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Goodhart’s cry of despair

The doyen of monetary economists grasps what is at stake

Five years after the international banking system fell into the arms of the central banks and governments, there is still a paralysing uncertainty about the extent and cost of regulation, the viability of banking models and the monetary policy regime.


More about financial regulation and banking models in future columns. Now let us look at monetary policy.


Stephen King of HSBC observes that central banking has necessarily become more politicized as ostensibly “monetary” decisions under current conditions have large distributional effects, benefitting some sections of society at the expense of others. In such circumstances, central bank independence is bound to come into question.


There is speculation that another shift in the policy paradigm might be imminent. After all, don’t different stages of the debt cycle call for different policy mixes? When both the private and public sector are deleveraging, then the central bank may need to monetise debt. Zoltan Pozsar and Paul McCulley suggest that in such circumstances “central banks need to lose …independence and work under finance ministries instead”. (Gillian Tett, FT, Jan 10). Perhaps, with public and private debt still at unsustainable levels in many countries, there is no option but to inflate it away. If that’s what you are saying be open about it – don’t hide it under the pretence of moving to a better monetary rule!


Politics and media comment have started a bandwagon in favour of such a shift.


Mark Carney has shown he understands the politics involved – as does Ben Bernanke. In Japan, Masaaki Shirakawa seems likely to submit to newly-elected PM Abe and adopt a 2% inflation target, while knowing it will do no good.


Central bank solidarity is crumbling along with their independence. Other central bankers around the world are watching the big beasts.


What this will mean in practice for policy is childishly simple. Whatever the academic arguments may be, policy makers will in fact use NGDP targeting as a convenient cloak under which  to try to engineer an old-fashioned “dash for growth”. The last time the British tried this was in the 1970s. I warned about its consequences then and I do the same today. It will end in tears.


Don’t take my word for it. Charles Goodhart and economists at Morgan Stanley feel so passionately about the risks involved they have written a devastating critique of all varieties of NGDP targetry. They show that even though, in practice, the difference between a nominal GDP growth target and recent Bank of England policies would have been small, the dangers of making a switch are huge:


“Perhaps the main claim of monetary economics, as persistently argued by Friedman, and the main reason for having an independent Central Bank, is that over the medium and longer term monetary forces influence only monetary variables. Other real (e.g. supply-side) factors determine growth; the long-run Phillips curve is vertical. Do those advocating a nominal GDP target now deny that? Do they really believe that faster inflation now will generate a faster, sustainable, medium- and longer-term growth rate?”


In talking of a NGDP target of around 5% at a time when trend growth is unlikely to be more than 2% at best, advocates want an inflation rate of 3%. As he asks despairingly, what good would that do?


That is not all:


“Communication is much harder too: The prime aim of setting, and achieving, a monetary target is, surely, to maintain price stability. Communication of this role is easier when the index involved has a clear meaning to a wider audience. A Consumer (or Retail) Price Index has such a clear meaning; the GDP deflator has not (hands up any reader who really understands it)….”


“And it involves a confusion of monetary and fiscal roles:

Under nominal GDP targeting, the roles of government and central bank would become even more blurred than they are at present.”


This powerful attack on a fashionable thesis is to be welcomed.


But I suspect that the real reason for Goodhart’s despair is deeper. I think that he understands that once inflation targeting is abandoned, we do not just open the doors to higher inflation, we are throwing away one of the last props of the monetary regime as a whole. Though Goodhart does not say this, I feel he sees that this is a far more momentous stage in financial history than is generally recognised.


In The Money Trap I predicted that nominal GDP targeting would  be tried but that over time it would come to be seen not just as marking no improvement on inflation targeting, but also as a final end to the credibility of central banks as monetary guardians. And of all rules to control fiat money.


There are very few if any potential rules available. Many countries have tried monetary aggregate targeting, some have tried exchange rate targeting, then came independent central banks with mandates to pursue low inflation, then explicit inflation targeting, then the collapse, now nominal GDP targeting….they have all been tried and found wanting. We have run out of possible rules. There are no other anchors to the price level in sight. We shall be cast adrift in an ocean of discretion.

What is at stake is the fate of the historic efforts of the past half century at rational, collective control of money.


It is time to think about alternatives.