Wednesday 28 July 2010

Stagflation à la 70s redux?

"Bank of England's Mervyn King warns over inflation."

No way? Really...

This is a title from an article published today's in the Telegraph as per below's link.

“There will come a point when we will certainly need to ease off the accelerator and return Bank Rate to more normal levels,” Mr King told MPs today.

Given the very weak saving rate in the UK and the high level of private debt and the still ongoing deleveraging, this would lead to another double dip and additional pressure on housing prices to the downside. Mr King is fully aware of the risk but given his current mandate, at some point he will have no choice but to raise rates. It cannot be avoided.

Back in April an even in March I stated that the only result that would be gained by the use of QE would be inflation down the line.

It was obvious then and more obvious now.

Mr King also added the following in this article:

Mr King also suggested the US has been wrong to prioritise growth over cutting debt levels.

"All countries need to have a credible medium term plan within which they can demonstrate that they will get back to a position in which structural deficits are eliminated and there is a sustainable path for the long-term public finances," he said.

Structural deficits need to be tackled now, not only in the US but in the UK, France, Portugal, and all European countries which have been living beyond their means for too long, relying on cheap credit and the complacency of the markets. Make no mistake, the bond vigilantes are still out there and although some of the problems have been kicked down the road, for Greece for example, the problems are yet to be solved as highlighed by the sour recent discussions between the IMF and Hungary in relation to their proposed austerity measures which are not enough.

As a reminder:

MV=PT as per Irving Fisher's equation. The Bank of England bought 200 Billions worth of long dated Gilts with QE. The BOE by pumping M (M4) is expecting T to rise and it is not really happening...
MV = PT. M is the stock of money in the economy,V is the velocity of circulation or the speed at which money flows around the economy. P is the price level and T the value of transactions, or gross domestic product (GDP). Hence by
increasing ‘M’, QE aims to increase ‘T’.

The main risk of QE was that the money pumped into the system would not result in higher
spending and economic activity
. Banks are currently using all these additional funds to help repair balance sheets. Increased availability of credit is not resulting in more lending. Many companies and individuals do not want to increase borrowing during a period of economic uncertainty and this is the reason why savings are going up and people are trying to repay their debt.

Therefore the initial MV = PT equation means that a rise in ‘M’ leads in reality to a fall in ‘V’ leaving no net benefit.

On the 30th of January I warned about the risk of Stagflation 70s style.

Keynes clearly understood the risk of QE and the effects of debasing your currency.

The temptation of reducing the debt burden by increasing inflation is clearly in the mind of our politicians.

We are still in a deflationary environment.

Deflation then inflation. Low growth and high unemployment whith a rise in inflation will led to stagflation at some point. No doubt about it.

It is not only a UK problem.

As highlighted as well by Ambrose Pritchard-Evans in the Telegraph recently, it is affecting India as well:

India's current inflation stands at 11%.

"Maya Bhandari from Lombard Street Research said New Delhi had been far behind the curve in tackling price pressures. The central and regional budgets are heavily in deficit and this is being "monetised" by central bank policy. The inflation rate for primary articles has reached 16pc. "This is not far from British inflation just before the bitter stagflation years of the later 1970s," she said."

China is also facing similar prospect due to overcapacity and price controls.

Back in January I quoted Keynes in relation to the negative effect price controls can have on triggering inflation:

Price controls discourage production.

"The presumption of a spurious value for the currency, by the force of law expressed in the regulation of prices, contains in itself, however, the seeds of final economic decay, and soon dries up the sources of ultimate supply. If a man is compelled to exchange the fruits of his labors for paper which, as experience soon teaches him, he cannot use to purchase what he requires at a price comparable to that which he has received for his own products, he will keep his produce for himself, dispose of it to his friends and neighbors as a favor, or relax his efforts in producing it. A system of compelling the exchange of commodities at what is not their real relative value not only relaxes production, but leads finally to the waste and inefficiency of barter."

Stagflation can not only happen because of the rise of short supplies of commodities like oil in the 70s, but can be caused by a rise in the money supply, due to QE for example.

To conclude I encourage you to read the latest article published by Doug Noland in Asia Times in Credit Bubble Bulletin:

Enjoy the summer and enjoy the read!

You cannot bring about prosperity by discouraging thrift.
You cannot strengthen the weak by weakening the strong
You cannot help the poor man by destroying the rich.
You cannot further the brotherhood of man by inciting class hatred.
You cannot build character and courage by taking away man's initiative and independence.
You cannot help small men by tearing down big men.
You cannot lift the wage earner by pulling down the wage payer.
You cannot keep out of trouble by spending more than your income.
You cannot establish security on borrowed money.
You cannot help men permanently by doing for them what they will not do for themselves.

written in 1916 by the Rev. William J. H. Boetcker, a Presbyterian clergyman and pamphlet writer

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