By Nicholas Wapshott
Nov 13 There have been some extraordinary
headlines in recent days. Here's the Economist: "The perils of
falling inflation." Here's the Financial Times: "The eurozone
needs to get inflation up again."
For those with memories of hyper-inflation and "stagflation"
in the 1970s, these cogent pleas for higher prices is heresy, an
irresponsible clamor for the return of an ever-changing fiscal
landscape that led to widespread misery and economic turmoil.
A little history. By the mid-1970s the Western world was
engulfed in an inflation typhoon - with prices rising rapidly
and out of control. As companies increased prices to keep up
with the higher costs of basic raw materials - such as oil,
deliberately hiked way beyond the norm by the Organization of
the Petroleum Exporting Countries - trade unions demanded higher
wages to protect their members' standard of living. This led to
higher costs, and higher prices, and so on.
The world became entangled in an apparently unstoppable
upward spiral, like a crazy dog chasing its tail. Governments
were blamed for it and broken by it, and new bold champions
promising to slaughter the inflation dragon were elected in
President Ronald Reagan here and Margaret Thatcher in
Britain largely owed their precipitous rise to voters' weariness
with the curse of inflation. And they both turned to economist
Milton Friedman as a savior.
A perceptive student of economic history, Friedman and Anna
Schwartz concluded that inflation was caused neither by rising
costs nor the push of increased wages, but the amount of money
in the system. As Friedman put it, "inflation is always and
everywhere a monetary phenomenon." Monetarism was born and
Keynesianism was put aside. A new Age of Inflation emerged -
where inflation was the key indicator by which all government
and central bank policies were measured.
It was not so much the Iranian hostage crisis that ditched
President Jimmy Carter, but rather his failure to conquer
inflation. He had appointed Paul A. Volcker, a Democrat, to be
chairman of the Federal Reserve. But Volcker's prescription - to
deliberately trip a recession to reboot the economy, and then
keep a tight control of the money supply - came too late to save
Carter from defeat after a single term.
Reagan's appeal for a return to "sound money" rang true with
voters, and he kept on Volcker to finish the job. The result:
inflation was licked, for a long while.
Fast forward to the fall of 2008, the collapse of the stock
market and the freezing up of the financial system. Ruinous
deflation became a serious risk. The emergency measures taken
around the world, including the near $1 trillion injection of
public money as a stimulus to keep the economy from total
collapse, appeared to fly in the face of Friedman and all his
I say "appeared to" because Friedman is often misunderstood
- not least by those who say they are devoted to him. Friedman
and Schwartz had explored the reasons for the Great Depression
and concluded that rather than the pricking of a stock prices
"bubble," as Friedrich Hayek contended, the slump resulted from
too little money in the system.
Friedman thought President Herbert Hoover should have pumped
vast amounts of cash into the system, through public spending or
what is known today as quantitative easing (QE). Friedman's
embrace of ideas that are an abomination to today's
conservatives explains, in part, why his centenary last year was
barely celebrated: Most conservatives have switched their
allegiance from Friedman to Hayek.
Friedman's main preoccupation was with inflation, but he was
not against rising prices per se. He believed a certain amount
of inflation was good for the economy - as long as it was kept
in check. In practice, average inflation at or around 2 percent
was considered optimum to keep the economy as a whole on track.
Inflation is good for business. It lubricates the wheels of
commerce, allowing businesses to set prices at a level at which
decent profits can be made. It automatically reduces wages over
time, meaning workers have to return to employers each year
simply to keep pace with the dropping value of their incomes.
But there are downsides, too. If inflation is too rapid,
businesses find it hard to plan ahead and err on the side of
higher prices, so as not to get caught out. People on fixed
incomes, particularly those dependent on pensions and annuities,
can slip behind as they watch their hard-earned savings melt
We are stuck now in a period of near stagnation, with growth
ticking up but horribly fragile. Despite the Friedmanite
prescription of QE, generously applied by Federal Reserve
Chairman Ben Bernanke, Friedman's most distinguished disciple,
growth remains elusive. Coming out of a slump as deep and
treacherous as the 2008 Great Recession was always going to be a
slow affair and those who blame it all on the current
administration only betray their ignorance - or cynicism. To
suggest that high growth can be instantly restored by slashing
government spending and paying off the national debt is as
rational as the gobbledygook spouted at the Mad Hatter's tea
party in "Alice in Wonderland."
With the Tea Party rump in the House preventing any fiscal
measures by the administration, and with the European Union
stuck in a deflationary spiral thanks to austerity, there is
growing pressure on both sides of the Atlantic to try to
energize economic activity by provoking inflation. So far, no
one who can make that happen is listening, since they are still
trying to keep the world economy from slipping into ruinous
deflation and another general recession.
The European Central Bank last week reduced interest rates
to a record 0.75 percent. Bernanke, after frightening the
markets by hinting that QE would be "tapered" soon, is keeping
interest rates low and has extended QE to the horizon. The
message from the central banks is clear: if you are thinking of
borrowing to invest and create jobs, be assured, cheap money is
here to stay.
The central bankers are right. This is no time to pretend
that all is well and that a little more inflation is in order.
Inflation will return in its own good time. But right now a hike
in interest rates would deter borrowing, undermine the frail
housing market revival, kick the stock market in the teeth as
investors rush to safer, more predictable savings havens, and
stifle the mewling recovery in its crib.
So, enough with the talk of cranking up prices and interest
rates. The best way to get the world spinning faster is to
increase economic activity - not to slow it.