Second part of inflation cover

In: Uncategorized

19 Oct 2011

This is the second part of my Fund Strategy cover story on inflation. It is particularly timely given that Britain’s CPI inflation rate has just hit 5.2%. I will post the final part of the story tomorrow.


It is possible to probe more deeply into the two main fundamental explanations for inflation. The inflation hawks are usually monetarists: this is the school of economics that sees increases in the money supply as the main driver of rising prices. Its main advocates include American economists such as Milton Friedman (1912-2006), Anna Schwartz and Allan Meltzer. It was Friedman who famously said back in 1970 that: “Inflation is always and everywhere a monetary phenomenon.” Although its advocates are typically free marketeers it should be recognised that not all market liberals are monetarists.

The heyday of monetarism was back in the early 1980s. Back then the governments of Margaret Thatcher in Britain and Ronald Reagan in America placed great emphasis on controlling the money supply. Their view was that by curbing the growth of money into the economy they could curb inflationary pressures that were particularly intense at the time. At the time even the mainstream media debated the best measures of money for the government to target.

Monetarism is far less influential today but its advocates are still vocal in the inflation debate. Understanding the monetarist model is also a precondition for grappling with the alternative dovish perspective on inflation.

It is easiest to understand monetarism in relation to a simple economic model. Imagine an economy with an annual output of, say, $1 trillion and perhaps the equivalent of $5 trillion of its own currency in circulation. If the government printed enough cash to double the money supply and dropped the extra notes from helicopters all over the country what would be the effect?

From a monetarist perspective such an operation would, sooner or later, lead to higher inflation. The money supply would have doubled but the productive capacity of the economy would remain the same. As a result the value of each unit of currency is likely to depreciate rapidly.

Perhaps the most infamous real life example is Weimar Germany in the early 1920s. Since Germany was struggling to pay reparations imposed on it after the first world war it simply printed more money. As a result the value of the currency rapidly depreciated until people were literally paying for groceries with wheelbarrows full of cash. The social dislocation this caused helped pave the way for the second world war. Some 90 years later it is still common for German politicians to refer to the Weimar experience as an argument for monetary prudence.

The best known contemporary example of extreme hyperinflation is Zimbabwe. The Zimbabwean currency became almost worthless despite the government issuing notes in huge denominations. In practice, the American dollar has emerged as a parallel currency.

No serious economist is arguing that Weimar or Zimbabwean levels of inflation are imminent in the West. The hawks’ fear is that the massive monetary expansion will sooner or later drive inflation to runaway levels.


It may surprise many, particularly given the ferocity of the disagreements, that there is much agreement between the hawks and the doves. Both agree in principle that excessive monetary expansion should stoke inflationary pressures in the long-term.

The disagreement focuses on the time horizon. As John Maynard Keynes said: “In the long run we are all dead”. Keynesians emphasise that what may be the right course of action in the long term does not necessarily apply for a shorter time horizon.

In relation to inflation, they argue that if an economy is operating significantly below capacity, with unemployment high, a monetary stimulus is likely to be beneficial. It should have the effect of bolstering demand and consequently kick-starting growth. Only when growth becomes sustainable should monetary policy be tightened.

Nowadays this approach is normally understood in relation to the output gap – the difference between potential and actual GDP – an idea first conceived by Arthur Okun (1928-1980) in 1962. The idea is that if the output gap is large, then a monetary stimulus is not likely to be inflationary.

Indeed, some Keynesian economists have gone even further and argued that in some situations higher inflation can be beneficial or even necessary. Paul Krugman, a Nobel prize-winner and New York Times columnist, was putting this argument in relation to Japan as far back as the late 1990s.

For Krugman, a new era of “depression economics” emerged in East Asia whereby Japan was caught in a liquidity trap. In other words future prices were likely to be lower than current prices. For example, a car might cost ¥1m one year and ¥950,000 the next. Under such circumstances consumers have a disincentive to buy a product that is likely to be cheaper in the near future. A resurgence of inflation could therefore encourage them to start spending again.

Although the inflation rate is particularly low in Japan, some prominent economists have called for the encouragement of inflation in the West. As far back as 2008 Kenneth Rogoff, a former chief economist at the IMF, was arguing that western central banks should promote inflation. He recognised that bond holders would suffer as a result, but for him it was a price worth paying to get the world out of recession.

No serious Keynesians are arguing that sustained high inflation would be a welcome development. Their ­contention is that in the context of what could be an imminent depression it is necessary to take desperate measures. If inflation does start to take off it can, in their view, be tackled when the developed economies start to grow again.

However, there also good reasons to call the Keynesian orthodoxy into question. On a conceptual level the idea of an output gap, although it may have common sense appeal, is open to challenge. For example, the idea of measuring potential output – something that by definition is not being realised – is inherently problematic. What meaningful assumptions should be made about the economy’s potential? Even if it does makes sense in theory how can it be measured in practice?

Perhaps even more fundamentally the problem of defining a time horizon could return to haunt Keynesians. Western governments have, in essence, promoted credit expansion to offset economic atrophy from as far back as the 1980s. They have tended to keep interest rates relatively low, public spending relatively high and have encouraged the growth of a large financial sector.

Keynesian stimulus is meant to be a way of kick-starting an economy that is suffering a cyclical downturn, but the West’s economic weaknesses are structural. The calls for monetary stimulus are arguably yet another set of demands in a long line of calls for credit expansion. From this perspective the economy’s weaknesses do not look like failures of confidence or temporary interruptions of demand. Instead they appear to be chronic structural weaknesses that cannot be resolved by further stimulus. Although extending credit can push problems into the future, they only return in a more virulent form.


The shocking truth is that neither the hawks nor the doves have a convincing case in the inflation debate. Despite many years of monetary and fiscal expansion the inflation rate has not surged in line with what monetarists would expect. At the same time the Keynesian assumption that the advanced economies are simply suffering a cyclical downturn looks threadbare.

Neither does either side appear to offer a convincing way out of the world’s economic problems. Extending the stimulus may postpone the resolution of problems but it will not solve them. Tightening the money supply may stem the flow of excess credit but it does not address weaknesses in the real economy either.

If anything, the angry but arid debate about inflation shows the need for rethinking some basic assumptions about economics. Neither of the two main models of economic thinking does a good job of capturing contemporary reality. Yet without a proper understanding of our plight it is not possible to find the best way to resolve some formidable material challenges.