Should Labour adopt the 4% inflation policy?

A 1998 proposal by Paul Krugman that the western world should target inflation at 4% rather than 2%, has got the backing of the IMF. The intention would be to erode government debt, and to give policy makers a more flexible tool in the future, rather than resorting to QE.

In our battle to combat inflation, we fought for it to be as close to zero as it can be without grinding growth out. 2% seemed to be that point. However, now that we’ve got that control, we don’t have to keep it so low.

In 2007, if inflation had been at 4% instead of 2%, then interest rates would have been 7% rather than 5%, and the Bank of England would have had more room to cut when crisis struck. In other words, they wouldn’t have needed to go beyond zero; to engage Quantitative Easing.

Some people might say that since we’ve finally beaten inflation, it’s not wise to bring it back? But it’s not inflation that causes problems, it’s unpredictable inflation that we fear. If we had a high rate of say 10%, but steady, year in year out, then companies and people would be able to plan around it. But if we didn’t know whether inflation will be 5% or 15%, then how much should a bank charge for a loan? Can a company calculate the profit they’ll make, if they don’t know how much the money will be worth. So 4% is fine, as long as it’s steady.

The other benefit of running a higher inflation rate is that we would erode our debt much faster. If the interest on a gilt is 4%, then 4% inflation would cancel it out. If your mortgage were 2%, then 4% inflation would leave you with a negative real interest rate of -2%.

Krugman accepts that this would be rewarding debtors for their past excesses, but argues that “economics is not a morality play.” Is he right to dismiss morality so easily? Surely modern day politicians make their living from telling bankers they are not good citizens. Is it appropriate to dismiss investors with the refrain of caveat emptor, buyer beware?

It’s worth remembering that no investor complained when QE was buying up that same debt for higher than it’s real value. Besides, if investors had feared inflation, they could have bought index linked gilts. These track inflation and rise in value proportionately. They make up only about 10% of gilts. So when it comes to the other 90%, I contend that ethical arguments are insufficient to reject the policy.

The big question is whether policy could easily switch inflation from 2 to 4. Much of the cause of inflation is expectation. In the 70s, inflation was high because trade unions made demands for wage rises on the expected future inflation rate. These rises then caused inflation to rise to the same level, and unions would demand a rise again. It was self-perpetuating.

Conversely, when Gordon Brown made the Bank of England independent, inflation markedly dropped off and stayed low. This wasn’t due to a policy of the bank, but due to the confidence inspired by it’s independence.

Should a policy of increased inflation be kept a secret? My experience of politics is that if you have something controversial to say, then be confident, say it forcefully, then stick around to face down your critics. The public aren’t experts on economics. They will make judgements on the confidence of the advocate and the reaction of pundits.

On the question of whether the markets will react badly to such a policy, I think that depends on the timing. Right now, with no demand in the economy, the market wouldn’t react badly because they have nowhere else to go. These days most savers keep their money on deposit with an interest rate lower than inflation. They are losing money in preference to the uncertainty elsewhere.

There are few safe havens in today’s investment world, partly due to the bad policy imposed by politicians such as David Cameron and Angela Merkel. When considering our economic policy for a future government, we must recognise that controversial ideas of the past are becoming consensus of the present, and deserve our serious consideration as policy for the future.

4 Responses to Should Labour adopt the 4% inflation policy?

  1. Leola Zamora says:

    The topic of this conference–the formulation and conduct of monetary policy in a low-inflation environment–is timely indeed. From the late 1960s until a decade or so ago, bringing inflation under control was viewed as the greatest challenge facing central banks around the world. Through the application of improved policy frameworks, involving both greater transparency and increased independence from short-term political influences, as well as through continued focus and persistence, central banks have largely achieved that goal. In turn, the progress against inflation increased the stability and predictability of the economic environment and thus contributed significantly to improvements in economic performance, not least in many emerging market nations that in previous eras had suffered bouts of very high inflation. Moreover, success greatly enhanced the credibility of central banks’ commitment to price stability, and that credibility further supported stability and confidence. Retaining that credibility is of utmost importance.

  2. Nick says:

    How does it erode debt?

    222 bn of Gilts is inflation linked. That will rise at over 4% per year.

    375 bn of the rest of gilts is owned by the state.

    Then there is 5,300 bn of pensions debts, hidden off the books. That’s linked to above inflation rises, the triple lock. However, if you go by the rules, there’s less than a 50% chance they will pay it. That’s the definition of ‘contingent liabilities’

    So the true state debt is over 7,000 bn. Only 500 bn owed to people who aren’t the state, is fixed rate. You can screw them, but that isn’t without consequences. First is screws annuitants, and they will end up on welfare. It screws the banks, because there aren’t any people investing new capital in banks, so loans will be frozen at today’s levels.

    The rest of the debt goes up at over inflation. Or is your plan to say, we won’t pay CPI linked pension rises?

    So over 7,000 bn of debt. Taxes of 550 bn, spending of 700 bn.

    The state is bankrupt. The state has ripped off pensioners.

    Growth doesn’t work either. How does growth get the state out of its mess? Get people back to work perhaps. Then you don’t pay them welfare, and you get some tax. Lets say some magic dust gets a million working without spending anything. How much does the state get? 15K per unemployed (12K less in benefits, 3k in tax). That’s 15 bn out of a 150 bn overspend. Where’s the other 135 bn going to come from? Whose wage packet?

    • Dan McCurry says:

      Index linked is about 10% of gilts.
      Inflation only affects previously issued gilts and doesn’t effect stocks and shares if they rise proportionately.

      • Nick says:

        The state owes 5,300 bn for pensions.

        In summary, the estimates in the new supplementary table indicate a total Government pension obligation, at the end of December 2010, of £5.01 trillion, or 342 per cent of GDP, of which around £4.7 trillion relates to unfunded obligations

        Two years out of date. Triple lock means that is now at 5,300 bn.

        Looks like a debt, walks like a debt, quacks like a debt, its a debt.

        Indexed linked gilts are 222 bn out of 1,100 bn. Where do you get your 11% from?

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