This extended post is prompted by numerous debates on whether or not Quantitative Easing (QE) is inflationary, whether or not creating new money to fund public spending is inflationary and whether inflation is really such a bad thing anyway. Note to any real economists out there. In this post I will be describing some economic concepts, such as NAIRU, in layman's terms. If I get something wrong, please correct it (gently), but remember that I am not writing for an audience of economists so am trying to keep things simple! I am old enough to remember the inflation of the 1970s. In 1975 wage-price inflation in the UK touched 25%. This is nowhere near high enough to qualify as hyperinflation, which is defined as a monthlly inflation rate of 50% or more (Cagan 1956). The UK has never experienced hyperinflation. But the inflation of the 1970s was quite bad enough, since it destroyed people's savings and led to a vicious spiral of higher prices leading to increased wage demands leading to increased production costs leading to higher prices..... The 1970s inflation was also coupled with economic stagnation - it was then that the term "stagflation" was coined. Those who suffered from the inflation of the 1970s tend to have a horror of price inflation that is perhaps out of proportion: they will put up with all manner of economic ills and injustices as long as price inflation is low. We see this effect more clearly internationally. Germany, which suffered appallingly from the hyperinflation of the Weimar republic in the early 1920s, has a horror of inflation which drives their economic policy - and recently not only their own economic policy, but because of their economic dominance in Europe, much of the EU's economic policy. The consequence of this, in European countries experiencing recession, is deflation (not inflation) and appallingly high levels of unemployment, especially among young people. Many people are now arguing that inflation is no worse an evil than unemployment, and that higher inflation may be a reasonable price to pay for economic policies that increase employment. I suspect that many of the people calling for higher inflation have never lived through an episode of high inflation. Because the fact is that there has not been high price inflation in any major Western economy since the 1980s. Retail price inflation has substantially been contained. We have become so used to retail price inflation being contained that we now don't notice the policy that contains it. People argue that government since 1979 has abdicated its responsibility for economic management to the whims of the market. They use as justification for this view the fact that unemployment has generally been higher since then than at any time in the post-war period. This is indeed true - because at the margin, higher unemployment is the trade-off for lower price inflation. Let me explain. When there are more people chasing jobs than there are jobs to be had, wages tend to fall because employers can dictate the amount they are prepared to pay and generally speaking job-hunters will accept it. This is basic supply & demand logic. I don't intend to discuss here whether this is a good thing or a bad thing, and the merits or otherwise of government intervention to support wage levels (such as the minimum wage and unemployment benefits) or trade union muscle to force up wages. I'm simply describing the basic dynamic when there is unemployment. When everyone who wants to work is fully employed, employers have to compete with each other to attract workers. So the supply-demand equation is reversed: job-hunters (who are, of course, simply seeking to change jobs, rather than being unemployed) can choose among employers and will tend to choose those that pay the most. This tends to push up wages. So far this is obvious, yes? Labour costs are a significant factor in production costs for most goods and services. So rises in wages will affect one or more of three things: the price eventually charged to the customer, the profits made by the company, and the productivity demanded of labour. Companies don't like to earn less, and workers don't like to work harder for their pay, so unless there is limited demand for the product or service, the price to the end customer tends to rise. If prices to end customers rise in aggregate across the economy as a whole, that is price inflation. In simple terms, therefore, if everyone who wants to work is fully employed, there can be price inflation arising from the fact that employers will prefer to agree to high wage demands rather than lose workers. And if price inflation is anticipated by workers, they will price that inflation into their wage demands, which will push prices up further. This is known as cost-push inflation - or, in 1970s jargon, a wage-price spiral. If the aim of the government is to control retail price inflation, therefore, it is necessary for there to be some degree of unemployment. Exactly how much is a matter of debate. The aim of economic policy is to have what is known as the "Non-Accelerating Inflation Rate of Unemployment", or NAIRU - which is the amount of unemployment that maintains equilibrium between