Inflation is rising and it seems the world’s central banks have critically misjudged the situation. Until a few months ago, most commentators worried about a repeat of the Great Depression. But the 1930s have virtually no relevance to our situation – except that some paranoid economists remain obsessed with this period. The only historical period that bears any resemblance to what is happening today is the 1970s.
Then, and now, an oil price shock turned into a rise in the general price level. Both then and today, central banks largely accommodated this price rise, which was a mistake then and is a mistake now.
According to a calculation by Joachim Fels, managing director of Morgan Stanley, the global weighted average inflation rate will be 5.4 per cent this year, while the global money market interest rate is currently only 4.3 per cent. This means that global short-term real interest rates are negative – at a time when inflation is rapidly accelerating. As monetary policy has been excessively accommodating for more than a decade, inflationary pressures have built up in the global economy. This was concealed initially by a series of asset price bubbles. But when too much money finally stopped chasing too many assets, it started chasing too many goods.
As the central banks remain complacent, inflation will continue to go up. In the US, a survey-based measure of inflationary expectations recently showed an increase to more than 5 per cent. I would estimate there are now several hundred basis points of difference between the current Fed funds rate and an interest rate that would be consistent with price stability in the medium term. This is the 1970s Arthur Burns Federal Reserve all over again. The European Central Bank is also off-target, though not quite as badly.
The main difference between the situation in the 1970s and now is today’s absence of wage inflation, which explains why absolute inflation rates are a little more moderate. I guess this is probably because of some combination of deregulated labour markets and globalisation. But the lack of wage-push inflation is not necessarily good news. Falling real wages mean falling disposable income and tighter credit conditions mean less borrowing for consumption. Both factors coincided in Germany in the early part of this decade and I recall well what a depressing period that was. It is now happening elsewhere, and it could be a lot worse, given the precarious state of the global financial system. When purchasing power and credit lines fall, less will be purchased. As private sector consumption is the biggest component of gross domestic product, a long buyers’ strike will be the biggest coolant of world economic growth for several years to come.
In such a situation, we should expect to see more global trade protection and this would further reduce global economic growth. There is no inevitability to this. It is a policy choice. There was never a question that globalisation would produce losers. But the number of losers is getting larger and their ability to form effective political coalitions is improving. I would expect the anti-globalisation crowd to protect their interests eventually. In this respect, our situation could be worse than during the 1970s, a period when global trade was progressively liberalised.
The readjustment of the global economy is occurring under a regime of stagflation and possibly rising protectionism – hardly ideal circumstances. Inflation will also have huge implications for global capital flows. Contrary to what economic theory suggests, current account surplus countries were net exporters of capital during the boom years. But as inflation in the US rises, these countries will find it hard to maintain their currency pegs to the dollar. The end of the system known as Bretton Woods II will eventually lead to a reduction in foreign capital flows into the US and a rise in real US interest rates. As neither the US nor Europe is in a position to play the role of consumer of last resort, the entire scheme ceases to function. The higher the rate of inflation, the harder the adjustment will turn out to be.
Of course, there are still people out there who believe that deflation is a bigger threat than inflation. They say a US recession will automatically take care of the inflation problem. These same commentators predicted that the US economic slowdown would lead to a fall in global demand for oil and other commodities. This is consistent with another view, according to which the financial crisis is an isolated freak event – brought on by bad regulation, for example – and that the best policy response would be to support growth.
I have a very different view of this crisis. I have always believed that the global economic readjustment and the financial crisis are one and the same thing. An extreme degree of monetary expansion for more than a decade fuelled unsustainable consumption in the US, unsustainable rates of investment in emerging economies and a string of asset price bubbles – in property, in credit, in equities and now in commodities. The bursting of these bubbles triggered a financial crisis, to which monetary policy overreacted, thus producing even more inflation, on top of the pressure that was already in the system.
All crises eventually end. But in this one, adjustment will be unnecessarily long and painful. In the end I would expect that our policy response to this crisis will have caused more damage than the crisis itself.
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