Fear of inflation is not grounded in facts
A high rate may be a risk in the very long run – but right now the risk is that it may be too low
Milton Friedman, recipient of the 1976 Nobel Prize for economic science.
Almost three years ago, at the World Economic Forum’s “Summer Davos”, in Tianjin, I heard a Republican politician say that the US would be in hyperinflation within two years. I was stunned. Yet a large number of people believe that hyperinflation is coming. If the US is in trouble, so, surely, is the UK. Is there anything in such predictions? The answer is: possibly, in the very long run. At present, however, the risk is that inflation may be too low, not too high. Paradoxically, that increases inflation risk in the long run.
What drives an inflationary process? The late Milton Friedman gave the classic answer: “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
But this does not explain why the quantity of money should grow more rapidly than output. The answer of those now terrified of inflation is twofold. First, central banks are “printing money” through “quantitative easing”, which will ultimately produce an explosive rise in broad money. Second, prospective levels of public debt will ultimately encourage governments to default, via inflation.
Let us look at this big issue for the UK, which has rising public debt and relatively high recent inflation.
Whatever the longer-term dangers, the picture for the next two years or so is quite the opposite. Both core and headline inflation rates are reasonably low. Wage inflation is close to zero and, despite falling productivity, unit labour costs are rising at below 2 per cent a year. The exchange rate has stabilised, as have commodity prices. The International Monetary Fund forecasts that they are likely to fall in the next few years. On balance, then, short-term inflationary pressures are very weak. What is true for the UK is even truer of the US and the euro zone.
Now turn to the next five years. Over that period, demand and capacity utilisation will become important. Alas, UK gross domestic product is 16 per cent below its pre-crisis trend.
Official estimates also indicate much excess capacity: the IMF estimates the “output gap” – the difference between actual and potential output – at 4 per cent of the latter this year. Though not as high as one might expect, unemployment is at about 8 per cent.
Furthermore, the expansion of the central bank’s own balance sheet has not offset the declining willingness of the banks to lend. As a consequence, the amount of credit and so-called “broad money” in circulation is shrinking. Finally, fiscal policy is highly contractionary.
Even over the medium term, then, it is hard to believe inflation is more than a will-o’-the-wisp. So what about the longer term? Could the 2020s see an inflationary upsurge? Many believe so because there is a direct link – the so-called “money multiplier” – between the reserves of commercial banks held at the central bank and the lending by commercial banks to the public.
They assume banks will lend more against these reserves, meaning that the current high level of reserves at the central bank is an indicator of future monetary expansion.
But a solvent bank can obtain the reserves it needs from the central bank. Moreover, the central bank will make sure that such a bank never falls short of reserves, since the alternative could well be a breakdown of the payment system.
So what limits banks’ lending? The answer is: its own solvency and that of its customers.
So the equity capital of the bank is, accordingly, a far more important determinant of its ability to create money than its reserves. Moreover, should the central bank wish to lower excess bank reserves, it can either sell government debt to the public or raise their reserve requirements. Thus, the idea that a high level of reserves guarantees a future surge in broad money is false.
A more cogent argument for the likelihood of high inflation is not that it is a necessary consequence of today’s policies, but rather that it is the simplest way for policymakers to deal with the overhang of public (or private) debt. In this view, distributional conflicts – between creditors and debtors or perhaps between young and old – are resolved by inflationary default on liabilities.
It is easy to think of precedents for such an inflationary redistribution of wealth. What, after all, are the alternatives?
Broadly speaking, they are: austerity; growth; and financial repression (reductions in interest rates, probably combined with exchange controls and other restrictions on investors). Inflation can fit quite comfortably with these alternative elements.
In fact, the UK has an interesting recent history of managing high public debt. After the second World War, net debt was more than 200 per cent of gross domestic product. By the early 1970s, that was down to 50 per cent.
How did this remarkable change happen? The answer is that nominal debt outstanding rose by just 29 per cent between 1948-1949 and 1970-1971, while nominal GDP rose by 336 per cent. Both real GDP (up 91 per cent) and the price level (up 128 per cent) contributed to this happy outcome: the compound rate of growth of nominal GDP was 6.9 per cent, of the real economy 3 per cent and of the price level 3.8 per cent.
Unless the UK turns out to be just like Japan over the past two decades, the level of public debt relative to GDP should, on most forecasts, end up, in the 2020s, at less than half of what it was in 1948. Given that, even growth of nominal GDP at 4 per cent a year should do the job.
This assumes that it will be possible to put the primary fiscal deficit (before interest payments) into a surplus of, say, 2 per cent of GDP by the early 2020s and that long-term real interest rates will also be no higher than 2 per cent. Under these assumptions, the strategy of growing out of the debt becomes perfectly plausible.
What is the greatest threat? The answer has to be: a sharp fall in real GDP that would crush house prices, raise unemployment, push the economy into deflation and, quite possibly, even generate a further financial shock.
This would make the numerator (public debt) even bigger and the denominator (nominal GDP) still smaller. The only offset could be lower interest rates. But, as Japan’s experience shows, even ultra-low interest rates do not protect an economy against the adverse impact of very prolonged fiscal deficits and deflation.
Strong and sustainable growth is the solution. That can turn the inflation threat into a paper tiger. – (Copyright The Financial Times Limited 2013)