As 2011 closes and the possibility of a recession in Europe remains rather too high for comfort, concerns about high inflation have more or less faded out the picture as far as most market commentators are concerned. Recessions are more associated with deflation than inflation, they argue. However, John Cochrane, Professor of Finance at the University of Chicago Booth School of Business, has produced a compelling paper “Inflation and Debt”, arguing that current thinking on inflation dramatically misses the point and understates the dangers.
Both Keynesian and Monetarist economists neglect the fact that severe inflation almost always accompanies fiscal breakdown (ie out of control levels of government debt), he argues. Cochrane points out that a study of major inflationary episodes shows that inflation breaks out regardless of how much slack there is in the economy in terms of unemployment. In his words:
“One serious problem with this view is that the correlation between unemployment (or other measures of economic “slack”) and inflation, is actually very weak.”
If there was a strong correlation, you wouldn’t see high unemployment accompanying high inflation, but you do. This was exactly the state of affairs in the US “stagflation” between 1973 and 1975, when inflation and unemployment both rose dramatically. Three years later, from 1978 to 1982 there was the same combination of high inflation and high unemployment. Similarly, expectations that inflation always accompanies periods of near full employment and boom times were confounded during the period from 1992 to 2001, when inflation and unemployment declined simultaneously, he points out. Not much correlation there.
Where both Keynesian and Monetarist economists go wrong, Cochrane argues, is in their shared confidence that central banks have the tools to keep inflation under control regardless of what governments are doing. Both sets of economists take it as read that the Fed or the ECB or central banks generally can act successfully if they are minded to act, and their worry then is whether central banks will have the intestinal fortitude to intervene decisively enough to crush rising inflation.
Moreover, Cochrane goes on to argue that moving from an argument for a non existent correlation between slack in the economy and deflation, to an even stronger position, where slack is regarded as causing deflation, is even less warranted by the facts:
“In the Fed’s view, slack and tightness cause inflation and deflation. There is even less support for this view than for the idea that slack, or the lack thereof, can reliably forecast inflation."
What causes severe inflation (think Zimbabwe or the Weimar Republic), by and large, is governments getting themselves hugely into debt and seeking to monetise their way out of it through the printing presses. Cochrane argues that there is a risk that the general pubic will see through government policy and will form the view that despite any protestations to the contrary, their government is actually embarked on a campaign to devalue their currency. If you are convinced that your future dollars will buy much less than your present dollars there is no point hanging on to dollars. They will simply turn to ashes in your pocket. So people will, in his words, “try to get rid of dollars today”. When everyone spends simultaneously you get more demand than there are goods available and that drives up the price of goods and, eventually, wages as well. When this happens you are in an inflationary spiral.
“This would amount to a “run” on the dollar. As with a bank run, we would not be able to tell ahead of time when such an event would occur. But our economy will be primed for it as long as our fiscal trajectory is unsustainable.”
What central bankers forget is that serious inflation “often comes when events overwhelm ideas – when factors that economists and policymakers do not understand or have forgotten about, suddenly emerge. That is the risk we face today,” he says. And if it happens, there is not going to be a lot that the Fed or any other central bank can do about it.
What really keeps inflation under control for long periods, Cochrane argues, is not a fantastically skilled balancing act by central banks, but simply the fact that governments run reasonably sound, balanced fiscal policies. “It is hard to think of a fiscally sound country that has ever experienced a major inflation,” he says. The problem, of course, is that right now most advanced markets are anything but fiscally sound. Which means we are all dancing on the brink…
- The Globalization of Inflation, by Diana Choyleva
- Steering Between Deflation and Inflation—A Troubled Road for Developed Economies, by Neil Williams
- Investment Lessons from the Crash, by Jeremy Beckwith
Tags: banking , central banks , ECB , economic slack , European Central Bank , Federal Reserve , inflation , Keynesian , Monetarists , recession