T C A Srinivasa-Raghavan: Monetary policy consensus - global or only western?

OKONOMOS

The author doesn't give enough credit to chance which, in this case, consists of both a Marxian and a Schumpeterian element, namely, technology-induced improvements in profits and productivity.

One of the many things that mystify economists is how, for much of the 20th century, governments failed to see the obvious and positive connection between money supply and inflation. From a political standpoint, though, the puzzle is immediately solvable.

It has its roots in the Russian Revolution of 1917 which seemed to prove that Marx's "vast army of the unemployed" would one day dethrone capitalism and capitalists. Western owners of capital responded in a variety of ways, including fascism, socialism, Fabianism, welfare statism, and so on. But at the core of each lay the fundamental recognition that labour would have to be accommodated, or appeared to be accommodated. The new name for this in developing countries is "inclusive growth."

Therefore, for nearly 70 years (or more-or-less the life of the Soviet Union), a trade-off between unemployment and inflation had to be found. This is because of the inflation that was resulting from expansionary monetary and fiscal policies. It also became the obsession of macroeconomists.

But, thanks to the short-termism of political parties, the scales came down in favour of employment and against inflation. The reasoning was that although high prices hurt the poor, it hurts even more not to have a job. The confusion caused by two conflicting objectives foxed macroeconomics completely.

But after the many shocks of the 1960s and the 1970s, the consensus (as Marvin Goodfriend* would call it), began to break down. First through Margaret Thatcher and then through Paul Volcker and Ronald Reagan, the owners of capital managed to turn the tables. Those who did not own capital but only their own labour were told to go take a walk.

In the 1980s, inflation became the target, never mind if the pursuit of low inflation led to high unemployment. The brunt of bearing the cost of unemployment benefits shifted from a few fat-cats to everyone in society via higher taxes to fund social security payments.

The theory and practice of this were tested in the 1990s. Both worked like a charm. The period has come to be known, somewhat fatuously if you ask me, as the "Great Moderation". As Goodfriend describes in the paper under review, "the world achieved a working consensus on the core principles of monetary policy."

To quote further: "The Volcker disinflation taught several lessons...First, the main monetarist message was... monetary policy alone""without wage, price, or credit controls, and without supportive fiscal policy""could reduce inflation permanently at a cost to output and employment that, while substantial, was far less than in common Keynesian scenarios.

"Second, a determined independent central bank can acquire credibility for low inflation without an institutional mandate from the government, although this 'stand-alone' central bank credibility for low inflation may be fragile and periodically tested by potentially destabilising inflation scares.

"Third, a well-timed aggressive interest rate tightening can reduce inflation expectations and preempt a resurgence of inflation without creating a recession."

He may well be right, but in human affairs it pays to be tentative. The problem is this: although his paper is one of the best I have ever read, it doesn't give enough credit to chance which, in this case, consists of both a Marxian and a Schumpeterian element, namely, technology-induced improvements in profits and productivity, respectively. He discusses them but not as chance factors.

In my view, the real question is, therefore, this: had the electronics revolution not come along when it did, would the political class have embraced inflation targeting so eagerly? Perhaps not. And the proof of this lies in the monetary policies of the developing countries with decently functioning democracies. The Western consensus on monetary policy is not very visible there because technology is yet to permeate in such a way that you get permanent gains in profits and productivity.

*How the World Achieved Consensus on Monetary Policy, NBER Working Paper No. 13580 November 2007