Some Reflections on the Inflation Targeting Approach

Following my last post it may well be interesting to clarify some of my differences with Paul Krugman, as I have apreviously tried to make clear in my posts, my differences do not especially relate to his ‘push this button’ , inflation targeting approach. This may, or may not, work, I am not especially against giving it a try. There are, of course, pros and cons. Among these is the question of time, we may loose time and confidence if we keep trying solutions with a low probability of definitive success. Also, using a rather violent metaphor from the late Rudi Dornbusch, there is the question of how many bullets we have left in the magazine. Wasting one, leaves us with one less.

My preoccupation is that science would seem to require of us that we try and understand why, and not simply that we concentrate only on ‘how’. If the telly isn’t working properly, and we remember that giving it a knock once seemed to help, it may not be the best approach to pick up the hammer we have handy, simply because we have it handy, and see what happens. So if, as I feel, we are now entering a period of global deflation, one which carries with it the accompanying problem of producing a liquidity trap, it does not seem to be sufficient to content ourselves with a close examination of techniques we might use for ‘springing the trap’. By the same token, Lars Svennson’s foolproof path, may well be foolproof in the case of an isolated case, as Japan might appear to have been some years ago, but can hardly serve as a guide in a case of generalized global deflation.

I have therefore sought to go to the root of the problem by beginning to examine what might be the causes of this phenomenon. So far, as can be seen on my deflation page, I have come up with a list of three ‘usual suspects’: the decline in tech prices, the rise of China and India in the global economy, and the ageing process in the OECD countries. I do not pretend that these are exhaustive, but they are a starting point.

Clearly I am arguing a number of things, not all of which may be music to everyone's ears. One of the important points that I feel stands clearly out is that macro economic processes cannot be understood in terms of an abstract state space. Here I am certainly planting my flag on the path-dependent and evolutionary side of the fence. Time, for better or worse, does come with an arrow.

Now many would make the case for ‘good’ and ‘bad’ deflation. In this sense both IT and China and India might be thought to be examples of ‘good’ deflation. My response would be to nuance just a little by suggesting that this depends on where you are situated. Clearly inside China and India themselves the deflation produced by large scale labour market and structural reforms and declining IT hardware (China) and software (India) costs may be only short-lived as a rapid expansion of the internal market lifts upwards both boats, but the impact on the OECD countries with falling global prices and contracting real internal GDP (as the labour force declines), will surely be a deflationary encounter of the worst kind.

Many hope to counter this tendency by increasing human capital, and increasing the capital-labour ratio. On the latter argument, even conventional neo-classical theory would suggest that you can only increase the capital-labour so far without running into diminishing returns. On the human capital side, much could be said, but perhaps the most important point is that there is a trade-off. Human capital needs time to acquire, and while you are acquiring you are out of the labour market. With the pace of technological change accelerating this factor becomes even more problematic. Also young people would seem to be more ‘quick on the uptake’ in general, therefore younger societies would seem to have an advantage here. Finally, increasing ‘participation rates’ may be fine, but there is the problem of labour quality. One has to be careful here, as I do not want to say anything perjorative, and do not wish to hurt feelings, but the point should be obvious. Dornbusch used to joke that the German worker doesn’t work too often, but when s/he does s/he’s highly productive. The implication is that if the participation rates went up in Germany, the productivity would probably go down.

I have learnt a great deal recently by thinking about the four phases approach proposed by Malmberg. This model can also help us understand that the two problems, that of the entry of China and India, and that of the OECD stagnation are interconnected, and that the connecting link is demography.

So while I am arguing that ‘springing the liquidity trap’ is fine by me, the assumption which Paul appears to be making is that there is a natural growth path which can then be resumed. This may be wrong. It is certainly ‘a-historical’. It is more probable that the OECD economies are following their ‘historical’ path, and that pushing the button will only succeed in throwing them off course temporarily before they then fall back into their former trajectory. I suppose here I am very near to being a fully fledged heretic, since I am implicitly questioning the mantra coming from Ahearne et al, that cutting early and cutting often would have saved Japan.

Before leaving this topic, there is one more strong negative attached to a short sharp shock of inflation therapy: the likely distributional consequences. I noticed very clearly in the 1970’s that the different age cohorts do not see inflation in the same light. Younger, and more indebted, cohorts tend to react more favourably, at least to mild inflation. The reaction among the older cohorts is clearly different. Once savings are ‘burnt off’ they are not recovered, and, if Japan will never be a young society again, this may have important economic AND political consequences. I think it is important to remember that Argentina is currently suffering from an acute form of political, path dependent, lock-in. The responsible politicians burnt up what political capital they had defending a peso-dollar peg that was clearly indefensible. Argentina is now stuck with a collection of irresponsible politicians, a public which is in denial over what has happened, and no easy way out. It would be a bad mistake to send Japan down the same path.

So what then am I suggesting. Above all else I am suggesting the politically unthinkable in Europe and Japan: systematic immigration. This will not be a permanent solution, but will alleviate the problem somewhat, and buy some time. Since all our theory seems so wide of the mark, time is something we badly need. Pension and labour market reforms will be necessary, but the impact of these is only likely to be more deflation.


All of this explains some of my recent obsessions with Bulgaria. What is important is the demographic profile of Bulgaria, and indeed of the whole of Eastern Europe. Bulgarian immigrants do not therefore fit the stylized fact of immigration from a country with a large surplus of young people, quite the contrary. What is also interesting is to note that the latest (post 1998) wave of migration comes after a major period of hyperinflation followed by serious pension and labour market – structural – reforms. Certain questions inevitably arise: is Bulgaria unique, or will there be more? Is Bulgaria dying? What are the role of the pension and labour market reforms in the current tragedy? What can we learn from Bulgaria about the future of western Europe?


Is the future I am painting an appetising one for the OECD vountries. Probably not. But distaste cannot be a reason for not investigating.