UK Stagflation Raises Questions for US and EU Too

15 July 2010. By David Caploe PhD, Chief Political Economist, EconomyWatch.com

From a global point of view, the current situation seems a little strange:

on the one hand, the so-called advanced industrialized world seems to be stuck in a Japan-like “deflation trap”:

prices keep falling, so people hold back buying in hopes they’ll continue to drop,

which only slows the economy even further, creating the dreaded “depression spiral”;

15 July 2010. By David Caploe PhD, Chief Political Economist, EconomyWatch.com

From a global point of view, the current situation seems a little strange:

on the one hand, the so-called advanced industrialized world seems to be stuck in a Japan-like “deflation trap”:

prices keep falling, so people hold back buying in hopes they’ll continue to drop,

which only slows the economy even further, creating the dreaded “depression spiral”;

on the other, inflation seems to be a real danger in the world’s two fastest growing economies, China and India –

and much of the region in between, including places like Vietnam, Malaysia, Indonesia and Singapore –

all of which are hoping the consciously-induced slowdown by the Chinese leadership in the second quarter

is going to result not in the traumatic bust many have been predicting for years now,

but rather the “soft landing” we and others have been forecasting,

in which growth continues at a relatively rapid – 5+% per year – rate,

and the roar of inflation becomes relatively tame, rather than the dragon-like figure of the first quarter of 2010.

In this context, the consensus view seems to have been that

China and India would become the new “engines” of a new world political economy,

rather than the one in existence since the Marshall Plan and the end of World War II,

in which countries either sold to the US – or sold to countries that sold to the US.

But there have always been two major problems with this scenario.

The first and most important is that China has, until quite recently,

faithfully followed the post-WWII East Asian “export-led growth” strategy,

which means it’s been a fundamentally “sell”, rather than “buy,” economy,

in which case, it’s simply not set up to be an engine of anyone’s growth – except itself and its raw material suppliers.

India, on the other hand, has been perfectly set up from a structural point of view to become a “buy” economy,

since its basic strategy has been to “in-source” relatively high-skill / high-tech jobs out-sourced from the “advanced” world,

and concentrate more on selling to its own huge domestic market,

rather than seeking markets overseas as China / Japan / South Korea / Taiwan et al. did.

The major problems there, however, have been three-fold:

a)    the massive corruption, engendered partly by India’s highly DE-centralized political system,

which not just allows, but almost demands, systematic bribery at nearly every step of the supply chain –

thus not only increasing expenses, but also radically slowing the entire manufacturing / distribution process; 

b)   the extraordinarily high level of debt owed by the Indian government,

albeit to its own people and corporations, rather than foreigners,

which is what has made the Greek situation so difficult, and, finally,

c)   RADICAL income IN-equality,

which has skewed not just the benefits, but also the maco-level economic pull, into a relatively small number of hands,

rather than the literally hundreds of millions of Indians who remain trapped in abject poverty,

while just a short distance away, others live the lives of kings and queens, a la Slumdog Millionaire or, on an esthetically more exalted plane, Lagaan.

Given these structural problems for both China and India,

the idea of either one or both becoming the “engines” of global economic growth isn’t really credible,

despite the enthusiasm – or is it desperation – of people, including economists, looking for ANY way out of the world’s current dilemma.

From an overall perspective, then, it’s not hard for people to envision a situation that simultaneously combines

IN-flation pressures – China / India / SE Asia etc –

AND DE-flationary dynamics as well – Japan / the US / EU etc.

But the situation becomes quite a bit more befuddling –

from both an intellectual AND policy-making point of view –

when those same opposing tendencies show up in the same country, as they have in Britain.

Not surprisingly, standard economic theories – neo-classical, monetarist, and even Keynesian –

have shown themselves unable to explain a situation that persisted for years during the 1970s and now appears to be well advanced in the UK:

stagflation, a dreaded combination of slow / low / no growth AND rising prices –

a situation the universally taught, but totally irrelevant, Phillips curve is SUPPOSED to “prove” is impossible.

And, yet, as the King in Amadeus says, “there it is”.

