Pursuing zero inflation or very low inflation costs the economy dearly (see Akerlof et. Al).

The US experience provides evidence that a moderate inflation rate is better for all. Unemployment settles at a much more acceptable level and moderate growth can be sustained.

"History shows that once inflation begins to take hold, the seeds of a recession are sown. The worse the inflation, the worse the subsequent recession."

Ten years after the Bank of Canada declared war on inflation, arguing that inflation was to blame for Canada’s ills, the bank’s governor is still "rather optimistic about the prospects for an improved employment situation in Canada."

Ten years is a long time. In the past ten years, this writer has lived in two countries, changed jobs four times, married, purchased a home, had a child and almost completed an MBA. One of the reasons I decided to pursue an MBA degree was in order to expand my horizons, open more doors, improve my chances of lucrative employment. I did not know that my prospects depend on several variables beyond my control, but not beyond Mr. Thiessen’s.

Before engaging in a business education, my knowledge of economics and finance was akin to my knowledge of quantum physics, namely nil. Ah, but I knew about inflation. Inflation was a part of daily life in Mexico from 1976 on. That year the Mexican government devalued the currency from $12.50 pesos per USD to $23. This was the beginning of a series of devaluations that culminated in December 1994, when the peso hit $7500 to $1USD. Devaluations were followed by hyperinflation periods that devastated the average Mexican’s purchasing power. In this context, anyone who did not have extensive knowledge of economics would readily agree that inflation was the mother of all evils. Mexicans, in their usual way, blamed the problems on corrupt politicians.

Some Mexicans blamed it on United States policies, citing the old saying "So far from God, so close to the USA."

I was surprised when I learned that inflation is not necessarily bad. The question is how much inflation is tolerable? What rate of inflation is truly beneficial to the economy? The answer does not lie in the inflation rate as the Bank of Canada leads us to believe, but rather in real interest rates. These rates are behind real economic growth, real wage growth and real prosperity or lack thereof. Smithin makes a very strong argument for sustained low real interest rates in his book Macroeconomic policy and the future of capitalism, the revenge of the rentiers.

Mr. Thiessen, like his predecessor Mr. Crow, has followed low inflation policies arduously on behalf of rentier interests. Mr. Thiessen is quoted above blaming recessions on inflation. He conveniently neglects to tell the public that it is the Bank of Canada’s governor, who actually triggers those recessions to fight inflation.

Where does this inflation phobia come from?

As in accounting, it depends on who is doing the numbers and what data he or she is using. In 1982 two economists working for the Bank of Canada (Jarret and Selody) claimed that "inflation is the single and most important explanatory variable in explaining slow (or negative) productivity growth." Seccareccia and Lavoie (1996) argue that evidence from this and other follow-up studies under John Crow was not very strong. Nevertheless, "the negative effects of inflation on macroeconomic efficiency was generally inferred from their analysis." They further question the validity in the methodology of those studies concluding that zero-inflation proponents "stood on its head the causal link in the productivity-inflation nexus. It is inflation that impacts negatively on productivity growth and not the reverse as had traditionally been argued."

By the time the Mulroney government came to power, this view of inflation was accepted within the Bank of Canada. The new government designed a plan to attack the deficit and debt problem with a very specific fiscal policy. The cornerstones of this policy were revenue growth and expenditure control. Monetary policy was to support the government’s policy. George Bouey, the Bank of Canada Governor, "continued to identify inflation control as a key objective of monetary policy. But oversaw monetary conditions that accommodated economic expansion."

In 1988, Bouey’s deputy governor, John Crow, was appointed governor and his view on inflation was not the same as his predecessor. What determines a governor’s decisions is not clear and it is an important issue in monetary policy. Mr. Crow pursued a zero inflation policy that pushed the country to the worst recession in decades and undermined the government’s fiscal policies. "The thrust of monetary policy shifted from an expansionary or accommodative approach in the government’s first term to an anti-inflationary or restrictive one in its second term."

