The chairman of the Federal Reserve, Ben Bernanke, has delivered his semi-annual ?Humphrey-Hawkins? Testimony to the US Congress on monetary policy and the state of the US economy. Despite an economy mired in recession, with unemployment now over 15 million, a number of people have urged the Fed to have a less expansionary monetary policy, or at the very least, map out the conditions for when the emergency measures will be withdrawn. My colleague on the Pew Charity Trust Task Force, Harvard economics professor, Marty Feldstein, argued recently that the combination of huge central government budget deficits, over 10% of GDP (even bigger than India?s) coupled with quantitative easing raised the serious threat of inflation.
Others, like Nobel Laureate Paul Krugman argue that there is no inflation today and the real threat is deflation. Moreover, if inflation was to raise its head, they argue, central banks have the instruments and policy frameworks to respond adequately. There are elements of truth on both sides of this debate. Quantitative easing is pretty close to the monetisation of deficits?printing money?and we know that this can be dangerously inflationary. Equally, there are more signs of deflation today than inflation, the central banks have greater independence and greater clarity around their anti-inflation stances than before and have shown themselves adept at finding extraordinary instruments.
I am not in the ?spend while you can and don?t worry about inflation today? camp for two reasons. First, much of the expenditure is being wasted from an economic point of view. Less than you think is being spent on boosting demand today (tax cuts are being saved); or on supporting the supply side of the economy (on average less than a third of spending is on infrastructure); or supporting the labour market (few dollars are being spent on re-training programmes or extensions to unemployment benefits). Saving Detroit or Wall Street, has benefits?mainly avoiding short-term horror in politically sensitive localities?but there are better ways of dealing with failing firms.
The second reason stems from the profile of interest rates. The general pattern is that interest rates rise slowly into a boom. So slowly that the boom gets out of control and when interest rates finally catch up the resulting crash is great and interest rates are slashed quickly. My point is that there is little symmetry in tightening and easing cycles. Tightening is slow; easing is quick. The lesson of history is not that governments are as quick to respond to inflation as recession.
This reflects uncertainty and politics. Booms progress unevenly. In the early days in the life of a boom, for every sector doing well there is another that appears to be in terminal decline. The political fall out of pushing certain companies and industries off the cliff edge is such that it can only be done when you are absolutely confident that a boom has taken hold, but you can never be confident until it is too late. To cap it all there is the memory of the Japanese mistake of raising consumption taxes too early during the 1990s, killing off a nascent recovery. Western policy makers still believe that they can avoid the Japan scenario?which means that all the bias will be on raising rates too late, rather than too early. Moreover, I would not be so sure that central banks will find it easy to mop up all of the liquidity that has been created. New macro-prudential levers may be fully employed without the certainty of success.
There are a couple other, less direct, reasons to worry about the inflationary consequences of the current policy stance. The name of John Maynard Keynes is frequently used to defend the current stance of policy, but it is important to remember that Keynes was writing in the context of a long period of slump and permanently high unemployment through 1930s Britain. He was not trying to support demand at all costs after a consumption binge. I am less sure than my Keynesian friends that he would have approved of what is being done in his name today.
I started off my life as a bond analyst. In bond analysis you are taught to be instinctively pessimistic and suspicious of governments and, over the long view, this has been the correct bias to hold. Consequently, I find it hard to like either the dollar or sterling. I prefer the monetary rectitude of the European Central Bank and the Bank of Japan and the policy responsibility of Canada and Australia and I like their currencies too. Currencies, remember, are not an equity, they are a bond. Strong currencies in the long run are not those with unbridled equity markets, or proactive governments, but those where underlying inflation is low for long.
The author is chairman, Intelligence Capital, emeritus professor, Gresham College and member, UN Commission of Experts on International Financial Reform