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Sovereign wealth funds on euromoney.com

Sovereign wealth funds on euromoney.com

The facts and figures revealed by Euromoney are used by many other information providers today.

June 2003

Deflation is the real danger




At its latest committee meeting, the Federal Reserve stressed the perils of deflation. Fed chairman Alan Greenspan made it clear that if there's a whiff of it the Fed will act. In sharp contrast, European Central Bank president Wim Duisenberg slumbers on, occasionally mumbling about the dangers of inflation.

The Fed and everybody else is printing money. The state, too, is spending cash as if it grew on trees, with eurozone governments slipping into massive annual budget deficits and the Bush administration launching huge defence spending programmes and tax cuts.

The Fed has made 11 interest rate cuts since the beginning of 2001. The US federal budget has already swung from a surplus of 2% of GDP to a deficit of 3% and is heading towards 4% to 5%. The dollar has fallen nearly 10% against all other currencies and over 25% against the euro in the past 15 months. And to add a further supposedly inflationary factor, the oil price has doubled in five years.

A suspension of disbelief

Let us suspend disbelief and pretend that Iraq will become a buoyant emerging market as a result of US re-engineering. And suppose that no other war is impending. The question then is: will all this authoritarian largesse not only avoid deflation but instead fuel inflation?

Well, despite all this monetary and fiscal easing and a falling dollar, headline consumer inflation in the US has never exceeded 3%, and core inflation (excluding food and energy) has continued to slow, to reach a 45-year low.

The reason for this is clear. Although oil prices have soared, as have those of industrial raw materials, prices at the factory gate have not moved. As a result, prices in American and European shops for goods are static or falling and price rises for services are slowing.

Why hasn't the great liquidity binge brought back inflation? First, because although inflation is always a monetary phenomenon, printing money does not always fuel inflation. Of course, there must be spare money about to finance price increases. But cash can vanish into a liquidity trap and cause neither ordinary inflation nor asset price bubbles. The same goes for fiscal policy. If people save as much as is added to their spending or tax breaks, nothing happens to real or nominal output.

Second, European and US corporations cannot raise prices because they are facing up to Asia's hyper-competitive production platform (goods in China and services in India). This is adding to global capacity faster than the US is destroying it. And, by expanding the products and services in which Asia competes and sets prices globally, a new deflation will maintain pressure on profit margins, jobs and wages in the rich countries. This mix of growth in global capacity and downward wage pressure on rich countries' employees means that Pricing Power to the People is alive and well and not about to be destroyed by central banks.

Indeed, the only measures of inflation that are accelerating are those that include energy prices. And these act more as a tax on other types of consumer expenditure than as a genesis of inflation itself. This is not the stuff of reflation. Indeed, with oil prices now subsiding, any inflationary effect is dissipating.

Some observers argue that a plummeting dollar will restore corporate pricing power in the US and generate the sort of inflation that will wipe out consumer debt. I'm not convinced that a falling dollar helps US corporations much. China and other hyper-producers will simply match US domestic prices. China can do so for three reasons: the renminbi tracks the dollar; it is a low capital cost economy; and there is no feasible shift in the renminbi exchange rate that would bridge the competitiveness gap.

Despite all this Duisenberg keeps on raising the spectre of inflation in the eurozone. As he does so, the ever strengthening euro and competitive pressures on European exports will combine to puncture Europe's wage bubble.

Suppose I'm wrong and inflation does come back? What would this mean for asset prices? Nothing good - inflation will only help lift profits if output prices rise faster than labour costs. But that means wage earners would get poorer while firms get richer and their products less affordable. Who then will buy the products? This sort of inflation would soon cause demand and profits to collapse.

Also, inflation always reduces productivity growth, so unit labour costs would rise to match any price increases. Inflation does this because it distorts price signals and causes resources to be allocated inefficiently.

We need to banish the notion of mild inflation that is good for equities because it kills the bond markets. Sure, more money might initially be lost in bonds than equities. But the full impact of higher inflation would be almost as bad for equities as bonds.

Fortunately, a return to inflation is not likely. Instead, we are in a grey world where it takes five years to work off the excesses of the last 10. The risk for the world is Greenspan's: deflation, not Duisenberg's: inflation.







I’m learning new tricks at the moment. For example, I have to spend the day with our private bankers in Mayfair, so I have hired a poodle and am practising walking it

One investment bank structurer on his way to explain to the private bank how to market some of their structured products

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