Sunday, May 21, 2006
Ghosts of past inflation come back to haunt us
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

When markets panic, as they did last week, two things are guaranteed. The first is that they over-react, as on Wednesday, when the FTSE 100 recorded its biggest points fall (171) for nearly four years. The second is that the chorus of bears saying “I told you so” becomes cacophonous.

That it was an over-reaction was plain. The immediate cause of the panic, American inflation, was at worst mildly troubling, at best gave no cause for concern. It may be the markets are worried about the loss of their sagacious comfort blanket, Alan Greenspan, and can’t yet work out his replacement, Ben Bernanke. But that, too, offered a limited excuse for selling fever.

What of the wider bearish argument, that the stresses and strains in the world economy have got to give, possibly soon, and investors have been living in a fool’s paradise? A month ago the International Monetary Fund told us the world economy was going through an “extraordinary purple patch”, with even the poor economies of Africa enjoying their best performance for 30 years. Since then, something has been nagging at me.

The last time we had a sustained global expansion as powerful as this one was in the early 1970s. Then, as now, commodities — and eventually oil — soared in price. But it ended in tears, a stagflationary mess of simultaneously rising inflation and unemployment from which it took many years to recover. Are the strains in the world economy bad enough to mean history could repeat itself?

Back then much of the trouble began with the dollar. Richard Nixon’s decision to suspend its convertibility into gold precipitated the collapse of the Bretton Woods system of fixed-but-adjustable exchange rates. The dollar is again in the spotlight now, the key question being how far and how fast it will fall in reponse to a current-account deficit that is approaching 7% of gross domestic product.

But there are other worries, including the debt build-up by households in Anglo-Saxon countries and governments throughout the advanced world; the oil-price rise, notwithstanding its muted impact so far; those inflation stirrings; and rising long-term interest rates.

As it happens, figures last week showed Britain is experiencing simultaneously rising inflation and unemployment. Consumer-price inflation was up from 1.8% to 2% and unemployment by 44,000 in the first three months of the year to 1.59m. The claimant count also rose, up more than 100,000 in the past year.

Those figures, while unwelcome, also underline why things are very different this time. In the 1970s the world had fairly high inflation — more than 5% a year for three years, even before the 1973-74 oil-price shock pushed inflation much higher (in Britain’s case to more than 27%). This time, despite high oil prices, inflation is low and stable.

The unemployment figures also continued the recent unusual pattern of simultanously rising employment and unemployment. Redundancies are happening all the time, Vauxhall workers in Cheshire being the latest victims. But employment rose 127,000 in the first quarter. The labour force is growing, partly as a result of migration.

The Bank of England’s monetary policy committee (MPC) tackled these issues in its meeting this month, the minutes of which were released last week.

The MPC noted the risk of a big dollar adjustment, booming commodity prices and higher export-price inflation in Britain’s trading partners.

The last of these could be important. Falling import prices, notably of goods from China, have been a vital element in keeping inflation low in Britain. If that begins to change, the impact on inflation and interest rates could be serious.

As if to underline the uncertainty, the MPC split three ways, the outgoing member Steve Nickell voting for a cut, David Walton voting for a hike and the other six (the committee is one member short) opting to hold. With Nickell leaving, the committee is shifting towards a “tightening” bias. If the data continue strongly, rates could rise, possibly as soon as August. That, in my view, would be a mistake. The case for rate cuts has gone but it is much too soon to be talking of hikes.

The markets, like the MPC, are being pulled both ways. One worry is that the forces building up in the global economy will lead to much higher inflation, the other is that it will derail growth. Or, of course, both could happen together.

Or not. A paper by Peter Oppenheimer, strategist at Goldman Sachs, is determinedly optimistic. The Globology Revolution (forgive the title) argues that the trends that have given us growth without inflation for the past decade have further to run.

Those trends include “technological deflation” — new technology always leads to lower prices but the effect in recent years has been more powerful than ever. It includes the downward impact of China, India and other emerging economies on the global price of goods (and increasingly services), which has a long way still to go. And it includes the huge expansion of the global labour force, again largely the China and India effect. Put together, the effect is akin to a new industrial revolution, Oppenheimer argues.

To be really worried about the world economy and stock markets, you would have to ignore other positive signs. If we go back to the early 1970s, remember that corporate earnings were in the doldrums. Not only were commodity producers exerting themselves but so was labour. The share of gross domestic product claimed by profits was squeezed. In America it came down from 8% in the mid-1960s to 5% in the early 1970s. There was little basis, in what was happening to profits, for a stock-market boom.

This time, in that respect, it really is different. Ian Morris, an American-based economist with HSBC, points out that America’s after-tax profit share, at nearly 9% of GDP, is at an all-time high, and has been on an “amazing run”, climbing from 5% in the space of three to four years.

That could partly reverse itself next year but, on equally plausible assumptions, could rise further. Those who think the global recovery and the rise in world stock markets has been built on sand should look at profits. Companies are awash with money. And until that changes, nothing really bad is likely to happen.

PS: Britain’s exporters are enjoying their greatest success for years — on the face of it. Official figures show export volumes in the first quarter up more than 17% on 2005 after years of underperformance.

Unfortunately, the figures are distorted by a huge Vat scam, so-called missing trader intra-community (MTIC) fraud. Exclude it, and growth comes down to 7.7%, which, as David Owen of Dresdner Kleinwort Wasserstein points out, is in line with world trade growth.