workers' tendency to demand more pay and employers' desire to drive down pay. If it is achieved, the theory is that labour costs will not affect inflation. The trouble is no-one agrees on what the NAIRU is, and it has been used to justify very high levels of unemployment in some societies, especially where there are benefits systems and legislation that limit the downward pressure on wages that high unemployment causes. So inflation targeting in Western government economic strategy since 1980 has indeed contributed to higher unemployment. But that's not abdication - it is simply a different strategy from the strategy adopted by most Western governments from WWII until 1980, which targeted full employment and legislated wage and price repression (prices & incomes policies) to control inflation. It could be argued that the pendulum has moved too far, and unemployment has been allowed to rise freely when more interventionist policies to control it would have been appropriate even at the cost of higher inflation in the short term. But the move to inflation targeting happened because the traditional (Keynesian) assumption that it was not possible to have both rising inflation and rising unemployment was shown to be false. The 1970s was a decade of high inflation, economic decline and increasing unemployment - so-called "stagflation". To this day there is no agreement on the reasons for this: some economists say that the main problem was the external supply shocks caused by the oil price hikes of 1973 and 1979, while others argue that the problem was inefficiencies in the labour market (notably, excessive union power) coupled with loose monetary policy. Personally I suspect that both views have some validity. But the stagflation of the 1970s is in my opinion one of the reasons why Keynesian economics fell out of favour. It simply did not explain the phenomenon and could provide no solution for it. The other accusation that is levelled at governments since 1980 is that progressive deregulation has rendered them unable to prevent or control inflation in other areas of the economy - notably in asset prices (especially housing) and credit (the money supply). There is some merit in this view. It is painfully evident that while retail price inflation has indeed remained pretty stable since the late 1980s, asset prices have been anything but stable. There have been two house price bubbles during that time, the first of which burst in the recession of the early 1990s and the second in the recession of 2008/9. Both were preceded by progressive relaxation of lending standards, enabling people to obtain mortgages that in normal times would have been denied to them. Contrary to popular belief, subprime mortgages and negative equity are not new phenomena. I bought my first house in 1988 with a 100% endowment mortgage and consequently spent the first half of the 1990s trapped in a tiny house which was worth less than the mortgage. And other asset prices have not been stable either: there have been several stock market crashes, the most severe being the falls of 1987 and 2008. So with hindsight, it is evident that inflation targeting alone is not sufficient to prevent serious economic problems arising. It successfully addressed the dominant problem of the 1970s. But it doesn't address the problems that have arisen since. The challenge for governments is to develop an economic management strategy that addresses all areas of the economy, rather than focusing on one indicator and ignoring the rest. We really don't want to see a return to 1970s-style inflation, which destroyed savings and reduced real incomes for anyone who wasn't in a union. But the deflationary policies we are seeing in much of Europe at the moment are equally destructive, wiping out jobs by the million and wrecking the future of an entire generation. Greece is now in its fifth year of deep recession but is being expected to impose severely deflationary measures on its economy. And in the UK, the government is busy imposing a range of public spending cuts on an already depressed economy while the central bank is creating money at a rate of knots in order to ward off an anticipated deflationary spiral. Interest rates are at an all-time low, but people are saving like mad and businesses are hoarding cash. This is what Keynes called a "liquidity trap". In an odd reversal of the 1970s, this time Keynes both describes the situation and has an answer for it. Monetarism does too, though - and at the moment it is monetarist, rather than Keynesian, solutions that are being adopted. The Keynesian solution to a liquidity trap would be to increase public spending to compensate for the deflationary effect of private saving. Conversely, the monetarist solution is to expand the money supply to compensate for the deflationary effect of private saving. Both agree on the problem, but the Keynesian solution is fiscal expansion whereas the monetarist solution is monetary expansion. Worldwide, there is a fashion for austere fiscal policy and public spending cuts, offset by the loosest monetary policy in history. We are in uncharted territory: never before has money been created at the rate that the Fed, the Bank of