How can there be such a disparity between the policies of the government on the one hand and the Bank of Canada on the other? The issue of central bank’s independence and power is at the root of this problem. "The Bank of Canada was set up in 1935 to lift the country out of a deep depression. That rings out as clear as a church bell from the very first paragraph of the Bank of Canada Act that proclaims as its purpose ‘to mitigate fluctuations in the general level of production, trade, prices and employment.’" The definition of the word mitigate is "to make less severe, intense, painful, etc." Crow’s zero inflation policy did not mitigate the Canadian economy’s health. It aggravated it. Interest rates increased, output decreased and unemployment skyrocketed. The notion of short-term pain for long-term painmay have been behind Crow’s approach. However, history has shown that the long-term gain has been to slow in coming.

The banks’ profits have been breaking records.

The Toronto Stock Exchange has reached historical heights benefiting many people, mainly financiers. For regular Canadians the story is very different. Comedian Mary Walsh of CBC’s This Hour Has 22 Minutes-fame put it very while playing one of her characters: "The TSE has reached the 7500 mark. Well, freaky la di da! That’s almost my yearly income!"

In their book Where the Buck Stops: The Dollar, Democracy, and the Bank of Canada, Michael Babad and Catherine Mulroney criticize the bank’s power and make a case for change. They argue that the bank should be more democratic and that its policies should be aimed at the employment/unemployment problem.

Rentiers interests in North America and elsewhere have such influence that the political will to try to change the direction of the Bank of Canada’s policies is difficult to muster. Jean Chretien was on record as a critic of the bank’s policies during the Mulroney government’s second term. "What was needed. Mr. Chretien would theorize, was a governor who would let inflation grow to perhaps 5% or 6% as a way to stimulating the economy." Mr. Chretien was on to something, but it did not materialize. Of course, proponents of zero inflation or something close to it, cringe at the prospects of an inflation rate of 5%. Nevertheless, as Smithin has pointed out, they do not give reasonable explanations why zero or next to zero inflation should take precedence over other variables. What should be important to central bankers are standards of living as reflected in the citizens’ employment participation levels and their purchasing power.

The Bank’s views are supported by several studies undertaken by the institution’s researchers. As mentioned above, the validity of these studies is quite questionable. The comparison of Canadian anti-inflation policies with American policies provides evidence that some moderate inflation is better for all.

As per legislation, the Federal Reserve’s mission is to promote three goals: maximum employment, stable prices, and moderate long-term interest rates.

"The Federal Reserve Bank, under the leadership of Alan Greenspan, has paid lip service to the objective of price stability, but has not manifested the ideological zeal of the Bank of Canada. It has been content to live with inflation of 3 per cent or so. It consequently has pursued a less restrictive monetary policy, with positive effects for economic activity."

Some United States politicians have proposed to change the Fed’s approach to price stability by advocating a zero inflation policy. They argue that zero inflation is better for the economy and the nation than the current rates. Senator Connie Mack of Florida has introduced legislation to change the Fed’s mandate to mostly pursue price stability. Senator Mack must not be aware of Canada’s recent economic history and the effects of this nation’s zero inflation policy from 1988 to 1993 and the current policy of maintaining inflation within the 1% to 3% range.

Canada’s experience supports the work by economists George Akerlof, William Dickens and George Perry. These economists studied the effects a zero inflation or a low inflation policy has on the economy. Their argument counters the two main reasons advocates of zero inflation policies espouse, namely:

"that the costs of even a fairly low rate of inflation are quite high, while the output and employment costs of maintaining zero inflation are low," and

that "there is only one level of unemployment that is consistent with constant inflation," the so-called "natural rate."

The cornerstone of their work is a model that simulates "an economy with thousands of firms, each subject to random demand and supply shocks that affected its desired employment and wages." The model disputes classic believes about downward nominal rigidity in wage setting.

