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Forget the housing collapse, the ‘credit crunch’ and - in isolation - higher oil prices. The real economic menace may be resurgent inflation, which is the broad rise of most prices. To understand why, some history helps.
The United States government’s worst domestic blunder since World WarII was the unleashing of high inflation: In 1960, annual inflation was 1.4per cent; by 1979, it was 13.3per cent. This terrified Americans, who feared falling living standards. It also destabilised the economy, causing harsher recessions that culminated with 10.8per cent unemployment in 1982.

We do not want to go there again, and US Federal Reserve chairman Ben Bernanke has been insisting we will not. In a recent speech, he argued that the economy today is much different from that in the mid-1970s. He is right. In 1974, inflation (as measured by the Consumer Price Index) was 12per cent. Unemployment in the parallel recession peaked at 9per cent in early 1975. We are not close to that havoc.

Unfortunately, Mr Bernanke’s comforting analogy is misleading. The question is not whether it is 1975; it is whether it is 1966.

It was then that the inflationary psychology - which later led to so much grief - took hold. Vietnam War spending and the Fed’s easy money policies created an economic hothouse. Government officials and most academic economists underestimated the danger. Inflation crept from negligible levels to 3.5per cent in 1966 and 6.2per cent in 1969. There are eerie parallels now. From 1997 to 2003, inflation averaged slightly more than 2per cent. Now, it is 4per cent; some economists expect 5per cent soon.

Hmm.

To be sure, differences abound. Then, we had a classic wage-price spiral. Strong consumer demand allowed businesses to raise prices, which spurred demands for higher wages that companies paid because they needed the workers and could recover the costs via higher prices. In 1959, labour costs rose 4per cent; companies could offset most of that through efficiencies (aka ‘productivity’). By 1968, labour costs were up a less forgiving 8per cent.

By contrast, there is not yet a wage-price spiral today. Inflationary pressures seem to originate mostly in rising raw material prices. In 2002, oil was US$25 (S$34) a barrel; now it is US$135. Corn was US$2.30 a bushel; now it exceeds US$7. Copper was 70US cents a pound; now it is US$3.80.

Meanwhile, a powerful anti-inflationary force - cheaper manufactured imports - is waning. The weaker dollar and higher transport costs have raised import prices. In the past year, prices for imported consumer goods (excluding vehicles) are up 3.6per cent.

We seem to be hostage to global forces. Economists Richard Berner and Joachim Fels of Morgan Stanley call this the ‘new inflation’ because it is not squelched easily by domestic policies. Up to a point, that is true.

Although the Fed influences interest rates, it does not own oil rigs or cornfields. Long-term price relief for oil involves switching to more fuel-efficient vehicles and increasing worldwide - including American - oil production. Removing subsidies for corn-based ethanol would reduce food price pressures.

Still, all large inflations involve ‘too much money chasing too few goods’, as economist Milton Friedman often noted, and this episode is no exception. The Fed’s easy money policies have global effects.

Many countries peg their currencies to the dollar - formally or informally - and shadow Fed policies. Meanwhile, oil producers and other commodity exporters have been flooded with dollars; in practice, the extra cash allows them to run easy money policies. The result is that, despite the US slowdown, much of the world is booming.

Developing countries, now about half the global economy, have been growing at about 7per cent since 2002. Higher inflation is a worldwide phenomenon. In China and India, it is about 8per cent. In Russia, it is 15per cent.

One antidote to rising raw material prices is for the Fed to reverse its easy money policies. Combating inflation is rarely popular or easy, as it involves slowing the economy - even inducing a recession - to relieve the pressure on prices and wages. Unemployment rises. There are usually plausible reasons for waiting. Surely there are now.

Housing remains in disarray. More loan defaults could increase bank losses. No matter what the Fed does, there are dangers. Perhaps inflation will spontaneously subside (as some Fed officials hope) because the economy is already weak.

But similar arguments for delay were made in the 1960s with disastrous results. The resulting inflationary psychology made inflation harder to extinguish. The initial unwillingness to take a modest slowdown or recession led to deeper subsequent recessions.

There are now signs that we are at a similar juncture. Surveys show that people’s ‘inflationary expectations’, after years of stability, are rising. The Fed is holding its key interest rate at 2per cent, well below prevailing inflation. In the 1970s, this condition stoked inflation.

An indecisive Fed risks repeating its previous blunder.

WASHINGTON POST
WRITERS GROUP

Source : Straits Times - 25 Jun 2008