Friday, June 18, 2004

The Economist: Sounding the Inflation Horn

Despite the fact that The Economist accepts the premise that the official inflation gauges are to be relied upon (at least formally, who knows what the writers affirm in the privacy of their own chats over the water cooler or at the pub) they have begun to sound the alarm over inflation and monetary policy - a theme the oldman has been griping about nigh on a year or more.

Even if central banks retain their independence, they too can make mistakes. Two reasons are commonly offered for why 1970s-style inflation cannot return. First, it is argued that central banks have a better grip on money and hence inflation these days. And second, that bond markets would not let inflation take off; instead, rising bond yields would automatically curb growth. In other words, central banks will police inflation and the capital markets will police the central banks. The snag is that both assumptions may reflect exaggerated confidence in the skill of central bankers and bond investors.

The view from the red planet

Suppose a Martian returned to Earth today, a quarter century after his last visit. He would be unaware of the success of independent central banks in taming inflation over the past two decades (and of concerns about deflation last year), and much less in awe of Mr Greenspan than are financial markets. He would note that America's economic slack is disappearing fast, that its nominal GDP has risen by 7% over the past year and that inflation is around 3% and rising. From this he might guess that short-term interest rates should be around 4%—ie, positive in real terms. Tell him that America's interest rates are currently 1% and he would probably jump on the next flight back to Mars.

From this point of view it seems bizarre that financial markets are worrying about whether interest rates will be raised by a quarter or half a percentage-point at the Fed's meeting on June 30th. The real questions are: why has the Fed not tightened sooner? And how high do interest rates need to rise?

Indeed, global monetary policy as a whole would look dangerously lax to a Martian, with average interest rates in the big economies at their lowest in recorded history. All the liquidity being pumped out by central banks has to flow somewhere. Even if inflation in the prices of goods and services remains lower than in the 1970s, overly lax monetary policies will fuel bubbles in house prices or equities in many countries. Central bankers should be just as concerned about this as about old-fashioned consumer-price inflation. Instead, some seem to be just as complacent as they were in previous periods before inflation took off.

It still looks unlikely that inflation will return to the double-digit rates of the 1970s. But central banks would be wise to do more to mop up today's excessive flow of liquidity. Mr Volcker, who bravely launched the successful fight against the ruinous inflation of the 1970s, would understand why. “The truly unique power of a central bank”, he once observed, “is the power to create money, and ultimately the power to create is the power to destroy.” Today's central bankers need to remember that.

The power to create is the power to destroy. How apropos. However the other side of the coin needs to be addressed. The government is out of control. Why I heard on the radio the other day that Senator McCain was having to defend his stance taken with three other Republicans Senators of opposing additional taxcuts in the new budget resolution without offsetting spending cuts. While being true to conservative ideals of spending austerity, that statement isn't the news. The news is that Republican lawmakers in 2004 were attempting to push through even more taxcuts even as spending spirals out of control. This is flabbergasting. A third round of taxcuts on top of advocation of making permanent the previous ones.

It is attempting to finance precisely this kind of profligancy that is driving our country literally toward bankruptcy. If a central banker with the credibility and prestige of Alan Greenspan does not feel that he has sufficient credibility in order to raise interest rates and make borrowing a real burden in order to improve savings and curtail the red ink then no central banker can ever be anything approaching independent. There is no point to the myth of central banking independence if in fact with this level of public confidence that Greenspan and the Open Market Committee cannot curtail the asset-base of money. To quote Stirling Newberry:
Asset money differs from fiat money, and it does so in crucial ways. In fiat money, the supply of currency is under the control of the agency which creates it: someone prints money, and they print as much of it, or as little of it, as they feel is beneficial to their own policy. The money supply is not related to the currency supply directly: the printing agency prints what it wants, spends it, and whatever happens to inflation from oversupply of money is beyond its power or concern, if there is deflation, that is, equally, not its responsibility to correct. Asset money removes the direct link between printing and spending, the government prints money, loans it to the economy.

