Contradictions in Monetary Policy
Monetary policy is heavily biased in favor of price stability over investment. Monetary policy consists of actions of the central bank that control the supply of money. The primary goal of monetary policy is to maintain the value of the currency, i.e. to prevent inflation. Unfortunately, the goal of stimulating investment for rapid economic growth conflicts with the goal of fighting inflation. This is because a large percentage of investment is financed through borrowing. Borrowing increases the supply of money in circulation. Saving decreases the supply of money. As long as borrowing is matched by saving, the supply of money remains constant. To the extent that borrowing for investment exceeds savings, the money supply is increased (just the same as if the treasury printed money). When the money supply increases faster than the supply of goods and services available in the market, prices rise.
This leads to the first of three fundamental contradictions that are inherent in present day monetary policy.
Contradiction #1
The central banks of the world, including the Federal Reserve Bank in the United States, must pursue diametrically opposite goals. They simultaneously attempt to
- promote rapid economic growth, and
- prevent inflation.
The problem is that rapid economic growth requires a high rate of investment, which in turn requires low interest rates and easy lending policies so that businesses can readily and cheaply borrow money for investment. On the other hand, restraining inflation requires slow growth in the supply of money, which in turn requires high interest rates and tight money, so that it is difficult and expensive for businesses to borrow. Clearly it is impossible to have high and low interest rates at the same time. Banks cannot pursue tight and easy money policies simultaneously. Therefore, central banks are constantly balancing the need for rapid growth against the requirement for restraining inflation.
Because of the nature of democratic electoral processes, politicians find it difficult to exercise fiscal restraint. Voters tend to elect politicians who promise to lower taxes and increase benefits -- a sure formula for budget deficits. Chronic lack of fiscal discipline shifts the primary burden for preventing inflation upon monetary policy. Therefore, central banks around the world, including the Federal Reserve Bank in the United States, most often find themselves in the mode of fighting inflation. They are compelled to impose restrictive monetary policies that cause slow economic growth.
Contradiction #2
Prescribing tight monetary policy as medicine for inflation is counter-productive in the long term. Restrictive policies reduce borrowing and slow growth in the money supply. This creates unemployment, dampens consumer demand, and reduces inflationary pressures -- but only short term. In the long run, monetary restraint actually increases inflation, because it slows investment in the technologies that generate productivity growth.
Tight money policies reduce borrowing for investment. This causes delays in procurement of modernized plant and equipment, reduces support for worker training programs, and slows down research and development efforts. Therefore, tight monetary policy slows productivity growth. This perpetuates less efficient and more costly methods of production. The long term effect of monetary restraint is therefore inflationary, not deflationary. In the long run, tight monetary policies lead to both slow growth and inflation.
Contradiction #3
In order to increase savings, interest paid to savers must be increased. But, in order to increase investment, interest charged to borrowers must be reduced. It is simply not possible to increase interest rates to attract more savings, and at the same time, decrease interest rates to encourage more investment. In a culture with heavy emphasis on consumption, this contradiction alone can produce a rate of saving and investment that is far below what is needed to produce rapid economic growth.
Economic growth and prices
The three contradictions listed above are not new. They have plagued economic policy makers for decades, if not centuries. An inability to resolve these contradictions has caused slow economic growth for so long that it is largely taken for granted by economists and policy makers that rapid economic growth simply cannot be achieved without inflation.
However, rapid economic growth based on productivity growth is not inflationary. Quite the opposite -- economic growth based on productivity growth is deflationary! Productivity growth enables more and better goods and services to be produced at lower cost. Output can grow and profits rise for producers, while prices fall for consumers. Rising profits can be converted into more jobs, higher wages, and/or bigger dividends, while simultaneously falling prices make consumer incomes more valuable. Economic growth based on productivity growth can be very rapid, without producing any inflationary pressures at all.
