argue that on each occasion when monetary growth accelerates, inflation will necessarily follow. The 2008 financial crisis was followed by a huge increase in bank reserves due to Quantitative Easing (QE). Inflation did not take off, but that was because bank lending was constrained by the inadequacy of bank capital and banking regulations. The difference between then and now is that banks are well capitalised and encouraged by central banks to lend freely.
A second lesson is that inflation has a real cost to the economy which many economists have been slow to recognise. Hyperinflation is recognised as a disaster, but it is thought that lesser inflation can somehow be managed. The Nobel Prize-winner James Tobin of Yale famously caricatured the cost of inflation as the lost time and worn shoe leather in making extra trips between savings banks and commercial banks in order to earn a return on deposits. If only it were true.
Inflation is costly because it diverts real resources from productive to unproductive use, the full impact of which is only captured when we recognise, with Frank Knight, Mervyn King and John Kay, that the world in which we live is characterised by radical uncertainty. When the monetary taps are turned on, we know that inflation will rise in the foreseeable future, but we do not know enough about its likely course to act with confidence. This creates uncertainty for business and households as to when to invest, the need to hedge decisions, anticipate what actions government might take, negotiate wage increases and decide when and by how much to mark up prices. If all contracts could be index-linked to inflation its cost would be reduced, but the insight of radical uncertainty is that this is precisely what we cannot expect to know.
A third lesson is that inflation undermines the legitimacy of a capitalist economy and a parliamentary democracy. Keynes saw this very clearly.
“ Lenin is said to have declared that the way to destroy the capitalist system was to debauch the currency… Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction and does it in a manner which not one man in a million is able to diagnose.” (J.M. Keynes: The Economic Consequences of the Peace, 1919)
Keynes is right to emphasise the importance of subtlety and certainty. Inflation results in a capricious redistribution of income and wealth. Those on fixed incomes (pensioners or families receiving welfare benefits not adjusted for inflation) lose out, those with incomes indexed to inflation (e.g. civil servants’ pensions) gain, those borrowing money are subsidised, those holding money and conventional gilt edged securities (e.g. pension funds) are penalised. This redistribution bears no relation to extra work, greater risk or increased saving. It is totally arbitrary, the equivalent of a random wealth tax, with an outcome little different from a lottery. It is a tax which no specialist in taxation would ever advocate.
As inflation rises , a witch hunt begins to find the guilty parties: speculators, trade unions, foreigners, estate agents, merchants, bankers, traders. Effect becomes mistaken for cause as higher wages, increased rents, rising commodity prices and remarkably high interest rates are seen, not as the result, but the cause of inflation. Typically governments respond by imposing price and wage controls, which never succeed but make matters worse by creating conflict between labour and management.
Inflation as a form of concealed taxation has a further and important dimension. When during a period of inflation the Bank of England issues a new £20 note with the words printed on its face: “ I promise to pay the bearer on demand the sum of £20,” signed by the Chief Cashier for the Governor and Company of the Bank of England, it does so recognising that in all likelihood inflation will continue. If inflation is expected to be, say, 20 per cent, the Bank acts in the knowledge that the purchasing power of the note will only be worth £16 one year later. This is a form of deception enshrined at the very heart of the financial system. It creates a corrupting influence, prompting others to abuse their potential monopoly powers, evade taxes and practise other forms of dishonesty, such as creative accounting.
In the very short term, a matter of months, prices may rise for all sorts of reasons: a bad harvest, an oil price hike, panic buying, higher import prices, a rise in VAT or even social distancing in restaurants. In the longer term, inflation is invariably associated with the increasing growth of monetary aggregates, as governments find themselves under pressure to finance budget deficits.
The common cause of all hyperinflations is the inability of governments to finance excessive spending. This was true of Germany in 1923, Hungary in 1946, Chile in 1973 and Zimbabwe today, where the annual rate of inflation is 785 per cent. At present there is no reason to think that hyperinflation is a threat in the UK. Yet the staggering increase in government spending and borrowing, not just at present but for some time to come, will need to be financed.
The only way a government can finance deficit spending, without defaulting on its debt or reducing existing expenditure, is through taxation. It can raise existing tax rates, introduce new taxes, defer taxes through borrowing or permit inflation to tax those holding the monetary liabilities of government. It can hope for increased economic growth which will increase tax revenue. It can rely on “ fiscal drag ” through inflation and real economic growth as individuals pay proportionately greater tax through moving to higher tax brackets.
The important point is that if the government increases expenditure and does not cut existing programmes it can only finance the expenditure through increasing taxation. All taxes raise issues regarding incentives and fairness which doubtless will be debated at length over coming months.
