Why Price Stability? A Brief Answer from the Perspective of the New Institutional Economics

The concept of general price stability became only a topical issue of famous monetary theorists around 1900. Naturally, people knew that a stable gold price was not equivalent with general price stability, and there was also talk about the relation between new discoveries of gold deposits and general price increases. Missing was, though, a general measure of the price level and, as a result, of general price stability. Index calculation began only to prevail during the second half of the nineteenth century (Pfanzagl 1955). The today worldwide used Laspeyres and Paasche indices appeared in the Jahrbücher für Nationalökonomie und Statistik of 1871 and 1874 respectively.

Of interest are the opinions of Knut Wicksell and Irving Fisher. On both a few words, beginning with

Irving Fisher (1913, p. 28) who claims that the development of index numbers enables us to “scientifically standardize the dollar.” Contracts expressed in money units (money loans) are nothing more than sub-species of general futures contracts. It does not matter how monetary units are expressed—in quantities of money good (a gram of gold) or an abstract number of units of account (DM, €). The ideal standard for future payments (standard of deferred payments) would be the money of constant purchasing power.

Knut Wicksell (1898, 1936, p. 194) wrote that it was possible to “establish a stable measure of value and of maintaining prices at a constant average level.” Such an aim would be attainable, “not only in theory but also in practice. Its fulfilment calls for every effort on the part of statesmen and thinkers. It is a thing unworthy of our generation that without pressing cause the most important economic factors are left to pure chance” [viz. the discovery of precious metals]. For Wicksell, the ideal solution was an international paper standard—at that time, a hair-raising idea. Even 25 years later, Friedrich Wieser claimed in the Handwörterbuch der Staatswissenschaften that a paper currency is unsuited for use in world trade, and that only gold can serve as world money.

We thus see, the aim of price stability was for Wicksell and Fisher to ensure that money debts can be redeemed with money of the same purchasing power as that of the preceding money loan. The “mark = mark” or “nominalistic principle” of the underlying legal order prevails.¹ It concerns the “old-fashioned” principle of individual liability for contractual obligations, which is now largely disregarded by monetary policy makers. What counts presently are functional aspects like impairment of economic efficiency (=economic growth) and distortion of transfer payments (=income redistribution) through inflation or deflation. Not amazingly, only such functional aspects are listed by the ECB (see The Monetary Policy of the ECB, Frankfurt/M. 2001, 37f.). From the new (and the old) institutional economic perspective is of interest, instead, the “old-fashioned” principle of individual liability (as understood in real terms). The liability-from-contract principle is one of the vital three elements of the basic legal system underlying free market economies² and will be used as the basis for answering this paper’s thematic question.

The nominalistic principle went quite well in the long term with the gold standard. For Germany, these were the years between 1876 and 1914. Of course, there were crises but none like the Great Depression. The social product per capita grew on the average by 4.35 % p.a. during that time. But the rates of change of the index for food-stuffs and housing varied between −5.2 % and +6.0 % p.a. Still, in the long term prices were pretty stable. They increased in the average only by 0.8 % p.a. between 1876 and 1914.³

While there can be no scientifically exact indexation, as Irving Fisher (1911) believes, there is still a practicable method of proceeding: since the individual indices taken together vary uniformly, we could speak of the movement of an aggregate price-level and even make an approximate calculation of it.

If that is so, why not measure the degree of price stability by means of a (probabilistic) sample of the inflation rates of individual consumer goods, perhaps weighted by the rate of turnover of the goods concerned? That does not occur in Germany and many other European countries. The reason for that may be that the population, which is being sampled, must be clearly defined. That is difficult for consumer goods or goods in general, because what precisely is a good? While the answer is simple to the theoretician, to the statistician or practitioner it is not (Pollak 1998, p. 174). A way out that suggests itself is to enumerate a selection of concrete goods.⁴ The goods basket of the standard family that figures in the cost-of-living index is in consequence not much more than a convention agreed upon by statisticians (Pollak 1998, p. 74), suitable for measuring changes in the price of a bundle of particular goods over the course of time. Whether it is useful for measuring the change in the actual cost of living is another question. Nevertheless, in Germany that index is often used for the indexation of long-term contracts, and so it is not only a convention agreed upon by some statisticians but also a social convention among the users of money. Still, the precise composition of the commodity basket is known only to very few of them, a fact that invites to political manipulations.

The European Central Bank (ECB) uses as indicator of inflation a concept, whose content is even less conceivable than, e.g., the goods basket of the German consumer index: the Harmonized Index of Consumer Prices (HICP).

The Harmonized Index of Consumer Prices (HICP) is a weighted average of price indices of member states of the Euro-Zone. It has been under development by Eurostat, the European Commission’s statistical arm (see O’Donghue and Wilkie (2005).

As a matter of fact, some far away residing statistical office, difficult to access for average money users, determines this number. It requires not only confidence in the wisdom of its definition and trust into its correct calculation by 18 national statistical offices but also trust in the European Statistical Office far away in Luxembourg. As usual with price indices: no error terms are mentioned. Nevertheless, the Governing Council of the European Central Bank seems to believe into the HICP figures up to the last digit.

