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Now that there is considerable concern
in most commentators’ and economists’ minds over the economic
outlook, they are forming into two uneven camps: those more afraid of
deflation than inflation, and vice-versa. The deflationists are in the
overwhelming majority, and include nearly all Keynesians and monetarists
– the establishment. Those afraid of inflation are a rag-bag of
refuseniks, including Austrian economic theorists. Readers will not be
surprised that I see uncontrollable inflation as the likely outcome of
current economic policies, given my derision for the theories of Keynes and
Friedman.
The
purpose of this article is to show where the establishment is wrong about
deflation and to identify the inflation risks. For the purpose of this
analysis, we will assume the global economic outlook deteriorates further in
the coming months, and fears of deflation drive the central banks’
monetary response. This is a recipe for stagflation.[i]
Most
economists make the mistake of conflating the two separate issues of inflation
and deflation into a single outcome. The deflation they fear is the Irving
Fisher debt-deflation spiral, defined as an imploding cycle of falling asset
prices driving loan foreclosures. Since such a collapse has the knock-on
effect of increasing bankruptcy and unemployment, consumption will suffer and
drive down demand for goods, leading to a fall in price levels for most of
the goods in the consumer price indices. Ergo, a collapse in bank
lending is deflationary.
It
is hard not to be seduced by this argument, but like many economic
generalisations it is too simplistic, placing too much emphasis on the likely
extent of the deflation.
There
is no doubt that a fall in the general level of consumer demand has a
negative effect on general price levels, but this effect is uneven. Goods and
services in over-supply will obviously be hardest hit. For the consumer,
these are generally capital goods rather than consumables. Services that are
unnecessary for everyday life are also vulnerable. The reason these
categories are in over-supply is that the markets for them have been fuelled
by credit, either from finance companies or from home-equity withdrawal.
Until recently the credit bubble was expanding, leading to an over-allocation
of economic resources to these sectors. However, finance for consumers has
now been contracting for about two years, so these goods and services are now
suffering chronic over-capacity. It is this over-capacity which is now
causing problems, and while there is bound to be some overspill effects into
the general economy the more basic consumer sectors are fundamentally in
better supply/demand balance.
This
is because Man has got to eat. Even the bankrupt and unemployed still require
food, heat, transport and other basics, so aggregate demand for these items
will not fall by much. Indeed, agricultural commodity prices are now rising
for very good reasons, even though the global economic outlook is
deteriorating rapidly. Economists play down this dichotomy, by pointing out
that food is a small component of the consumer price indices, but they make
the mistake of being slaves to this inadequate measure of inflation.
So
whether prices rise and fall will to a large degree depend on a product or
service’s necessity. But all this assumes the yardstick for measuring
prices (paper money) is itself constant. We all assume it is, but in practice
it is not: we think in hard currency terms, but deal in fiat money. And the
one certain bet we can make on future central bank action is the continual use
of the printing press. So, the purchasing power of our paper money is set to
fall at a pace likely to at least offset the fall in prices for many goods
not in chronic oversupply. Indeed, this is a fundamental purpose of central
bank policy.
Deflation
is therefore far from certain as Keynesians and monetarists might have you
believe. Furthermore, central banks are likely to offset contracting bank
credit with aggressive production of narrow money. If the rate of bank
credit contraction speeds up - as seems possible - so will the production of
paper money. This money will be issued through three broad mechanisms:
·
There will be further “quantitative easing” through the purchase
of government debt by central banks. The distribution of the resulting fiat
money into the economy will be through government spending. As a result of
economic deterioration budget deficits will expand rapidly, as tax receipts
collapse and welfare spending increases; so QE will become an increasingly
important source of funding for government spending as deficits balloon.
·
By utilising currency swaps, central banks will have the facility to help
fund each others government spending. Central bank co-operation will have
funding government deficits at its centre.
·
Central banks will inject money into the financial system to prevent systemic
failure and underwrite asset values.