At present the UK government is relying on borrowing to finance extra spending. The official interest rate, the Bank rate, is at an all time low of 0.1 per cent, which means that the cost of borrowing is exceptionally cheap. However, market sentiment is fickle, nowhere more so than in financial markets. If investors feel that the cost of financing the government ’ s programme is not credible without accompanying tax increases, they will sell gilts, bond prices will fall and interest rates will rise, with all their damaging effects.
Bank of England Independence
The independence granted to the Bank of England by Parliament by the Bank of England Act, 1998, set out a new regime for controlling inflation. The Act states that “ the objectives of the Bank of England shall be to target price stability.” The 1970 s and 1980 s demonstrated that inflation could not be brought under control without control of the monetary aggregates. But what should the Bank target? From that period the Bank has unsuccessfully targeted narrow money (the monetary base), broad money (M4) and finally the exchange rate, all without success. The demand for money (velocity) was unpredictable and the chosen exchange rate never got it right. In the end the Bank and Treasury agreed that the objective for price stability should be a 2 per cent rise in the price level, but importantly subject to the Bank supporting the government ’ s economic policy and its objectives for growth and employment.
The new regime, introduced by Norman Lamont, has advantages. It is clear and easily understood. It is operationally independent of political interference, while supporting overall government economic policy. It involves expert outsiders, the members of the Monetary Policy Committee, offering independent advice. It is transparent, publishing transcripts and reports of Committee meetings. It is accountable to Parliament, as the Governor is invited to give evidence to Select Committees of the House of Commons and the House of Lords. It is flexible: the 2 per cent target has permitted inflation to range from 4 per cent to just below 0 per cent but, crucially, without changing expectations of longer term inflation of 2 per cent. Its one weakness is that because monetary policy has become so entwined with QE, banking regulation and macro-prudential policies, the relationship between changes in interest rates and the monetary aggregates is much more diffuse and complex.
Replacing the 2 per cent target by a money income growth target not only risks inflation rising, but also risks expectations of inflation being cut free from the anchor which has proved invaluable over recent decades. A short term boost to output and jobs, like a sudden sugar rush, will feel good — only to be dashed by rising inflation followed by higher unemployment. For the general public, replacing the 2 per cent target invites mistrust as to the government ’ s intentions. Including real GDP in a forecast of money income growth adds uncertainty because real GDP is frequently subject to revisions. This may improve over time as real time data gives more accurate forecasts of GDP. However, we are not there yet. So at a time when the indices of inflation are already being distorted by food subsidies and reductions in VAT, a change now will simply lead to arcane disputes among economists, raising the public ’ s distrust even more.
Perhaps most significant of all is that the present regime mandates the Bank of England to take into account the government ’ s policy on economic growth and unemployment as well as inflation and provides it with more than sufficient tools to do its job. It has discretion over the sales and purchases of government debt and foreign currency, the level of bank reserves, the liquid assets banks should hold and the level of Bank rate, even possibly setting negative rates.
However, even with this caveat the Bank’s independence is far from absolute. The 1998 Act gives the Treasury reserve powers: “ The Treasury after consultation with the Governor may by order give the Bank directions with respect to monetary policy if they are satisfied that the directions are required in the public interest and by extreme economic circumstances.” If there was ever a candidate for “ extreme economic circumstances”, the present is it. For the independence of the Bank to be a reality requires the commitment of the Treasury to abide by the convention of allowing the Bank operational independence and in particular specifically targeting low inflation as at present.
Priorities for the Recovery
For the past three decades inflation has been under control. With the prospect of a serious recession the only option for any government was to spend money. The UK and the US took different approaches to dealing with the problem. However, both approaches have resulted in staggeringly large public sector deficits. With the probability of large job losses in the autumn and winter as well as a possible second wave of the virus, inflation, were it to rise, would erode people’s savings and pensions and drive small businesses and possibly larger ones into bankruptcy. Now is not therefore the time for the government to take risks with inflation.
Rather, the Treasury should confirm its commitment to the 2 per cent inflation target, publicly endorse the operational independence of the Bank of England, and produce a convincing plan to show how the deficit can be financed without excessive money creation.
We must hope that the government will avoid a repeat of the post-2008 programme of austerity. But if the public is to have confidence in the recovery and the currency, what the government cannot avoid is setting down certain fiscal and monetary rules, targets or guidelines to which it will adhere. In the October Budget it should set out a medium term plan which brings together expenditure, taxation and inflation targets, along with an open-mindedness on the most effective way to deliver public infrastructure investment and support for business.
Finally, with the prospect of large numbers of jobs being lost, there needs to be a comprehensive strategy for more apprenticeships, training and retraining programmes and further education for people of all ages. What matters most is that these are high quality initiatives, with a long term outlook. A short term cash handout is not the answer.