The interview of Charles Goodhart by Sam Fleming in FT is excellent. Apart from discussing the ongoing debate on inflation and monetary policy, the interview covers the argument made with Manoj Pradhan in a 2020 book that demographics and reduced labour supply is likely to lead to a return of inflation in the long-run. He points to the current anti-immigration trends globally as one more reason for the possibility of inflationary labour market pressures.
He responds to one of the biggest deviations from his thesis on labour market scarcity driving inflation, of Japan where an ageing society has co-existed with low inflation.
The critique about Japan we answer by saying that those who criticise us largely do so on the basis of looking at Japan as if it was a closed economy. Japan was growing old at exactly the same time, in those years, 1990 to 2020, when the rest of the world and particularly China, was swimming in relatively available, effective and quite cheap labour. A lot of the Japanese firms benefited from that by offshoring to China. So they had the same world disinflationary forces as the rest of us did, and that was the dominant factor.
In the book he has attributed the sustained period of low inflation more to the China effect than any central bank expertise.
During the three decades up to 2020, you saw sustained periods where the prices of core goods in the US on average tended to fall by about 1 per cent per annum while the prices of core services tended to rise about 3 per cent. And much of that persistent trend decline in goods prices was due to cheap stuff coming out of China. If we’re going to get less of that, clearly the downward pressure on goods prices will be less.
He points to the global indebtedness as a major cause of worry and is concerned about an impending fiscal crisis
We’re in for a fiscal crisis down the road. We don’t know how to solve it. And politicians always say ‘we know what we should do, we don’t know how to get re-elected if we do it.’ It’s difficult given the other problems that we have — climate and defence expenditures. Expenditures will have to go up, and how are you going to finance that? Trying to do it by borrowing will simply overburden the public sector debt market and lead at some stage to a crisis only too reminiscent of what happened in UK in September 2022 [with then Chancellor Kwasi Kwarteng’s “mini” Budget]...You know that something is unsustainable but you don’t know when the dam will burst. In macroeconomics things can go on pretty much as normal, because that is what people have come to expect, and then suddenly something happens. It’s never possible to set out what the trigger will be, and everything goes pear-shaped. And one of the great problems that we face at the moment is this is just as likely to happen in the US as anywhere else. And with the US, being the most important centrepiece of the world’s economy, what would happen if the Treasury bond market did the same kind of thing as happened in the UK? Undoubtedly the Fed would have to step in, but that would reverse quantitative tightening of monetary policy. And then the question would arise under those circumstances, would monetary policy become fiscally dominated? And if monetary policy was fiscally dominated, what would that do to inflation, and how long would that fiscal domination enable the system to go on working reasonably effectively?
On the changes required to be made to central bank's policy making models, he proposes three,
I would certainly start by junking rational expectations. When nobody knows the future and when there is no clear certainty about what the correct model is, it’s not clear what is rational anyhow. And in practice, people don’t know models, and the ordinary person tends to extrapolate the past rather than apply the same kind of forecasts that world trade and macroeconomists apply. Next I would pay more attention to asset prices. And if the monetary aggregates were behaving in a very unusual manner, as they are at the moment, I think I would actually seek to question myself about why that was happening, and what were the implications. Even if you came to the decision that the implications were very small. And third, and perhaps most important, I wouldn’t go for a single point forecast, because that is used by recipients to reduce their uncertainty in a situation where the uncertainty is inherent. And it’s actually wrong for central banks to pretend, or appear to pretend, that they know the future that well. Instead, I would much rather they used a process of scenarios.
And he makes this very important psychological point that's relevant to the application of the method of scenarios analysis,
There always ought to be scenarios of an even number, because if you had scenarios of an odd number, the recipients will always pick the middle scenario and assume that that is the point forecast on which they can rely.
In fact, the point about the problems with the application of rational expectations to Fed's monetary policy decisions has been highlighted in a Fed internal paper by Jeremy B Rudd
Economists and economic policymakers believe that households' and firms' expectations of future inflation are a key determinant of actual inflation. A review of the relevant theoretical and empirical literature suggests that this belief rests on extremely shaky foundations, and a case is made that adhering to it uncritically could easily lead to serious policy errors.
Goodhart draws the distinction between regulation and supervision, and highlights the failings on the latter in the US.
You’ve got to distinguish between the US and Europe and the UK. I regard the turbulence of SVB and the others as being a failure of supervision, not of regulation. In other words, the regulations were there. And indeed many of the things that were going wrong with SVB had been well pointed out in advance. The problem was that the supervisors, for reasons that I’m not entirely sure I understand, were not able or not prepared to respond quickly and strongly enough. So I think that in the US, the question is how do you make supervision more effective? I don’t think the same argument holds, or at least not with anything like the same force, in the UK and in Europe.
This I think is about elite capture and forced weakening of regulatory capabilities of the state.
He makes the very important and less discussed point about the moral hazard and incentive distortions arising from the condonation of bad decisions by individuals and institutions.
My concern has always been that one of the great drivers of moral hazard has been the limited liability of those who take the major decisions. And I would like to see enhanced penalties, financial penalties, being applied to those who take the decisions when they, admittedly, with the benefit of hindsight, were clearly reckless. The problem is that if you’re going to increase penalties, which I would like to see, bankruptcy can occur for reasons well beyond the ability of management to address the issues. The example I often make is a massive earthquake bringing Tokyo to collapse. That would make most of the Japanese banks insolvent immediately. And you can’t do anything about that. So if you’re going to impose greater penalties on management when you do get bankruptcies, I would want to have some kind of quasi court of appeal where they can claim that the imposition of such extra penalties would be unfair because of x, y and z.
Finally, there's the very wise point about challenging central bank models to shake up any groupthink happening.
There is a need for people who are not in central banks to challenge and redo models which are being constructed by those who have been in central banks. The challenge needs to come from the outside. Not that the insiders are wrong, it’s just that the insider is quite happy to stop at a particular point which shows central banks in the best light.
Several less discussed but very important and wise points made in the interview.
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