High inflation combined with a sluggish, or stagnant, economy is described as 'stagflation'. The last time the world saw anything like this was in the 1970s.
It is the consequence of pursuing Keynesian economic policy. It should come as no surprise that the return of Keynesianism during and after the Global Financial Crisis could see the return of stagflation.
In 2007 Kevin Rudd argued, 'this reckless spending must stop'. He was quite right then, he would be even more correct today. The Australian economy is in trouble – according to the Australian Bureau of Statistics (ABS), the first quarter of 2011 experienced negative growth. Second quarter figures will be published in early September. This week the ABS reported that inflation is well above the Reserve Bank's two to three per cent inflation target.
Normally an inflation result like that would see an increase in official interest rates. After all the previous inflation figures were also on the high side. But the economy is very sluggish at the moment. A second consecutive quarter of negative growth would mean that the economy is officially in a recession.
Yet many Australians are very likely to be surprised by how poorly the economy is performing. The government has not prepared the population for an economic slowdown. Quite the contrary, the government is pursuing other interests; imposing a carbon tax that will increase the cost of living and, as Treasury admits, slow the economy. All while the ABS tells us that inflation is increasing anyway and the economy at stalling speed already.
Given the logic of Keynesian economics, stagflation can't happen. It is theoretically impossible to have inflation and a stagnant economy at the same time. Yet we all know that the real world can deliver nasty surprises to theoretical modelling.
Dealing with stagflation is quite difficult. It requires tough choices.
A combination of policies must be pursued to get the economy moving.
Monetary policy alone cannot solve the problem. Increasing interest rates to deal with the inflation problem will simply slow the economy even further. Yet inflation cannot be allowed to continue.
Government spending isn't the solution either. In fact it is a huge part of the problem. Most government spending is simply not productive and doesn't add value to the economy. Sure some government spending – the legal system and law and order – is very valuable, but diminishing returns set in very quickly.
Getting the economy moving again means less crowding out and more private sector expansion. Right now productivity is low because the government spends too much, taxes too much and regulates too much.
To his credit Wayne Swan talks a good talk about the importance of moving to a budget surplus. But he hasn't done nearly enough to cut spending.
Or cut taxes. On his watch tax rates for low-income earners will rise – effective marginal tax rates will also increase from next year.
This is precisely the wrong economic policy for an economy facing a stagflation problem. To deal with stagflation the economy must be stimulated through tax cuts and inflation controlled through interest rate rises.
This sort of policy is hard – especially for a government that is unused to making decisive and difficult decisions.
The fact that Swan is carrying on about banana prices indicates no urgency to act on his part. Yet it was Swan who in 2006 invented the phrase 'Treasurer's banana alibi' when Peter Costello used the same argument to justify inflation. At that time, of course, the budget was in surplus and the economy growing. Yet Swan was able to argue,
The problem is the Government has put all its eggs in its commodity basket and mining is very important to the Australian economy and a huge generator of wealth but it has precious little to say about the services sector of the Australian economy and the manufacturing industry.
How is this government any different? The problem with economic policy over the past few years has been the view that commodities will make us rich. Indeed they have. Policy makers have become complacent. The idea that any old policy is a good policy simply because the Chinese will buy our stuff at any price leads to sloppy policy making.
In the past few years government spending has ramped up, taxes have increased, new taxes have been proposed, labour markets massively re-regulated, business red tape increased, and so on.
Small wonder people are getting very nervous about the future and have cut back spending. Once stagflation takes root it is very difficult to combat.
Academics call for RBA to raise inflation target to 4% (as predicted!)
As I predicted, the calls for the RBA to raise its inflation target grow louder in the AFR today:
"All this calls into question the wisdom of the RBA’s target inflation numbers. The 2 to 3 per cent per year target is far too low in the current economic climate, and adhering to it can only exacerbate the developing exchange rate, interest rate and export issues we are now experiencing. Instead, the RBA should raise its inflation target to 4 per cent, a move that would help us avoid some of the economic problems we have seen internationally. Raising the target would certainly take some of the pressure off the RBA to raise interest rates, and it would also take some momentum out of the $A’s strength."
