SOME CONTRASTING VIEWS
Marion G. Wrobel
TO FURTHER TARGET REDUCTIONS
Keep Present Targets
A Challenge to the Data
FOR PRICE STABILITY
The Benefits of Price Stability
The Costs of Achieving Price Stability
THE TRANSITION TO LOW INFLATION WAS SO COSTLY
SOME CONTRASTING VIEWS
The Bank of Canada and the
Government of Canada are committed to price stability as the goal of monetary
policy and the Bank currently tries to keep "core" inflation
between 1% and 3% annually. Soon new inflation targets must be established,
as the current ones expire at the end of 1998. The Bank and the government
are expected to decide upon a more concrete definition of price stability
and establish a path to get there.
In deciding upon a new set
of inflation targets, the Bank and government will have to judge whether
or not existing policy has served Canadians well; if it could be improved
upon by moving more rapidly to price stability; or if the policy stance
was a mistake and should be reversed. Such an assessment will undoubtedly
be influenced by Canadas poor macro-economic performance in the
1990s: does this performance reflect bad monetary policy, the temporary
costs of an essentially good policy, the unnecessary costs of a badly
implemented policy, or something beyond the realm of monetary policy?
The answers to these important
questions are not obvious, and monetary policy is still a matter of deep
controversy. Some, such as the ex-Governor of the Bank of Canada, John
Crow, urge the completion of the task of achieving true price stability.
Others, such as Professor Pierre Fortin, say lets recognize that
we have made a serious and costly mistake and allow inflation to grow
slightly so as to reverse some of the job losses imposed on our economy
by the Bank of Canada.
This paper provides an overview
of the monetary policy debate now taking place in this country, and the
implications for the future of the Banks monetary policy.
TO FURTHER TARGET REDUCTIONS
The following looks at the
main arguments of critics of the Bank of Canada who oppose any further
reduction in inflation targets. The first argument, after examining the
benefits of low inflation and the costs of achieving it, concludes that
targets should remain where they are. The second argument perceives the
costs of low inflation as large and concludes that the targets, rather
than being lowered, should be raised.
The discussion makes no
mention of the previously popular notion that higher inflation can be
traded off permanently for lower levels of unemployment. This "Phillips
curve" view has now been virtually abandoned by serious analysts
of monetary policy and does not play any significant part in the current
debate on this issue.
Keep Present Targets
Some economists argue that
the temporary costs associated with further disinflation will likely exceed
any permanent benefits. It takes an enormous amount of monetary restraint
to reduce inflation, especially when the rate is already low. While there
may be some real benefits to lower inflation, they could be outweighed
by the costs of getting there.
This is particularly true
if some of the costs prove to be permanent. Under the phenomenon known
as hysteresis, those who, because of monetary restraint, lose their jobs
for a protracted period may also lose their job skills through attrition,
hence becoming unemployable on a permanent basis. This outcome is more
likely if we experience severe monetary restraint due to a high sacrifice
ratio (i.e., the amount of restraint required to achieve a one percentage
point drop in inflation), or if the authorities try to achieve a large
reduction in inflation over a short period of time.
If the costs of further
disinflation, whether temporary or permanent, would exceed the benefits,
the Bank of Canadas targets should not be further reduced, according
to this view. It does not follow, however, that these commentators believe
that inflation targets should be raised. This analysis does not attribute
any benefits to higher inflation and the costs of past disinflation are
not recovered. One might conclude that the Bank of Canada should never
have reduced inflation to 1.5% per year; however, once this target has
been achieved, there is nothing to be gained by raising it again.
The most persistent critic
of the Bank of Canadas current monetary policy is Professor Pierre
Fortin, as he showed in his recent presidential address to the Canadian
According to him, Canada is in the worst economic slump since the Great
Depression, leaving the economy 850,000 jobs below our pre-recession level.
His explanation for this is that the Bank of Canadas single-minded
pursuit of price stability through tight monetary policy resulted in high
interest rates that led to the fiscal crisis of the early 1990s and a
subsequent fiscal contraction that has further exacerbated our economic
In this view, our poor labour
market performance is not only destructive but completely unnecessary;
the American approach to monetary policy (now yielding approximately 3%
inflation per year) produces virtually all the benefits associated with
low inflation while still allowing the economy to be a veritable job machine,
producing full employment.
Professor Fortin believes
that Canadas inflation targets should be raised slightly, to a 2%
to 4% range, with monetary policy aiming to keep inflation at about 3%
per year. He claims that this slight increase from the current inflation
rate of 1.5% to 2% would produce significant benefits for the Canadian
These monetary proposals
are based primarily on different reasoning from that discussed in the
previous section. Most important in this view are not so much the costs
of reducing inflation, but the costs of maintaining a permanently low
rate of inflation. These costs would be even higher with true price stability.
This thesis suggests that the high costs of our current monetary policy
could be reversed by slightly increasing the average rate of inflation.
According to this view,
inflation can be a valuable tool of economic adjustment because it enables
firms to reduce their real costs of production without having to take
explicit measures to do so. This is the notion of "greasing the wheels
of the economy," that was suggested by the American economist James
Tobin in 1972, and is described below.(3)
In any economic environment,
the circumstances of firms vary widely. Some are facing growing demand;
for others, demand is contracting. Some are becoming more productive;
others less so. Some are profitable; some are on the verge of bankruptcy.
Consequently, the real wages of workers will change at different rates:
some will grow while others will fall. The distribution of these changes
generally exhibits a symmetrical pattern, like a bell curve.
