TCS Daily


By Christopher Lingle - February 22, 2008 12:00 AM

Bangkok, Thailand

In the wake of a global investment boom driven by cheap credit, a central-bank-induced crisis marks the beginning of the liquidation phase of the current business cycle. Unlike the past two business cycles, the current one involves rising price levels that presage a likely return of "stagflation" or what might be called an inflationary depression.

During the stagflation of the 1970s, high consumer price inflation was observed over 4 recessions in the US: 1970, 1973, 1974-75 and 1979-80. In March 1975, industrial production declined by nearly 13% and the yearly rate of growth of the consumer price index (CPI) rose to about 12%. By December 1979, the yearly rate of growth of industrial production was almost zero while the annual rate of growth of the CPI was over 13%

Up until the Seventies, the simultaneous occurrence of recession and inflation was a phenomenon that mainstream theory suggested was impossible. The conventional notions were that recessions and high unemployment could be ended with price inflation and that price inflation would be ended by recessions.

As such, both could not occur at once. Clearly, mainstream economists were wrong then and most seem now to be sending misguided messages to policymakers.

Then as now, policymakers around the world are trying to force interest rates lower or to use fiscal deficits in vain attempts to stimulate their economies. And so it is that in response to a so-called credit crunch, many central banks lowered their benchmark rates and injected more fiat-currency liquidity into markets. While these actions were widely accepted with relief, it is likely that the end result may be to destabilize the global economy.

What is happening now is reminiscent of the early 1970s when US central bankers engaged in relentless attempts to inflate the money supply to fend off recession led inexorably to stagflation. Lowering rates by pumping fiat-currency liquidity may stop credit from contracting, but it will only delay necessary, inevitable liquidations and cleanup of bad loans.

With many other central banks playing follow-the-leader, the Fed is pumping out cheap money again. As this flows into stocks and other assets, more air will be pumped into asset bubbles that will set conditions for a harder, eventual economic slump. Meanwhile, central bankers at the Fed and elsewhere remain oblivious to the whirlwind of lower purchasing power they have unleashed. This seems improbable since the loss of buying power is one of key arguments against allowing inflation from getting out of hand.

And so while China and India have very high rates of growth of the domestic money supply, their central banks seem unable to detect the strong evidence of price inflation. In the end, central bankers that refuse to use simple logic to understand how monetary policies have destroyed purchasing power will be to blame for an avoidable hard landing.

When the money supply is increased in order to stimulate the economy, it leads to an exchange of nothing (green pieces of paper) for something (real goods or services). Money created out of "thin air" (or is counterfeited) to be used in exchange will undermine the basis of real wealth formation and the process for real economic growth.

As such, expanding credit can only delay the necessary liquidations of poorly-advised investments and the clearing of bad loans associated with the sub-prime debacle. By allowing more credit to support inflows into stocks and other assets to keep air in bubbles, the eventual market "correction" may be longer and deeper than it might otherwise have been.

A recession may be delayed for a few quarters, but it will not disappear and is likely to have the same outcome of stagflation as the policy mistakes of the 1970s. Then, as now, excess money generated through inflationary financing creates an illusion of prosperity that will simply evaporate.

As it is, the choice of central bankers to engage in monetary pumping suggests that they are ignorant of the monetary disasters of the 1970s. Then, what began as mild inflation over the two decades after World War II accelerated into "stagflation" that contradicted existing theory and confused policymakers.

Just how bad is the price rise component of the forthcoming stagflation? Well, consider that the gold price has risen 239% since 2001 while the oil price is up 267% over the same period when both are measured in dollars. Non-US dollar-based economies were only able to duck a portion of this burden as their own currencies appreciated against the dollar.

With the global purchasing power of the dollar down by nearly 7% over 2007, it lost more than 20% of its value against a broad group of currencies since the start of 2002. as the Fed pushes interest rates lower, the value of the US dollar will deteriorate further. This will undermine the purchasing power for all dollar holders in terms of both commodities and consumer goods.

