Awkward Utopia

No sooner do I publish a post about the politics of monetary policy than does Joseph Stiglitz make waves with a post that directly contradicts substantial portions of my post. It is therefore worth a cursory survey of his claims. Stiglitz is going for shock value at the outset of this column, where he writes:

The World’s central bankers are a close-knit club, given to fads and fashions. In the early 1980’s, they fell under the spell of monetarism, a simplistic economic theory promoted by Milton Friedman. After monetarism was discredited – at great cost to those countries that succumbed to it – the quest began for a new mantra.

Importantly, Stiglitz does not explain how monetarism was discredited. Presumably he speaks of the temporarily high unemployment and lost wealth that occurred during recessions shortly after more responsible monetarism came into place in the United States and the United Kingdom (though the UK never put as big a foot on the brakes as we did). On the other hand, since those painful recessions and their commensurate correcting of misallocations (i.e. prices based on non-market signals), the countries that have stuck to monetarism have had unprecedented sustained growth. Would we have done better but for monetarism? Not bloody likely. ( Even Australia’s new Labor government seems to be concerned with inflation. If that’s not a victory in the war of ideas, I don’t know what is! )

Not one to be left out from parroting liberal views on macroeconomics and international economics issues, Stiglitz continues by challenging inflation targeting:

The [new mantra] came in the form of “inflation targeting,” which says that whenever price growth exceeds a target level, interest rates should be raised. This crude recipe is based on little economic theory or empirical evidence; there is no reason to expect that regardless of the source of inflation, the best response is to increase interest rates. […] Today, inflation targeting is being put to the test – and it will almost certainly fail. Developing countries currently face higher rates of inflation not because of poorer macro-management, but because oil and food prices are soaring, and these items represent a much larger share of the average household budget than in rich countries.

Probably not coincidentally, current Federal Reserve Chairman Ben Bernanke is an advocate of this policy. My understanding of inflation targeting comes only from UES discussions. It seemed that the main rationale was based on the following assumptions: 1) inflation will be greater than 0%; 2) signals from the Federal Reserve impact the allocation of resources. Therefore, the Fed Chairman and Board of Governors would select a reasonably attainable goal of a very low sustainable inflation rate (2-3%). In so doing, the markets would be able to plan for the future better because they know that the Federal Reserve will either loosen or tighten the money supply based on certain signals of inflation. Transparency is introduced. I think that the theory goes that this transparency does improve the efficiency of the market by more than trivial gains. Although I have argued against inflation targeting before, there are worse things that the Fed can do. For instance, they could stop reporting M3 — oh, wait, umm…

Stiglitz lists several countries that currently employ inflation targeting. None seem to be falling off the face of the earth. Most, in fact, seem to have an air of current and future prosperity about them:

Israel, the Czech Republic, Poland, Brazil, Chile, Colombia, South Africa, Thailand, Korea, Mexico, Hungary, Peru, the Philippines, Slovakia, Indonesia, Romania, New Zealand, Canada, the United Kingdom, Sweden, Australia, Iceland, and Norway.

This does not mean that it works, of course. But Stiglitz never, at any point in the column, explains why the costs outweigh the benefits of this policy. Rather, he seems mostly offended by the fact that the United States isn’t bringing more pain on itself with higher interest rates — something I have wondered about myself — but which doesn’t seem to be evidence for his claims. I’m frankly not even sure if Stiglitz has a handle on what inflation means. It seems like his inflation is really just higher prices caused by supply and demand issues, not inflation as we all understand the term. Maybe someone can set my straight on this and tell me how wonderful an economist Stiglitz remains to this day.

Is monetarism discredited? Or is it science? Perhaps the verdict will remain out so long as monetarism is decoupled from the understanding that central banks will cause more distortions than they solve.