Firms not competitive in
the current environment need to cut costs and this usually means cutting
labour costs. In a world of moderate inflation and productivity growth,
this is not especially hard to do. If, for example, we have 5% inflation
and 1% growth in labour productivity, a firm that freezes wages enjoys
a 6% cut in real labour costs after one year. It would still enjoy a 5%
reduction in real labour costs if it gave employees a 1% wage increase.
Tobin, Fortin and others
contend that nominal wages are "sticky" downwards. The most
firms can do is freeze wages, so that the flexibility of labour markets
is seriously constrained once inflation rates approach zero. This problem
is compounded when labour productivity is growing only slowly. In this
case the distribution of wage changes loses its symmetry; too few workers
receive the necessary cuts to their real wages and the result is higher
Institutional factors also
add to nominal wage rigidity. Minimum wages are rarely, if ever, reduced.
Where wage equity legislation comes into play, it also prohibits a reduction
in wages, thereby in some circumstances possibly hindering labour adjustment.
As an example, consider
the case of a firm that must cut its real labour costs by 5% to remain
competitive and whose labour force becomes 1% more productive every year.
With inflation of 5% per year, this firm could raise wages by 1% and still
achieve the needed 5% reduction in real labour costs. If inflation is
3% per year, a wage freeze would reduce real labour costs by 4% per year,
leaving the remaining 1% to be achieved through layoffs. If inflation
is only 1% per year, a wage freeze would reduce real labour costs by only
2%, requiring 3% in savings to be achieved via layoffs. Clearly, this
firm would have to lay off more workers in a world of 1% inflation than
in a world of 3% inflation.
Moreover, the total number
of firms in the economy that must resort to layoffs grows as the inflation
rate falls towards zero. Similarly, as the growth in labour productivity
declines, firms must resort more to layoffs to reduce labour costs.
This conclusion depends
on the assumption that nominal wages are seldom cut. A recent Brookings
Institution study(4) concludes
just that. It presents historical data that show virtually no instances
of wage decreases and cites surveys indicating that a large proportion
of employees and employers consider wage cuts to be unfair, a hindrance
to good employee morale, and justified only in exceptional circumstances
such as a firms imminent bankruptcy. This study also cites Professor
Fortins Canadian data for the early 1990s, collected from large
contract settlements without cost-of-living adjustments, which show that
very few contracts included wage rollbacks, though a large proportion
The implications of these
data are not pleasant. According to Professor Fortin and the Brookings
investigators, the downward rigidity of nominal wages is a permanent feature
of labour markets, regardless of the economic environment. Workers and
employers are as reluctant to cut wages in a world of low inflation as
they are in a world of high inflation; both are as reluctant to cut wages
in times of high unemployment as in times of low unemployment. An inflation
rate close to zero raises unemployment permanently. In Professor
Fortins view, the Bank of Canada policy has cost our economy over
500,000 jobs.(5) Unless that
policy is changed, this job loss will remain indefinitely. And the longer
the policy remains unchanged, the greater is the possibility that the
unemployment will become irreversible as laid off workers lose their job
skills through attrition.
Fortin notes that prior
to the last recession the Canadian and American economies each employed
62.5% of persons aged 15 years or over. As the recession progressed, this
percentage fell faster and further in Canada than in the U.S. Today, the
American labour market has fully recovered from the recession but the
Canadian has not.
A variety of factors could
explain our poor labour market performance. Professor Fortin examines
globalization and free trade, technological change, political uncertainty
regarding Quebec, minimum wages and unionization; however, he concludes
that they fail to account for what has been happening. Increased payroll
taxes do not contribute to higher permanent unemployment because they
are eventually passed on to workers in the form of lower real wages (though
they could have caused some observed increase in unemployment if low inflation
rates were slowing down this adjustment). Fortin concluded that there
is only one significant explanation for the difference in Canadian and
American performance: American policy has kept U.S. inflation closer to
3% in the 1990s and as a result the American labour market has been fully
flexible; the Bank of Canadas monetary policy has kept inflation
close to 1.5%, thereby preventing flexibility in the Canadian labour market.
A Challenge to the Data
Various criticisms have
been levelled at data put forward in support of the wage rigidity hypothesis.
In the 1960s to 1980s, the North American economies were characterized
by high inflation and/or high growth in labour productivity. The absence
of wage cutbacks is not surprising; they would have been seen as unfair
at a time when average wages were growing quite rapidly. Extrapolating
from that period to one of low inflation should be done with great care.
It might be assumed that when average wages are growing only slowly, cutbacks
would not be so unusual. Studies of still earlier periods have concluded
that wages are in fact very flexible.(6)
For example, Robert Gordon, commenting upon the Brookings study notes
that American wages fell 17% between 1929 and 1933.(7)
Moreover, it is suggested that surveys provide only weak evidence on this
issue; respondents are known to conceal sensitive personal information
and would be far more likely to report that an acquaintance had had a
wage cut than to admit that they themselves had had this experience.(8)
A study of the earnings
of 5,000 American families since 1968 also provides little support for
the wage rigidity hypothesis.(9)
For most workers, the distribution of wage changes is not skewed away
from wage cuts, in sharp contrast to the claims of the Brookings study.
Observations of zero wage change represent only 7% of the sample; in contrast,
17% experienced nominal wage cuts in any year. Most important, there is
no evidence of money illusion; that is, respondents recognized the impact
of inflation on individual prices and wages.
data appear to be on more solid ground as they pertain to the Canadian
low-inflation environment; nevertheless, they are not as convincing as
they seem at first glance. The main criticism is that public sector settlements
make up a very large part of his sample (60%), far in excess of that sectors
importance in the economy. More important, 90% of the wage freezes were
public sector wage freezes.(10)
Governments do not behave in the same way as private sector employers.
