Sonntag, 15. März 2009

Inflation? Deflation?

More and more people seem to think that current monetary policy coupled with ever larger fiscal stimuli is a recipe for runaway inflation (in particular in the US and Britain, but also in the Eurzone).

Is that so?

As usual, the answer is: "It depends".

Typical causes for inflation are:

- Demand exceeds supply. As in: There's so much demand from consumers, firms and the government that supply capacity cannot keep up, and prices rise to balance supply and demand. Not really a major concern right now, but might be an issue once private demand comes back, in case government spending isn't cut back to size.

- Sectoral shifts. As in: There may be excess capacity in some sectors, but demand has shifted to other sectors, were capacity is not sufficient to meet the increased demand. This isn't much of a concern in the US, where demand is down for pretty much everything, but is - for example - a major issue with German infrastructure stimuli, as the German construction industry isn't doing too badly anyway, and doesn't have the excess capacity to deal with all the extra orders coming in due to the stimulus package. Unsurprisingly, significant price increases for various building materials have already been flagged.

- Supply shock. As in: Some things (think: oil, foodstuffs, or any other commodity) are suddenly no longer in sufficient supply. The 2008 oil price explosion is a prime example. Back in the 70s, the sharp hike in oil prices sparked a wage/price-spiral, with unions insisting on pay hikes sufficient to cover rising costs of living. Unfortunately, this was not possible, because higher input costs meant that the overall standard of living had to decrease, so the rising wages caused prices to increase further, and inflation spiralled higher and higher. A supply shock is certainly possible (some - including myself - would say: very likely) once the world economy recovers: High oil prices in mid-2008 were not caused by speculators, they were caused by fundamental factors (a capacity ceiling for oil production). Those fundamental factors remain unchanged - the supply constraints are still there, and are arguably turning worse due to lower investments in additional capacity.

So what can we conclude?

Firstly: It's not true that expansionary monetary policy and large budget deficits "automatically" cause inflation: In the past, bank-bailouts have massively increased government debt in various countries. Inflation didn't generally ensue. And Japan has had interest-rates around zero for decades, together with sky-high budget deficits and total government debt that is twice as high as America's in % of GDP. Still, inflation stayed around or even below zero for the last two decades.

Secondly: Government spending and lose monetary policy can and does turn into a problem when demand starts to exceed supply. If/when that happens, the policy response has to be firm (in other words: they have to know when to stop, and when it's time to shift into reverse). Considering the large budget deficits currently projected for the US, "stopping" might imply quick and massive spending cuts and/or tax hikes. So I suppose there is a risk that American politicians will not be willing to shift into reverse fast enough. But it's not automatic: What the policy response will be when the time comes, is pretty much impossible to predict. (And in any case, this is mostly an American problem. The Eurozone's situation is quite different, and at least for the next few years, Eurozone inflation is unlikely to be caused by excess government spending.)

Thirdly: In my humble opinion, a supply shock is by far the most likely reason why the world will face inflationary pressure if/when the economy recovers.


  1. I would suggest that while the massive destruction of wealth might offset the printing of money, it's the added debt that will kill you. At some point in the future, interest rates will rise again. We're taking out a variable rate line of credit and continually adding to the balance.

    We're living through the consequences of doing that on an individual basis right now.

  2. I would argue that things aren't so clear cut:

    If there is no sustained recovery, then things will play out the Japanese way: Interest-rates stay close to zero, and the government's debt mountain stays easy to service.

    If a recovery does come, there are two scenarios:

    a) The Fed keeps interest-rates too low, and inflation will indeed heat up quickly.

    b) The Fed brings interest-rates up to market-clearing level, which makes servicing the debt mountain rather difficult to do. Politicians then have to rise to the challenge by lowering spending and hiking taxes. If they don't, debt can spiral out of control, and private investment is crowded out.