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Monday, November 13, 2006

Central Bankers To Eat Humble Pie?

Well, follwoing on from the last post, perhaps it is worth asking just how much longer things can continue like this before the central bankers really have to start eating humble pie, since they have obviously been misreading all of this, and very profoundly so.

We could start with Trichet's declaration of his monetary principles last Thursday:

I have always been impressed by the contribution of my compatriot, Jean Bodin, to our understanding of monetary economics. Drawing on his experience of the inflationary consequences of the influx of precious metals from the Americas into 16th-century Europe, Bodin postulated a direct relationship between the quantity of monetary gold and silver in circulation and the general price level. Thus was born the quantity theory of money, which has survived to this day.

Or has it? Over the next two days, the European Central Bank will host a conference to discuss the role of money in monetary policymaking. At present, the dominant academic view seems to be that monetary aggregates should have no part in monetary policy decisions. From this perspective, money does not deserve to be central to one of the two “pillars” of the ECB’s monetary policy strategy. I do not share this view. In this I follow Friedrich Hayek, who wrote in The Pure Theory of Capital: “It is self-contradictory to discuss a process [inflation] which could not take place without money and at the same time to assume that money is absent or has no effect.”

So we are in the hands of a wanna-be Jean Bodin: hardly an appetising prospect. Of course the key point would be that no-one I have heard of has been arguing that monetary aggregates play *no part* in monetary policy, but just that they are not as reliable an indicator as Trichet seems to imagine. So if you start of by knocking down a straw man, and in addition fail to notice what the real problem you are trying to address relates to (ageing societies and global savings gluts) then it will hardly be surprising if at the end of the day it all ends in tears.

Unsurprisingly similar issues are also arising in Japan, although please kindly note that they are arguing the exact opposite to Trichet, in the sens that the monetary policy link has been broken since the mid 1990s. Trichet and co at the ECB would do well to examine the Japanese experience more closely:

Most BoJ officials are dismissive of Mr Takenaka’s analysis, arguing that the link between money supply and nominal growth has broken down since the mid-1990s when Japan first slipped into deflation. Flooding the markets with liquidity did nothing to stimulate broader money supply, bank officials argue, so draining it off should have no impact on real economic activity.

The bank, which holds a policy board meeting on Thursday, is highly sensitive to any suggestion that its actions could be damaging the modest but long recovery, now into its fifth year. Shinzo Abe’s government has told the bank, an independent body, to support growth.

Toshihiko Fukui, BoJ governor, has said the bank will keep interest rates low for a long time. However, he has also made clear it will not refrain from acting pre-emptively against inflationary pressures.

Takatoshi Ito, a member of the government’s powerful economic policy council, says the BoJ does not appear to understand that the risks of tipping back into deflation outweigh those of acting too slowly against inflation. He accused the bank of targeting interest rates, rather than inflation, something the BoJ firmly denies.

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