Here’s a nightmare: The Kazakhstani economy in the early 90s. Monthly rates of consumer inflation were as high as 3,300% in the summer of ’94, estimates the National Bank of Kazakhstan.
Post-Soviet nations had printed rubles sans the oversight that Moscow had exercised in the days of the USSR. Each nation in the former Soviet bloc could pass along, to its neighbors, the costs of inflating its own supply of money, since the inflation reduced the value of the money received by foreigners. So each nation printed too much money. Result: Regional hyperinflation. Kazakhstan’s transition to the tenge in 1993 proved rocky.
By comparison to the early 90s, Kazakhstan no longer has a problem with prices. Even so, in the ongoing recovery, the price level has fluctuated quite a bit, tripling in one six-year stretch. Annual consumer inflation has never fallen below 5%, according to Kazakhstan’s central bank.
This sort of persistent inflation, like the hyperinflation of 1994-5, is the fault of the National Bank of Kazakhstan, which is supposed to manage the supply of tenge. Some events, like a labor strike or a bad harvest, can create inflation temporarily by raising production costs, compelling firms to raise prices. But the only cause of continued inflation is an ever-increasing supply of money. When it grows more rapidly than output, it provides more and more currency units per output unit. Prices must rise.
Fooling all of the workers some of the time
In 1968, the Nobel laureate Milton Friedman explained why a central bank tended to print too much money. The bank wants low inflation and low unemployment, but if it has to choose, then it may well prefer the latter.
In Friedman’s vision, the economy usually produces as much as it comfortably can – a level of output called “full employment.” The unemployment rate corresponding to this output is “natural.” To lower the unemployment rate below the natural rate, the bank must over-stimulate production. To do this, it seeks to raise the price level above what people expect, so that the real wage – the cost of a labor hour – falls below what workers think it is.
(The “real wage” expresses the purchasing power of the wage. A higher price level reduces the amount of output that a given wage can buy, diminishing its purchasing power. If prices double, then a wage of 10,000 tenge will buy only half as much as before.)
To raise the price level surreptitiously, the central bank prints money. Producers respond to the cut in wages by hiring more workers, thus increasing output. Workers will provide this additional labor because they don’t realize that their real wage has fallen. Once they do realize this, they will demand higher wages, to pay for the higher prices of the goods that they buy. To pay for the increase in wages, producers will raise output prices throughout the economy. The price level will rise, choking off aggregate demand. The fall in spending will force firms to lay off workers and curtail production until output returns to the full-employment level. Friedman does not explain why workers are slower than producers to discern the initial fall in real wages.
Money rules
What, if anything, should we do about excess in the money supply? Some economists – monetarists and New Classical economists -- argue that the National Bank should adopt a “money rule” that limits either the rate of inflation or the supply of money. For example, the Bank could declare that it would no longer tolerate rates of inflation higher than 2% or lower than 0% (that is, the Bank would not permit deflation). Such a rule would build the confidence of consumers and investors in the national economy. So they would continue to spend and invest even when an external shock, such as a bad harvest, reduced output for a while. The result would be a more stable business cycle – shorter, milder recessions.
The trouble with a money rule is that the National Bank must convince people that it will adhere to it. Otherwise, the rule won’t work. Since the rate of inflation has never fallen below 5% in Kazakhstan, people would have trouble believing that the Bank would now hold it below 2%. The Bank would have to demonstrate its determination, by withdrawing enough money from the economy – enough units of currency per unit of output -- to bring down the rate of inflation. In the short run, this withdrawal probably would reduce spending and create unemployment. If the Bank is not willing to risk a recession, then it might as well not even bring up the subject of a money rule. And so we continue to muddle along.
Scarce knowledge
Supporters of a money rule contend that we don’t know enough about Kazakhstan’s economy to fine-tune the supply of tenge to its daily needs. The National Bank seems to accept this argument. At one time, it used complex computer models, simultaneously solving many equations, in order to forecast economic conditions. Now it appears to rely more than before on back-of-the-envelope models. A money rule would be consistent with such simplicity.
Economist Robert Lucas, a Nobel laureate, points out that the parameters in large computer models are calibrated using past data. But what is relevant to forecasts is how people behave today, not how they behaved in the past. When they draw up their spending plans, they use all the information available to them, not just past information. A central bank acting on a model based on past data is like a general who keeps fighting the last war.
For example, the bank’s model might assume that a consumer spends 60 tenge of every 100 received. This assumption is based on what consumers used to do. But the economy is different now. If people expect a recession, then they may start now to build up a rainy-day fund, by saving more of their income. Today, they spend just 40 tenge of every 100 – and save the other 60. This decision is based on economic expectations. These, in turn, are based on today’s headlines, not on yesterday’s spending.
Do money rules work?
The central banks of New Zealand, the United Kingdom, Sweden and Canada have targeted inflation, with some success. In New Zealand, the Parliament could strip the governor of the central bank of his job if he did not keep inflation between 0 and 3 percent, noted Bennett McCallum. Canada’s economy settled down after the central bank stopped targeting the money supply – which had not stopped inflation – and decided to reduce inflation directly, in 1991, wrote Ben Bernanke (now chairman of the Federal Reserve) and Frederic Mishkin. In Europe, the Bundesbank and the Banque de France provoked recessions so that they could stabilize their prices for the new European Monetary Union, wrote Robert Hetzel. Other countries that have targeted inflation include Australia and Israel, as well as Finland and Spain under their old central banks, according to Bernanke and Mishkin.
Typically, countries target a sort of consumer price index, usually excluding food and energy prices as too volatile to express underlying inflation, wrote Bernanke and Mishkin. When oil prices rose, the Bank of Canada ignored them when calculating inflation, wrote David Dodge.
At the moment, inflation is not a problem. Although bank reserves skyrocketed in the United States after 2008, the commercial banks there have yet to dole out most of this money to borrowers. Since no one is spending the vault cash, it doesn’t push up prices.
But according to monetarists, the time to worry about inflation is before it happens. As a famous joke has it, the job of the central bank is to take away the punch bowl before the party begins to swing. Is the National Bank of Kazakhstan allowing itself enough time to confiscate the good stuff? – Leon Taylor, tayloralmaty@gmail.com
Good reading
Ben S. Bernanke and Frederic S. Mishkin. Inflation targeting: A new framework for monetary policy? Journal of Economic Perspectives. Spring 1997. Analyzes the policies of various central banks.
David A. Dodge. Untitled remarks. Economic Review. Federal Reserve Bank of Kansas City. Fourth quarter 2002. About Canada’s central banking.
Milton Friedman. The role of monetary policy. American Economic Review 58: 1-17. May 1968. Readable and influential.
Robert L. Hetzel. German monetary history in the second half of the twentieth century. Economic Quarterly. Federal Reserve Bank of Richmond.
Juliet Johnson. A fistful of rubles: The rise and fall of the Russian banking system. Ithaca, New York: Cornell University Press. 2000. Discusses the early years of post-Soviet banking.
Mankiw, N. Gregory. Macroeconomics. New York: Worth Publishers. Fourth edition, 2011. Chapter 15 analyzes policy rules.
Bennett T. McCallum. Recent developments in monetary policy analysis: The roles of theory and evidence. Economic Quarterly. Federal Reserve Bank of Richmond. Winter 2002. Discusses New Zealand’s central bank.
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