The Bogey of Inflation

How real is the danger of inflation for the world economy? Opinion on this matter is divided between conservative economists and official bodies like the IMF and OECD.

The IMF and OECD project very low inflation rates over the next few years. But former US Federal Reserv e Chairman Alan Greenspan warns of inflationary dangers. Some bond markets, too, seem to expect sharply higher inflation.

Which view is right has big implications for policy. If inflation has succeeded recession as today’s main problem, governments should withdraw their stimulus policies (money out of the economy) as soon as possible. If recession remains the problem, the stimulus policies should stay in place, or even be strengthened.

Everyone expects some inflation. During the low-inflation era, which dates from the early 1990’s, developed-country annual inflation rates averaged 2.4%. Central bank inflation targets are now normally set at 2%.

Monetarists hail the low-inflation era as their great achievement. They take pride in the expert “management of expectations” by central banks.

But monetary policy had little to do with it. Low inflation resulted from a combination of cheap supply and low demand. There was huge downward pressure on manufacturing prices from low-wage Asian economies, while unemployment in the developed world averaged 5-6% – about twice as high as in the earlier post-war decades. Inflation was on the rise before the recession of 2008 struck, mainly because of spiking commodity prices.

This is the background against which to judge the reality of today’s inflation threat. The first thing to notice is that, as a result of the slump, capacity utilization is lower than it was 15 months ago: global output has declined by roughly 5% since 2008, and developed-country output by 4.1%.

One would expect inflation to fall with the decline in output, and this is exactly what happened. OECD inflation fell from an annual average of 3.7% in 2008 to around 0.5% in 2009. It has now started to rise again, but from a low level, mainly as a result of a turnabout in commodity prices. Moreover, the IMF and OECD estimate that global inflation will remain below the pre-2008 average for years. In other words, the low-inflation era will become the lower-inflation era.

But what about the vast quantitative easing (printing of money) that has been occurring? Since the start of the crisis, the Bank of England has pumped $325 billion into the British economy, the Fed has expanded the US monetary base by close to $1 trillion, and the People’s Bank of China originated a record amount of $1.4 trillion in loans. These measures alone correspond to 4% of global GDP. Surely that means that inflation is just round the corner unless the money is withdrawn fast, right?

For those who have had a couple of lessons in the Quantity Theory of Money, this seems a plausible conclusion. The quantity theory states that the general price level will rise proportionately to the increase in the money supply. So if the money supply increased by 5% globally in the last year, world prices will rise by 5% after a short lag.

But, as John Maynard Keynes never stopped pointing out, the Quantity Theory of Money is true only at full employment. If there is unused capacity in the economy, part of any increase in the quantity of money will be spent on increasing output rather than just buying existing output.

This is only half the story, however. By “quantity of money,” experts normally mean M3, a broad measure that includes bank deposits. Flooding banks with central-bank money is no guarantee that deposits, which arise from spending or borrowing money, will increase in the same proportion.

In the 1990’s, the Japanese central bank injected huge amounts of money into banks in an attempt to boost the money supply. At one time, central-bank money was up by 35% in one year, yet M3 was rose by only 7%. Data from Europe and the US show that M3 has been falling for most of 2009, despite exceptionally low interest rates and quantitative easing.

What matters is not printing money, but spending it. It is when money is spent that it becomes more than an inert bundle of useless paper. A central bank can print money, but it cannot ensure that the money it prints is spent. It may pile up in bank reserves or savings accounts, or it may produce asset bubbles. But in such cases, little or no increase in the money supply occurs. The new money simply replaces the old money, which has been liquidated by economic collapse.

That is why official data points to extremely low inflation rates over the next few years, despite the monetary and fiscal stimulus. But this should be a warning signal: to say that with unemployment now much higher, inflation is expected to remain low is really to say that there will be little recovery over the next five years. After all, when economies recover from recession, they usually grow above trend. This means that prices will rise above trend. The fact that there is no evidence of higher prices in the pipeline means that there is no real evidence of economic recovery.

Our economies are still on life support. To withdraw the stimulus at this point would kill the patient. To talk about the dangers of inflation is scaremongering. Instead, we should be thinking of ways to restore the patient’s health.

To be sure, different economies are at different phases of convalescence, and faster growth in some regions – for example, China and India – will help feebler ones like Europe and America. But, unless firmer evidence of recovery comes in the next quarter, European and American officials should prepare to accelerate and expand their spending programs. Otherwise, their economies risk remaining stuck in recession.