The Disastrous Effects of Central Banking: Let’s Get the Story about Inflation in New Zealand Straight

As the prices of some traded goods have gone up and house prices are relatively very high, the New Zealand economy is experiencing “inflationary pressures.” This has opened the door to a debate on the sources of inflation (see for instance here)—with the current and the ex-Governor of the Reserve Bank of NZ (RBNZ) holding surprising views.

The New Zealand Reserve Bank Act of 1989 is one of the best pieces of legislation ever designed (by a government, that is). It has a single focus on price stability. Originally, the government and the RBNZ signed policy agreements to specify the inflation target (something that the US Federal Reserve doesn’t have). In 1990, the inflation target was 0-2%; it is now 1-3%.

In recent years, broader economic goals have been added to the mission of the RBNZ including avoiding “unnecessary instability in output, interest rates and the exchange rate” (Alan Bollard, Governor). There is now more fuzziness in the medium term about when inflation needs to be within the band. In other words, the RBNZ is in charge of doing more than strictly focusing on price stability. This raises some issues.

First, central banks have tried to do many other things (than focusing on price stability) in the past and they failed. Second, having different objectives enables the central bank to find excuses when the goal of price stability has not been met. And that’s exactly what has happened in the last three years in NZ: inflation has overshot the 3% band (up to 3.4% in 2006). Inflationary pressures have been mounting and it’s getting “harder” for the RBNZ to mitigate them. (To continue reading, click on the link below.)

 

It is surprising to read that both the current governor, Alan Bollard, and the ex-governor, Don Brash, believe that inflationary pressures are, to some extent, outside the control of the RBNZ. It is probably fair to say that Bollard has had a very soft attitude towards the price stability objective since he started his tenure (an early indicator was the change in the inflation band to 1-3%). Don Brash has recently published an article on petrol tax as a means to control inflationary pressures (see here). The idea is that the tax would reduce the general level of spending in the economy without the central bank having to change its monetary policy. For Brash, taxation is a means to control inflation.

Considering that Don Brash is one of the heroes of late Milton Friedman (see here) and that he presided over the establishment of one of the best monetary policies in the world, his view is really surprising to say the least! For his part, Bollard is not a monetary policy specialist, is Keynesian in his economics, and has more a “mandarin” attitude in his job than that of an inflation fighter.

Now, let’s get the record straight: inflation is always and everywhere a monetary phenomenon (Milton Friedman), i.e. the RBNZ is fully responsible for whatever level of inflation existing in the economy over a given period. This means that as long as the money base doesn’t grow (relatively) faster than output, there cannot be any inflation—and the money base is under the control of the RBNZ. Now, central banks (because they don’t have the means to do so) may have a hard time assessing the demand for money in the short-term (and measuring true price inflation is also another problem). However, there is no doubt that inflation is entirely due to their actions at the end of the day. Consistent with its price stability objective, the inflation range for the RBNZ should be between -1% and +1% and not between +1 and +3%, as is the case now. The reason why the former is not an option is because (a) deflation is regarded as a political evil, (b) the belief that a bit of inflation is unavoidable and good for the economy, and (c) inflation is a form of tax (let’s be frank about it).

Since a picture is sometimes worth a thousand words, see the graph above from Bryce Wilkinson at Capital Economics Limited New Zealand, which depicts the evolution of the NZ consumer price index over the period 1860-2007 (courtesy of Bryce Wilkinson). There is no need to do complex econometrics to see on the graph that inflation is a monetary phenomenon (the “optical least squares” method is enough). In 1934, after the sterling and the gold standard were abandoned, the RBNZ was created. By some interesting coincidence, the creation of the RBNZ corresponds to the starting point of a very long trend in price inflation. Between 1934 and 1995, there was a 36-fold increases in prices, and between 1934 and 2007, it’s a 50-fold increase! Moreover, inflation started to level off after the adoption of the Reserve Bank Act in 1989, which focused monetary policy on price stability. The graph confirms what Federal Reserve Bank economists found in a study: “money growth and inflation are higher” under fiat standards than under gold and silver standards (see Lawrence White’s Cato Briefing Paper). Unlike what Alan Greenspan contends, central banks have not been able to mimic the gold standard system and cannot do so anyway for the reasons that Mises, White, and Selgin have explained.

While no one knows what Bollard will do in the future, I suspect his tenure at the head of the RBNZ will be marked by a substantially higher level of inflation than in the years 1990-2002 (i.e. Don Brash’s tenure minus the first two years during which inflation had to be reduced). Clearly the Reserve Bank Act 1989 was not a guarantee against inflation because it could be tweaked enough (by subsequent governments) to reintroduce the possibility of a progressively fuzzier monetary policy. All this also shows the limits of institutional designs, the limits of the notion of independence from the executive, and the truly disastrous effects of central banking.

