Milton Friedman embarrassed some of his sound money followers by advocating indexed contracts

TO BE NOTED: From the FT:

"Inflation can act as a safety valve

By Samuel Brittan

Published: May 28 2009 19:57 | Last updated: May 28 2009 19:57

Are we faced with inflation or deflation? It seems to depend on which analyst you read and on which day of the week. Complaints about a new inflation due to, say, government money creation or budget deficits come hot on the heels of moans that deflation is still a menace. Looking at actual numbers adds to the confusion. On the UK official consumer price index, year-on-year inflation was still 2.3 per cent this April, slightly above the government’s 2 per cent target. On the traditional and more comprehensive retail prices index, it was -1.2 per cent.

Can we just say, then, that as there are both inflationary and deflationary fears, policy is on the right lines and we are enjoying rough price stability? Unfortunately we cannot. For great uncertainty about the direction and size of price movements is itself a danger to economic stability.

Not enough attention has been paid to the fact that after their recent plunge, oil and commodity prices are creeping up again. It was the effect of rising prices in these areas in generating inflation that accounts for the slowness of some central banks to shift last year from restrictive to expansionary policies. A renewed upsurge in primary product prices would make life more difficult for central banks’ monetary strategy. But this is not the most important danger. The real worry is that shortages of energy and basic commodities may be imposing real speed limits on world growth well before anything like full employment is regained.

Let us go back to the problem of uncertain overall price movements. There is a long history of indexation proposals for living with inflation. Milton Friedman embarrassed some of his sound money followers by advocating indexed contracts. In the UK the income tax starting points have been indexed to inflation since the 1970s, although the government has the option of suspending indexation when revenue needs are pressing. Social security benefits have long been indexed to inflation, earnings or some hybrid of the two.

There was a long battle during the Thatcher period in the 1980s over whether the government should issue indexed gilts. A long-time governor of the Bank of England, Gordon Richardson, was fiercely opposed as he regarded it as a moral surrender to inflation. But one of his successors, Eddie George, was happy to see the government push them through and was worried mainly that they were not as popular as they should have been. Some 30 per cent of the UK national debt is now in indexed bonds, as is 10 per cent of US debt.

My own view was that refusal to index out of a moralistic disapproval of inflation was akin to refusing to stop knocking one’s head against a brick wall in the hope that the wall would go away. The main snag about indexation lay in the indexation of wages. There are circumstances in which real wages need to rise less quickly than usual or even to fall. This is difficult enough to accomplish when pay talks centre informally on the “cost of living”. It will be far more so if it comes to renegotiating a formally indexed pay agreement.

The indexation discussion has been revived by an American economist, Robert Shiller, with the aid of Lawrence Kay, who has adapted the argument to British conditions. (“The Case for a Basket”, Policy Exchange). One novelty is that the case is now presented as a way of dealing with deflationary as well as inflationary threats. If you buy a widget on an indexed basis you do not have the embarrassment of asking the seller for a reduction because prices in general have fallen. This happens automatically. A second and more important innovation is that he suggests a new unit of account, which he calls the basket, defined to retain its value whatever national inflation indices do. He believes that the failure to supply such a unit is one reason why indexation has not caught on. “It is far easier for most people to say ‘I will lend you 500 baskets at 3 per cent interest’ than to say ‘I will lend you £500 at an interest rate equal to 3 per cent plus the percentage change each month of the CPI’.”

Prof Shiller’s main modern example of such a basket is Chile’s Unidad de Fomento. But the separation of the unit of account from money used as means of exchange goes back a long time. From the time of Charlemagne, trade and contracts in Europe were based on imaginary or ghost monies that were ultimately based on the silver denarius, which no longer circulated or was even seen.

If a unit of account different from the coin of a realm is to be introduced, it would be better to find a more appealing name than “basket”. I cannot imagine anyone being thrilled to be told by his employer that he had been awarded a pay increase of 0.2 baskets.

But the real snag about indexation remains the problem of wages. As Keynes, Prof Shiller himself and many others have observed, workers accept more readily a real wage cut arising from a rise in the general level of prices than an actual reduction in what they are paid. Prof Shiller tries hard to find a unit in which workers could accept with good grace a reduction in real pay; but I do not think he succeeds. In some circumstances a little bit of old-fashioned inflation is the best safety valve available.

Write to samuel.brittan@ft.com
More columns at www.ft.com/samuelbrittan"