These
are the practical and impelling reasons for escalating money production. The theoretical
reasons can be summed up as targeting price stability. In this
deteriorating economic environment it means supporting prices for assets
generally (pace Irving Fisher), while governments intervene to
subsidise demand for goods and services in chronic oversupply. To achieve
financial stability requires no less than central banks underwriting asset
values, which can be done in two ways: by buying private sector debt and
tolerating default, and by buying assets such as listed stocks and bonds to
maintain their values. This is indeed a summation of the Federal Reserve
Board’s strategy since the credit crunch, and the Federal
government’s cash-for-clunkers scheme typifies intervention by subsidy.
So
the reasons for a global escalation of monetary inflation are compelling for
both practical and theoretical reasons. Even the cost of government’s
intervention by subsidy is funded by the printing press. The authorities have
honed their interventions over the last eighteen months, so believe they know
what to do. And since financial markets around the world are interdependent,
no central banker dares not to join in.
How
inflation will be transmitted to prices
We
can therefore assume that there will be a rapid expansion of money in
circulation in the major currencies. Other currency-issuing central banks
will have to join in through currency intervention and by expanding their
money supply, or risk a rapid rise in currency exchange rates. There is
therefore likely to be an attempt by all central banks to keep currency exchange
rates reasonably stable. The effect is that every paper currency will suffer
escalating monetary inflation.
So
the question arises, if quantities of all fiat currencies are being expanded
at the same time, how will this be reflected in price inflation, given that
monetary inflation will not be transmitted to prices through relative
currency devaluations?
The
first step on the path of price inflation is through costs faced by producers
of basic goods. Bearing in mind that the risk of severe deflation is generally
restricted to sectors in chronic oversupply, basic goods are unlikely to see
their costs of production fall. These costs are labour and raw materials;
labour costs are maintained by inflexible labour markets, but raw material
prices are free to rise. And it would be a mistake to expect substantial
falls in key commodities, because there is not the build-up of speculative
long positions that fed the collapse in base metal and energy prices in 2008.
Raw
material prices are already developing inflationary characteristics.
Agricultural commodity prices are rising sharply, partly because they
have been low for a long time, and partly because the world’s
population has fundamentally changed. Not only have the numbers increased to
nearly seven billion, but nearly two billion of them living in emerging
nations have seen or expect to see a substantial improvement in their
standard of living, while fewer are employed on the land. And while emerging
nations have access to metals and energy to varying degrees, they anticipate
future shortages so have strong incentives to stockpile.
In
the context of renewed weakness in the consumer economies these nations have
a simple choice: either hold on to dollars et al and hope that lower
commodity prices will offer more favourable stockpiling opportunities, or
take the view that dollars et al should be dumped in return for
strategic commodities while paper money still has any value. Whatever the
rhetoric, an acceleration of monetary inflation in the major currencies is bound
to encourage the latter view.
If
history is any guide, rising price inflation will generate labour unrest,
notwithstanding high levels of unemployment. Those actually in employment no
longer have the desire or ability to borrow to make ends meet, so will press
for higher wages. This leads us onto the well-trodden path of stagflation.
How
long it will take for stagflation to morph into hyperinflation is
anyone’s guess. The last time we had stagflation was just over thirty
years ago, but it was halted before it went out of control. It took dollar
interest rates of over 15% to achieve this, a policy option which would be
far more difficult today. The levels of private sector and government debt
now are of a greater magnitude compared with thirty years ago, and to
deliberately bankrupt whole economies by raising interest rates sharply is
inconceivable.
But
we should take one step at a time. A deteriorating economy is bound to
provoke an acceleration of monetary inflation. The deflationary effect on
prices is broadly limited to assets, capital goods and consumer sectors
suffering chronic oversupply. But for all other goods price inflation –
stagflation - is already in the pipeline with lots more to come.
[i] The first reference to this
portmanteau word, according to the Oxford English Dictionary gives its true
definition: “1965 I. MACLEOD Hansard
Commons 17 Nov. 1165/1 We now have the worst of both worlds -
not just inflation on the one side or stagnation on the other, but both
of them together. We have a sort of ‘stagflation’
situation.”
Alasdair McLeod
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