The inflation hawk
19-11-2008 | Other news
Not very long ago inflation was deemed to be one of the greatest threats facing the world economy. Deflation has now, however, assumed the dubious honour of being considered the number one threat.
Confidence in the financial system is currently evaporating and a global recession is looming as a result. And if recession is accompanied by a shortage of credit, it will indeed be impossible to rule out the possibility of a self-reinforcing process of falling prices.
Deflation monster
Deflation is a dangerous and many-headed monster. Like inflation, it leads to an arbitrary redistribution of income and capital. But in contrast to inflation, deflation places people with nominally fixed capital at an advantage rather than at a disadvantage. What’s more, deflation can turn nominal debts into heavy millstones. Because nominal debts such as mortgage loans are generally high nowadays, deflation clearly poses a greater danger than inflation in the short term.
Inflation hawk
However, this does not mean that the danger of inflation has been eliminated. Recently, the Chief Economist of ABN AMRO, justifiably described me as an inflation hawk. I am indeed one of a group of people who continues to be concerned about the threat of inflation. But, this does not mean that I underestimate the danger of deflation in the short term. Even though structural inflationary processes are still at play, they are currently being pushed into the background as a result of current falling demand.
Consequently, monetary policy has been eased considerably worldwide and more interest rate cuts are in the pipeline. This is one of the lessons that has been learned from the Great Depression of the 1930s. It is, however, important to realise that structural inflationary processes remain firmly in place. Simply consider the forecasted shortage of crude oil. And, can all the data pointing to an impending ageing population and labour shortages simply be thrown out the window? I don’t think so.
If one lesson can be drawn from the numerous smaller and larger crises that the global economy has undergone in recent decades, it is that the threat of inflation is consistently underestimated during periods of decline. In virtually all cases, it must be concluded afterwards that the monetary policy was eased excessively in response to a crisis. Hence, while we search for solutions for an existing crisis, the basis for the next crisis have already been laid.
Past bubbles
There are numerous examples. The overly expansive monetary policy of the 1970s and the ensuing high level of inflation led monetary policy to be tightened significantly in the early 1980s. This was, in turn, followed by a global recession. In the wake of the 1987 stock exchange crash, an excessively eased monetary policy laid the groundwork for recession in the early 1990s. The prolonged period of economic depression and years of deflation in the 1990s in Japan can also be traced directly back to the overly expansive policy in the second half of the 1980s.
And let’s not forget about the present crisis. After all, the environment in which the run-up to the subprime crisis was able to take place was largely shaped by overly low interest rates in the United States. The underlying reason for these low rates was, incidentally, an initially highly justified fear of deflation after the internet bubble had burst.
Especially in times of crisis, monetary policy makers have a tremendously difficult tasks to fulfil. On the one hand, the slowdown must not be reinforced by an overly slow pace of monetary expansion. But on the other hand, there is the danger that, in combating the current crisis, the seeds for the next crisis are already being sown. The danger of underestimating the threat of inflation is the greatest if we lose sight of the symptoms. This is why it is good to have inflation hawks around. Even now.
Dr. Wim Boonstra, Chief Economist Rabobank Group
Dr. Boonstra has published numerous articles on banking, financial markets, international economics and business cycles.
