



I came into economic consciousness in 1972, and was an observant witness of the break-up of Bretton Woods, and the subsequent Great Inflation of the late seventies. I watched as Paul Volcker and other central bankers went to war against inflation and, by controlling money growth, began the process by which global inflation was exterminated by the 1990s. That was the seminal monetary experience of my generation: the slow strangling of the inflation monster.

The heroes of this era were the central bankers who had the sang-froid to stand up to the pleasure-seeking politicians and to impose recession on the masses in order to break the “wage-price spiral”, as it was known at the time. The measure of a central banker became his ability to impose pain in the face of popular hatred, and thus restore monetary discipline. These heroes won that war; they killed the snake.

Thus, the standard by which central bankers have been measured since the eighties has been their commitment to “price stability”, the most heroic version of which is zero inflation, the Holy Grail. Indeed, today all of the world’s central banks have an explicit price stability mandate. Mark you: not an inflation-targeting mandate, a price-level targeting mandate, a nominal growth mandate, or an NGDP-level mandate. No: price stability, in all its austere glory.

And so we have transitioned during my conscious economic life from a world in which 5% inflation was tolerable to a world in which 2% is the absolute ceiling, and lower is just fine. We now live in a world in which two of the most important central banks have been targeting ultra-low inflation for years, the ECB and the BoJ, and in which the other important central bank harbors a large faction of “inflation hawks” on its policy committee.

And then, in 2008, came Lehman and the shutting down of the global credit system. The world’s central bankers, with their generational commitment to disinflation, were confronted by: deflation! And what did they do? Nothing. They stood back and allowed the price level, NGDP and RGDP to fall. They had long ago locked the storeroom where the reflationary tools were kept. And they had never seen or used those tools, either. They fell right into the same complacent psychology that their official predecessors fell into in 1931: they opened the credit spigots and offered an “accomodative” monetary policy: “We’ve done all we can.” Not the slightest attempt to raise an army to fight deflation and negative growth. Raised to fight inflation, they were stupefied by the challenge of deflation. (None of this applies to Bernanke, but he was a lone voice in a wilderness of stupidity and denial.)

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So, the FRB, the BoJ, the ECB, and the BofE all stood back and watched as prices, nominal growth and real growth went negative. The wise and experienced central banks of Southern Europe had been silenced, having surrendered monetary sovereignty to Germany a decade earlier. (Banca d’Italia, once a highly sophisticated central bank, would never have permitted the post-crash deflation, but it’s been only a posh Italian think tank since 1999.)

Since the deflation of 2008-09, global growth has downshifted permanently into second gear. We now live in a world of low inflation, low nominal growth, and low real growth. Salt has been sown over the grave of the inflation monster.

True, millions of young people are now facing a lifetime of unemployment, but isn’t that the price we must pay to create a world without inflation? Won’t workers over time redevelop the psychology of the nineteenth century, when wages rose and fell with the business cycle? Why should nominal wages be sticky? Once people have been unemployed long enough, and once their unemployment benefits have run out, they will happily return to the labor force at lower wages, and the neoclassical equilibrium will be restored. It will be 1913 again.

I love the neoclassical equilibrium as much as the next guy, but we now know that it cannot co-exist with universal suffrage. The masses always vote for full employment at higher wages. Neoclassicism can only succeed in a plutocracy, which we gave up in the 19th century. Today we must devise a monetary policy that does not depend on the “reserve army of the unemployed” to discipline wages. We allow the unemployed to vote.

The High Priests of the new religion of extreme price stability are Jens Weidmann, president of the Bundesbank, and his subordinate, Mario Draghi of the ECB. The collected works of these men will someday be titled “Growth Was Not Our Mandate”. These men have assumed the roles of the central bankers of the Depression, who believed that the “purging of the system” and a reduction in wages was the only way to restore growth.

They are actively pursuing what Irving Fisher characterized as the “natural” way out of a depression:

“Unless some counteracting cause comes along to prevent the fall in the price level, a depression tends to continue, going deeper in a vicious spiral for many years. There is no tendency of the boat to stop tipping until it has capsized. Only after almost universal bankruptcy will the indebtedness cease to grow. This is the so-called "natural" way out of a depression, via needless and cruel bankruptcy, unemployment, and starvation.”

---Irving Fisher, “The Debt-Deflation Theory of Great Depressions”, 1933.

Professor Fisher (Yale) not only invented the debt-deflation theory, he also invented the quantity theory. He stands as a monumental figure in 20th century economics, along with Keynes and Friedman. You can’t be an anglophone economist and not know his work. Of course Draghi, the smartest man in Europe, knows all about Fisher and his theories. But does anyone else in the eurozone read Fisher? Is this all new to them? Is the deflationary catastrophe of the early thirties not part of their fundamental curriculum?

I dare say that it is not, at least in the Fatherland. Germans remember selectively their country’s monetary history. They choose not to remember the deflation of 1930-33, nor do they want to remember the successful post-1933 reflation under Hjalmar Schacht. They only remember the postwar hyperinflations, which were indeed awful but are absolutely irrelevant today.

Today, the world needs a new generation of central bankers who are not students of the Great Inflation, but are instead students of the Great Deflation and of Irving Fisher, Milton Friedman and Barry Eichengreen. The lesson of the past five years is that the world needs inflation, and some economies need it more than others. While Northern Europe can discipline itself to live with low inflation, Southern Europe never has and never will. Starving them won’t change their national character, it will only lead to chaos, which we are already beginning to see.

The following editorial appeared in El Pais (Madrid) earlier this month:

The consolidation of a fascist party in Greece. The success of Beppe Grillo and Silvio Berlusconi in Italy. The 6.2 million unemployed in Spain, its highest since the year after Franco's death, and the 26.5 million in the EU. The collapse of the French hope for François Hollande. The rise of anti-European parties in Greece, France, Finland, UK, Germany. The dismantling of the welfare state and the return of starvation wages in Southern Europe. None of this seems to move the Germans. With her hard countenance and furrowed brow, Chancellor Angela Merkel observes the perfect storm on the Continent without raising an eyebrow.

The risk to Europe today is what Fisher said about America under Hoover:

“If our rulers should still insist on "leaving recovery to nature" and should still refuse to inflate in any way, should vainly try to balance the budget and dis- charge more government employees, to raise taxes, to float, or try to float, more loans, they will soon have ceased to be our rulers. For we would have insolvency of our national government itself, and probably some form of political revolution.”