In addition, these data are from the period of the "Rae days"
in Ontario, when the Ontario government used unpaid days off as a means
of reducing real labour costs. Professor Fortin also treats multi-year
contracts with a wage freeze in the first year as examples of wage freezes,
when they should have more properly been treated as examples of wage increases.
His treatment overstates the incidence of wage freezes and gives more
importance to the zero point than it deserves.
But even at that, one must
treat this kind of data cautiously. While economic theory can speak of
a wage rate, nominal or real, it is far more difficult to frame such a
concept in practical terms. So we must rely upon imperfect proxies.
Most workers are not unionized,
do not work for large employers and are not part of large settlements;
thus labour contracts do not necessarily reflect what is happening in
the labour market in general. In addition, these data tend to reflect
only the wages of those who are paid hourly, rather than on a salary basis.
For example, a firm with excessively high wage costs goes out of business
or lays off some workers, who then take on jobs with lower-wage employers
in the same or different industries, (ex-Eatons employees going
to work for WalMart, for example). Wage flexibility can manifest itself
in a variety of ways. Studies indicate that those who change jobs or are
paid on a salary basis experience greater wage flexibility than those
who stay put or are paid hourly.(11)
A recent study by Statistics Canada indicated that of the 19% of Canadian
employees who worked overtime in the first quarter of 1997, 60% did so
By itself this figure says nothing about wage flexibility; however, as
the amount of unpaid overtime changes, so does the effective compensation
of employees. To the extent that austerity measures and/or recession-induced
downsizing have increased the incidence of unpaid overtime, they represent
a cut in real wages. As well, fringe benefits could be reduced, work could
be contracted out, etc. None of these effects is captured by contract
John Crow makes the further
point that Canada is very much an open economy, with about 40% of GDP
resulting from international trade. When coupled with a flexible exchange
rate, even wages that are nominally inflexible in Canadian dollars could
be highly flexible in real terms when measured against an international
The arguments for slightly
increasing the rate of inflation in Canada are probably made by a minority
of Canadian economic analysts. Clearly, however, Canadas poor labour
market performance needs to be explained and Professor Fortin has attempted
to do this. His critics believe that his arguments are not sufficiently
compelling to change the stance of monetary policy, yet they will have
to be addressed when the post-1998 inflation targets are debated.
In addition to the problems
mentioned above, there are also problems inherent in the data upon which
we base comparisons between American and Canadian unemployment rates.
The Centre for the Study of Living Standards concluded that only one-half
of the difference between Canadian and American unemployment rates was
due to cyclical factors and attributed the other half, in equal parts,
to measurement differences and structural factors. Other analysts, such
as Professor Herb Grubel, attribute a much greater importance to structural
factors, noting for example that the recent changes to Employment Insurance
in Canada will not alleviate unemployment rates for several years. Finally,
a recent Statistics Canada study suggests that the drop in the participation
rate of the population may reflect an increase in early retirement, rather
than worker discouragement to the extent previously thought.(14)
On the surface, the idea
of a little more inflation to grease the wheels of the economy seems acceptable.
It alludes to an economy that is like a machine, needing a little lubrication
to work smoothly. The minor increase in inflation being proposed by Professor
Fortin, from 1.5% or 2% per annum to 3%, does not appear to be particularly
radical or contentious. The underlying premise, however, is that workers,
fooled into thinking they were earning more than was really the case,
would keep jobs that they would otherwise abandon.
This is why the wage rigidity
thesis is hard to accept. It requires workers and employers to demonstrate
irrationality and an unbelievable unwillingness to learn. It is one thing
to say that workers would not accept a wage rollback when inflation is
unexpectedly, and possibly temporarily, low. It is much harder to believe
that workers would reject a rollback in an environment of clearly low
inflation or persistently high unemployment. Wage rollbacks might be seen
as a good alternative to unemployment at a time when jobs are scarce.
Paul Krugman, another noted
American economist, argues in support of Professor Fortins thesis
by putting forward a moderate compromise to the price-stability advocates
on the one side and the easy-money/growth advocates on the other. He dismisses
the previously popular notion that longer-term unemployment can be reduced
by raising inflation. He refers to the "reasonable proposition"
that people arent fooled by inflation and can calculate the real
wage gain in a 10% inflation world as easily as in a 5% inflation world.
In his opinion, "there is overwhelming evidence that this hypothesis
is right."(15) In the
next paragraph, however, he claims that it takes a "hyper-rational"
worker to recognize that a wage gain that is less than the rate of inflation
is the same thing as a nominal wage cut. Surely a worker who can subtract
10 from 8 to get -2 can also subtract 3 from 1 to get the same result.
Furthermore, given what
is now known about the accuracy of our price measures, the difference
between Canadian and American inflation rates is not large; yet it is
credited with having a great impact on labour markets. It would be truly
ironic if we found that our high unemployment problem is due, not to monetary
policy, but to an inaccurate consumer price index.
Moreover, labour strife
(measured by time lost to strikes) is substantially reduced in a low inflation
environment. This may suggest that workers do not suffer from money illusion;
rather, they are aware of the consequences of high inflation and the difference
between nominal and real wage changes.
The issue is not whether
workers willingly accept nominal wage cuts -- they clearly do not; when
they accept cuts, they do so grudgingly. But are they any more willing
to see their wages fall during times of higher inflation? Strike data
suggest that this is not the case.
Moreover, if inflation "tricks"
workers into staying in jobs with declining real wages, is this a good
thing? Some industries are declining as others are flourishing. Real wages
decline in the former and increase in the latter, sending a signal to
workers that better opportunities exist elsewhere. If inflation blurs
this message, labour will not migrate to more productive uses.
