The material on this site is for financial institutions, professional investors and their professional advisers. It is for information only. Please read our Terms & Conditions, Privacy Policy and Cookies before using this site.

All material subject to strictly enforced copyright laws. © 2020 Euromoney, a part of the Euromoney Institutional Investor PLC.

Inside investment: Greek is better than Japanese

The Federal Reserve is playing mind games by trying to persuade investors that the biggest danger to economic stability is deflation. It is both disingenuous and bad news for the dollar.

Federal Reserve chair Janet Yellen’s speech to the Economic Club of New York in mid-April brought to mind the movie Star Wars. Perhaps it was her Yoda-like demeanour. (One can easily picture her smiling knowingly, telling the Fed board in a raspy, Brooklyn-accented voice: “Set the funds rate we shall.”) 

Or, more likely, her speech recalled the scene in the movie where Obi-Wan, Luke and the ’droids are stopped at a checkpoint by stormtroopers.

Asked to produce their identity papers, Obi-Wan quietly interjects, with a small wave of his hand: “You don’t need to see his identification.” The stormtrooper dutifully parrots: “We don’t need to see his identification.” Later Obi-Wan says that Jedi mind control works only on the weak-willed. 

That made the Economic Club of New York the ideal venue for Yellen to demonstrate her proficiency in a similar ability: ‘Fedi’ mind control, mastery of which is a prerequisite of the chairmanship. Note the following exchange: 

Economic Club of New York: We are worried about easy money and inflation. Yellen: [with a small wave of her hand] No, you don’t need to worry about inflation. ECNY: No, we don’t need to worry about inflation. Yellen: That’s not the problem we should worry about. ECNY: That’s not the problem we should worry about. Yellen: We should worry only about deflation. ECNY: We should worry only about deflation. Yellen: We don’t have any more questions. Thank you. ECNY: We don’t have any more questions. Thank you.

Freed from her mind-bending gaze, it is worth considering if she is right about deflation being the greatest danger. We have been experiencing levels of inflation that would have once been considered too high: for example, in the good old days of 1960, when inflation stood at 1.6%, or 1961 (0.7%), or 1962 (1.3%), 1963 (1.6%), 1964 (1.1%) and 1965 (1.9%). Inflation was less than it has been in the aftermath of the recent financial crisis: 2009 (2.6%), 2010 (1.7%), 2011 (3%), 2012 (1.6%), and 2013 (1.6%).

It is puzzling that today’s higher rates are seen as insufficient and even dangerous when lower rates in the 1960s soon got out of control. The answer to the puzzle is that when the authorities today say “deflation” they are really worrying about “price stability”. Does, then, the Fed know what dangers impend? Apparently not, according a recent study by Neil Fligstein, Jonah Stuart Brundage and Michael Schultz, three professors of sociology at the University of California, Berkeley.

Fed exegesis

They analysed, word for word, Fed meeting transcripts between 2000 and 2007 – about 15,000 pages – and found that the housing bubble and the financial markets received almost no mention in this period, while the Fed focused on what it saw as the single greatest risk: rising inflation.

This was an apt precursor to the first deflationary year (2008 at -0.1%) since 1954 (Nice going, Fed!). The authors prove, convincingly, that the Fed was “clueless” and attribute this nescience to a servile devotion to flawed macroeconomic models. In one way, however, the Fed was predictive: its forecast had a correlation coefficient of minus one.

Highly leveraged societies fear deflation the way elephants fear mice (and elephantine musophobia is apparently real): the mouse cannot damage the elephant, but the elephant’s fear of the mouse can cause it to damage itself. But radical change wrought by deflation can be a good thing. Consider the case of Greece.

Between 2000 and 2008, unit labour costs in Greece rose 17% relative to other industrial countries (in Germany they fell 5%). Greece’s balance of payments deficit increased from €10 billion to €36 billion in 2008. Greece had become a rent-seeking economy: everyone wanted to be on the gravy train. When the cutbacks at the state-owned enterprises led to massive strikes, the joke going around Athens was that it was the first time in years that most of these people had showed up at work.

The negative trends have been reversed by the crisis: in 2013 Greece had a current-account surplus for the first time in recorded history, as a result of increased tourism and declining imports, with negative 1.7% inflation. Government expenditures have dropped from €42 billion in 2008 to €31 billion in 2013, and household consumption has dropped from €166 billion to €129 billion.

Greece is a service-based economy: the health of the external accounts depends on strong tourism and shipping, and keeping domestic spending under control. Deflation has restored a healthy balance.

Most countries have been trying to resuscitate dying social and economic models based on debt-financed consumption growth. The prevailing fear is not the mouse of deflation (a code word for price stability) but the elephant of social change, which might be deferred temporarily by inflation. Rather than continue on this doomed course, we should look to Greece, not Japan, as a guide to future prosperity and stability.

As for the Fed’s balance sheet, Fedi master Yellen should – but won’t – say: “Hmmmm... Shrink we must.” Until this happens, we can expect an inflation-weakened dollar and a deflation-strengthened euro.

We use cookies to provide a personalized site experience.
By continuing to use & browse the site you agree to our Privacy Policy.
I agree