The Economist asks the question as to whether or not the current price stability targets of central bankers are proper given the effect China is having on the world economy. Some "good deflation" may be the natural result of doing business with China. If thats the case then forcing 2-3% inflation every year could be causing problems. Due to China's deflationary effect, 2-3% inflation requires the current ultra-low interest rate environment. Such as environment of course leads to excess liquidity which inflates asset prices. Instead of enjoying lower prices and thus higher real wages, consumers are left to only misallocate cheap capital into inflated assets.
During the late 19th-century era of rapid globalisation, falling average prices were quite common. This “good deflation”, which was accompanied by robust growth, is very different to the bad deflation experienced in the 1930s depression. Today, we would again have had “good deflation”—but central banks have instead held interest rates low in order to meet their inflation targets. The BIS frets that this has encouraged excessive credit growth.
This echoes a fierce debate in the 1920s. At that time, a similar jump in the world's productive potential (then caused by technology-driven productivity growth) was reducing manufacturing costs. Some economists suggested that, in such circumstances, overall price stability might be the wrong policy goal. Instead, they argued, average prices should be allowed to fall to pass the productivity gains on to workers and consumers as higher real incomes. But just like today, monetary policy prevented prices from falling. And an overly loose policy then inflated the late-1920s stockmarket bubble.
The Austrian school of economics offers perhaps the best framework to understand what is going on. The entry of China's army of cheap labour into the global economy has increased the worldwide return on capital. That, in turn, should imply an increase in the equilibrium level of real interest rates. But, instead, central banks are holding real rates at historically low levels. The result is a misallocation of capital, most obviously displayed at present in the shape of excessive mortgage borrowing and housing investment. If this analysis is correct, central banks, not China, are to blame for the excesses, but China's emergence is the root cause of the problem.
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