FOR PRICE STABILITY
Some economists claim we
should go all the way to achieve true price stability. They believe that,
while todays moderate inflation is much better than that we experienced
in the 1970s and 1980s, it can still be improved upon. In their view,
it is now becoming evident that even low or moderate inflation imposes
large and long lasting costs on society and hence can do significant harm
over a long period. Indeed, the more than two decades of high inflation
that we experienced can be blamed for many of our current economic ills.
By contrast, the costs of reducing inflation, according to these economists,
are relatively small and short-lived.
First, it is useful to consider
just what is meant by price stability. On the surface, it is a concept
that seems relatively easy to define -- it is the absence of inflation
over time, or the constancy of aggregate prices over many years. But the
aggregate price level, and inflation are economic concepts that, in practice,
are represented by imperfect measures, the best-known being the Consumer
Price Index (CPI).
It is generally recognized
that the Consumer Price Index overstates the degree of inflation. This
happens for a variety of reasons. The CPI is slow in adjusting its market
basket to reflect actual purchasing patterns so that the effect of consumers
switches to less costly products can be masked. Price indices also tend
to take product improvements insufficiently into account, again overstating
the rate of inflation. As well, indices may not take account of new products,
thereby missing the dramatic declines in prices and improvements in quality
that are found during the early part of the product cycle.
The Bank of Canada and most
Canadian economists believe that the bias of the CPI is no more than 0.5%
per year, although some, notably Pierre Fortin, believe it to be somewhat
higher.(16) In the United
States, the upward bias is generally thought to be greater than in Canada.
The Boskin Commission recently concluded that the best estimate of the
upward bias of the American CPI is 1.1% per year, with a plausible range
of values from 0.8% to 1.6%.(17)
Price stability can also
be viewed as a state of mind. It has been described as either as "a
state of confidently held expectations about the absence of inflation,"
by John Crow,(18) or as
a situation "when people do not consider inflation a factor in their
decisions," a phrase attributed to both Paul Volcker and Alan Greenspan.(19)
In other words, we have price stability when individuals and firms make
consumption decisions based on the relative merits of the expenditure,
not because they fear the price will be higher tomorrow; when families
buy houses because it is what they want and can afford and not as a hedge
against inflation; when individuals can confidently make long-term investment
decisions without worrying about purchasing power in the future; when
employees dont care whether or not their longer-term contracts contain
COLA clauses; and when seniors arent concerned about whether their
pensions are indexed and taxpayers arent affected by a tax system
not indexed to inflation.
This approach has the advantage
of not depending upon the accuracy of CPI statistics, in which our confidence
is diminishing as the structure of our economy changes. Given the growing
importance of services in the economy, it is becoming increasingly difficult
to define a unit of output.(20)
If, however, the Bank of Canada is going to continue to use a CPI-based
measure of inflation, achieving price stability would probably demand
a target below 1% per year. Thus the Bank of Canada today is aiming for
a low rate of inflation, but not price stability.
The Benefits of Price Stability
Price stability generates
benefits in that the economy avoids the costs to society associated with
inflation. In the past, it was thought that significant costs resulted
from only very high rates of inflation or unexpected inflation. Today,
analysis and evidence suggest that even low and stable rates of inflation
can be costly, as advocates of price stability emphasize.
A modern market economy
is based upon specialization and exchange (in which money is the intermediate
good that allows us to trade what we produce for what we want to consume).
Anticipated inflation raises the cost of holding money and causes individuals
to reduce their holdings of this intermediate good. In this way, inflation
is like a tax, increasing transaction costs and leaving fewer resources
to produce other things. Consumption, investment and work effort are all
reduced as a result. It is a well recognized principle of public finance
that intermediate goods should not be taxed, yet inflation does just that.
Our economy also relies
heavily upon the signals given by the price system, which provide a great
deal of information on what to produce, how to produce it, when to produce
it, and where to produce it. Inflation (and deflation, for that matter)
decreases the accuracy of the price signals we use in our roles as consumers,
producers and investors. When individual prices change in a world of price
stability, we know that some underlying condition has changed, either
on the demand or supply side. When such an individual price changes in
a world of inflation, however, we dont know the cause; it could
be a delayed reaction to inflation, or an early reaction to anticipated
Probably the most pernicious
effect of inflation is on capital formation. Capital formation has a profound
and well-known impact on labour productivity, real incomes and economic
growth. As taxes are applied to nominal, not real, returns from investment
and as nominal returns tend to increase with inflation, even a moderate
increase in inflation can cause a dramatic fall in the real after-tax
returns from investment upon which capital investment is based. Reducing
inflation from 3% to zero, for example, increases the expected after-tax
real return by 35%.(21)
Such an increase would have a significant impact on capital formation
and economic growth, with the cumulative effects over time being quite
substantial. This suggests that we have indeed paid a heavy price for
former inflation rates that were far greater than 3% per year. Peter Howitt
estimates that the ultimate value of higher growth due to a reduction
in inflation from 3% to zero could be equal to about 85% of current GDP.(22)
An American study by Professor Martin Feldstein estimates that reducing
inflation from 2% per year to zero would, over time, confer a benefit
whose present value would equal about 35% of current American GDP.(23)
The Feldstein calculation
concentrates on the harm inflation does to savings and investment, since
"fictitious" returns at both the business and personal levels
are taxed. Although some features of the tax code tend to reduce taxes
in an inflationary environment, on balance real tax levels are increased.
In the United States, inflation also tends to increase the demand for
housing; not only does it reduce the returns from alternative forms of
saving, but, because Americans can claim a tax deduction on nominal rather
than real mortgage interest, inflation also reduces the after-tax cost
of housing. (This tax deduction is not available in Canada).
