The case for a top-down approach
Thursday, 9 August 2007
Samuel Brittan
"THE past 15 years have seen inflation settle at low levels throughout the industrialised world. And many countries in the developing world, which had previously experienced high inflation, have seen it falling. If you ask the average business person why this is the case, he or she is almost certain to reply that it is down to cheap imports from the Far East and eastern Europe. Monetary policy probably won't get a mention."
These are the words of Charles Bean, the Bank of England's chief economist, in an article called "Globalisation and Inflation" in the January-March issue of World Economics. Mr Bean is not shy to tackle this version of businessmen's economics, saying that it is based on a confusion of relative prices with the absolute price level. A flood of cheap imports from newly industrialising countries may temporarily depress inflation. This will leave consumers better off, with more to spend on other products whose prices may then be driven up. Even if this does not happen, "if a country does not fix its exchange rate and is free to pursue an independent monetary policy, it can ultimately always choose its own inflation rate".
A glance at the data over the past 20 years shows not just a trend drop in inflation, but a remarkable narrowing in the spread of rates in the industrialised world, especially but not only among members of the eurozone. The range now extends from just over 1.0 per cent to just under 3.0 per cent. But there are, as always, outliers. Turkey, for instance, enjoys a rate of 9.2 per cent and Hungary one of 8.5 per cent. As I have said before, give me control of a central bank and I can guarantee an inflation rate in double digits, whatever China and India are doing.
What, then, are the implications of globalisation for monetary policy? Suppose that there is overheating in a country or a worrying expansion of money and credit. It will not be so easy to tighten policy, as much of the effect will leak out in lower imports and lower immigration. Indeed, I alluded to this last year in an article titled, only semi-facetiously, "Why the Bank is the migration ministry" (October 6 2006). This effect can be seen even more clearly if the central bank tries to stimulate demand to fight an incipient recession. Much of the benefit will go to importers and to an increased number of immigrants.
International factors also limit the ability of central banks to impose a domestic squeeze. Borrowers who face expensive credit or credit stringency in their own countries can often go abroad to borrow. As Mervyn King, the Bank of England governor, has occasionally hinted, the world money supply may be the relevant factor in inflation control.
That is not, however, quite the whole story. As long as the area for which the central bank is responsible has a floating exchange rate, that can act as a safety valve. If the bank pursues a tight money policy hard enough and long enough, the exchange rate will eventually rise, exerting a downward pressure on prices and wages. If it relaxes enough, the currency will fall, thereby providing at least a temporary stimulus of the kind familiar from discussions of devaluation. Because sterling's devaluation after the UK departure from the European exchange rate mechanism took place at a time of pronounced recession, the stimulus to real activity was much greater than the inflationary impact.
The spillover effects into other countries of any loosening or tightening of domestic policy have long been known in discussions of the Keynesian multiplier. The multiplier is simply the way any policy stimulus expands as payment passes from hand to hand. The multiplier has long seemed surprisingly low under the impact of leakages. Originally, the external leakages were mainly into imports. But with the new sensitivity of immigration and capital movements to variations in economic activity, as well as the communications revolution, the leakages may now have become the main effect.
The time may thus have come for central banks, instead of treating international effects as a complication, to begin their analysis with an estimate of the inflationary trend in the industrial world as a whole and then asking whether that trend is too high or too low for their own countries. As long as the recent prudence is maintained, departures from the international norm are likely to be infrequent and limited.
With the international dimension now so important, the time may have come for a degree of joint management of world demand. The last thing I want to propose is yet another intergovernmental committee or another high-sounding body with a new acronym. The informal monthly meetings of central bankers at the Bank of International Settlements in Basle could do the job, as long as the emphasis is gradually shifted from comparing notes about each central banker's own country to a top-down view of world activity and inflation.
There are many different ideas about how exactly this should be done: for example, on the emphasis to be placed on real activity and asset bubbles as well as indices of consumer prices. The important thing is to make a start before the likes of Nicolas Sarkozy get in on the act.
