Transperency and inflation targets

Inflation targeting is a popular trend in modern banking. In early 2000s majority of central banks started to pursue a goal of greater transparency and inflation targeting was viewed as necessary tool for achieving it. However critics like M.Friedman stress a point that inflation targeting is deliberately making bank policies more obscure. I don’t believe this critique is entirely valid, yes practise of maintaining price stability could create some confusion, but with the help of the public situation can be improved.

In his paper on “Why the Federal Reserve Should Not Adopt Inflation Targeting” M.Friedman claims how central banks take one issue of inflation and put it at the center of all problems. This is a deliberate practise because it allows banks to do what they do and only talk about price stability. Okay that might be the case, but lets take a look at FED in 2004 , which at the time had no target and had to constantly look forward for possible threats to price stability in order to avoid time lags within monetary system. This practise did not require possible use of disinformation, instead it kept market participants totally in the dark guessing about the next policy move by the bank (this is so-called “just do it” approach). Both examples might seem flawed,but the difference is former could be improved  by the public involvment.

Bank communicates with other market agents by using multiple channels. Signals sent through these channels help to manage expectations within the market and avoid possible economic downturns. Bank can not reveal too much information about its strategies, because that could create confusing signals, that would lead to instability and finally lack of transparency, thus the idea is to simplify information, make it more approachable. Inflation targeting is the right tool for the job, summarising the whole financial strategy by using the desired percentage, but oversimplification attracts too much suspicion causes distrust and finally once again lack of transparency. Keeping those points in mind if central bank decides to use inflation targeting it must find a middle ground on how much information it should reveal, problem is it can’t decide that on its own.

In my view, inflation targeting should be understood as a frame allowing public to interpret economic activity if some measure moves out of this frame public has the right to demand the reason behind this change  that way banks are forced to consider releasing right amount of information. For instance, ECB uses flexible inflation target, during the recent recession deflationary pressure increased leading the public to ask for greater accountability, pushing ECB to finally publish its minutes and end the silence ( in 2015 ECB adopted this practise). Thus, ECB example shows that public in inflation targeting regimes has the power to determine the right amount of information

One question still remains what if public would become too concerned about monitoring inflation allowing bankers to put all their decisions under the inflation label (problem touched in the first paragraph)? That is improbability, like I mentioned inflation targeting frames  the economic activity, as S. Mishkin proved in his paper (replying to the same critique by M.Friedman) it affects other measures like output as well, thus it can’t use inflation to obscure other issues. For example central bank has to address negative output shock within the boundaries of inflation, if there is no other choice and interest rates have to be cut to the point of pushing inflation away from the target, public would demand a response why the change was made and whole issue would be explained.

To conclude, M. Friedman in his paper touched on the problem that too much focus on price stability can negatively effect transparency. I partly agree with this view because policy makers sometimes tend to oversimply matters and that could lead to the lack of proper information. However, public can address this problem, by analysing economic developments  through the frame of price stability and voice their concerns allowing the bank to measure the right amount of transparency

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For the critics

Although internationally austerity measures taken in Lithuania (Latvia and Estonia)  was hailed as a good example of crisis management( Paul Krugman and Christine Lagarde praised the austerity measures in three Baltic states) many people I know, who take  keen interest in economics,  disagree with such statements. In their view years of economic indiscipline, which preceded the crisis and the tought years that followed are all products of flawed government policies. For example critics often point at inability to cope with budget and trade imbalances as a reason for financial default, however I don’t believe this judgment is entirely valid. In my view, broader social factors contributed to the severity of recession.

Lithuania before the financial collapse was a rapidly developing economy, very dependant on international capital inflows. Source 1 clearly illustrates that in the boom years borrowing from abroad was getting out of hand, however government responded by attempting to restrain credit growth unfortunately it failed and in 06 an 07 deficit continued to increase. I believe policies were ineffective simply because public refused to comply with them. At the time Lithuanians were very optimistic about the future. Property boom, which started in 2000 and the excessive borrowing clearly indicate that. Consequently, enormous trade deficit put Lithuania into vulnerable position making it unprepared for impending financial shock, although certain measures were taken to improve the situation public refused to support them.