In addition to lowering
capital formation in general, inflation also shifts investment activity
away from plant and machinery, which are growth-enhancing, and towards
real estate, which is not. Inflation also affects labour force decisions
and encourages individuals to enter financial fields, which (because of
inflation) can be extremely lucrative, rather than technical and scientific
fields, which are ultimately more beneficial to society and promote ore
are higher than Feldsteins primarily because they include price
signals distorted by inflation, and the resulting reduced efficiency of
investment. Even perfectly anticipated inflation affects reported profits
and the real after-tax rate of return from investments, but the distortions
vary from sector to sector and firm to firm. For example, inflation causes
an overstatement of profits in firms with high inventory-to-sales ratios
and large amounts of depreciable capital, but understates profits in firms
with high levels of debt. As a result, investors are less able to make
informed decisions about the profitability of different firms and different
sectors of the economy and may well invest in some areas with low rates
of return while withholding capital from areas with high rates of return.
Inflation variability further compounds these problems, as reported financial
statements give investors mixed and inaccurate signals.
These costs of inflation
are permanent. Some might be mitigated via an indexed tax system, but
indexation of investment income would be difficult to put in place. Indeed,
no jurisdiction has ever come close to implementing anything like a comprehensively
indexed tax system, which in any case might just further distort economic
behaviour. More important, not just the tax system is fooled by inflation,
investors are as well and indexation of the tax system will not necessarily
solve their problems.
Feldstein estimates these
benefits of price stability to equal about 1% of GDP per year. The one-time
costs of eliminating 2% inflation, amounting to about 5% of current GDP,
could be exceeded by the benefits within six to nine years, depending
upon their timing. After that, price stability would continue to generate
annual benefits without the costs. Howitt estimates the annual benefits
to be about 50% higher.
In this view, the costs
of inflation are seen as diffused over the whole economy, showing up in
a variety of ways that are not always apparent. This is in sharp contrast
to the Fortin thesis that the costs of price stability take the form of
higher unemployment and/or lower labour force participation rates. These
statistics are reported monthly and followed closely by analysts, the
media, politicians and voters.
Many factors have also affected
growth and productivity since WWII, including demographic change, a more
important service sector, an increasing role for the public sector, and
technological development. As noted above, however, inflation reduces
the efficiency of the economy and its rate of growth.
The following chart plots
over four decades of inflation and productivity change in manufacturing.
The erratic changes in productivity from year to year can mask longer
term trends. To remove that volatility, the chart plots five-year rolling
averages of these two variables. It shows low inflation and high rates
of productivity growth in the 1950s and 1960s. Two decades of rising inflation
also witnessed a long-term decline in productivity, until about 1982,
after which, as inflation fell, productivity grew. A similar pattern exists
for the 1990s. While the business cycle also plays a role in this pattern,
the data are consistent with the view that inflation is damaging to the
economy. The cumulative effect over 20 years is undoubtedly large.
The data are also consistent
with the fact that some of the costs of inflation show up as economic
activity making up part of GDP, where, because we think of GDP as a proxy
for overall economic welfare, they are incorrectly measured as benefits
rather than costs. This is analogous to many of the costs of regulation.
If, for example, a regulation increases the costs of producing cars, it
might have the effect of somewhat lowering GDP. More important though,
the additional labour and other input resources required to produce a
car all count as economic activity. If the resulting car is no better
than one produced without the regulation, and if regulation-induced features
are substituted for those consumers would otherwise have chosen, these
input resources are wasted. GDP accounting does not recognize this, however.
The same is true in a world
of inflation; firms and households are forced to increase their use of
financial, accounting and legal professionals, merely to cope with inflation,
rather than to assist in the production of desired goods and services.
The GDP, however, cannot distinguish between the purposes for which financial
services are used. If, instead of spending $1,000 on a short vacation,
a family spends it on ways to cope with inflation (financial advice, books
on investment strategies, extra costs of shopping to find bargains, etc.)
the level of GDP is not changed, but its composition is and clearly the
family is worse off.
Inflation also imposes costs
on society in the form of labour strife. In periods of high inflation,
more days are lost to strikes than in periods of lower inflation. In the
early 1980s, for example, three to eight times as many of days were lost
to strikes as today, even though the unemployment rate was also high at
The Costs of Achieving Price Stability
It is all well and good
to cite the benefits of lower inflation or price stability; however, whether
or not monetary policy should pursue such goals depends upon their costs.
It might well be rational to forgo such benefits if the price would be
too high or if benefits would accrue too far in the future while costs
were imposed today. The following considers these costs of disinflation.
The primary argument against
"disinflationary" monetary policy (i.e., a policy that reduces
the rate of inflation) is that it virtually always temporarily reduces
the level of economic activity and raises unemployment. The magnitude
of these costs can vary enormously. The costs of disinflation are temporary,
however, while, according to Professor Fortin and others, the more controversial
costs of maintaining a low rate of inflation are permanent.
There are two major reasons
for the temporary costs of transition. The first is that prices tend to
be set in nominal terms, based on the previous expectations of inflation.
It is costly to reprice items and firms will not do so on a continuous
basis. Thus if prices for 1997 had been established on the basis of 3%
expected inflation and inflation was only 2%, prices will have been set
too high. Although these excessive prices may be costly to firms, repricing
items might be more so. Moreover, a wide variety of prices are set in
longer-term contracts. If prices were set in anticipation of higher inflation
than actually came about, firms and workers would be competitively disadvantaged.
Breaking or renegotiating these contracts, however, entails substantial
Disinflation might also
be costly because economic agents are slow to incorporate the central
banks disinflationary policy in their expectations and may expect
5% inflation at the same time that the central bank is pursuing a price
stability goal; this will make the path to price stability slower and
more painful. Even falling inflation might not alter expectations if it
is viewed as an aberration from our long history of inflation rather than
a reflection of a new monetary environment.