England and the Bank of Japan have created it in the last few years. Even the European Central Bank has now joined the party, providing cheap funding for European banks through the Long-Term Repo Operation (LTRO), which has already created nearly 5 billion new Euros and will create a whole lot more at the end of February. All this money creation is renewing fears of inflation in some quarters. Despite what I have said above about cost-push inflation, to monetarists the only cause of inflation is excessively loose monetary policy. Interest rates are currently close to zero and various central banks are doing, or have done, QE or some variant of it. This is, by definition, loose monetary policy, hence their worries. But is it loose enough to cause significant inflation? Well, by all reasonable measures, the money supply in the UK and indeed in much of Europe is falling despite QE. So on that basis, no, it isn't. It is simply compensating for the deflation caused by tight fiscal policy, private sector saving and general economic decline. And it doesn't do it very effectively, either. Although base money - money created by the central bank - is increasing, broad money - money created by commercial banks, which is most of the money that actually circulates in the economy - is still falling. This is because despite the increase in their reserves provided by QE, banks aren't lending enough to offset the amount of money being destroyed or removed from circulation by businesses and households paying off debt and/or saving. I am personally of the opinion that QE makes very little difference in the short run. I've explained elsewhere why QE is simply ineffective. Yes, all that extra money will have to be withdrawn at some point in the future, whether by allowing purchased gilts to expire, doing reverse QE or simply by raising interest rates. But at the moment it is largely irrelevant. I believe we have reached the limits of monetarism. So if the monetarist solution is ineffective, what about Keynesian fiscal stimulus? The problem with this, of course, is that if done conventionally, that would increase public debt - which already stands at about 80% of GDP. Borrowing costs are, of course, very low at the moment, but there are still worries that massively increasing public debt would result in much higher interest costs. And, increasingly, people who favour fiscal expansion as a solution to the liquidity trap - or are simply suffering because of the depressed economy - are looking enviously at the QE programme and asking why, if money can be created for monetary expansion, it couldn't also be created for fiscal expansion. So there are calls for money created by the Bank of England to be spent directly into the economy rather than used to purchase financial assets. The so-called "helicopter drop" would give a free handout to everyone in the country, either to spend as they please or to pay off debt (this alternative is also known as a "debt jubilee"): saving could be prevented by time-limiting the handout. Other suggestions are for created money to be used to finance investment in public infrastructure, including green initiatives and housing. There have also been suggestions for new money to finance job guarantees and benefits increases, cut income and consuption taxes, and guarantee all retail bank deposits. Money-financed fiscal expansion would in my view be far more powerful than QE and far more effective at getting us out of the liquidity trap. But it is certainly not risk-free and if not carefully planned and managed it could have unfortunate effects. This is a bit of a no-brainer, really - if it is a more powerful stimulus than QE, as I believe, then it is also much more dangerous if misused. I think there are some essential rules for "safe" money-financed fiscal expansion: - The business case for every public infrastructure project should show how it will generate the future taxation required to pay for it. If projects can't generate the returns required to pay for themselves then higher taxes or spending cuts would be needed at some point in the future. - Short-term expansionary measures targeted at particular groups such as people on low to middle incomes must not create expectations of longer-term support. - All expansionary measures must be strictly limited to the purpose of fiscal expansion and not be capable of extension to meet political objectives or buy votes. Maybe I'm displaying my own political scepticism here, but I don't trust politicians not to take the opportunity to pursue pet projects and build white elephants. Failure to adhere to these rules could have very serious consequences. Money financing is just as much a form of debt as actual borrowing, but without the "brake" of interest costs and the possibility of investor flight. And historically, there is a strong association between money financing of public spending and inflation. Admittedly, that is because as far as I know, money financing has always been a last resort of distressed sovereigns unable to raise finance elsewhere because their economies are in such poor state, so runaway inflation was a risk anyway. I'm not aware of any examples of money financing by