“The primary objective of the ESCB shall be to maintain price stability.” Thus the first sentence of Article 105, clause 1, Treaty on the Foundation of the European Community of 7 February 1992 in the proposed amendment of 2 October 1997.⁵ However, at the end of 1998, shortly before the euro was put in circulation, the Governing Council of the European Central Bank redefined “price stability” as

… ‘year-on-year increases in the HICP for the euro area of below 2 %.’ Furthermore, it was made clear from the outset that ‘price stability is to maintain in the medium term.’ (ECB, Annual Report 2000, p. 10)⁶

A few years later, the Governing Council clarified that,

within [above] definition, it aims to maintain inflation rates below but close to 2 % over the medium term (Emphasis added, see, e.g., The Monetary Policy of the ECB, Frankfurt/M. 2004, p. 51)⁷

That would be less than the average inflation rate of the Deutsch mark between 1946 and 1998, which amounted to 2.8 %. However, “in the beginning was the word.” Above declaration of the Governing Council is the first step toward a complete re-evaluation of the by Germans abhorred term “inflation”. It also amounts to a transition from the old, contractually agreed upon (“German” ⁸) principle of price stability to the new (“American” ⁹) principle of inflation targeting. While the principle of price stability is the natural consequence of the nominalistic principle underlying the German legal system, this is not true for the principle of inflation targeting. Thus, in effect, the Governing Council of the European Central Bank violated with its management resolution, without raising much attention, one of the basic principles of the German legal system.

Interjection on Inflation Targeting: The idea of inflation targeting comes from a long and heated dispute between followers of Keynesianism and Monetarism. It replaces (for the time being at least) the money supply target of monetarists in countries like Canada, United Kingdom, New Zealand, Sweden, Australia, Finland, Spain, Japan and Israel¹⁰ (According to Bernanke et al.)

Inflation targeting is a framework for monetary policy characterized by the public announcement of official quantitative targets (or target ranges) for the inflation rate over one or more time horizons, and by explicit acknowledgement that low, stable inflation is monetary policy’s primary long-run goal (Bernanke et al. 1999, p. 4; emphasis added).¹¹

Not even 10 years have passed since the ECB started with inflation targeting and the German-speaking press uses the word “inflation” already in a matter of fact sense without any negative connotation. As an example of this linguistical shift of value the following report from the Neue Zürcher Zeitung (NZZ) October 10th, 2014 (No. 235, p. 19):

The President of the European Central Bank (ECB), Mario Draghi, has given assurance that the ECB will boost the low inflation rate of the euro area from its latest figure of 0.3 %. Price stability in the euro area currently means to lift the inflation rate from its unreasonable low level, said Draghi on the occasion of a talk he gave at the Brookings Institution in Washington. “And exactly that is what we are going to do.” (emphasis added)¹²

The expression “lowflation” arose—a term unimaginable 10 years ago.¹³ Even in 2007, the upcoming re-evaluation of the “inflation” word must have been inconceivable to the German legislator. In that year the German parliament introduced its Preisklauselgesetz (price-clause-law) as a substitute for the old indexation-ban of § 3 Bundesbank-Law, which had become invalid with the foundation of the European Currency Community in 1999.¹⁴ If the German legislator accepts that the ECB interprets its international obligation of “price stability” as an “inflation target” of “below but close to 2 % over the medium term,” it ought to give up the nominalistic principle underlying German legal order (think of German tax laws or corporate accounting!) and discard its price-clause-law. As a matter of fact, there are good reasons to distinguish in case of a currency union like the present Euro Area between “harmful” and “good” deflations.¹⁵ Anyway, the Euro Area is not comparable with the USA.

So much on the contractual obligation of the ESCB to ensure price stability. To repeat, the principle of price stability is a consequence of the nominalistic principle (the mark = mark principle) underlying the German legal system. Both together are to be seen as conceptual pair, which will be dealt with in the next section.

Remark in Passing on the Monetary Employment Policy

Several economists and politicians were, and still are, convinced of the possibilities of monetary employment policy. They appeal, among other things, to Phillips (1958), who provided the statistical proof that a higher level of employment might be purchased at the cost of a lower level of price stability.

After the epochal articles of Milton Friedman (1968) and Edmund Phelps (1967), who both recurred to the classical theory, and after the utilization of the rational expectations hypothesis by Robert Lucas (1973) in this connection, this conviction weakened. Nevertheless, there are today many well-known economists who regard the Friedman-Phelps conclusion as valid only for the long-term, and so believe that monetary employment policy can still be of some effect in the short-term (cf. Stanley Fisher 1977). A central role in this context is played by the Taylor Rule (Taylor 1993), or the work of the “new classical macroeconomics”, according to which in the short-run, despite the hypothesis of rational expectations, room remains for monetary stabilization policy (see, e.g., Persson and Tabellini 1994).

The Maastricht Treaty also obliges the ESCB to support not only the employment policy of the Community but also its economic policy in general, subject to the limitation that “this is possible without impeding the goal of price stability”. This phrase is object of interpretation. It does not exclude the reading that the ESCB is obliged to help combat deflationary tendencies in the level of economic activity with short-term inflationary measures beyond its miracle 2 % rate.

Money in its capacity as a unit of account, means of payment and store of value (or standard of deferred payment) is part of the money order of a currency community.¹⁶ That is true for both, redeemable and irredeemable paper money. The difference between both is that it is much less costly for money users to check whether the issuer of redeemable money kept its word (viz., the legal standard of coinage) than for the holder of irredeemable paper. It would be a time-consuming and costly task for an individual to check whether the cost of living index has been correctly calculated. Insofar, the users of irredeemable paper money have to trust not only their central bank but also their statistical office—and their government. As for the latter, the following praxis to make the promise of price stability credible has been successfully applied:

The state (Parliament) passes a law according to which