Great debate over inflation goes global

WORLD VIEW:'IF CENTRAL banks cannot mop up the huge liquidity when economic recovery comes through, asset bubbles and inflation may once again be triggered. Furthermore, inflation has become a global phenomenon in recent years, and a policy mistake at one major central bank could create inflation risks for the whole world."

And this: "Central banks are punishing savers to redeem the sins of debtors and speculators."

It may sound irrational to be worrying about inflation in the middle of a deflation crisis. These two curmudgeonly quotations come from China, signalling that solutions deemed obvious in one part of the world may look quite different from another with conflicting interests.

The first, from the People's Bank of China this week, is a clear warning that savers there could become the victims of a western economic recovery tempted to inflate off the debts incurred in the current recession, including by currency devaluations. The second, from an article in the Financial Times by Andy Xie, a Shanghai-based economist, warns that US policy is pushing China towards developing an alternative financial system to protect itself from such an outcome.

Because of its reserve currency status the US can print money, in the spirit of its former treasury secretary John Connolly, who told his European counterparts in 1971 that "the dollar is our currency but your problem". Ireland is currently suffering from a similar British attitude. Xei says Obama's decision to redeem mainly those who caused the recession rather than its ordinary US household victims will reinforce the pressure for competitive devaluations. This makes a 1970s-style global stagflation the likely outcome. In that case China would be forced to float its currency and create a single, independent and market-based financial system. The dollar would then collapse.

The Chinese are not the only ones concerned about inflation. Combating it is the main mandate of the European Central Bank, inspired especially by German recollections of hyper-inflation in the 1920s. The European Central Bank's decision on Thursday to issue €60 billion covered bank bonds designed to stimulate credit markets is a belated recognition that deflation demands a different approach. This represents 0.5 per cent of euro zone GDP, compared to the equivalent 2 per cent in the US - and a huge 8 per cent in the UK, which issued another £50 billion that day.

This deep recession shows how closely coupled the US and euro zone economies are, and also how bound up the financial sector is with the real economy in both regions. German banks are exposed to a surprisingly huge €816 billion toxicity, for example. And Irish mortgage holders were relieved by the ECB's interest rate reduction to 1 per cent not least because an estimated 340,000 (one in five) Irish homes are worth less now than when they were bought and that the wider household indebtedness taken on in the boom is obscured by such low rates. None of this is yet factored into the cost of bank rescues here, should there be widespread defaults.

Increasingly there is a common debate on the danger that inflation could accompany and subvert economic recovery in the US and Europe. It has been sharpest in the US, largely because the Obama administration's actions have been so radical and rapid.

During the 1990s the 1970s became known among economists as a period of great inflation and output stagnation summarised as "stagflation". In contrast the phrase "great moderation" was coined to describe the subsequent two decades of relative stability, during which policymakers came to believe they had found the means to control inflation by judicious targeting of its causes and had flattened out the business cycle previously so integral to the history of capitalism.

Monetarists convinced that the quantity and velocity of money in circulation determines inflation influenced policymaking, while neoliberals drove home their view that self-regulating, efficient markets optimise socially beneficial outcomes. Economic theorists built mathematical models predicated on these narrow and questionable foundations which then profoundly influenced risk management policies over the last decade.

This recession has exploded these assumptions and exposed their ideological bases (for an accessible self-criticism by leading US economist Barry Eichengreen see http://www.nationalinterest.org/Article.aspx?id=21274). It has revived Keynesian macroeconomics, largely discredited in the 1970s and then disregarded in subsequent decades. It is more geared to tackle such large systemic questions in which there is a great overlap between economics, politics, history and society.

Both of these traditions are involved in the argument about inflation. The Keynesians see governments resorting massively - even if inadequately or insufficiently - to deficits, state indebtedness and stimulus programmes to arrest economic slump, rescue financial systems and revive activity. They approve of this, saying it is essential in the short term to tackle deflation and that the theory and policy to control inflation with higher interest rates and other measures during a recovery are adequately known and understood.

Monetarists disagree, worrying that the immense quantities of money printed and released by governments since September last will inevitably result in a higher inflation that could smother any recovery. To some extent this is a left-right issue, pitching social democrats against conservatives. From the German or Chinese points of view - different interests crosscut these ideological cleavages.