sovereigns that weren't associated with an inflationary spiral - if anyone knows of any, please let me know. But because of that association with inflation, there is a worldwide fear of money issuance as a means of financing public spending. So great is the fear of inflation that direct financing of public spending by central banks is actually illegal under EU and IMF rules, although those rules could probably be circumvented by a determined government. And however well-managed these interventions are, some inflation is inevitable. Indeed "some" inflation is the whole point, really. You see, both monetarist and Keynesian solutions to a liquidity trap involve pursuing policies that lead to higher inflation. And therein lies the problem. Keeping inflation low has for so long been the main priority of government and central banks that pursuing policies that seem to undermine this priority are anathema. Hence the Bundesbank's continuing opposition to any form of monetary expansion by the ECB, and Germany's insistence on maintaining fiscal austerity even though it is running large trade and fiscal surpluses to the detriment of other members of the Eurozone. The UK's problem, though, is rather different. Here inflation is NOT low - it is currently running at 4-5%.*UPDATE - now down to 3.6%* The Monetary Policy Committee (MPC) forecasts that it will fall significantly this year. But the MPC's record on inflation forecasting is frankly terrible - it has persistently understated inflation by 1-2% for several years. Why should anyone believe it this time? And why on earth would we pursue expansionary policies - monetary or fiscal - when inflation is already above the MPC's target? Actually, on this occasion I think the MPC is right. The other characteristics of a liquidity trap - excessive saving and restricted bank lending - are evident. We have inflation due to commodity price rises and sterling devaluation (and until recently, consumption tax rises), not because of domestic demand or cost pressures. So maybe it could be safe to indulge in a small amount of carefully-targeted fiscal expansion. In fact, because it is potentially far more powerful than QE, we should need much less of it. So this can't be an opportunity to open the floodgates and spend huge amounts of money on political hobbyhorses. There are always lots of ways of spending money. It doesn't grow on trees. For me, the best use of created money for fiscal expansion would be a partial debt jubilee. Figures show that the private debt burden in the UK is enormous - it dwarfs public debt. Overall - even leaving out financial services - the UK is the most indebted nation in the western world. About half of non-financial services private debt is owed by households, of which the greatest part is mortgages: the rest is unsecured debt of one sort or another. Servicing this debt takes up a large amount of many people's incomes, and voluntarily paying it off takes even more. I argued some time ago that worrying about public debt when the private debt level was so high was insane. I have not changed my mind about that. Freeing people of some of their debt burden would enable them to spend more, which would be quite an effective short-term stimulus. There should in parallel with this be measures to improve the availability of finance for SMEs, and perhaps other measures to encourage companies to expand and employ more people. Will this lead to inflation? Well, yes. It's supposed to, actually. But a bit of domestically-generated inflation would enable the MPC to get interest rates back to something approaching a normal level, which would benefit the savers who are currently getting terrible returns on their investments. And the impact on borrowers would be mitigated by the partial debt jubilee. I don't see any great danger of runaway inflation from such a limited use of created money for fiscal expansion, especially if the MPC is doing its job properly. But there would be other dangers: in the prevailing economic ideology across the world, such fiscal "profligacy" is anathema and the UK would undoubtedly be punished in the international bond markets if it attempted it. I actually see a greater inflationary danger from the enormous amounts of base money being created by the QE programme: they aren't doing anything much at the moment, but when banks start lending again and people and businesses start spending again, what will they do with all that extra money? Milton Friedman said "Inflation is always and everywhere a monetary phenomenon". Too much money chasing too few goods and services....will production in our economy really expand fast enough to absorb all the extra cash? And if not, will the BoE reverse QE quickly enough to mop it up? If not, then we can expect high inflation to appear once more. I don't ever want to see high inflation again. But the fear of inflation is preventing governments in the Western world from taking the fiscal steps necessary to restore their economies to health and growth. And the millstone of private debt is weighing us down. The real risk we face at the moment is deflation and depression, not inflation. It's time to put fear aside and do something about it.