Inflation, a factor unknown to destroy our prosperity
June 8, 2010 The Economic Club, Toronto
Maxime Bernier, MP for Beauce
(Acknowledgements)
Monetary policies are one of the most difficult questions in economics. But also, I think, a matter of absolutely crucial to our prosperity.
As you all know, the Bank of Canada raised its key rate last week by a quarter point to 0.5%. Much speculation has been raised in recent weeks about the decision to finally raise rates after having kept a record low for over a year. And as usual, there will be plenty of speculation about the future actions of the Bank. How far will she? How quickly?
All these assumptions about the fixing of interest rates has nothing to do with capitalism and the free market, it has more to do with central planning and state control over the money supply. In a market free money, the interest rate would be determined by demand credit and the supply of savings, just like any other prices in the economy.
The state control over the currency has serious consequences that few people seem aware.
One of them is that central banks are constantly increasing the amount of money circulating in the economy. In Canada, for example, by the strictest definition of money supply, it has increased by 6-14% annually the past dozen years. That's pretty much the same situation in other countries.
This money creation out of nothing is to devalue the value of our currency, forcing up the price considerably. Prices are rising not because companies are greedy for profit, or because the wage increase, or because the price of oil rises. Ultimately, only the central bank is responsible for having created the conditions for higher prices by printing more money.
The Bank of Canada has an inflation target of 2% over the past fifteen years. This may seem small, an average inflation rate of 2% per year. But 2% depreciation years after year, it's bound to accumulate. Thus,
1990 to the present, inflation in Canada has been a total of about 45%. That means your dollar is now worth less than 70 cents when compared to that of 1990.
As recognized by the Federal Reserve chairman himself, Ben Bernanke, inflation is the equivalent of a fee. One of the most insidious tax, which most directly affects those who are least able to pay it. This tax erodes our purchasing power, our revenues and savings.
It is true that most of we get salary increases that offset the loss of purchasing power. But all those whose incomes are not growing as fast as prices are getting poorer.
Several interest groups, including governments, love the easy credit. There is a tendency inherent in the framework of monetary policy in favor of lower interest rates. But it also has consequences that we did not necessarily want.
One of them is that it encourages people to save less, because the return on savings is lower. And they are more likely to go into debt, because credit is becoming easier to obtain.
is precisely what happens in Canada, the United States and around the world for 20 years. In 1990, total debt of Canadian households as a percentage of disposable income was 90%. Today, this ratio reached 144%, the highest of all time.
into debt seems to have become a way of life. Fortunately, the public debt in Canada is at a reasonable level. But as can be seen worldwide, several countries such as Greece are now on the verge of bankruptcy because they have become too dependent on easy credit.
monetary inflation creates all sorts of distortions in markets and is also due to the cycle of artificial booms and recessions experienced by our economy.
It became very clear that this cycle is not a flaw inherent in the capitalist system, like many people think. It is rather caused by the policies of central banks, as we explained long ago economists such as Nobel laureate Friedrich Hayek.
Remember, we had the dotcom bubble in the late 1990s. When this bubble burst, Greenspan flooded the markets of liquidity. Between 2001 and 2004, the Federal Reserve has cut interest rates to 1%
.
If you factor in inflation, real interest rates were actually negative. It is like subsidizing people to encourage them to go into debt. But we all know: to live on credit cards, it can not last forever!
We then had another bubble, which was amplified with the help of the U.S. government. This has prompted banks to provide mortgages at risk and has encouraged its citizens to buy houses they could not really afford.
You know the rest of the story. These loans were converted into securities and resold on the market around the world. Financial institutions worldwide that held these securities were left struggling when owners become unable to pay their mortgages and house prices began to fall.
In 2007, this housing bubble has also started to deflate. And since then, central banks have again lowered interest rates almost to 0%. That means that once again, the real interest rates are negative, since prices are rising faster than that. Central banks have flooded money markets and have allowed governments to dramatically into debt to avoid a recession.
It is true that economic growth seems to be back. But how can it be maintained permanently? How governments and households they repay all that debt, if not by cutting in their spending? Some countries they decide to monetize their debt and thus generate high inflation? Have we created new bubbles in other sectors that will lead to another global recession when they explode? And if that happens, what kind of stimulus can we take if we are drowning in debt?
Despite these negative effects of inflation, most economists and commentators seem to believe that a little inflation is good. And they say that deflation is to say lower prices would be a disaster for the economy. But this is false.
start with common sense and what we can observe in our daily lives. Is that you, as consumers prefer to buy goods that are cheaper or more expensive? I think we all know the answer to this question!
We are all consumers, and we all benefit when prices fall. If we can pay less for property, that means we have surplus money to buy other goods.