If assets become nonperforming - that is, if it prints too much money for the asset base - it must pay for the defaults that result. It must also go to the asset economy for "permission" to spend by selling bonds. In other words, overprinting can generate short term inflation, and the government receives a short term advantage, but then it must raise interest rates to get more money to spend, or it must pay for the consequences of default. Under fiat money the printing authority has no check on its ability to create money. Under various "hard" money schemes, some external yardstick is set, and the government is measured against it. But the new model of the monetary system, in development, but codified by the FDIC, was that the economy itself was the basis for the money supply. The bond market, in effect, was the first check on the authority of the government, and the second was the supply and demand for money itself: rather than merely being a supplier of liquidity, the government became part of liquidity demand, and if it oversupplied the market, or undersupplied it, government itself would end up footing the bill. In effect, the solution to fiat money was to create hazard for the government, by forcing it to back the money it printed.

What would happen if in fact the linkage were broken and the central bank, nominally independent but feeling as if it had an obligation to finance the government expenditures for the sake of social stability, failed to raise interest rates to reflect appropriately the pricing of the asset base? The result would be an asset bubble inflation that sooner or later given a cyclical business cycle unwinding or an exogenous pricing shock would result in an immense unraveling of the entire financial base.

There are three courses open to us. The first and the one the oldman advocates is raising short term interest rates now as tough love and strong medicine. There would be pain but it would also impose discipline both at the consumer level and at the political level. This would require a central bank that was independent in fact as well as theory. The second alternative is to fail to raise interest rates to the level needed in order to deliver a cure, and this would generate inflation and indeed given further decline of purchasing power to production through currency devaluation it would generate stagflation. This is the outcome that I think will actually happen.

The economist believes interest rates need to be 4% or 1% above what it perceives to be core inflation rate. Since I believe the core inflation rate to be artificially suppressed my recommendation would be interest rates of 6.5% - or one percent above headline inflation. This would kill the economy in the short term however. The actual position I believe that the Federal Reserve will take is no more than 3% or 2% above the current short term rate and big enough to usher in stagflation since it isn't big enough to bring down inflation.

The third outcome and the one that Buttonwood is considering is that the time for mere stagflation has already passed us by and there instead there is a sharp asset price deflation scenario with the possibility of systemic risk. The market is supposed to discount for this but apparently isn't. Systemic risk could take any number of forms from hyperinflation, cascading debt default, hyperdeflation, or currency devaluation. It's just a term that means everything falls apart.

The market is expecting an 0.25% point increase in the Federal Funds rate come mid-August 2004, and Federal Funds rates above 3% by the spring of 2006, and above 4% by the spring of 2007.

Looking at the fiscal outlook, I have to say that either (a) George W. Bush is about to have a Road to Damascus moment and become a deficit hawk Real Soon Now, or (b) long-term U.S. Treasury bonds are overpriced--even with my belief that the inflation risk premia of the 1980s and 1990s have finally been wrung out of the bond market.

Posted by DeLong at April 20, 2004 02:12 PM

Essentially the markets would go bonkers and everything would go to hell in a handbasket. Who the hell knows what would happen, except that this would be the mother of all meltdowns given that there is no collection of economies large enough to bail the US out the way that exports to the US helped bail Asia out, the US bailed Mexico out, or the IMF (the US and Europe in another guise) bailed out Argentina and Turkey. When you get to a crisis point like that it all depends on the crisis management. If you're getting worried perhaps it's because the crisis management skills so far displayed by our banking system and the government have of late been less than stellar.

Now I don't happen to think that it's that bad yet. However when you talk about probabilities on the margins like that one can never be quite sure. The oldman is still betting on the stagflation scenario. Systemic risk in my estimation is not to be unless there is a complete failure of political will over the public pensions issue and continued fiscal immoderation moving past 2011. However I could be wrong and the wolf could be at the door now instead of merely howling off in the woods.


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