Tuesday, March 07, 2006

Can the central banks control inflation?

As long as a man knows very well the strength and weaknesses of his teaching, his art, his religion, its power is still slight. The pupil and apostle who, blinded by the authority of the master and by the piety he feels toward him, pays no attention to the weaknesses of a teaching, a religion, and soon usually has for that reason more power than the master. Friedrich Nietzsche

I remain convinced that central banks are always in control of the liquidity spigot. Stephen Roach

In a recent research report, Stephen Roach notes, the biggest news in close to a decade is that the Bank of Japan now appears to be on the cusp of abandoning its policy of ├╝ber accommodation. In doing so, the BOJ would be following the lead of the other two major central banks in the world -- the Federal Reserve and the European Central Bank. Expectations, as Mr. Bernanke would be quick to remind you, are key to guiding behavior. In that regard, I think the next few quarters will be quite key to affirming or dashing expectations of the power of Central Banking to control inflation.

As quoted at the opening of this post, Mr. Roach believes that Central Banks are still in control of the money supply. I agree, but only in the abstract. As a practical matter, I disagree. Ex-Fed Chairman Arthur Burns also disagrees and he knew whereof he spoke.

As Mr. Burns noted in his Anguish of Central Banking; As the Federal Reserve, for example, kept testing and probing the limits of its freedom to undernourish the inflation, it repeatedly evoked violent criticism from both the Executive establishment and the Congress and therefore had to devote much of its energy to warding off legislation that could destroy any hope of ending inflation. In other words, just as the FISA courts were supposed to have the power to stop the Executive Branch from spying on Americans without a warrant, but as a practical matter could not, so too, I contend is the Fed supposed to have the power to stop inflation, but as a practical matter will not.

Mr. Burns points to the expansion of government deficits in the context of "undernourished inflation" as the primary cause of inflation in the 60s and 70s. I assume that still holds true today. To curb inflation not only will the Fed need to tighten the money supply, the government will need to move back into surplus.

Thus, it seems to me, the Catch-22. In order to protect dollar hegemony, the US military must be used as enforcer. Yet, wars are expensive, and given the unwillingness of US politicians to pay as they go, inflationary- consequently destructive to dollar hegemony. The very act of protecting dollar hegemony reduces the value of the dollar.

As Mr. Burns has much more experience in these matters I'll let him close the argument. But whatever the virtues or shortcomings of central banks may be, the fact remains that they alone will be able to cope only marginally with the inflation of our times. The persistent inflation that plagues the industrial democracies will not be vanquished-or even substantially curbed-until new currents of thought create a political environment in which the difficult adjustments required to end inflation can be undertaken.