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Don’t Worry About Rate Rises, Fear Stagflation

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As the summer holidays approach, it seems appropriate to take stock of the extraordinary economic events since last summer and consider what risks they still pose for the year ahead.

Before proceeding, let me issue a health warning. This time last year, I failed to see the global catastrophe about to be triggered by the collapse of Lehman on September 15. This may or may not devalue what I now have to say about the future, especially in comparison with the predictions of many other pundits who apparently foresaw the entire course of this crisis with absolute precision from the start.

Subject to that disclaimer, there seem to be three widely-feared threats to the British and world economies that are not worth worrying about and three others that are definitely ominous.

To start with the good news, what are the three problems not worth worrying about? First, there are widespread fears of a sharp rise in interest rates from their present rock-bottom levels. Second, many pundits have warned that the vast sums of new money being printed, or more precisely created on computer discs, by the Bank of England and the Federal Reserve Board will fuel a big upsurge in inflation. Third, there is a widespread perception that governments, especially in the US and Britain, have borrowed so much that national bankruptcy lies ahead.

These risks are all far-fetched, yet are often presented as indisputable facts. As a consequence many homeowners are trying to protect themselves from rate rises by locking in to long-term mortgages at interest rates of 6 per cent or more. This may seem prudent, but is probably a mistake. While short-term interest rates may not remain near zero for more than another year or so, an increase above 2 per cent is almost inconceivable until well into 2011, and is unlikely so long as unemployment remains high and large amounts of industrial capacity stand idle.

But what about inflation? Even if unemployment keeps prices and wages down in the next year or two, won’t central banks want to pre-empt the inflationary threat they have created by printing extra money? Won’t this mean raising interest rates to normal levels as soon a decent recovery appears?

The answer is no. Central banks have certainly created a lot of money. The so-called monetary base, consisting of cash and the central banks’ electronic deposits, has roughly doubled in the US and Britain since 2007. However, the creation of all this central bank money has been offset by shrinking private bank credit, which accounts for a much larger part of the total money supply. As a result, growth in total money the world over has been very slow, implying that the threat of a purely monetary inflation in the next few years is almost non-existent.

If growth does recover faster than expected, bank lending could revive and deflationary pressures abate. But even if that happens, central banks are unlikely to raise interest rates quickly. Instead, the focus of economic policy will shift to the huge expansion of government deficits during the crisis. A revival in growth will probably be viewed, both by central banks and governments, as a signal for drastic cuts in public spending and tax increases to reduce deficits. If governments do undertake large fiscal retrenchments from 2011 on, the last thing central bankers will want to do is to risk another slump by raising rates significantly.

But what if governments do nothing to reduce their deficits in 2011 and beyond? This brings me to the bad news: the three genuine dangers that lie ahead.

The first is that nothing is done to rein in public borrowing, even after a world recovery. A political consensus seems to be forming in America and Britain for large-scale deficit reduction starting in 2011, but this could be an illusion. If so, trouble would lie ahead in the very long-term future as current levels of government borrowing might become unsustainable by around 2020. But excessive borrowing by profligate governments is only a potential problem for the long-term future, after the world economy has recovered, not an immediate threat.

The second genuine danger is the need for a rebalancing of the world economy between countries with excess consumption — the US, Britain and the periphery of the eurozone — and those with excess savings and production, especially China, Germany and Japan. In the past ten years, China and Japan have powered export growth by selling goods to US consumers, recycling a large part of the earnings back to America by buying dollars from the US Government, which in turn gave the money to American consumers, who spent it on more Asian goods.

A similar circle of manipulation has been spinning in Europe, with Germany recycling the revenues of its export industries to Spain, Italy, Britain, France and the smaller Eastern European and Mediterranean economies. While there were hopes that the financial crisis might force both excess consumers and excess savers to adjust their behaviour, there is not much evidence of this, especially in Germany and China.

As a result, further financial crises may lie ahead. Such a crisis could strike Europe very soon, if the German election in September provokes debate about the enormous monetary transfers Germany is committed to paying to consumers elsewhere in the eurozone under the single currency project. These effective subsidies to Eastern Europe and the Club Med countries are already approaching the cost of German reunification and will eventually dwarf it. If German voters begin to understand this, their reaction could trigger a financial crisis in the eurozone at least comparable to the Lehman shock.

The third reason for genuine worry is the threat of long-term inflation created not by central banks but by adverse structural changes in the world economy. In the 1970s the world learnt that galloping inflation was possible even in conditions of high unemployment, if competition was thwarted by militant unions, expanding public sectors, protectionist governments and energy cartels.

If unions and commodity cartels grow stronger, public spending keeps increasing and trade barriers start to rise, a return to the nightmare of stagflation — the lethal combination of rising prices and stagnant economic activity — will become a genuine threat. The consolation is that such structural changes occur over decades, not years. Stagflation, therefore, is not a monster that will suddenly appear between now and the end of the summer holidays. Until then enjoy a pleasant break.

So Kaletsky is going for stagnation.

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