Friday, 24 April 2009

Inflation in a Toothpaste Tube


24th April 2009

The Malta Independent - Friday Wisdom

Ironing out inflation from the economy is often like pushing on a sealed toothpaste tube.

For all the concern which central banks routinely express in their fight against inflation they know that the economy can only grow stably if there is a small degree of inflation. Given that economy is a very dynamic system, if there is no inflation there grows the risk of falling into a deflation spiral which is much more feared.

Generally an inflation level up to three per cent p.a. is considered ideal. The European Central Bank, known as typically more conservative in the old Bundesbank tradition, has an express inflation target of below but close to two per cent. Inflation at this level is considered necessary to oil economic growth within a context of reasonable price stability. Investment is stimulated as stable macro-economics make visibility of demand more predictable. Investors become more willing to undertake debt to finance investment with the comfort of predictable demand for the goods produced from their investment and with the assistance from inflation in lessening gradually the burden of the debt. Savers on the other hand are not deterred as the erosion from inflation is unobtrusive, while consumers are encouraged to take on personal credit to augment demand beyond what is affordable from normal incomes.

Inflation is of two kinds. The one that is most generally referred to is inflation at the retail price level, meaning inflation of the goods and services bought regularly for consumption purposes. However there is also asset price inflation, meaning inflation in prices of assets that we normally buy for investment purposes, especially real estate and financial investments.

Central banks have so far tended to focus on the former type of inflation i.e. retail price inflation. But if the current financial turmoil is delivering a lesson, it is that the dynamics of the economy are such that going forward central banks will find it inadvisable if not dangerous to ignore asset price inflation in their execution of monetary policy. The economy is a wholesome affair, and ironing out inflation in one place could simply be transferring it to another. Hence the analogy of pushing on a sealed toothpaste tube!

The economic history of the last forty years shows alternating period of general price inflation which when controlled merely shifts to asset price inflation. The massive retail price inflation caused by the oil shocks of the seventies was addressed by tight momentary policy and high real interest rates which threw the economy in a stagflation recession throughout most of the eighties and early nineties.

When retail inflation was brought under control through recession-induced reduction of demand and through increasing supplies resulting from efficiency gains of the evolving IT technology, inflation merely showed up as asset price bubbles in the financial capital markets leading to the technology bubble which burst in 2000 and 2001. When this was overcome through accommodative monetary policy and retail inflation was rendered even milder through the increase in supply as China started being integrated in the global economy after its joining the WTO in 2000, inflation showed up as real estate bubble in the US and other countries like UK, Spain and Ireland.

The real estate bubble burst in 2008. China’s accumulating huge balance of payments surpluses became too weighty in ironing out retail inflation from the sealed toothpaste tube. The pressure building up in the real estate sector blew the tube apart and presently we have toothpaste all over the place.

This is the analogy of the financial turmoil with governments being constrained to perform massive interventions to put the toothpaste back in the repaired tube before the economy gets dragged into a deflationary environment.

Putting toothpaste back in its tube is never easy but there should be little doubt that given the massive size of government interventions the world will succeed in avoiding a depression and will gradually return to a normalised demand and gradually start creating inflation again.

This scenario is very distant from present reality where world trade is collapsing; OECD global output is expected to contract 4.3 per cent during this year, and OECD unemployment is seen rising to 9.9 per cent next year (unemployment being a lagging indicator). The output gap is just too big to start envisaging a quick return to retail inflation and this after a sharp correction in asset prices which has caused unquestionable asset price deflation in real estate and equity and corporate bond markets.

Yet there is no doubt in my mind that if we are to avoid a depression or a prolonged recession, we have to create inflation and this will come quicker than we can presently envisage for two reasons. Firstly there is going to be considerable reduction in supply capacity as corporate restructuring and bankruptcies will wipe away whole swathes of supply capacity. Secondly exporting economies like Germany, Japan and not least China will be forced to reduce their export supply capacity and re-direct it towards their domestic markets.

Asset prices have a long way to go before they start absorbing inflation pressures so inevitably inflation will show up across the board in retail price indices. This will be assisted by major shifts in the exchange values of the major currencies with currencies of deficit countries like the US falling substantially against currencies of surplus countries like Japan, China and to some extent Europe.

The massive size of debts being undertaken by governments needs exchange rate adjustments to ease the burden and to some extent this has already happened in case of Sterling for the UK.

This week I spent a soul inspiring few days at the Salzburg Global Seminar sharing these experiences with renowned central bankers, professors from major universities and economic institutions, representatives of the financial media and many peers from all over the world but with substantial representation from Asia.

Having heard such a wide cross section of views I realise more and more how important it is for central banks and principal world Treasuries to put the toothpaste back into the tube, and to avoid for the future exerting acute pressure on any particular spot in the tube by allowing structural macro-economic imbalances.

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