Stagflation during the 1970s arose from the same sort of monetary blunders and fiscal irresponsibility that is being witnessed at present. In the past, developed countries registered double-digit rates of price increases with low rates of economic growth along with historic highs for unemployment rates.

Unfortunately, the asset bubbles in emerging market economies were all sparked by similar bad monetary policies and leaves them exposed to the ravages of stagflation. As mentioned above, China as well as India is especially vulnerable due to extremely high rates of money supply growth in their respective economies.

Stagflation arises from economic theories that induce policymakers to ignore the real (supply) side of the economy and focus on aggregate demand and price levels. As such, the way that loose monetary policy interferes with the coordination of real economic activities was not anticipated by most economists.

Conventional macroeconomic analysis assumes that prices are rigid in both absolute and relative terms so that the effect upon the structure of relative prices is assumed away. As such, changes in the structural composition of production are ignored or deemed unimportant. In turn, unemployment and excess capacity are assumed to appear in a uniform manner throughout the economy as the business cycle enters a trough.

An abiding belief emerges from this analysis that the level of output and employment can be boosted by raising the rate of increase of monetary expenditures. But loose monetary policy causes discoordinations and maladjustments in economic activity that affect the structure of prices and outputs.

In the first instance, imposed increases in the availability of money and credit lead to inequitable transfers of wealth. Those that first receive it will have higher purchasing power than those further down the chain of spending.

Secondly, artificially-cheap credit creates misleading information needed for economic decision making by consumers, entrepreneurs, and resource owners. As such, monetary pumping reduces the stock of potential and realized wealth while weakening currency values on international markets, as seen with the US dollar.

In the end, what initially appears to be prosperity will eventually morph into excess productive capacity before it all disappears in a flurry of bankruptcies and liquidations. Faced with these prospects, politicians tend to "socialize" losses from poor business judgments. These moves contribute to larger public-sector budget deficits as seen in the US in reaction to the subprime issue.

Populist pressures to avoid policies that worsen short-run unemployment and stagnation problems that lead to continued monetary expansion will contribute to inflation. Since inflation-driven prosperity feeds on continued inflation, increases in prices less than expected will have a depressing effect on the economy and will lead to recession.

The primary lesson to be learnt here is that more credit expansion is wrongly being seen as the remedy for the economic ills that were already caused by loose monetary policy. Instead of blaming irresponsible monetary and fiscal policies for creating artificial boom leading to recession, false accusations will be pointed at capitalism and globalization.

Now, the US is in an unenviable position. While America was a net creditor in the Seventies, it is now a debtor, owing vast sums of money to much of the rest of the world. Also, during the 1970s the US had a strong manufacturing base that depended on imports only for raw materials.

Stagflation can be avoided if central banks stop inflating money supplies to allow interest rates move back up towards market-determined levels. This requires tighter money supply growth to dampen expectations of rising prices while living with lower nominal GDP growth rates and restructuring of troubled businesses.

But the prognosis for the future is not very good. It may be politically impossible for the FED to follow a Volcker-style monetary squeeze to stop the monetary expansion. Such a decisive reversal in monetary policy might trigger economic collapse and force much of the financial sector into bankruptcy.

It turns out that monetary expansion and recession are inseparable aspects of business cycles. The halting of the expansion by reversing expansionary monetary policy precipitates the recession that it set into motion.

And so it is that stagflation and the Great Depression should not be seen to be a crisis of capitalism. Instead, disastrously-loose monetary policy during the 1920s set into motion an inevitable recession and the Roaring Twenties collapsed in a paroxysm of economic stagnation. It seems that similar circumstances are in place today to set off another round of stagflation.

This new round of impending stagflation provides a cautionary tale for those that would divine the future stock markets around the world. And it can be summed up in a simple phrase. Stock markets hate nothing more than inflation. As such, it is the moment to remember, caveat emptor.

Christopher LINGLE is Research Scholar at the Centre for Civil Society in New Delhi and Visiting Professor of Economics at Universidad Francisco Marroquin in Guatemala.


TCS Daily Archives