There are many examples of the deflationary impact of rapid productivity growth. Perhaps most dramatic is the case history of the computer industry. In 1963, a typical computer cost on the order of $1,000,000. Today a computer with comparable performance can be purchased for less than $1000. The price of computing, measured in terms of computational power per unit cost, has fallen by a factor of a thousand in three decades, or a factor of ten per decade, even in inflated dollars. This corresponds to an annual price deflation rate of more than 30% per year, due to productivity growth. This price/performance deflation rate has been sustained in the computer industry for over forty years, and shows no sign of slowing down for at least another decade.
By way of comparison, if similar productivity growth had occurred in the automobile industry over the same time period, a luxury car comparable to what sold in 1963 for $8,000 could be purchased today for $8.00!
Meanwhile, there has been enormous growth in the production of computers, as well as in the number of jobs in computer-related industries. (This illustrates the point that jobs are created by the ability to meet a payroll, not by the existence of work that needs doing. Prior to the invention of the computer, there was no work to be done in computer related industries.)
What is it about the computer industry that has allowed it to sustain such high productivity growth rates for so long, with no end in sight? How was this achieved? The answer in a word is -- INVESTMENT. Massive investment in research, development, and implementation of new process technology. From the beginning of the computer era, governments around the world have poured enormous investments into process technology for manufacturing and programming computers, and have lured private investment by guaranteeing markets for computers used in anti-aircraft guns, machine tools, ballistic missiles, air defense systems, space flight, and smart weapons. This enabled computer manufacturing technology to advance rapidly. During the last two decades, the development of massive commercial markets has generated additional private capital, and fierce competition has kept the industry investment rate in excess of 30% of output.
There is good reason to believe that similar high rates of investment could produce similarly rapid productivity growth in other wealth producing industries such as manufacturing of automobiles, appliances, furniture, and pharmaceuticals; construction of homes, office buildings, highways, and factories; and in other economic sectors such as agriculture, transportation, and health care. For many applications, fundamental technological breakthroughs in intelligent control, advanced materials, and bioengineering might support productivity gains comparable to those that today are routinely experienced in the computer industry.
Investment pay back delay
A fundamental difficulty is that investment in productivity improving technologies produces economic growth with falling prices only in the long run. In the short term, borrowing for investment, in excess of savings, creates short term inflationary pressures. This is because investments create demand for labor, capital, and raw materials long before they pay back dividends and earn profits. It takes time before new plants can begin producing more and better products at lower cost. It takes time for workers to learn new skills and become more productive. It takes time before research and development creates more efficient processes and lower-cost higher-quality materials. Most investments in new equipment take three years to pay back. Investments in new plants may take five years or more to pay back. Investments in research and development, or education, may not pay back for a decade or longer.
Therefore, it is necessary for savings to increase along with borrowing for investment in the short term, in order for benefits of investment to be realized without inflation.
How much investment is needed?
If the goal is to raise all Americans above the poverty line, the per capita income must be at least doubled, and probably quadrupled. Formula (8) suggests that if the U.S. investment rate were increased by 12% of GDP, from 17% to 29% of GDP, the U.S. economy would grow at a rate of about 6% per year. With a 1.5% population growth rate, per capita GDP would double every 16 years, and increases by a factor of four every 32 years.
Of course, increasing the investment rate by 12% of GDP would require an enormous amount of capital. The current GDP is about $6.6 trillion. 12% of GDP is almost $800 billion per year. That is more than three times the current federal budget deficit. It amounts to about $3200 per year for every man, woman, and child in the country.
Since all income is either consumed or saved, the share of income that is consumed must drop to finance an increase in investment, unless that increase is financed by borrowing (or other measures that increase the money supply and produce inflationary pressures). Unfortunately, there are no voluntary incentives that conceivably could increase the savings rate by enough to finance $800 billion per year of new investment. Interest rates couldnÕt possibly be raised high enough to attract $800 billion of new savings, while simultaneously lowering them enough to stimulate $800 billion of new investment. Other measures such as eliminating social security in order to increase incentives for saving, or raising taxes high enough to eliminate government budget deficits and provide a surplus of capital for public investment appear at this time to be politically infeasible.