Yesterday, I pointed out that the first instalment of the rescue package could be financed by cancelling the Stage 3 income tax cuts legislated for 2024-25. Today, the same suggestion is on the front page of the SMH. Morrison is apparently resisting the idea, but that can’t last long.
Trying to keep one day ahead, I’ve turned my mind to how the Reserve Bank should operate during and after the crisis. The first step is to abandon inflation targeting once and for all. The policy of using small interest rate adjustments to keep inflation in a range of 2-3 per cent made sense in the policy context of the (spurious) Great Moderation, when the target appeared consistent with maintaining unemployment at a stable level of 5 per cent or so, assumed to be the lowest the economy could sustain.
That all fell to pieces with the GFC. Inflation targeting, which did nothing to stop asset price bubbles, was a significant contributor to the crisis. Various ideas to address this problem were floated, but it ended up in the too-hard basket.
In the aftermath of the GFC, most central banks pushed their key interest rates down to zero. Even where this didn’t happen, as in Australia, inflation remained persistently below the target range, a problem that hadn’t been contemplated when the policy was first introduced in the 1990s, and the big concern was a resurgence of the inflation of the 1970s and 1980s.
It’s now obvious that we will never return to a world where inflation targeting makes sense. But what should replace it?
The first step should be a re-ordering of the Reserve Bank’s objectives to focus primarily on full employment rather than price stability. One way to implement this would be to target the level and growth rate of nominal income. My suggested target would be a 7 per cent rate of nominal growth, ideally made up of 3 per cent real growth* and 4 per cent inflation. The idea of the nominal target is that, if real growth falls below the target, the Reserve Bank loosens monetary policy and accepts higher inflation.
A 7 per cent growth rate would imply a doubling of nominal income over a decade. That in turn means that if we end the crisis with, say, debt equal to 60 per cent of national income, and balance the budget (on average) after that, the debt to income ration would fall to 30 per cent by 2030.
- In the longer term we should be looking at taking the benefits of technological growth in the form of more leisure rather than more output. But I haven’t had time to do the analysis on that.
55 thoughts on “Dump inflation targeting”
When the Bank of England (as a convenient example for this explanation) first issued banknotes, they came with a guarantee that each note could be exchanged with the bank for specie, so to the extent that the guarantee was trusted each note could be used as a gift or payment equivalent to the nominated amount of specie: in this sense, each note had the same value as a nominated amount of specie and it could be said that the note had value because it was backed by a guarantee to exchange for specie or, in short, backed by specie. To say that a five pound note was worth five pounds was to say that it had the same value as five pounds worth of specie because it could be exchanged for five pounds worth of specie, or so the Bank guaranteed. Now the banknotes issued by the Bank of England are not, in this sense, backed by specie. The Bank does not guarantee that it will accept a five pound note and provide five pounds worth of specie in exchange. The value of banknotes issued by the Bank of England is, instead, backed by a government stipulation that a five pound note is worth five pounds or a ten pound note ten pounds, and so on. The government’s stipulation is equivalent to saying ‘Let this note be worth five pounds [or whatever amount is stipulated]’. the Latin for ‘Let [it] be [so]’ (in this sense) is ‘fiat’, and that’s why this kind of money is called (by me, and by other people) ‘fiat money’.
The original fiat banknotes were, obviously, printed, and this is still the case, although they are increasingly being displaced from use by electronic transactions.
So I’ve explained what I mean by ‘fiat currency’, but I can’t answer the second part of your question, about what I think you think it means. I can’t tell what you think it means. All I know is that I got the impression from the question you posed to sunshine that you thought there was some kind of conflict between the concept of ‘fiat currency’ and the concept of ‘money printing’, whereas as I understand it there is none. But perhaps I misunderstood what you meant, in which case I look forward to your providing an extended explanation to correct me. If I a mistaken I prefer to be corrected.
“I do not think it means what you think it means.”:
It does suggest you know what I think it means. What is more it suggests that what I think it means is not entirely correct. Hence my question.
The phrase “money printing” (leading to inflation) is often used by people who implicitly assume that the currency is backed by specie. I was trying to ascertain from sunshine.if that was the implicit belief behind that statement.
When banknotes carried a guarantee of redemption in specie, it was still possible for banks to issue notes in excess of their holdings of specie, on the reasonable assumption they would not be called on to redeem all notes issued for specie. At the same time, the guarantee could act as a restraint on the volume of notes issued. Now that there’s no such guarantee, that particular restraint doesn’t operate.
However, both when notes were backed by that guarantee and now when they are fiat money, it’s still possible for the issue of notes in excess of some limit (a limit which is, however, not exactly ascertainable in advance) to produce a decline in confidence in the currency and hyper-inflation. Just having a fiat currency doesn’t make possible unlimited issue without adverse consequences (and this applies just as much to the issuing of currency electronically as it does to the literal printing of banknotes).
I don’t keep my age a secret, but anybody who wants to know which generation I identify with can do the other thing. If I had to choose, I’d prefer to be called a Wood Dragon. It (Chinese astrology) makes about as much sense, and I don’t have to interact regularly with people who believe in it.
J-D: Thank you for your tutorial on the dangers of money printing even with a fiat currency.