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.