Or WAS, at least, during the 70s – for reasons most economists have never been able to explain,

and, indeed, have been so afraid of what they fear it MAY mean for their beloved theories

that they almost always avoid it, if they possibly can –

but since it may be now rearing its ugly head in the UK,

a debate has been raging over a) whether it can actually be happening, and b) if so, why.

Indeed, committee members at the Bank of England and most economists

have been puzzled by persistently high inflation in Britain,

causing concern that the country’s recovery might stagnate.

What a surprise 😉 .

Unlike in the United States and in countries that share the euro,

inflation in Britain never came close to zero in 2009.

And while core inflation, which excludes food and energy prices,

has declined in countries like France, Germany, Italy and the United States since the beginning of 2008,

it has risen in Britain, and is now above 3 percent, more than twice the rate in the euro zone.

The reason depends on whom you ask.

Mervyn King, the governor of the Bank of England, Britain’s central bank, has written six letters to the British Treasury since the beginning of 2008

explaining why inflation had risen more than one percentage point above the bank’s 2 percent annual inflation target.

The letters — until recently a rare reminder of the working arrangements between the government and the Bank of England —

became so frequent that many economists joked that Mr. King was happy to have found a new pen pal

in George Osborne, the chancellor of the Exchequer.

In each letter, Mr. King named a different set of one-off events,

including a drop in the pound and higher commodity prices,

as the reason for inflation and predicted that the effects of a weak economy would push inflation lower.

Don’t you just love economists ???

So certain of themselves and their explanations –

but so unable to deal adequately in any way with a real world situation.

After two years, however, some of them are questioning whether there is not more to the persistence of the inflation rate,

which was at 3.4 percent in May.

“It’s noticeable that the U.K. is growing in the opposite direction of the U.S. and the euro zone,”

said Danny Gabay, a director at Fathom Financial Consulting in London

and a former author of the Bank of England’s inflation report.

Very observant, Danny-boy, whose pipes, whose pipes must be calling him.

“Economic growth surprised on the downside and inflation on the upside. That’s a very uncomfortable position to be in.”

Indeed.

Britain’s economy grew 0.3 percent in the first quarter, helped by growth in manufacturing.

Persistently higher inflation rates could limit the Bank of England’s ability to keep interest rates low

to allow for a more stable recovery, some economists said.

Don’t you love the “some economists,” a phrase we’ve already edited out several times, lest you think we’re making this up.

The bank, which has a mandate to keep inflation low, is expected to keep interest rates unchanged at 0.5 percent on Thursday.

The bank previously said that it was “very concerned about what’s been happening to inflation” and “how resilient inflation has been,”

especially against the background of a recession.

Yeah, you can just see them tearing out their hair because their precious theories are unable to explain it.

It named three main factors as causing the higher rate:

·        Oil prices were on average nearly 80 percent higher than at the beginning of 2009;

·        the government restored a 17.5 percent sales tax in January after cutting it to help consumers;

·        and a 26 percent drop in the pound against the dollar in 2008 drove prices higher.

Some economists pointed out the problems with attributing inflation to each of these factors, however.

Higher commodity prices were not unique to Britain,

and the euro also slumped against major currencies, albeit recently.

Economists – who ARE these “people” anyway ??? – also pointed out that price increases were especially strong in the service sector,

pushing up the cost of items like insurance, which are not directly related to currency exchange rates.

“The inflation issue recently has been higher levels of service sector inflation,”

Stuart Green, chief British economist at HSBC in London, said.

“That’s very unique to the U.K.”

The inflation rate also generated a debate within the Bank of England.

Charles Bean, the deputy governor, said

a lack of lending by banks might have made companies more concerned about cash flow

and less willing to cut prices than in previous economic downturns.

Although, according to conventional economic theory of any persuasion,

if their products / services aren’t selling at a certain price level,

then sellers have no choice but to cut them –

so either they are selling, which seems weird given the recession,

or they’re refusing to cut their prices despite the fact they’re NOT selling.

Either way, no conventional theory – neo-classical / monetarist / or Keynsian – can explain how this can be happening.