Developed countries are experiencing asset deflation but the opposite is occurring in developing countries. There's a correlation between house prices and ease of credit. If the amount banks are willing to lend falls then asset prices will fall. If I was holding an IP now, I'd cash in and pay down my PPOR debt as fast as possible.
The median expected inflation rate, reported in the Melbourne Institute Survey of Consumer Inflationary Expectations, decreased to 2.7 per cent in August from 3.4 per cent in July.
According to Dr. Michael Chua, a Research Fellow at the Melbourne Institute, “Consumers have lowered their inflationary expectations this month. This may be a reaction to the waves of negative news − there was news about “plummeting” share markets following the United States credit rating downgrade, news about contracting retail sales, and news about the RBA lowering their GDP growth forecast for 2011.”
Fears over the safety and solvency of European government debt and banks are haunting the stock market.
Amidst the financial flight-wave to safety, with stocks plunging, gold soaring, and Treasury bond rates collapsing — and all the European banking fears which go with that — there’s an important sub-theme developing: An almost-forgotten monetary indicator, M2, which is mostly cash, demand-deposit checking accounts, savings deposits, and retail money-market funds, has been soaring.
According to the St. Louis Fed, M2 is up 24.2 percent at an annual rate over the past two months. Almost out of the blue, that comes to a near $500 billion increase. In rough terms, the M2 explosion breaks down to $165 billion in demand deposits and $335 billion in savings deposits.
What’s going on here? There’s a flight to government-guaranteed accounts. Some people believe Europeans are withdrawing from their own banking system and parking their money in the U.S. banking system, guaranteed by Uncle Sam. Kelly Evans reports in her Wall Street Journal column of a $30 billion outflow from equity mutual funds that has probably gone into cash.
This is a very disconcerting development. Normally, big M2 growth would signal a faster economy, and maybe even higher inflation. But as economist Michael Darda points out, the velocity, or turnover, of money seems to be plunging.
“The recent pickup in broad money in the U.S. looks like a dash for risk-free cash assets,” writes Darda. He also notes that widening corporate-credit risk spreads and shrinking government-bond rates signal a recession risk, not a coming boom.
So contrary to monetarist theory, the M2 explosion seems more closely related to a deflation/recession risk. Economist-blogger Scott Grannis writes, “The recent growth of M2 surpasses even the explosive safe-haven demand for money that accompanied 9/11 and the financial crisis of late 2008. Something big is going on, and it can only be the financial panic that is sweeping Europe as money flees a banking system that is loaded to the gills with PIIGS debt.”
Grannis concludes, “In short, it looks like there is a run on the European banks and the U.S. banking system is the safe-haven of choice.”
On the other hand, all may not be lost — at least from the standpoint of the American economy.
Economist Conrad DeQuadros, who acknowledges the precautionary demand for high cash balances in the current financial uncertainty, believes that the economic data do not yet signal recession. DeQuadros points out that jobless claims, hours worked, retail sales, and industrial production are all picking up. He also notes that profits are still rising, even though their growth is slowing. And C&I business loans have grown at an 8 percent annual rate over the past three months.
I would just add to all this: The biggest problem for the plunging stock market is coming out of Europe. Fears over the safety and solvency of European government debt and banks are haunting the stock market. I still don’t believe it’s 2008. But yes, like everyone else, I’m worried.
That said, we are awash with liquidity everywhere. U.S. banks and companies have more cash than they know what to do with. The problem is they are immobilized by fiscal policy run amok. We desperately need a regulatory rollback and flat-tax reform to boost asset prices and to get banks to loan, companies to invest, and America back to work.
As predicted US core inflation (excl. food and energy) surges past 3% over last 3 months
Check out this chart of core monthly CPI in the US. This is bad news for the RBA. The US is running 3% core inflation already with 9.1% unemployment and a commitment to keep interest rates at zero until 2013. This is one of the problems when economists driven by financial markets do not look past their own nose. Year-on-year core CPI in the US is now 1.8%, almost smack on the Fed's maximum comfort rate of 2%. It is not impossible that we will see double-digit inflation in the US at some point.
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