Over the past decade, a number of countries have set explicit targets for inflation and mandated control of inflation as the paramount objective of monetary policy. Critics argue that such a narrow focus detracts from a monetary authority's responsibility to protect the stability of the financial system. These critics argue that a central bank with price stability as its sole objective might not respond to financial instability unless its inflation goal was threatened.
Others argue that a monetary policy directed at maintaining stability of the price level would lessen both the incidence and severity of financial instability. Anna Schwartz, for example, contends that a central bank "that was able to maintain price stability would also incidentally minimize the need for lender-of-last-resort intervention." Financial instability, according to Schwartz, often has been caused or made worse by fluctuations in the aggregate price level. A monetary policy that maintains price stability, thus, also would promote financial stability.
Michael Bordo, a professor of economics at Rutgers University, and I have examined whether the financial histories of the United States, the United Kingdom and Canada are consistent with Schwartz's claim. The most recent episode of significant financial distress in the United States occurred in the 1970s and 1980s and was reflected in widespread bank and S&L failures. Sharp declines in commodity and real estate markets after several years of price increases were the proximate causes of these failures. The financial distress, however, occurred in an era of aggregate price inflation followed by a sharp disinflation, which, according to Schwartz, worsened the resulting financial problems.
Sustained inflation, Schwartz argues, encourages speculative investment and borrowing on the expectation that prices will continue to rise. When inflation abruptly declines as it did in the early 1980s, however, borrower incomes may be insufficient to repay loans made on the expectation of continuing price increases. The resulting rise in defaults reduces the equity of lenders, possibly causing an increase in financial institution failures.
In the absence of inflation and disinflation, shocks like those affecting commodity markets in the 1970s and early 1980s might still cause significant financial problems. Schwartz argues, however, that if the aggregate price level is stable, or at least if its movements are predictable, then resources will be employed more efficiently and financial distress, regardless of its proximate cause, will be less severe.
Bordo and I find that many of the most severe episodes of financial distress in U.S. history coincided with sharp declines in the rate of inflation after sustained periods of rising prices. For example, the first serious banking panic and recession in U.S. history occurred in 1797, a year of deflation that followed three years of moderately high inflation averaging 8 percent per year. One historian described the inflation years as being prosperous, with "active internal trade; land speculation, many new companies formed," as well as "booming" foreign trade, and a rapid increase in the number of banks. Defla-tion, however, brought "depression, panic and many failures."
Similar cycles of inflation and deflation, with increases in speculative activity and bank lending in the inflation phase, and bankruptcies and bank failures in the deflation phase, punctuated the 19th century. In the 20th century, the Great Depression also was associated with a major deflation and the failure of some 9,000 banks.
A definitive test of Schwartz's view would require information about the decisions of individual households, firms and financial institutions. The association of severe financial instability with fluctuations in the price level historically, however, would seem to support those who argue that price level stability and financial stability are very much compatible, and not competing, goals for monetary policy.