Economic activity does not stop because of it. It simply means we can buy more things with the same amount of dollars. And greater purchasing power allows us all to enjoy a higher standard of living.
In reality, there is nothing mysterious about the impact of lower prices. Think computers.
Fifteen years ago, they were big, not very effective, contained little gadgets and much more expensive than today. Since then, prices in the computer industry have not stopped falling every year.
Do people have stopped buying computers or have waited years before buying a new one to enjoy even lower prices? Absolutely not. On the contrary, the more prices fall, and it sells computers.
Imagine a situation where central banks no longer handle the money. Instead of increasing continuously from 6 to 14% per year, as was the case in recent years in Canada, the amount of money in the economy remains solid.
Each year, however, it becomes a little more productive. We create new goods and services. You can find new ways to produce them more efficiently. Technology improves. And if there is a growing population, there are more people working.
So there are more and more goods and services available in the economy, but the same amount of money to buy them. Obviously, prices will have to adjust down. If the economy grows, say, 3% per year, while money supply increased by 0%, there will necessarily be a deflation of prices.
Note that in this situation, companies can still make a profit because their costs also decrease.
This is not just theory. This is what happened repeatedly in the 19th century, an era of rapid economic development. When there was no central bank and the currency was calculated as the amount of gold or silver metallic.
Deflation is not a threat to our prosperity. In a context of stable money supply, rather it is the result of our prosperity!
prosperity, it has nothing to do with how much money we have, but rather with the amount of goods obtainable. And if we can buy more goods with the same amount of money because prices are falling, it is more prosperous.
is why the fear of seeing prices fall is unfounded. And central bank intervention to prevent a drop in prices could create more harm than good to the economy.
Given all this, what should we do? I think the next few years, we have to have a real debate on the return to the gold standard.
But here there, there are other more immediate measures to be discussed, such as the inflation target of the Bank of Canada. The agreement on the inflation target between the Bank and the Minister of Finance is fixed for five years and must be renewed next year, in 2011. The Bank is exploring various alternatives to the current target of 2%.
I was very pleased that the Bank has already rejected a suggestion in a report by the International Monetary Fund last winter to increase the target to 4%. The logic of the IMF is entirely based on the idea that central banks should have more flexibility when trying to manipulate interest rates and the amount of money in the economy. According to this view, if at the beginning of a crisis of inflation and borrowing costs are higher, this will allow central banks to further reduce interest rates aggressively and leave them at a low level longer if necessary to encourage consumption.
It's a bit like trying to cure a drug addict by giving them injections of drugs stronger. The problem is precisely that there is already too much inflation and too much manipulation of the currency by central banks. The solution is to have less, not more.
Another proposed solution is to focus on achieving a certain level of prices over a longer period rather than inflation each year. That would mean that if for example a year the inflation rate is 1%, the Bank would try next year to raise prices by 3% instead of simply returning to 2%. It would seek to maintain an average rate of inflation over time and compensate the deviations of the past by deviations in the opposite direction.
Let me rephrase it any differently from my own perspective. The inflation rate was only 1% last year. We should have depreciated the currency by 2% to be on track to reach the price level target. So this year, creating even more money out of nothing so that the dollar lost 3% of its value. This will compensate for the lack of depreciation last year.
Sounds absurd? I also think it is.
If we need to set an inflation target, I think the most appropriate and more realistic at this stage is to fix it at 0%. Indeed it would reduce the ability of the Bank of Canada to artificially stimulate the economy. He could no longer be any negative real interest rates as we have now, since the official rate of the Bank can not go below zero. But as I explained, the currency manipulation are part of the problem not the solution.
To keep inflation at 0%, the Bank should conduct monetary policy much more cautious and firm. This would actually preserve of our buying power. This would prevent cycles of booms and recessions that we have recently crossed. This would avoid the distortion of price inflation throughout the economy generates. And it would facilitate financial planning for individuals and businesses, while increasing the efficiency of our economy.
Last August, the Governor of the Bank of Canada, Mark Carney, said: "The most direct contribution that monetary policy can make to good economic performance is to give our citizens and citizens' confidence that their money will retain its purchasing power. "
An inflation target of 0% would reach exactly that goal, in addition to stating clearly that inflation in itself is something bad. There may be some immediate benefits to depreciate our currency but it always brings suffering in the longer term.
Such a change would be a major step in the right direction.
I'm probably a dreamer, but I think that monetary issues should be a hot topic! The current revision of the inflation target of the Bank of Canada is an excellent time to have this kind of debate. I hope more Canadians address the effects of the inflation target on our purchasing power, our standard of living and, therefore, on our lives in general.
Thanks.
