Thursday, November 03, 2005

Formal Inflation-Targeting is Useless

Many people think that government institutions will somehow behave better if the discretionary powers of government officials are limited by formal rules. But as it is government officials who will enforce these rules they are often ignored. We see that in how the U.S. Supreme Court repeatedly ignore the Constitution they are supposed to enforce either by ignoring the written rules it contain or by enforcing rules which is nowhere to be found in the Constitution depending on the arbitrary political whims of the Supreme Court justices.

Another example is how central banks with so-called inflation targets ignore those targets at will. The European Central Bank (the ECB) for example is supposed to according to its own rules hold money supply growth at around 4.5% and hold consumer price inflation below 2%. Yet even though money supply growth is now 8.5% and consumer price inflation is 2.6% , the ECB refused again to do what their own rules would require them to do- to raise interest rates.

The ECB is obviously trying to appease and bail out the politicians of countries with deep structural problems like Germany and Italy even though they are not supposed to do that and even though that will in the long run create a lot more problems than it solves.

The lesson of this is that government officials can't be restrained by formal rules as long as they are able to interpret these rules themselves. We should therefore also not expect any real change if Ben Bernanke succeeds in making the Fed adopt such a rule.


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