At issue is the amount and
duration of the higher unemployment that would result from an attempt
to reduce inflation permanently from, say 1.5% per year to 0.5% per year
(which in Canadas case would imply price stability). Some analysts
believe that because the costs of disinflation are high and rise more
than proportionately with the speed of disinflation, a policy of gradualism
would be less costly. It takes individuals time to learn about a new monetary
regime; the longer they have lived with inflation, the longer it will
take to persuade them that policy has changed.(25)
While the costs of the disinflation
of the early 1980s cannot be dismissed, they proved to be far lower than
the estimates of traditional Phillips Curve models. Michael Boskin argues
that the American economy permanently reduced inflation by six percentage
points in the early 1980s, at a cost of 12% of GDP spread over several
years. This implies a sacrifice ratio of 2:1; traditional Keynesian models
had predicted sacrifice ratios ranging from 4:1 to 10:1.(26)
Canadian estimates range from about 2.3:1 to about 5:1.(27)
Professor Fortin; however, suggests that Canada pays an enormous price
for disinflation in the permanent unemployment caused by hysteresis (as
described above). He claims that when central bank authorities try to
reduce inflation quickly, this effect can be very pronounced and generate
very high sacrifice ratios. Most other analysts, however, see little evidence
of such an effect in Canada.(28)
Two characteristics of central
bank monetary policy can help to reduce transition costs substantially.
The first is transparency; that is, enabling observers to see and understand
the central banks goals and actions. The second is credibility;
that is, the extent to which observers believe in the central banks
commitment to its stated goals. But neither of these two characteristics
is necessarily present. The preamble to the Bank of Canada Act,
for example, instructs the Bank to do a variety of things, some of which
we recognize today to be contradictory; thus establishing transparency
becomes more difficult. Credibility is even more elusive. While central
bankers today have nothing good to say about inflation, for almost three
decades they permitted and fostered rather high levels of it. The credibility
of todays central bankers depends on a perception that they are
distinctly different from those of yesterday, who may have talked a good
line but failed in the end to deliver.
Central banks may not always
be autonomous institutions, however. Thus while their officials may wish
to promote price stability, their ultimate masters may have no such inclination.
In Canada, the federal government is ultimately responsible for monetary
policy. Though there is an attempt, through regular meetings between the
Minister of Finance and the Governor of the Bank of Canada, to ensure
that the Bank and the government are "singing from the same hymn
book," the government has the ultimate power to issue a directive
to the Governor. Thus, in some instances, it is the appropriate level
of government that must be credible, as well as the central bank.
In Canada, jointly set inflation
targets help to establish transparency as they represent the only well
defined and announced goal of the Banks monetary policy. They also
add to credibility, in the sense that they are set not just by the Bank
but also by the Government of Canada, and can thus represent some commitment
that fiscal policy will do its part to maintain price stability.
Our long history of inflation
makes credibility a crucial element in the formation of inflation expectations.
A whole generation has become accustomed to inflation and would be difficult
to convince that price stability was now to be the norm. Any reversal
of central bank policy would lead observers to question the credibility
of the price stability commitment. This is precisely why so many are reluctant
to support the Fortin prescription in the absence of conclusive evidence
in its favour. If monetary policy was loosened, and this was found to
be a mistake, the initial transition costs would have been in vain and
the costs of re-establishing price stability would be even higher than
they were originally.
Inflation is essentially
a monetary phenomenon and any substantial change in it must be accompanied
by a changing monetary stance; however, the governments budgetary
constraint links fiscal policy to monetary policy, and could therefore
affect it directly. At the very least, a change in fiscal policy could
affect the credibility of a central banks commitment to price stability.(29)
In simple terms, a deficit
must be financed by selling interest-bearing bonds to the private sector
or by printing money. If, as has been the case for much of the 1980s and
1990s, the interest rate exceeds the growth of the economy, government
operating deficits lead to increasing debt-to-GDP ratios, an unsustainable
policy for any government already burdened with a high debt load. The
ability to run further deficits financed by bonds becomes compromised,
increasing the likelihood that such fiscal policy would have to be financed
by money creation. Fiscal policy characterized by large deficits is, then,
inconsistent with monetary restraint.
This was precisely Canadas
situation from the middle 1980s to the middle 1990s. Interest rates exceeded
growth rates in the 1990s by a substantial margin. The operating balance
of the government was either in deficit or, if in surplus, was too small
to constrain growth in the debt-to-GDP ratio. Consequently, markets saw
fiscal policy as untenable. At the same time the Bank of Canada was talking
about price stability; however, the governments fiscal policy was
not consistent with the rate of monetary expansion required for price
stability. Would the Banks monetary policy put a brake on the unsustainable
fiscal policy or would the fiscal policy make a mockery of the Banks
price stability goals? In the latter case, the Banks anti-inflationary
policy could lead to more inflation, because, by raising short run interest
rates, it would exacerbate government deficits, in the absence of other
offsetting fiscal measures, and aggravate the inconsistency in policy.
If the central bank authorities were ultimately subservient to deficit
fiscal policy, a more inflationary monetary stance would have to be adopted.
The two policies were inconsistent
over the long term and there was some doubt as to which would prevail.
Today, the sharp drop in the deficit and increase in the operating surplus
have made fiscal policy clearly more consistent with the Bank of Canada
price stability monetary policy. It did, however, take many years for
this to become evident.
THE TRANSITION TO LOW INFLATION WAS SO COSTLY
The poor performance of
the Canadian economy in the 1990s requires an explanation. Professor Fortin
argues that we are seeing the permanent cost associated with low inflation.
