A recent IMF paper caused a stir. Most attention was directed to a view in the paper that there might be advantage in increasing the inflation target from around the current 2 per cent used by most central banks to around 4 per cent. A first point to make is that the paper “Rethinking Macroeconomic Policy” (10 February 2010) was an internal staff research paper and did not represent any settled IMF position. Nevertheless it provided an insight into IMF thinking.
While it was couched in economists-speak, the basic theme of the paper was simple enough: that better countercyclical policies needed to be developed to deal with financial and economic downturns. Three propositions for consideration flowed from this. The first, and the one grabbing most media attention, was that monetary policy should keep more in the tank to deal with downturns. This would require a higher inflation target which in turn would keep interest rates higher and therefore give more scope to reduce them when downturns arrived. The second proposition was broadly consistent with the first but with a fiscal focus. This was that governments should run tighter ships when times were good to allow more scope for stimulus measures when times became bad. Allied with this proposition was the potential of building in automatic expenditure and tax mechanisms which would cut in quickly to boost demand when certain triggers were reached. The third proposition was that financial regulation could be used as a third arm of macroeconomic policy to control asset price fluctuations; while leaving monetary policy to concentrate, as it does now, on goods and services inflation. Thus when particular asset prices grow exuberantly (house prices in the US for example) bank liquidity or capital ratios or loan to valuation ratios could be increased to deter lending for the purchase of these assets.
I don’t want to get into a debate about the worth of these measures individually, except to say that the one that grabbed the headlines, to fashion monetary policy to keep inflation to 4 per, might be much more difficult to implement than keeping inflation to 2 per cent. Four per cent can easily morph into 5 per cent and a little more at times, and then inflationary expectations might become difficult to control and lead, for example, to industrial unrest and wage break outs. The community is more likely to treat 2 to 3 per cent inflation as no inflation to speak of; this would be less the case, I would think, with inflation of 4 to 5 per cent.
What I would like to do is to reflect on the mindset of the IMF and this applies generally to other international agencies (e.g. OECD) and to economic advisers to governments. They all have a view that the macro-economy must be controlled and this will potentially produce better outcomes, if only it is got right. The fact that we have just had a major downturn (on some measures comparable in its immediate impact to the Great Depression), despite years of practiced intervention by governments into economic affairs, moves them not at all. The thought is not that we have contributed to a complete mess with inappropriate intervention but that we didn’t get it quite right. It’s like latter-day socialists’ take on the Eastern Europe experience; it will work next time once we have tinkered. It is probably all Keynes’ fault but surely one man could not have that much influence?
Governments should understand that the best they can do is to run their own budgetary affairs prudently and otherwise create a stable and predictable background against which the macro-economy can play out, with all of its inevitable (and in large part valuable) ups and downs. But they don’t. They consider themselves as akin to engineers with machinery, with a similar ability to fine tune.
What makes the authors of the IMF research paper think that people can be found who will be clever enough to keep inflation at 4 per cent; to develop and orchestrate fiscal automatic stabilisers of appropriate detail, scope and dimension; and to intervene in a timely and appropriate way in altering financial regulations as particular asset prices rise and fall? We have never in the past found people clever enough to do anything like that. Milton Friedman once observed that governments inevitably get their timing wrong leading to more pronounced economic cycles than would otherwise be the case. Once they start fiddling with monetary, fiscal and regulatory levers, in the way canvassed in the IMF paper, who knows what further damage they would do. But never mind, each downturn will simply provide another opportunity to go back to the interventionist drawing board. As the paper says: “Capitalizing on the experience of the crisis, our job will be…to come up with creative policy innovations…” Who will save us from those who want to help us?