Critics are also quick to point to another important cost of the Bank of Canada?s contractionary policies during the early 1990s. High short-term interest rates have caused the interest bill on outstanding government debt to increase. And , by pushing down both real income and employment, the Bank has reduced government tax revenues. A vicious cycle has been the consequence, with the federal government?s added interest obligations and sagging tax intake forcing it to run higher yearly deficits which have increased public debt even further.
Thus, despite the success of reaching low inflation targets, low inflation monetary policy does tend to raise unemployment, either directly or indirectly. This can occur through its effects on investment or otherwise, unless the policy generates a great increase in confidence and public expenditure cuts. As the Canadian case demonstrates, this may not be possible. The danger of a narrowly focused monetary policy, then, is that if unemployment rises more than expected, which may well happen, political pressures are likely to be generated leading to the abandonment of the experiment. In Canada, the pressure is increasing, and though virtually independent of the government, the Bank of Canada may not be able to withstand the costs of the experiment for much longer. Abandoning the policy, however, would also be very costly in that, by undermining confidence in the authorities? capability and determination, it would make it almost impossible for the Bank?s future policies to have beneficial direct effects on expectations. The alternative strategy of defining a target path for unemployment, though liable to be condemned by the public as ?cold-blooded?, might minimise this risk and thus lower the expected unemployment cost of the ultimate reduction of inflation. But, this too may prove to be different in practice.
Empirical studies have shown that, contrary to the prevailing beliefs of many economists and central bankers, in the ?long run, a moderate steady rate of inflation permits maximum employment and output. Maintenance of zero inflation measurably increases the sustainable unemployment rate and correspondingly reduces the level of output.? Zero inflation inflicts permanent real costs that are much larger than envisaged by present-day policy makers. Following Canada?s path to zero inflation, empirical modelling demonstrates that the instigation of a policy of zero inflation immediately reduces employment, and it continues to decrease until the third year of the zero inflation ?experiment?. ?The effects of wage rigidity mount as inflation approaches zero, increasing the incremental unemployment cost of reducing inflation further. The zero inflation rate target is not reached until the 6th year, at which point unemployment has reached 10.8 percent. Unemployment declines gradually from that point, nearing its steady state rate of 8.4 percent after a decade.? Without much surprise, this does very closely reflect the effects of the zero inflation monetary policy pursued in Canada. Policy makers should not be satisfied with an ultimate unemployment rate of 8.4%. Not only is this rate of unemployment still high, but the costs involved in securing the target are certainly not worth it.
Observations and Conclusions
Inflation, both high and low, clearly poses great problems on the macro and micro economy. In higher doses, inflation erodes people?s savings, endangers economic growth and propagates social instability. So, it has been argued, ?why not in these more disciplined times try to eradicate the disease altogether, just as the world has gotten rid of smallpox? Why not, some central bankers and economists are asking, aim for zero inflation – at least in the industrial countries??
Only in recent years has this question even been feasible. Previously, if inflation was single digit, it was quite acceptable. ?Now, however, the world is entering an era of low inflation that brings more ambitious targets within reach. According to the International Monetary Fund, average inflation in the industrial countries is running at only just over 2 percent a year, and although the rate is much higher in the developing countries, it is falling quickly.? As shown in this study, the proliferation of low inflation monetary policies to pursue virtual price stability is at the root of this phenomenon. However, as shown in this paper, zero inflation objectives are not wise: Central banks and governments may be trying to kill something that is not capable of being made extinct. This is particularly true in the era of globalisation. ?Fiercer global competition and freer world trade, low oil and commodity prices, the declining power of labour unions, the growing resistance of consumers to price increases, and the heavy penalties imposed by financial markets on undisciplined governments? are working to complicate monetary policies, and further make zero inflation impractical. Thus, even if ?zero? or low inflation is readily achievable, as it seems to be, it does so in the face of very powerful variables.
But, there are several additional reasons to end zero inflation policies. Above all, this paper has demonstrated that the macroeconomics of low inflation is a delicate science. Macroeconomic performance is very different when inflation falls lower half of the 1-3 percent range than in the upper-half of the 2-4 per cent range, particularly in the long run. Numerically small, but effectively huge, differences arise from the sharp non-linearity of the long-run Phillips curve at low inflation rates. ?Wringing the last drops of inflation out of the system has painful consequences for growth, jobs and investment that are neither politically acceptable nor economically desirable.? Though central banks are reluctant to see the logic of this argument at the moment, the time may soon come when the credibility of giving up zero inflation experiments will be greater than their continued pursuit. A prerequisite to this, in all likelihood, is that the least unemployment costly path for stabilising prices must be found. And, unfortunately, this is a difficult, if not impossible, pursuit.
From all of the confusion, what is clear is that a little inflation, perhaps 1 to 3 percent, is a far more efficient policy choice than zero inflation. Such a moderate inflation target would allow real wages to decline where necessary without firms having to impose wage cuts or fire workers. Thus, ?rather than misusing their energy pursuing zero inflation, governments should be exploring the other policy options now available. In today?s low-inflation environment, central banks can afford to be less restrictive than they have learned to be over the past two decades and allow greater room for growth. Exchange rates can, if necessary, be nudged downward without automatically provoking the wage and price spirals they did in the past.? Such examples are not necessarily a panacea for the damage caused by zero inflation experiments so far, but they are certainly less harmful. As argued by Pierre Fortin, public opinion is starting to reflect the reality that ?promised ?large benefits? from zero inflation are actually a mirage and that the ?small? unemployment costs are actually huge.? This opinion has been voiced particularly loudly by Japan and France. And unless the elusive benefits of zero inflation soon manifest themselves, it is only a matter of time before the rest of the ?no inflation? pack realises they are barking up the wrong tree.
BIBLIOGRAPHY
Akerlof, George., Dickens, William., Perry, George., ?The Macroeconomics of Low Inflation?., Brookings Papers on Economic Activity (1996 NI)
Dale, Reginald., ?Zero Inflation is Not a Great Idea?., International Herald Tribune (Tuesday, September 10, 1996)
Fortin, Pierre, ?The Canadian Fiscal Problem: The Macroeconomic Connection? in Lars Osberg and Pierre Fortin (eds.), Unnecessary Debts (Lorimer, 1996)
Fortin, Pierre., ?The Great Canadian Slump?., Canadian Journal of Economics (November 1996)
Freedman, Charles, ?The Role of Monetary Conditions and the Monetary Conditions Index in the Conduct of Policy?., in Bank of Canada Review (Autumn 1995)
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Lovewell, Mark., ?Getting to Zero: Bank of Canada Policy in Context?., in Bank of Canada Review (Autumn 1996)