What are the fraudsters up to? MTIC fraud initially involved trade within the EU in portable products such as mobile phones and computer parts. Traders bought goods Vat-free in one EU country and sold them with Vat added in another, disappearing without paying the tax to the authorities.

Since then, sophisticated “carousel” frauds, involving Dubai and Switzerland, have developed. Sometimes goods are not physically moved between countries — a mouse-click is sufficient. The numbers, roughly 10% of Britain’s monthly exports of £20 billion, are enormous.

Does this mean that Britain’s trade figures are hugely distorted? The Office for National Statistics, quick to recognise and respond to the problem, thinks imports are as much affected as exports so the size of the trade deficit in goods, £66 billion last year, is untouched. A pity. We could have done with something to improve it.

From The Sunday Times, May 21 2006


Hello Dave, I fear you have been consistently underestimating inflation and oil prices over the last two years.

If our markets are doing well on a $70 dollar oil barrel then surely higher prices could be tolerated. The US hurricane season is just around the corner, not to mention the other geopolitical concerns.

As for inflation, it's far from over just yet. A large deflationary pressure is exerted via chinese imports. The chinese renminbi is effectively pegged to the US dollar. We just need the dollar to power up and chinese goods will inflate in price with corresponding higher UK inflation. Also, I wouldn't be suprised if the chinese announced further suprise renminbi adjustements.

The CPI conveniently misses out house prices, amongst other things. Houses largely comprise the greatest burden we bear in regards to out monthly outgoings. The montetarists among us have no doubt noticed the 3.5 trillion pound housing market which has tripled in the last 10 years. A 2 trillion pound increase in the green stuff and not even a mention in the CPI basket? NB. UK net worth is around 6 trillion.

You've mentioned previously that 'if you had a pound for every time that inflation was going to take off'. If this is the case, then I suggest you have not been an economist long enough.

Posted by: Werewolves at May 21, 2006 02:20 PM

I'm not aware of anybody who accurately predicted two years ago what would happen to oil prices, though there are plenty who jumped onto the bandwagon once they had risen.

I'd take issue with you on inflation, which has not been significantly higher than I was expecting. I'm basing this, incidentally, on the retail prices index, which does include house prices (in the depreciation component) and yet has been generally well behaved. As for the China question - one day it will happen that its exports are no longer exerting a downward influence on inflation. But not, as I say in the piece, for a while yet.

The past 13 years of low inflation have given me plenty of opportunities to win bets on it, though I was around during the high-inflation era. However you measure it - RPI, GDP deflator, private consumption deflator or CPI - inflation has been low.

Posted by: David Smith at May 21, 2006 05:13 PM

Werewolves, how could you? David's picture isn't that flattering is it? The grey hairs must be well hidden.

Of all the "-flations" there are David you're the first I've heard talking of stagflation! Ian Macleod invented stagflation (in every sense) didn't he? I was more thinking of deflation, which is probably the most damaging of the lot over a prolonged period with its effect on business confidence.

And talking of deflation, I think cheap money has made speculators myopic and the crunch will only truly set in when the Bank of Japan raises rates and throttles the currency carry trade. I think the BoJ's gainful employment as a kind of clearing bank for the currency market may be coming to an end.

As China's largest trading partner, Japan's also well positioned to gain considerably from the growth in Chinese exports, which will result in the same upward pressure on Japanese base rates and that all important carry trade.

Personally I don't think inflation is the real threat, because of the steady supply of cheap manufactured goods. I think the end of cheap money combined with massive trade deficits will have a much greater effect.

Oh yes, and haven't the Saudis been talking about settling up oil trades in Euros rather than USD recently? That would upset the applecart.

Posted by: Paul Owen at May 21, 2006 05:32 PM


if you happen to spot this I'm really keen to know what you think about current concerns about M4, broad money supply. If I've read the figures right this expanded by something like 12% last year in the UK, 8% in the Eurozone and by a similar order in the US, 12% or so. I'm sure you can corect me if I've misremembered or misread the figures.

This expansion of broad money, above and beyond inflation or bank base rates is being highlighted by those commentators who suspect that Anglo Saxon governments are looking to get themselves out of a tight corner with rising levels of consumer debt and high asset prices by allowing the value of money to fall while avoiding price falls in absolute terms.

All very well unless you're a saver in which case you watch the value of your liquid assets wither as the value of paper money falls.

As I recall (and bearing in mind that I was rather small at the time) the property price collapse of the mid 70s was brought about by inflation - householders found their mortgages reduced to manageable amounts, house prices didn't fall in absolute terms but once inflation had been built in they did in real terms - but that of course avoided the whole negative equity trap. But one did read a lot of letters from little old ladies in Bexhill on Sea living on fixed incomes bemoaning their being condemned to poverty.

So, in short, if broad money is expanding at super inflationary rates are we in danger of seeing aspects of the 70s situation repeated? Are there different dangers involved? Or is it all tickety boo and we should all be happily counting on building society interest to see us through.

Posted by: Jonathan at May 23, 2006 07:01 AM

Broad money has been a poor predictor of inflation but a pretty good predictor of what has happened to asset prices, notably property. There are some, notably Tim Congdon, who think the broad money growth we've seen - and are seeing - will lead to much higher general inflation. On the other hand, the broad monetarists have been saying that for years.

Posted by: David Smith at May 23, 2006 01:40 PM