Their simulation model predicts the costs of pursuing a zero inflation policy and predicts what would happen in the United States if such a policy were implemented, as Senator Mack wished. What their model predicts is exactly what we have seen in the Canadian economy as a result of monetary policy during the period 1988 to 1993 and indeed to the present.

The initial impact of Mr. Crow’s zero inflation target brought as a consequence very high interest rates and higher unemployment. As Mr. Crow reached his monetary policy targets, unemployment began to fall as did interest rates. However, as Akerlof et all predict, the unemployment rate settles at a higher rate than it would have by targeting a moderate inflation rate.

"Economic growth and employment growth from 1989 to 1992 were very weak. Substantial gains were made in lowering the rate of inflation by the end of this period, but the recession in growth was much deeper in Canada than in other countries, and it pushed the unemployment rate up sharply."

Since 1992, unemployment rates settled at around 9%. The rate has been much higher for certain segments of the population, particularly young people and much of the employment growth consists of mostly part-time positions (See Table B below). Cui Bono? Again.

One rationale for the Bank of Canada’s tight anti-inflationary monetary policy during the 1988-1993 period was the view that inflation creates uncertainty and a feeling of unfairness in society. Seccareccia and Lavoie (1996) comment on this Hayekian (1945) approach to prices and conclude that "it apparently did not occur to the bureaucrats of the Bank that a deliberate policy of high unemployment is both unfair and conducive to higher uncertainty among households, or that persistent high real rates of interest in a world of slow-rising living standards are eminently unjust for those who must borrow."

Moreover, in regards to investment they write:

"As to the negative consequence of inflation on investment, and thus on endogenous productivity growth, it is generally understood that the problem of long-term financing of investment is a problem of higher interest costs relative to expected net revenues and not, stricto sensu, a problem arising from inflation or its variance. The high real rates of interest imposed by central bank in its decision to curb inflation could thus lead the economy toward a slower productivity growth path as a result of a lack of new investment."

The numbers in Table A above show that this was the case. Growth came to a standstill between 1988 and 1992.

Pierre Fortin, professor of economics at the University of Otttawa, echoes other economists work by calling for a moderate inflation target. Fortin cites the work of Akerlof and Perry as evidence of the costs of low inflation targets. Critics of Mr. Fortin point to current low interest rates and economic growth, and indeed, interest rates at the end of 1997 had come down considerably from the highs of the late 80’s and early 90’s. However, the permanent costs of the then zero inflation policy are still evident today:

Lest we forget, the precondition to tolerate any amount of inflation is to compensate rentiers with positive real rates of interest. However as they say in Mexico: "Don’t use so little candle light that you can’t see the saint or too much candle light that you will burn it." There seems to be a middle ground:

The evidence is overwhelming. The pursuit of zero inflation carries a heavy cost for the nation. If the purpose of government and central bank policies is for the good of all, then there was something definitely wrong with the Bank of Canada’s monetary policy during the 1988-1993 period. Dismissing the pain and suffering 1.4 million Canadians out of work (1.6 million in1993) as a necessary evil for progress and growth is a disservice to Canada’s democratic system and values. Moreover, lest we sound too leftist, the policy of the United States, the bastion of capitalism, has proven more successful for the good of all than that of the Canadian experience. Fortunately for us, Prime Minister Chretien did dismiss Mr. Crow in 1993-94. Unfortunately his idea of pursuing moderate inflation targets did not come about and Mr. Thiessen’s inflation band has not been very helpful to the economy. Real Interest rates are still too high. Nonetheless, his policies have been somewhat better than Mr. Crow’s, who "never lost a wink of sleep when interest rates got too high and farmers were going bankrupt."

Higher costs could ensue if such policies gather momentum. Examples of these costs can be seen in the experience of countries like Mexico and Argentina.

"The Argentine economy hit a recession in 1995. It failed to reach financial goals set out by the International Monetary Fund. Unemployment is around 17 per cent. External debt is on the rise." During a visit to Canada in 1996, Argentine Finance Minister, Domingo Cavallo said, " We can now speak of zero inflation in Argentina."