Another member of the monetary policy committee, Adam Posen, in a speech last month

blamed expectations of inflation for rising consumer prices, according to this article in the New York Times.

This pains me, because usually Adam Posen is a pretty smart fellow –

but you wouldn’t know it from reading this little bit.

Mr. Posen argued that the Bank of England’s previous decisions to keep interest rates at a record low,

even as inflation crept up, led consumers to expect that inflation would remain high for a while.

No matter how many times I can’t read it, it still makes no sense that consumers would act this way –

or that a member of the monetary policy committee

could seriously advance “expectations of high inflation” as an explanation FOR inflation.

Expectations of higher inflation usually prompt companies to increase prices and workers to push for higher wages.

“The most logical and empirically reasonable explanation for inflation creep

is some unanchoring of inflation expectations, caused by a series of above-target outcomes for U.K. inflation in recent years,” Mr. Posen said.

To put it simply, well, we’ve had inflation, so people think there’s going to be more inflation –

even as the economy is cratering through the floor,

a fact of which they are apparently not aware,

and / or to which they’re not paying attention if they are aware.

But Hetal Mehta, an economist at the Ernst & Young ITEM Club economic forecasting group,

said that while there was evidence that some companies had increased prices or kept them steady,

there was little indication that workers were asking for higher pay.

Since 610,000 public-sector jobs are to be cut by 2016 under the government’s austerity program, that is not likely to change.

Still, concern among some economists – again, we edited several of these mysterious phrases out already – is mounting that

Bank of England policy makers might feel pressed to raise interest rates because of inflation, even if the economy has not recovered fully.

Those economists fear that increasing rates too soon could push the economy back into a recession.

Andrew Sentance on June 10 became the first committee member to vote for a rate increase in almost two years.

Do you see the transition ???

First, they’re talking about “economists” who fear increasing rates will throw the economy “back” into recession, as if it ever left.

But then they follow it up by talking about some moron policymaker who’s doing just what they fear might be bad –

but we still don’t have any sense of how THEIR concerns relate to HIS action.

Whatever.

Dr. Sentance later told Reuters that he was concerned about inflation expectations – there it is again –

and said he would prefer “gradual” interest rate increases.

Mr. Sentance also raised doubts about the strength of existing deflationary pressures,

hinting that prices might continue to rise – because more companies than initially thought went bankrupt – and the supply of products suffered.

Got that ???

Things are so bad more companies went under than first thought.

That means there’s less available supply, without a decrease in demand –

a somewhat bizarre assumption, given that a recession means precisely people don’t HAVE jobs,

and hence don’t have money to spend.

So as a result, the prices of what supply DOES still exist is going up,

either because people think it MIGHT go up – expectations again –

or there’s not enough for the existing level of demand,

which, due to the recession, has dropped visibly – but that doesn’t seem to matter here.

Make sense ???

Despite disagreements about the roots of higher consumer prices,

many economists – ahem – expect the Bank of England to keep interest rates unchanged until at least next year.

The government’s austerity program, which includes a sales tax increase to 20 percent next January, means inflation could remain volatile.

So, by cutting back and throwing people out of work, the general level of demand is going to rise, hence pushing up prices.

Totally, dudes.

“They should sound worried about inflation but also be mindful that there is a bigger danger,

and that’s to increase rates when the economy is still low,” Mr. Gabay said.

“If both consumers and the government save, things can turn ugly very quickly.”

Indeed.

Ugly.

And that’s why both the EU – which seems hell-bent on “austerity”, whose miserable effects for the last two years in Ireland we just examined –

and the US, which has a half-ass “stimulus” that is basically a present to already well-off power centers, like TBTF banks,

so they can make more money with interest-rate manipulation,

but not actually lend any out to people who might do something with it.

It’s not just the Brits who don’t know what’s going on –

it seems like the Europeans and the Americans don’t either.

All of which leads us to support the Chinese and Indians in continuing to ignore the West,

and do what they’ve been doing, on their own, pretty successfully, so far.

How, indeed, the mighty have fallen – and look like they have a long way to go.

 

David Caploe PhD

Editor-in-Chief

EconomyWatch.com

President / acalaha.com