Saturday, June 14, 2008

Back To The 1970s, Or The Early 1920s?

Back To The 1970s, Or The Early 1920s?

By Ambrose Evans-Pritchard, Telegraph.Co.Uk | 27 May 2008

As readers know, we 'Austrians' [monetary theorists] are not yet convinced by claims that inflation is spiralling out of control— though it obviously is in Eastern Europe, the Gulf, and much of emerging Asia. I suspect that headline CPI inflation in North America and Europe will peak soon as the commodity spike short-circuits, and then fall hard as recession/slowdown bites deeper. It may even turn negative late next year if central banks misjudge the "feedback loop" of debt deflation. So let me post the counter-view by Joachim Fels, joint-head of research at Morgan Stanley and one of the best minds in the City. His latest report— "Stagflation, More Than Just A Scare"— hits the nail on the head. He sees "scary parallels with the 1970s".

"What was still a threat six months ago has become reality in the US, and is likely to arrive in Europe soon. The current stagflationary phase will turn out to be longer and more serious than most people believe. Easy money is the culprit. On the surface, the rising demand in emerging market economies such as India and China for energy and higher-protein food is pushing commodity prices and headline inflation higher. But beneath the surface lies a very expansionary monetary policy stance in many of these economies. Weighted global interest rates stand at 4.3 per cent, while global inflation is running above 5 per cent. The real policy rate in the world is negative. On a global scale, central banks are both fuelling and accommodating the rise in food and energy prices."

Among the parallels with the 1970s:

  • Fiscal policy in many countries looks likely to be loosened in order to cushion the economic downturn.

  • US monetary policy is being exported to many countries pegged to a weakening dollar, stoking inflation pressures in these countries.

  • Productivity growth has slowed, meaning a lower speed limit for growth and upward pressure on unit labour costs.

  • The competitive pressure from Japan and Korea in the 1970s gave rise to protectionist pressures in the US and Europe.

  • An anti-capitalist mood in western societies favoured government intervention and regulation. Similar pressures have emerged in response to China. Re-regulation is inherently stagflationary.

"Of course history never repeats, but it rhymes. Sluggish growth is likely to prevent most central banks from
[effectively] fighting inflation. This is bad news for most asset classes. Equities and credit should struggle. Bonds should sell off because inflation is not in the price. Inflation-linked bonds should do relatively well."

To those who think the slowdown will create enough "slack" to contain inflation— as it has in recent episodes— Dr Fels has a warning.

"This time will be different. The Fed policy stance has been less restrictive going into recession, and is now more expansionary than it has been at similar stages of previous recessions. During the past three recessions, the global trend was disinflationary. Now inflation is on a rising trend almost everywhere. Global factors are a more important driver of inflation nowadays. The underlying reason for persistent pressures is a very lax global monetary policy."

My apologies to Dr Fels for a little condensation of his points here and there. He may well be right. He usually is. But, my schema is a little different. We could see a reply of the early 1920s, when the world system split in half as they faced the policy ructions following the 'Great War'.

Germany, France, Belgium, and Poland (I believe, I write from memory) all opted for varieties of hyperinflation, either because it was the lesser of evils or because the political pressures were overwhelming (Germany had little to gain from discipline: the hyperinflation was unanswerable proof that the Versailles reparations were unpayable) [[actually, they were repaid; in worthless Marks: normxxx]].

The US, the British Empire, Italy, and (I think) the Scandies, opted for various levels of deflation linked to pre-war Gold Standard parity. The contrast was extraordinary. Could this divergence occur in a modern global economy with (mostly) floating currencies? The emerging world inflates into the stratosphere; the Atlantic economies and Japan go into a deflationary slide?

I will make tentative bet that this can indeed occur. Tentative, mind you.



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