The doctrine of the pre-emptive strike against inflation is self-immolating.  Controlling (suppressing) demand growth invariably limits investment in new capacity and so the ability to improve productivity and/or maintain competitiveness.

The spectre of a return to the 1970s was (once again) raised when I dared to suggest recently that our interest rate policy was, to be blunt, self-defeating.  Unlike my accuser, I actually lived through the 70s - and I can remember the pain.  So, please don't accuse me of being soft on inflation.

But, not for the first time, I feel an overwhelming sense of deja vu as the monetary warriors stalk the land for any sign of the inflation ogre.  Here are some thoughts I wrote in June 2000.  I believe they continue to remain valid and relevant.

Economics is simple. Invariably, it is concerned with what happens (ie the adjustment) when demand and supply are "out of balance". That's it, really! The mantra ingrained into every budding economist during their first year or so of training is also simple: "if demand does not equal supply, price will adjust."

Unfortunately, the mechanics of how price will adjust, how quickly it will adjust and – most importantly – the consequences (or the side-effects) experienced by the economy during the price adjustment process remain the subject of critical debate amongst economic analysts. What has this got to do with the here and now? At the economy-wide level NZ has, more often than not, consistently been in a position where demand has exceeded supply.

During the 1970s and early 1980s, this was reflected in the traditional (but continual) adjustment of prices (ie inflation). Few will argue with the need to avert the rampant price inflation experience of this period. But if demand consistently exceeds supply, what are our other options? Two options come to mind:

(A) reduce demand
(B) increase supply

Earlier in NZ's economic history, the excess of demand over supply has been reflected by the need to regulate or control demand (usually in the form of punitive restrictions on the level of allowable imports).

During the 1990s, demand has been controlled through implementing (when appropriate) tight monetary conditions.  In so doing however, the gap between demand and supply has been exacerbated. This occurs because our chosen adjustment mechanism (monetary policy) has repercussions during the very process of adjustment. In particular, raising interest rates discourages investment, thereby harming capacity and ultimately our ability to supply. Thence the gap between demand and supply grows larger.

The common element in both the pre-1970s and the 1990s examples are their focus on the reduction (or at least control) of demand. That is, option A.  Thus we continually "live in fear of full employment" and move to dampen demand when capacity constraints arise (i.e. when demand looks like exceeding our ability to supply).

The doctrine of the pre-emptive strike against inflation, becomes self-immolating as the fixation with reducing demand will ultimately work against the desire to rectify the gap between demand and supply.

Of course, there is the other option - increasing supply. Or to use the correct jargon, enhance and increase capacity to improve our ability to satisfactorily meet demand.

Become cleverer; adopt and/or adapt new technology; work harder; et cetera.  (2014 note to self - the policy-speak hasn't changed that much has it?)

Of course, the incentives have got to be in place for these virtuous events to occur. The principal incentive undoubtedly is the prospect of good rewards in the form of being able to profit from one's endeavours (2014 note to self - I think the exchange rate has an impact on the income and profit of export earners)

The critical aspect is investment – in equipment (technology, machines, buildings, infrastructure) as well as in people. For that has implications on both the demand and supply sides of the equation. Thus both the demand and supply sides of the equation are unambiguously inter-twined. If this is accepted, then both demand and supply issues should surely be addressed in a co-ordinated manner.

By assigning control of demand to monetary authorities (with little incentive for it to address the supply side), while hiving-off supply or capacity-enhancing aims to a government ministry or department (2014 note to self - MBIE) misses the central point of the inter-relatedness of supply and demand.

(2014 note to self - here we go again).

Comments (1)

by Andrew R on March 24, 2014
Andrew R

Good account. 

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