What central banks are really up to

If not for high debt levels, central banks probably wouldn't be fighting the Digital Revolution's downward pressure on prices. They'd see 'stable prices' as moderate deflation, not inflation.

It is a great irony of the modern world that central banks are forced to battle the destructive effects of higher productivity.

If that statement seems ridiculous, bear with me. 

Central banks everywhere are currently engaged in a desperate war against deflation, with zero interest rates and money printing. 

In Europe it may be a losing battle – the EU appears to be one downturn away from deflation; in the US inflation is 1.2 per cent and falling; in Australia we have had tradable goods deflation for about two years and the only reason there is not overall deflation is because of non-tradables, like health, education, construction and child care services.

In fact global prices have been trying to fall for 20 years because of the productivity improvements of the Digital Revolution and the entry of cheap labour into world’s workforce as a result of globalisation.

The credit crisis of 2007-08 then tipped this trend towards lower inflation into potential outright deflation by crushing global demand. Demand has not fully recovered, especially in Europe but also in the United States. Meanwhile wages are rising in China but technology is continuing to drive up productivity through automation, while new, cheaper, labour forces keep entering the global trading system.

Central banks are trying to keep inflation within what they regard as the optimum target band of 2-3 per cent. They used to be battling to keep it down to that level; now they’re trying to keep it up to 2 per cent.

Why? Because of debt.

During the second half of the 19th century prices fell consistently – that is, there was deflation – because of the impact on productivity of the Industrial Revolution. Between 1870 and 1900 the purchasing power of the US dollar doubled as prices came down.

But in those days there wasn’t much debt. For those with savings and fixed incomes deflation is wonderful, but for those with debt it is catastrophic since the value of the dollar repaid is greater than the dollar borrowed.

Households, businesses and governments around the world are now deeply in debt after three decades of falling interest rates, asset price bubbles, a desire to consume today rather than put it off, and aggressive banking practices.

To preserve economic and social order, and prevent the crippling impact of deflation on an indebted society (like what happened in Japan after 1990) central banks are now working to preserve the world’s debtors.

That means fighting the impact of the third great technological revolution – the Digital Revolution (the first two were Agricultural and Industrial).

When the Industrial Revolution reduced costs, debt wasn’t an issue and prices could be allowed to fall. In fact, society’s most powerful were savers, not borrowers: for them deflation was a good thing so they made sure it happened.

This time around it’s different: borrowers are ascendant and central banks are working for them, not savers. In fact, savers are being plundered with super low interest in the name of promoting aggregate demand and maintaining inflation.

The Federal Reserve’s dual mandate requires it to “…promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” Leaving aside the fact that that’s three things, not two, the mandate calls for “stable prices”, not “rising prices”. The Fed has determined that this means prices rising by 2 per cent a year, not falling by 2 per cent a year.

If it weren’t for the high levels of debt, I believe they would not be fighting the tendency of prices to fall because of the Digital Revolution and would see “stable prices” as moderate deflation, not inflation.

By the way the Reserve Bank’s mandate is to “contribute to: the stability of the currency of Australia; the maintenance of full employment in Australia; and the economic prosperity and welfare of the people of Australia”. It doesn’t even mention “price stability”, let alone a target band of 2-3 per cent inflation.

In yesterday’s monetary policy statement, the governor, Glenn Stevens wrote that the Australian dollar is still uncomfortably high. Uncomfortable, that is, for the preservation of inflation, which is implicitly needed to “achieve balanced growth in the economy” – that is, the replacement of the resources investment boom with domestic non-mining industrial growth.

Without inflation, borrowers get crushed and don’t spend, because they are keen to reduce debt. Since most people are borrowers these days, the promotion of domestic demand requires some inflation so that the value of debt reduces naturally over time – and thus a lower currency.

That’s why “currency wars” became a thing last year, although it’s turned out to be more a low-level cold war than a hot one.

The real war is between monetary policy and the Digital Revolution – between the world of finance trying to reduce the value of money and therefore debt, and the world of technology pushing for greater efficiency and productivity, to drive prices lower and the value of money higher.