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Stuart Hill is a
former trader for an Investment Bank
There has been much discussion recently in both the
Financial and Mainstream Media regarding the comparisons between the current
Economic situation and that of the 1970’s. While most commentators agree that
there are some similarities and some important differences, there seems to be
little agreement on how the inflation picture will play out from here.
Many commentators point to the fact that with wages in G7
countries subdued (and likely to remain so due to the dual effect of
Globalisation and weaker Trade Unions) , Inflation will prove much less of a
persistent problem than in the past. Included in this group are many Central
Bankers who argue that the chances of a 1970’s wage-price spiral are remote
enough to justify negative real interest rates despite the elevated current
levels of CPI. They have also made the point that the Oil and Food price rises
will act as a Consumer tax , further reducing Inflationary Pressures in the
medium term.
While there is no doubt that the
US consumer is
being hit hard by this dual effect, I would argue that this mainstream analysis
has key faults in its logic. In particular, while pointing out the one key
advantage that the
US
in particular faces now compared with the 1970’s, it ignores the major
disadvantages between now and then. Firstly, there is the fact that many of the
benefits of Globalisation have been taken upfront, namely lower prices for
manufactured goods and a cap on wage demands by workers due to the overseas
outsourcing threat. Now there are, instead, the downsides of Globalisation,
which are striking both the Corporate and Consumer sector.
This includes the increased competition for Scarce
Resources that Globalisation necessarily entails as Developing Countries become
richer – it was clearly unrealistic to expect that the West could reap only
benefits forevermore from deeper integration with China et al , as the world
Stock Markets seemed to assume until recently. What many analysts appear not to
appreciate though is that this process of competition for resources was
temporarily suspended while Developing Countries chose to accumulate Dollars
(mainly Treasury Bonds) in order to stop their currencies from appreciating.
Now however the game has changed. Not only is China in
particular desperately trying to exchange some of its stock of Dollars for the
Real Resources that it needs to continue its growth , but also Inflation has
become a key issue in Developing countries generally ( not least with rising
food prices leading to rising wage demands there). This brings the added danger
that LDC’s will allow their currencies to appreciate in order to reduce
domestic Inflationary Pressures – this will of course mean that the US loses
the disinflationary effects of Globalisation just at the moment when it needs
them most.
The final key disadvantage that we face compared to the
1970’s is the changed Financial Landscape. We now (as Doug Noland has
eloquently demonstrated) have a Global Monetary System with no anchor or restraint,
where Central Bank Reserves and Credit generally have exploded higher. We also
have a sophisticated array of Financial Products (think ETF’s , Options and
Futures) that allow all (even retail) participants to switch from Financial to
Real Assets at the push of a button.
Given the failure of Paper Assets such as TIP’s to
properly protect Investors from the true ravages of Inflation (due to CPI
under-estimates in the Author’s view), Commodities have recently become the
only viable safe-haven to protect against the risk of ever-higher
Inflation.
So what we have in the Commodities market is relatively
inelastic Supply already straining to satisfy the increased Demand as a result
of
China and
India’s rapid
growth. But alongside this we also have the use of Commodities as the only true
potential hedge for Investors against higher Inflation, meaning a further
increase in Demand. As these trends have continued over the last few years, we
have seen the beginnings of a Commodity price spiral, where higher Commodity
prices (initially caused by China et al’s faster growth) have led to higher
Global Inflation, which in turn has led to increased demand for Commodities as
a hedge against the decreased purchasing power of their savings. This has led
to . guess what ? _ higher global Inflation ......
So a cursory reader might think that the solution lies
with applying a Volker-like dose of Monetary restraint to nip this problem in
the bud. Except, that this is where the world has an even greater disadvantage
than in the late 1970’s/early 1980’s in the form of Financial Fragility. The
world’s Banks have had their Capital base severely damaged by the wildfires
that have beset Credit markets in the past year. Added to that is the
destruction of much of the non-bank Credit markets ( CDO’s. SIV’s etc etc )
which allowed a further explosion of credit from 2003-07, boosting GDP into a
final unsustainable blowoff top.
And so, the policy options of the world’s Central Banks
continue to narrow. Bernanke appeared
caught between the headlights of Inflation and Slowing Economy at yesterday’s
Testimony to Congress, with little to offer apart from telling us how bad
things are. He did however mention that financial stability is a key priority-
a clue perhaps that the need to save the world’s financial system will take
precedence over containment of Inflation. In fact a strong case could be argued
that given the amount of bad debt in the Financial system, the only real
solution is higher inflation! ( so that the debt can be paid back in devalued dollars).
Given the willingness of his Fed to throw money at every
problem so far ( think TAF’s , Bear Stearns and now Fannie and Freddie) , there
is little doubt in the author’s view as to likely future policy – it is, as
Richard Russell has said, very simple – Inflate or Die.
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