Comments

[Terje (say tay-a)]

Nice chart. It suggests that from 1860 to 1890 the inflation rate averaged around -2%.

Comparing the gold standard to inflation targeting we can observe the following.

Gold standard delivered:-

1. Stable consumer prices.
2. Stable commodity prices.
3. Stable exchange rates.

Inflation targeting delivers:-

1. Stable consumer prices.
2. Volatile commodity prices.
3. Volatile exchange rates.

The former gave a greater sea of stability and probably would again if we cound convince the relevant parties (eg Fed, ECB, RBNZ, RBA etc) to target the gold price instead of interest rates.

[Terje (say tay-a)]

p.s. Good article.

[libertyfirst]

Terje: you touch an interesting topic but I'm not convinced.

Gold in the gold standard was used as money or for redemption at demand for money. I don't think that this is equivalent to gold price targeting.

Actual gold price has no exchange value, it has an industrial/jewelery use value and an inflation hedging investment use value. It has no exchange value from monetary use because there's quite no monetary use of gold nowadays. In the XIX century, monetary excesses would have resulted in gold losses. In a gold price targeting monetary policy setting, it wouldn't.

I believe that if the Central Bank had a commodity price target it would be less inflationary, because commodities are interest-rate sensitive and thus they immediately react to monetary excesses, while consumer pricese react only after the Fisher effect has worked itself out of the price system and ovewhelmed the Wicksell effect.

But this has nothing to do with gold, in my opinion: a copper price targeting or an oil price targeting would do the same (although the price of oil is extremely variable because of political and technical reasons, so it's not suitable for this purpose, but that's another problem).

[L.Baggiani]

Good work, mr Saudet; in my opinion all shows the limits of the institutional "designer", instead of institutional design, but I agree with your work.

@Terje: Gold standard directly links the amount of gold to the amount of money, while money pricing all goods. Gold price targeting sets the amount of money so to balance gold demand & supply via gold price; the setting is as unstable as both the former two variables then.
e.g.: fashion shifts from gold to steel, so gold price lowers, then the Central Bank should target gold price, hence buy gold, thus spreading money throughout the economy... thus spreading inflation. This does not look much simile like a gold standard indeed.

Thanks

[Aidan Walsh]

I know I am probably being stupid but how does an 'inflation' target deal with changes in relative prices (where some are in the basket and some are not)?

This has always bothered me but seems to be a real issue where fuel and food prices are going up not because of monetary factors but because of demand.

[theBuckWheat]

Can we finally be completely honest about fiat money? I mean, we are now to the point where rational (that is to say non-Keynesian) economists can bring themselves to that inflation "is a form of tax". Can we bring ourselves to admit the rest of the truth, that when someone authorized to "borrow money into circulation" from nothing, when they do, it is in effect counterfeiting private wealth?

As we all work to explain and understand inflation, can we now work towards also developing a theory and explaination of a monetary system that does not depend upon deliberate counterfeiting targets of "between +1 and +3%" like we have now at the RBNZ, or the US Fed's "targeted rate of inflation" (sic) of 2%?

The first hurdle of a non-inflationary monetary system will be to educate the public not to confuse (nominal) money with wealth. Maybe it will be too much to ask, but I am not aware of anyone seriously posing the relevant question: why do we put up with this grand fraud?

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[Steven Shaw]

Seems you're right about the difficulties of managing inflation when the RB has other responsibilities (such as the foreign exchange rate and ). Allan Bollard talks about the difficulties in the following speech. It's an interesting read. He cautions against the housing boom and warns against the economic fallout of lending to those who cannot repay.

http://www.rbnz.govt.nz/speeches/2157629.html

I am new to Austrian thought and am not an economist. I find it very attractive so far.

I'm wondering about the statement you made about the RBNZ being able to completely control price inflation by controlling the monetary base. I thought that one of the problems was that the retail banks create money-from-nothing when loaning money for a home purchase (for instance). I don't think this money is included in the monetary base. Is there a case that the RBNZ cannot control price inflation when the banks have a credit boom?

On a side note, it would be great to hear how folks came to be Austrian and/or Libertarian. In the programming field, for those who like the programming language Lisp, it is common to write a story called "Road to Lisp" or "My road to Lisp". It would be great to see this from Austrians and Libertarians in a "Road to Austrian Economics" or "Road to Liberty". These kinds of stories are wonderful sources of references to books and articles and of common misunderstandings and those "ah-hah" moments when they are swept away.

[Steven Shaw]

> foreign exchange rate and...

Sorry, forgot to insert the factors other than CPI that goes into the RBNZ decisions. From the "What is the Policy Targets Agreement?" [1]:

as it implements monetary policy to achieve price stability, the Bank "shall seek to avoid unnecessary instability in output, interest rates and the exchange rate."

[1] http://www.rbnz.govt.nz/monpol/pta/3027620.html