I have always welcomed constructive and reasoned criticism of the NBR’s monetary policy. This kind of criticism is also welcome because it informs monetary policy decisions to some extent.

Inflation is said to be the policy of the NDB and the Ministry of Finance and that both institutions can immediately reduce inflation to low levels

At the same time as constructive criticism, I have not hesitated to show critics of the NBR’s monetary policy wrong when appropriate. Recently, I have seen from a number of analysts, either in private discussions or in public comments, the type of criticism that follows this model: if inflation is not low, then it means that the central bank and the fiscal authority want inflation to be high.

In other words, it says that inflation is the policy of the NDB and the Ministry of Finance, and that both institutions can promote policies that will immediately reduce inflation to low levels if they choose. This criticism is not specific to our country, but rather widespread.

I wholeheartedly agree that inflation is politics, as Ludwig von Mises said. I devoted an article to this topic on May 11, 2022 (“Let’s not forget that inflation is politics”, luciancroitoru.ro), and we have shown that it is always important to understand whose policy it is, and what its underlying reasons are in the context of modern society, and why this policy does not always manifest itself in high inflation. Although I touched on these issues in the mentioned article, resuming the topic with direct reference to the mentioned criticisms could contribute to a better understanding of the causes of inflation.

Those who adhere to the aforementioned model of criticism, regardless of the specific formulations they make, miss two important points. First, I do not distinguish between the technical and political possibilities of monetary policy. Something similar applies to fiscal policy. These critics neglect political possibilities and refer exclusively to technical ones. By making this mistake, it is easy for them to say that if inflation is not low, it shows a lack of will on the part of the central bank and the fiscal authority.

To understand how some economists could fall into this error, I think the reader should put this thinking pattern into perspective.

After the Second World War and until the early 1980s, discussions about reducing inflation mainly had, overtly or covertly, two components: technical and political. Technical refers to operations with monetary policy instruments that are used to achieve a specific objective related to monetary aggregates or inflation.

After 1990, concerns about the ability of policy to reduce inflation have diminished significantly

The political component generally refers to any intervention that could affect these technical operations or affect an already established objective. At the time, central banks were generally not independent of governments, so political influence was always a concern. Milton Friedman’s most synthetic form of this concern was expressed in his 1960 proposal to increase the money supply by a constant percentage each year (the k-percent rule). This rule ensured the elimination of political influence.

Hayek is clear and says on May 18, 1970 that “…technically there is no problem to stop inflation… I am concerned not with technical but with political possibilities.” Later, everything started to change. Especially after 1990, concern about the policy options to reduce inflation decreased significantly, when there was a broad consensus in society that monetary policy should be increasingly independent of governments, and a shift to inflation targeting. But, as I will explain later, these conditions changed after 2008.

Second, the criticism I have in mind misses the point of an important difference in governance between the two institutions. The central bank has statutory powers to stabilize prices, and to do so it is given independence as to the instruments and their combination.

In addition, the central bank has a balance sheet, the size of which it sets independently, without asking anyone for approval. Instead, the government and other institutions have a budget, the goals and structure of which are democratically approved by the parliament. In other words, the government budget reflects primarily the political component of what taxes are collected, what expenditures are made, what deficits are accepted and how much public debt is issued in a year.

Higher inflation brings higher nominal revenues to the budget and reduces public debt in real terms. But politically, this assumption is not one hundred percent correct

Given these technical and policy differences between the two institutions, it is unrealistic to suggest that they might have a common interest in maintaining high inflation. The assumption is 100 percent realistic for the government, but only technically.

Indeed, higher inflation brings higher nominal revenues to the budget and reduces public debt in real terms. But politically, this assumption is not one hundred percent correct. Smart politicians know that high inflation is a great evil and are perceived as such, and to the extent that they do not blame the central bank for the inflation they have created, the political costs remain with them. This is also the main explanation for why politicians have given the central bank independence in conducting monetary policy.

At this point in our discussion, we need to better define what we mean by political influence. This does not mean phone calls or comments from politicians about the size and structure of monetary policy instruments. Although undesirable, they can be easily ignored if the central bank is independent. Effective policy influence refers to the technical element, namely the government’s budget constraints, which require that the amount of public debt be offset by the discounted amount of the future real primary budget surplus. Effective political influence occurs when fiscal policy is established that does not guarantee compliance with the government’s budget constraints.

The problem is that if this constraint is not respected, the government will cause a fiscal shock that will affect the rate of inflation, even if the central bank is independent in the sense that it established itself before the fiscal shock, ie. regardless of the dominance of fiscal policy, the monetary policy rule that provides the future interest rates necessary to achieve a particular inflation trajectory. I want to point out that even though monetary policy is independent, it cannot consistently follow the rule about its instruments if the government does not follow its intertemporal budget constraint.

I don’t want to go into detail to show how the government creates inflation. However, a short parenthesis is necessary because I understood from discussions with some of the most educated politicians with economics in the Romanian Parliament that there are difficulties in understanding this issue. So it is hard to see how the government can directly cause (fiscal) inflation.

Read the full article and comment on it on Lucian Croitoru’s blog

N.Ed: Lucian Croitoru is the chief adviser on monetary policy to the head of the National Bank of Romania