........................................
FT Syndication Service
"THE past 15 years have seen inflation settle at low levels throughout the industrialised world. And many countries in the developing world, which had previously experienced high inflation, have seen it falling. If you ask the average business person why this is the case, he or she is almost certain to reply that it is down to cheap imports from the Far East and eastern Europe. Monetary policy probably won't get a mention."
These are the words of Charles Bean, the Bank of England's chief economist, in an article called "Globalisation and Inflation" in the January-March issue of World Economics. Mr Bean is not shy to tackle this version of businessmen's economics, saying that it is based on a confusion of relative prices with the absolute price level. A flood of cheap imports from newly industrialising countries may temporarily depress inflation. This will leave consumers better off, with more to spend on other products whose prices may then be driven up. Even if this does not happen, "if a country does not fix its exchange rate and is free to pursue an independent monetary policy, it can ultimately always choose its own inflation rate".
A glance at the data over the past 20 years shows not just a trend drop in inflation, but a remarkable narrowing in the spread of rates in the industrialised world, especially but not only among members of the eurozone. The range now extends from just over 1.0 per cent to just under 3.0 per cent. But there are, as always, outliers. Turkey, for instance, enjoys a rate of 9.2 per cent and Hungary one of 8.5 per cent. As I have said before, give me control of a central bank and I can guarantee an inflation rate in double digits, whatever China and India are doing.
What, then, are the implications of globalisation for monetary policy? Suppose that there is overheating in a country or a worrying expansion of money and credit. It will not be so easy to tighten policy, as much of the effect will leak out in lower imports and lower immigration. Indeed, I alluded to this last year in an article titled, only semi-facetiously, "Why the Bank is the migration ministry" (October 6 2006). This effect can be seen even more clearly if the central bank tries to stimulate demand to fight an incipient recession. Much of the benefit will go to importers and to an increased number of immigrants.
International factors also limit the ability of central banks to impose a domestic squeeze. Borrowers who face expensive credit or credit stringency in their own countries can often go abroad to borrow. As Mervyn King, the Bank of England governor, has occasionally hinted, the world money supply may be the relevant factor in inflation control.
That is not, however, quite the whole story. As long as the area for which the central bank is responsible has a floating exchange rate, that can act as a safety valve. If the bank pursues a tight money policy hard enough and long enough, the exchange rate will eventually rise, exerting a downward pressure on prices and wages. If it relaxes enough, the currency will fall, thereby providing at least a temporary stimulus of the kind familiar from discussions of devaluation. Because sterling's devaluation after the UK departure from the European exchange rate mechanism took place at a time of pronounced recession, the stimulus to real activity was much greater than the inflationary impact.
The spillover effects into other countries of any loosening or tightening of domestic policy have long been known in discussions of the Keynesian multiplier. The multiplier is simply the way any policy stimulus expands as payment passes from hand to hand. The multiplier has long seemed surprisingly low under the impact of leakages. Originally, the external leakages were mainly into imports. But with the new sensitivity of immigration and capital movements to variations in economic activity, as well as the communications revolution, the leakages may now have become the main effect.
The time may thus have come for central banks, instead of treating international effects as a complication, to begin their analysis with an estimate of the inflationary trend in the industrial world as a whole and then asking whether that trend is too high or too low for their own countries. As long as the recent prudence is maintained, departures from the international norm are likely to be infrequent and limited.
With the international dimension now so important, the time may have come for a degree of joint management of world demand. The last thing I want to propose is yet another intergovernmental committee or another high-sounding body with a new acronym. The informal monthly meetings of central bankers at the Bank of International Settlements in Basle could do the job, as long as the emphasis is gradually shifted from comparing notes about each central banker's own country to a top-down view of world activity and inflation.
There are many different ideas about how exactly this should be done: for example, on the emphasis to be placed on real activity and asset bubbles as well as indices of consumer prices. The important thing is to make a start before the likes of Nicolas Sarkozy get in on the act.
........................................
FT Syndication Service