Source 1: Eurostat

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In 2009 New york times published a tear jerking article on the effects of fiscal consolidation in Lithuania. In it multiple citizens shared their stories how tax increases and spending cuts are pushing them into despair.  Compare these terrible experiences to those of Estonians. In their country government managed to balance the budget with limited effects on the domestic life of its citizens. This is another example critics like to use to stress the fact that austerity measures in Lithuania were ineffective considering the negative effects they had on society and the fact that Lithuania unlike Estonia failed to reach the desired balance  as illustrated by source 2. I disagree with this point. It would be wrong to put a blame on austerity measures when broader social factors like corruption and tax evasion played a role in undermining the budget.

Source 2:Eurostat

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it is no secret that this country is plagued by corruption, various international organizations (like transparency international) rate Lithuania among the worst cases in European Union. How does it affect our budget?  Bribery or fraud reduces revenue and funds available to the government. K S Kibet in his article established private investment equation, which indicates that increase of budget deficit taking high corruption into account leads to decrease in private investment, suggesting that if corruption decreased there would be more funds available to the private sector, this would lead to more public resources and finally less pressure on the budget. Reported cases of corruption increased during the crisis( according to European Research Centre)

Finally,I mentioned tolerance towards taxation as an issue. Lithuanians always complain about having to drag around enormous tax burden, naturally some  refuse to bother and simply choose to evade tax payments. This fact is reflected in statistics, according to source 4 Lithuanians and Latvians cheat more compared to citizens of Estonia.

Source 4: European Values Study 2008

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To conclude, I do not resent austerity measures taken in Lithuania, from economic point  of view government more or less did what it had to do, but it was not enough in the face of mounting social pressures like increasing corruption, tax evasion during the crisis and reluctance to comply with more restrictive measures during the boom years. In my view these problems made recession worse by stopping the attempts to improve the situation.

Trade deficit is a debt(nor is it good)

Sustainable trade deficit is important macroeconomic goal, but over the years some started to express their doubts about it. After all United States strongest economy in the world has been dragging enormous trade deficit for decades without much inconvenience ( except for terrible looking numbers in the balance sheet ). I guess this led american bloggers like coyote to start making mistaken assumption about the subject:” A trade deficit is not a debt nor is it bad” claims the author. In his view sloppy media people are causing panic about non-existent problem. Well I strongly disagree with this point. Thus, allow me present my  post on why trade deficit is a debt and why it is mostly bad .

First of all, what is the purpose behind balance of trade statistics.  It is used to measure international capital flows. If a country like US is sending more cash abroad than it is receiving Uncle Sam is running a trade deficit. Money sent abroad fall into the hands of investors. Foreign investment together with national savings supply resources to government and private firms. In the case of united states when a national savings are low (source 1) previously mentioned demanders receive most of their funds from abroad, in other words they are borrowing on net from abroad. If this practice continuous for a number of years nation simply starts running a debt..

Source 1:

From:http://pgpf.org/Chart-Archive/0078_Savings-Rate

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The example of US, a strong economy targeted by foreign investment and running a soring trade deficit is unprecedented. How long this situation might continue? There is no way to tell.. Although borrowing practises have changed since the 1980s, when investment from abroad was used to fund budget deficit,towards the more sensible direction (for the sake of increasing domestic productivity)  one question remains. What if trade deficit decreased? What if americans relied more on their own resources and invested abroad gaining even more profit, influence? These two questions illustrate my problem with high trade deficit. US economy is in a good shape so far, but what if there is a possibility of making it even better by reducing the debt (i.e trade deficit) . I Guess we would all agree that it would be foolish not to support such idea.

Debates about trade deficit are surrounded by confusion. Usually dependence on investment from abroad leaves country vulnerable to external pressures. What if  foreigners decide to leave like they did in Russia or South America in the 1990s? But United States is far stronger economy, thus it is hard to judge how growing trade deficit will affect it in the future. Despite that two facts remain clear: negative balance of trade is a debt and a debt can not benefit the economy. Thus, it is important to support the idea of reducing it instead of writing it off as mistaken message by „slopy media people“

PS: yes I realise that post on coyoteblog was posted ten years ago, but I still notice people( not nessecerily bloggers) preaching similar idea that trade deficit does not matter, thus this post is mostly answer to all those individuals and not some attack on other blog.