His critics argue that there is no conclusive evidence to support that
view. They stress the potential benefits of price stability and caution
against abandoning the hard won gains associated with our present low
inflation. Amongst other things, they claim that the current high unemployment
rates still represent to some extent the temporary costs of disinflation.
On the surface, this last claim is hard to accept. We have, after all,
had low inflation in Canada since 1991. Surely this should be long enough
to have accommodated the transition to a low inflation environment.
It must be remembered, however,
that our history of low inflation followed more than two decades of high
inflation. It is not so obvious that the Bank of Canadas policies
were viewed as credible throughout most of the early 1990s. As Mr. Thiessen
has recently remarked:
Credibility takes a long
time to establish and precious little time to undo once markets begin
to doubt ones commitment to stated policy goals. While it is true
that we now have four good years of inflation performance, we also have
a legacy of some 20 years of high inflation. To put behind us. The only
way to achieve this is by providing market participants ... with a strong
sense of continuity in economic policy.(30)
With hindsight, we can pinpoint
quite accurately the birthdate of the Banks new-found interest in
price stability. By the latter half of the 1980s, when monetary expansion
was setting the stage for an increase in inflation, the new Governor of
the Bank of Canada, Mr. John Crow, had begun to speak about the need for
price stability. His most important such statement came in the Eric J.
Hanson Memorial Lecture on 8 January 1988 in Edmonton, which is now viewed
as a turning point in the conduct of Canadian monetary policy. It committed
the Bank to a price stability goal over time, contrasting with previous
Bank statements about the evils of inflation, which had proved to be more
in the nature of platitudes than announcements of concerted action.
At the time, Mr. Crows
lecture did not seem to signal any obvious shift in monetary policy. Financial
markets had heard the same tune before. The lack of time frames, targets
and price measures also contributed to doubts about the Banks new-found
commitment to price stability. Moreover, projections in the federal budgets
of 1988 to 1990 did not suggest that the federal government anticipated
any significant change in the inflation performance. Indeed the higher
inflation rates in the budgets were necessary to justify revenue projections.(31)
Three years later, in the
1991 federal budget, the Governor and the Minister of Finance jointly
announced a set of inflation reduction targets: 3% by the end of 1992,
2.5% by the middle of 1994 and 2% by the end of 1995. A band of one percentage
point above and below the targets was also established to allow some slight
leeway in the conduct of monetary policy, in recognition of the temporary
shocks that, from time to time, affect the financial system. While targets
beyond 1995 were not established at that time, price stability, (the ultimate
goal of this disinflationary policy) was said to mean a rate of price
increase that was "clearly below two per cent."(32)
According to Deputy Governor Charles Freedman, it was obviously the intent
to further reduce inflation after 1995.(33)
Moreover, early in this
process, the federal government suggested, and the Bank recommended, amending
the Bank of Canada Act to specify clearly that the goal of the
central bank would be price stability and price stability only. This proposal
was rejected by a parliamentary committee in February 1992, however, thereby
somewhat undermining the Banks commitment to that goal.
When Mr. Thiessen became
Governor of the Bank of Canada in late 1993, he and Finance Minister Paul
Martin extended the inflation targets to 1998, keeping the target band
of 1% to 3% rather than reducing them, as had been originally suggested.
Market observers received
confusing signals for several years about the future stance of monetary
policy. Federal budgets did not predict lower inflation until 1991. Worse
still, the actual conduct of fiscal policy was inconsistent with price
stability. After Mr. Crows 1988 address in Edmonton, the federal
net debt-to-GDP ratio grew by more than one-third. It is only today that
the ratio has been stabilized and we can be confident that it will fall
Fiscal policy fails to support
monetary policy in another way. With inflation at less than 3%, the personal
income tax system has effectively been de-indexed. A de-indexed system
generates substantial revenues for the government in a world of inflation
but is of no benefit in a world of price stability. By restoring full
indexation to the tax system, the government would give up any fiscal
gain from inflation,(34)
thereby making any commitment to price stability more credible. That the
government has not done so, leaves it with a strong fiscal incentive to
maintain some inflation.
Finally, it is possible
that the Bank of Canada has also contributed to excessively high costs
of disinflation, not because of its policy but because of how that policy
was implemented. A C.D. Howe Institute publication argues that the Banks
reliance upon interest rates and the exchange rate as indicators of monetary
conditions has several times caused it to tighten monetary policy needlessly
when there was no threat of higher inflation.(35)
All these factors suggest
that the costs of disinflation have been higher than necessary. Now that
the Bank is seen as a credible inflation fighter and fiscal policy is
finally supportive of price stability, further reductions in inflation
targets might be less costly. Also important is the fact that that Canada
can clearly pursue a lower inflation policy than the United States with
correspondingly lower nominal interest rates.
The Bank of Canada and the
Government of Canada are both committed to the goal of price stability.
Though today we have inflation rates below any for decades, most would
agree that price stability has not yet been achieved.
In deciding where to go
with inflation targets after 1998, the government will undoubtedly take
into account the performance of the economy in the 1990s. What does that
performance tell us?
Three possibilities come
to mind. The first, that the economy was affected largely by non-monetary
policy factors, whose solution lies in other forms of government policy,
is not dealt with here. The other possibilities are two views of monetary
policy. One is the view of Pierre Fortin: monetary policy designed to
maintain low inflation has imposed large and permanent costs on the economy.
The second view is that the high unemployment of the 1990s came about
because expectations of high inflation were slow to adjust to falling
rates and the Bank of Canada commitment to low inflation originally lacked
credibility. Unfortunately, these two views of monetary policy could have
affected the economy in similar ways. A superficial glance at macro-economic
indicators provides support for both.
