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Title: New Wealth of Nations
Author: Surjit S Bhalla
Publisher: Simon and Schuster
Price: Rs 599
The great inflation decline (GID)
Today, we are back to the low inflation era of the 1950s and 1960s. For the 17 years following 1951, Consumer Price Index (CPI) inflation in the US averaged 1.7 per cent, and the medium inflation in the AEs averaged 2.8 per cent. For the years 2000–2016, US inflation was 2.1 per cent, and in AEs, 1.9 per cent.
Inflation jumped in the world in 1972 due to a wheat shortage, and the Yom Kippur war of October 1973 induced double-digit world inflation — the first time in world history, and very likely the last time. Oil prices quadrupled in 1973 and the world experienced a phenomenon which came to be known as ‘stagflation’ — a word invented to describe low output growth and high inflation, something neither the monetarists nor the Keynesians thought possible.
Then came Paul Volcker who fought inflation, and won. Volcker was brought in by President Carter to head the US Fed in 1979, with the near explicit mandate to fight double-digit inflation. This, he did. In fact, he was so successful and popular that Republican President Reagan reappointed him in 1983. Volcker’s second term came to an end in August 1987. No necessary causation here, but less than two months after his leaving, the US stock market crashed by 25 per cent in one day.
By 1984, OPEC inflation had run its course. From double digit inflation for most of the period from 1973 to 1983, median inflation in the advanced economies (AEs) was reduced to 6.2 per cent in 1984 and 5.7 per cent in 1985. From the early 1990s, median inflation has stayed well below 4 per cent and close to 2 per cent. This is what can be termed the ‘great inflation decline’ (GID), and it’s a phenomenon crying out for an explanation.
Economists have tried various explanations for the GID. My favourite explanation is also a favourite among many economists, including officials of the Reserve Bank of India. The reasoning centres around a three-letter word — oil — as it did 45 years ago. But has oil mattered for inflation since the early 1980s? Between 1998 and 2007, oil prices quintupled (from US $14.4 for a West Texas intermediate barrel in 1998 to US $72 in 2007, before peaking at around US $160 in 2008), and inflation in the AEs and in a large number of emerging market economies was lower by half a percentage point.
Today, the US economy is as close to full employment as it has ever been, and yet there is no sign of inflation. The GID has caused the central banks in the world to fight a different and unprecedented battle — how to increase the inflation rate. Over the last few years, central banks (the Fed, ECB, and the Bank of Japan) are fighting, clamouring, plotting, and begging to get the inflation rate up to 2 per cent, and ‘obviously’ not succeeding. What could be the reason?
The reason is that the world has changed, and the old models do not fit the facts of the new world. And the world changed more than 20 years ago. Misinterpreting this change or not acknowledging it has led central bankers to make big policy mistakes. One such prominent central banker was Alan Greenspan.
How one central banker misinterpreted the great inflation decline
In February 1995, barely two months after the large Mexican currency devaluation of December 1994, Fed chairman Alan Greenspan raised interest rates in the US by a half percentage point to 6 per cent. For the uninitiated, half a per cent (50 basis points) is a very large move by the US Fed and not that usual with inflation hovering around 3 per cent.
Greenspan was wrong on at least two counts. First, he could not conceive that a large Mexican devaluation of December 1994, affecting at least all of Latin America and most of the East, would or should have an impact on US inflation, and consequently on the US monetary policy and its fight to keep inflation low. Traditional monetary policy was fast declining as an instrument for attacking inflation even then.
The second error of the redoubtable Greenspan was in thinking that inflation in the US was a problem. In 1994, consumer prices had increased by 2.6 per cent, having increased by a seemingly large 3 per cent the year before. What Greenspan was apparently attempting to attack was not inflation, but future impending inflation to be brought upon by the higher than inflation-neutral GDP growth in the future. That is a mouthful (my apologies) but it gets to the heart of the puzzle, and how the central bankers have adamantly refused to see the… writing on the wall. In 1994, GDP growth in the US was a high 4 per cent and Greenspan (wrongly) inferred that this high growth would induce higher inflation.
It is instructive to see how un-right or un-prescient the leading central banker in the world was about future US events. In 1995, the year of the great strike against impending inflation, US GDP growth recorded 2.7 per cent, and would not record lower GDP growth until the 9–11 year. For the next five years (1996–2000), US GDP growth averaged 4.3 per cent per annum; US CPI inflation averaged 2.5 per cent per annum. During the previous decade, US GDP growth averaged 3.1 per cent, and US inflation 3.6 per cent. This was the first warning sign that ignoring higher education (skilled labour) in the developing world would lead to domestic policy mistakes.
Explaining the great inflation decline: The usual suspects fail
…Low inflation has been a phenomenon for the last 20 years. That is what we have to seek an explanation for. Topping the list of claimants seeking credit for low inflation, you guessed it, are central banks. These central banks are now more independent of government restraints (and constraints) than ever before, and surely this institutional change has helped decrease inflation. The number of inflation-targeting countries has also increased, and these born-again inflation hawks fight even nonexistent inflation with the tenacity of a raging bull. Hence, inflation is low because of sensible central bank policies.
Are there other princes vying for the throne? Not many; the fiscal deficits theory of inflation is not taken seriously any more, nor is the money supply variant. The rejection is on the same grounds — the theory does not fit the facts. High and low fiscal deficits (look at Greece and India, both with high fiscal deficits and low inflation) are irrelevant for predicting inflation; the Phillips Curve also does not work any longer, and neither does the newest inflation kid on the block — the Taylor rule — which advocates and explains the setting of policy interest rates on the basis of inflation gaps and output gaps. As Monty Python’s John Cleese’s dead parrot might say, Keynesians and monetarists are no more; they have ceased to predict inflation, they are discredited, tired, and retired; theirs are ex-models of inflation, they have gone to their keeper (history books).