In recent weeks, a debate has played out on the pages of the international financial press, and perhaps more importantly, in the international bond markets, as to whether the policies being pursued by the US and European governments will fuel inflation. The ?inflation school? point to massive budget deficits as a percent of GDP, spiralling debt and the massive explosion of central bank balance sheets as they buy up private securities in order to inject cash into the economy. They argue that ultimately this will be paid off with the inflation tax. When I was running global markets research for an investment bank in the city of London a few years ago, one of my economics staff was an inflation hawk who used to revel in saying that debt is spelled i-n-f-l-a-t-i-o-n.
The ?non-inflation? school, led by New York Times columnist and Nobel laureate, Paul Krugman, argue that inflation is nowhere to be seen today and if anything, deflation beckons. Moreover, if inflation were to arrive, governments would be able to change tack in monetary and fiscal policy. They point out that we have had large debts before, without high inflation.
Life, of course, is not black and white. Both schools are right. Both are also wrong. The stance of monetary and fiscal policy up to today has most likely not been inflationary. Enormous quantities of money and liquidity have been created, but at the same time, assets were being destroyed at an alarming pace. Trillions of dollars of assets have, effectively, disappeared into thin air. Not pumping cash in its place would have led to a severe deflationary force. Indeed, despite priming the pump in a fashion never seen before, industrialised economies still contracted by an annualised 5% in the first quarter of 2009. World trade fell off a cliff in the fourth quarter of last year, collapsing at the fastest pace since Smoot-Hawley tariffs of the 1930s.
The problem is that there are a number of reasons why it will be very hard to turn off the liquidity tap in time when the need comes to do so. The first problem is one of uncertainty. The point at which we will be certain that the economy has turned the corner, where the risk of a return to recession is slight, will be too late. How late will depend on the degree of aversion policy makers will have to the risk that higher interest rate and tax rates will tip the economy back into recession. The experience of Japan in the 1990s, when an attempt to raise the consumption tax did push the economy back into recession and the depth of economic dislocation today suggest this aversion will be deep and policy makers will prove very late. The second problem is politics. The crisis is so difficult to manage that no government will get through it with its reputation intact. Diminished political capital will make it even harder for governments to look homeowners in the eye, and despite seeing them submerged in negative equity, raise interest rates and tax rates. They will find it hard to look businessmen in the eyes, see their businesses pushed to the edge of viability by involuntary increase in debt levels, and raise interest rates and tax rates. They will delay, and in these circumstances, delay is spelled i-n-f-l-a-t-i-o-n.
It is important to remember why we are in this mess in the first place. The simple policy that would have avoided it would have been higher taxes in the United States. Higher taxes would have lowered the fiscal deficit, weakened the dollar, lowered consumption and reduced the current account deficit and the flip side of US deficits?the rest of the world?s supluses. However, despite the economy growing above potential, unemployment stabilising at a historically low level of 4%, the politicians were unable to raise taxes. How do we expect them to do so when unemployment is closer to 10%?
Inflation is not here today. Inflation need not come. However, it is highly unlikely that governments will do the right thing to avoid inflation coming. They will find it harder to do the right thing in countries with high debt and young populations like the US. They may finder it easier in ?old? Europe, China and elsewhere. Consequently, in addition to keeping away from bonds in general?except inflation-linked bonds?you need to keep away from US-dollar-denominated paper. Inflation is bad for currencies as we have argued before. A few columns ago I argued that you should sell the US dollar. I still think so, but the dollar has already fallen far against sterling and the Canadian and Australian dollars and from these levels you need to be more cautious. ?Take profits?.
The author is chairman, Intelligence Capital Ltd; chairman, Warwick Commission; member, UN Commission of Experts and member, Pew Task Force on International Financial Regulation. He is emeritus professor of Gresham College