The distinction between
these two competing explanations will become clearer over time. Professor
Fortin suggests that the costs of the present policy are permanent, whereas
those in the opposite camp suggest that the costs are temporary. If the
current strong economic expansion continues, it is the latter explanation
that will receive more credence.
Pierre Fortin, "The Great Canadian Slump," Canadian Journal
of Economics, XXIX, No. 4, November 1996.
Pierre Fortin, "Raise the Inflation Target and Let Canada Recover,"
The Globe and Mail (Toronto), 26 September 1996.
J. Tobin, "Inflation and Unemployment," American Economic
Review, Vol. 62, 1972.
George A. Akerlof, William T. Dickens and George L. Perry, "The Macroeconomics
of Low Inflation," Brookings Papers on Economic Activity,
No. 1, 1996.
House of Commons Standing Committee on Finance, Evidence, 10 October
A.L. Marty and D.L. Thornton, "Is There a Case for Moderate
Inflation?" Federal Reserve Bank of St. Louis, Review, Vol.
77, No. 4, July/August 1995.
R.J. Gordon, "Comment," Brookings Papers on Economic Activity,
N.G. Mankiw, "Comment," Ibid.
K.J. McLaughlin, "Rigid Wages? Journal of Monetary Economics,
Vol. 34, No. 3, December 1994.
These figures are cited by David Laidler in: House of Commons Standing
Committee on Finance, Evidence, 10 October 1996, p. 36.
D. Card and D. Hyslop, "Does Inflation Grease the Wheels of
the Labour Market?", in C.D. Romer and D.H. Romer eds., Reducing
Inflation: Motivation and Strategy, National Bureau of Economic Research,
Studies in Business Cycles, No. 30, The University of Chicago Press, Chicago,
B. Little, "Canadians Work Overtime - For Free," Globe and
Mail (Toronto), 15 July 1997.
J. Crow, "A Comment," in D. Laidler, ed., Where do We Go
From Here: Inflation Targets in Canadas Monetary Policy Regime,
Policy Study 29, C.D. Howe Institute, 1997.
E. Beauchesne, "Labor Force Dropouts Not Necessarily Discouraged
Workers," Ottawa Citizen, 12 June 1997.
"Paul Krugman, "Stable Prices and Fast Growth: Just Say No,"
The Economist, 31 August 1996, p. 20.
As cited in Michael Parkin, "Monetary Policy and the Future of Inflation
Control in Canada: An Overview of the Issues," in D. Laidler ed.
Advisory Commission to Study the Consumer Price Index, Michael J. Boskin
Chairman, Toward a More Accurate Measure of the Cost of Living,
Final Report to the Senate Finance Committee, Washington D.C., 4 December
John Crow, " A Comment," in Laidler ed. (1997).
George A. Kahn, "Symposium Summary," Achieving Price Stability,
Federal Reserve Bank of Kansas City, 1996.
Alan Greenspan, "Opening Remarks," in Achieving Price Stability
The calculation is based on a real return of 5%, a 30% tax rate and the
assumption that nominal returns increase fully to reflect higher inflation.
If nominal returns increase by only 80% of expected inflation, the reduction
of inflation from 3% to zero increases expected after-tax real returns
Peter Howitt, "Low Inflation and the Canadian Economy," in D.
Laidler ed. (1997).
This estimate is equal to
the present value of all increased future output due to price stability,
assuming that growth is increased from 2% per year to 2.075% for a period
of 30 years.
M. Feldstein, "The Costs and Benefits of Going from Low Inflation
to Price Stability," Working Paper 5469, National Bureau of Economic
Research, Cambridge Mass., 1996.
Howitt, in Laidler, ed. (1997), p. 38.
M. King, "How Should Central Banks Reduce Inflation? -- Conceptual
Issues," in Achieving Price Stability (1996).
M.J. Boskin, Reagan and the Economy ¾ The Successes, Failures and Unfinished
Agenda, Institute for Contemporary Studies, San Francisco, 1987, p.
Kevin Dowd, "The Costs of Inflation and Disinflation," Cato
Journal, Vol. 14, No. 2, Fall 1994, p. 323.
J. Selody, The Goal of Price Stability: A Review of the Issues,
Technical Report No. 54, Bank of Canada, 1990.
N. Wallace and T.J. Sargent, "Some Unpleasant Monetarist Arithmetic,"
in T.J. Sargent, Rational Expectations and Inflation, Harper &
Row Publishers, 1986.
Bank of Canada, Monetary Policy Report, November 1996. This opening
quotation comes from a speech the Governor gave to the London Chamber
of Commerce in June 1996.
G. Debrelle, "The Ends of Three Small Inflations: Australia, New
Zealand, and Canada," Canadian Public Policy, XXII:1, 1996.
D.E.W. Laidler and W.B.P. Robson, The Great Canadian Disinflation:
The Economics and Politics of Monetary Policy in Canada, 1988-93,
C.D. Howe Institute, Policy Study, 1993.
C. Freedman, "The Canadian Experience with Targets for Reducing and
Controlling Inflation," in L. Leiderman and L.E.O. Svensson,
Inflation Targets, Centre for Economic Policy Research, London,
J.D. Konieczny,"The Optimal Rate of Inflation: Competing Theories
and Their Relevance to Canada," in Economic Behaviour and Policy
Choice under Price Stability, Proceedings of a Conference Held at
the Bank of Canada, October 1993.
K.J. Boessenkool, D.E.W. Laidler and W.B.P. Robson, "Devils in the
Details: Improving the Tactics of Recent Canadian Monetary Policy,"
C.D. Howe Institute Commentary, No. 79, April 1996.