Global Policy Forum

Blame This Crisis on the Myth of Inflation

By Maurice Saatchi
May 8, 2009

Debt and house prcies were shooting up.  But keep one thing under control, we were told, and everything would be fine.

When things go wrong, it is a human instinct to attribute blame. Today, many people are routinely blamed for this economic crisis - investment bankers, for greed; central bankers, for being "behind the curve"; regulators, for being "asleep at the wheel"; credit rating agencies, for too many triple A ratings; even the public themselves, for foolishly borrowing too much.

What made all these people reckless at the same time? The record seems to show that they were all just victims. Their mistake was to believe what they were told. They were lulled into a false sense of security by an idea - that if policymakers could maintain low inflation (and more important, low inflation expectations), then all good things would follow: growth, employment, prosperity, stability.  Unfortunately, the idea turned out to be a myth - the largest public policy failure of our generation. The Myth of Inflation Targeting created the illusion of the new Jerusalem, the new paradigm, the end of the economic cycle.

But lack of clarity about the distinction between the necessity and sufficiency of inflation targets has been responsible for a misunderstanding of epic proportions. By first creating the false impression that low inflation meant financial stability, and then measuring the wrong kind of inflation, the inflation targeting policy encouraged the view that it was safe to borrow, safe to invest.

The myth led bankers to lend more, traders to risk more, homeowners to borrow more, regulators to relax more and politicians to boast more - about the end of boom and bust.  When the myth collapsed, it took all of us down with it: academics and auditors, bankers and bakers, economists and electricians. We all went into the dark.

The myth made the Bank of England concentrate only on inflation, and then compounded that error by obliging the Bank to focus only on one kind of inflation. The wrong kind. Whereas the Bank's consumer prices index (CPI) keeps a close eye on inflation in the price of a packet of peas and a bar of chocolate, it overlooks the very aspects of inflation that caused this crisis - all the debt, housing, mortgage ingredients of our present misfortune.

For the past five years "debt inflation" was on average 9.5 per cent a year, nearly five times the Bank of England's CPI inflation target. But where is "debt inflation" in the CPI? Not included. During the same period, the inflation rate of one asset class, property, was 13 per cent a year, six times the Bank's CPI target. Where is that in the CPI? Not included.  What about the cost of acquiring and holding these property assets, ie, mortgage interest? Where is that in the CPI? Not included.

CPI inflation barely moved. It was irrelevant. It neither registered the huge increase in asset price inflation, nor its huge collapse.  The Bank's measure of inflation was stuck in the past. It overlooked the fact that millions of people had become investors in a new asset class. They were home owners. This was the joy of debt, as practiced by the masters of private equity.

I borrow money.

I buy an asset.

The price goes up.

I exit the asset.

I repay the loan.

I keep the profit.

Remember, the great British public had been given specific assurances that central banks had achieved predictably low inflation, which meant prosperity and stability. So there was nothing to worry about.  The Myth of Inflation Targeting was also the direct cause of the excessive self-confidence that worked its way through the international banking system. In three stunning creative leaps, huge liabilities were contained outside the accounts of our giant global banks. This is why, when the crisis arose, it was all such a shock and is still unraveling.

Leap No 1: The War of the Acronym

In its accords in 2004, the Basel Committee on Global Financial Stability made recommendations about what the capital adequacy ratios of banks should be - in other words, what their multiple of deposits should be.

These accords represented a roadblock for banks, and stimulated the first example of bankers' remarkable creativity. They would get around the restrictions of the Basel committee with acronyms for items such as structured investment vehicles (SIVs). For some reason, never adequately explained by any bank auditor, a bank's "loans" became "investment", which could be contained "off balance sheet". In one leap, this transformed a bank's capital ratio and enabled the bank to do exactly what was intended - to lend more.

Leap No 2: "We are all triple A now"

In time, these extra levels of lending brought the banks to a second roadblock - the credit rating agencies were growing anxious about giving triple A ratings to some of the banks' so-called "investments". The bankers soon found a creative way around that obstacle. They created a new industry. They approached insurance companies that, until then, had typically insured cars, houses, lives, and so on, and made them an offer they could not refuse: a new profit centre, in which they could sell insurance policies for "securities", ie, debts. The insurance companies willingly obliged. The banks were then able to go back to the rating agencies and say: "There you are. These debts now deserve triple A ratings. Why? Because they are insured."

The rest is history.

Leap No 3: Computer shall speak unto computer

In 2000 David Li published an academic paper on the "Copula Function", a statistical method to evaluate risk. This model enabled computers to execute billions of dollars of trades with other computers. The bank's computers both sold the "investment" packages to other banks, and bought them from other banks. Computers were on both sides of the transaction. No human beings were involved.

Of course, the Copula-powered computer model was sensitive to the risk of falling house prices, but nobody was interested. Everyone was convinced by the Myth of Inflation Targeting - certain that low inflation meant long-term growth and financial stability. The true culprit is not a regulation or an accounting standard; not a person or an institution or an industry, but an idea - the Myth of Inflation Targeting. It blinded us to how an economic catastrophe could occur during a period of low inflation.

As we now know, none of us can rely on "inflation targeting" for our safety and security. It is not the guarantor of growth and stability, and never was. Why? It is a myth.

Never again.


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