Is fear of inflation holding back real growth?
As central banks search in vain for 'complete' recovery, it may be time to look again at outlawed fiscal policy, writes David Chance
The world's central banks have spent much of the past 30 years telling us that inflation was bad and that they would not sacrifice their credibility by allowing the beast they had slain to come back to life.
In the 1970s, surging oil prices helped push inflation higher, ushering in a new breed of politicians like Margaret Thatcher and Ronald Reagan, who once described inflation as being "as violent as a mugger, as frightening as an armed robber and as deadly as a hitman".
Central banks abandoned a focus on exchange rates and attacked inflation. They fell in line from the 1990s on to adopt an inflation target of 2pc.
By the mid-1990s, the 'Wall Street Journal' proclaimed the triumph of a "new economy"; not only was inflation on a firm leash, but the business cycle was dead.
Of course, all of this came crashing down in 2008-2012 as the financial crisis pushed countries into the deepest recession seen since the 1930s and some - Ireland included - came close to collapse.
With the world still wedded to the fiscal policies of Reagan and Thatcher which were additionally wrapped up in the Stability and Growth Pact in the EU, it was left to the Federal Reserve, European Central Bank, Bank of Japan and Bank of England to prevent a re-run of depression-era mass unemployment. By and large they succeeded and across much of the developed world there has been a steady, slow-burn economic expansion.
What hasn't happened is a sustained return to the path predicted by economic theory - that growth would lead to more employment and eventually to rising inflation which would indicate that the recovery was "complete" and that we could return to the certainties of the pre-crisis era.
What appears to have happened is that economic policymakers across the world congratulated themselves for slaying inflation in the 1980s and 1990s when in fact there were other factors at work.
During that period, China emerged onto the global stage.
Its exports to the US have risen 500-fold since 2001, when it joined the World Trade Organisation, and the price of making things like the smartphones and computers we all use has fallen sharply.
There are other long-term factors driving inflation lower, and none of them have anything to do with the success of central bank policy from the likes of the German Bundesbank, whose anti-inflation playbook was written into that of the European Central Bank when it was set up.
While China became the workshop of the world, wealthier nations were aging rapidly and the arrival of natural gas as a fuel meant we were less vulnerable to oil 1970s-style oil shocks as industry became much more energy-efficient. Central banks are of course full of smart economists who know all of this, but that hasn't changed their thinking or the way in which they frame the world's economic problems.
Their concern is that without a sustained rise in inflation, they will not be able to cut interest rates as far as might be needed in the next economic shock.
In the case of the Federal Reserve, rates have been cut by 4-5pc points in a recession, something that would require a shift to substantially negative interest rates if it were needed as the current Fed benchmark is 2.5pc.
If things are bad for the Fed, they are worse for the ECB, whose main rate sits at zero. Pity then the Bank of Japan which has been in the business of zero rates and economic pump priming for 20 years without any pickup.
The range of answers coming from policymakers on how to deal with the current problems are all framed in the ideas of 30-plus years ago and in the mantra of "independent central banks" which were supposed to pursue policy outside the political maelstrom and electoral cycle.
Some of the suggestions on offer from economists and central bankers include raising the inflation target from 2pc to say 4pc which would in the view of John Williams, the head of the New York Federal Reserve, give them more room to cut interest rates.
There's one glaring problem: no one is quite sure how they arrived at the idea of the 2pc inflation target which spread like flu across the world of central banking from New Zealand to the mighty Fed, which only got round to having an inflation target in 2012, when the financial crisis had hit.
The only explanation of why they agreed on 2pc was that it would mean a doubling of prices every 35 years, something that consumers would barely notice. That begs the question of how 4pc would make things better, given that they really meant about 2pc.
It is just that the age-old question of economic management, which is basically how to avoid a train-wreck likely needs a new answer as inflation targeting monetary policy has gone the way of exchange rate management, the gold standard and all the other old gods of central banking.
In the words of economist Tony Yates, all the central banks were doing when they started targeting inflation was the only thing they had not yet tried and failed at - simply fiddling with the justifications for a policy that has now clearly reached its limits and may in fact be doing harm, for example by increasing inequality by pushing up stock markets and house prices which benefit the rich.
Perhaps it is now time to kick the tyres on fiscal policy, the use of which has been outlawed by tough rules and penalties in Europe, or to look at the idea that central banks could themselves become fiscal authorities and finance deficits.