As the UK weighs up the possibility of inflation and when it should be raising interest rates (it should happen now, with a view to achieving normal rates in the next two years) we should spare a thought for the difficult position some of our closest trading partners now find themselves.
Inflation was the macro-economic challenges of the 1970s and much of the 1980s. As Milton Friedman said, inflation is always a monetary phenomenon. But the difficulty was the lag between the money-supply figures and inflation appearing was, and is, too variable to make such figures a useful policy tool to control inflation. Moreover, inflation is not just the supply of money, but the rate at which money circulates through the economy, its velocity. If people are too fearful of the future, too scared to spend, an economy can contract even if the money supply is increasing.
Fast-forward to today, and in the aftermath of the credit crisis the US and the UK launched programmes of quantitative easing (QE). Here central banks buy debt from the commercial banks, stuffing these banks with lots of cash which they then lent. Given people around the developed world were quite naturally afraid of the consequences of the credit crisis, with the result that the Fed and the Bank of England have had to date undertaken over $2.5trn (£1.5trn) of QE. Accepting that we are only half way through this process (and arguably the difficult half remains, draining the excess QE liquidity from the economy) we have to say, so far, so good.
In contrast the European Union has taken a different approach. The European Central Bank was created in the image of the German Bundesbank, with the Bundesbank’s aversion to inflation. This means no QE, and indeed EU policymakers have forced a dramatic curtailment in government spending to bring deficits within agreed guidelines, regardless of the broader macro-economic consequences. And these consequences are pretty serious.
For much of the eurozone there is now the very real threat of deflation, the ultimate sign of an economy in which fear has triumphed over hope. In deflation prices fall as retailers seek to sell to a populace which is so scared of the future they are reluctant to buy anything more than the bare necessities. Worse deflation sees the value of debt increasing, which for heavily indebted EU governments and corporates alike is a catastrophe.
So would a policy of QE for the eurozone succeed? The lessons of Japan are instructive. If you approach the problem piecemeal, you can spend a lot of money achieving nothing. Even if you spend a lot of money in a short and determined effort, you may well achieve nothing. Certainly bank lending in the eurozone has slowed dramatically, from an average growth rate of seven per cent to less than two per cent per annum, and this average hides the fact that in many Mediterranean countries, credit to the private sector has been shrinking. Businesses simply do not want to invest. The cost of the debt is not the issue, the ability to pay back the principle that is in question.
What is needed is a culture change, one where the route to a better society is not assumed to lie down the road of ever better regulation. What is needed is a robust questioning of the need for regulation at all. The solution to the malaise has to be a rekindling of the European entrepreneurial spirit, a longer-term and more difficult process than merely printing money. The good news is that the information revolution offers at least some hope of new, non-bureaucratic encumbered businesses emerging, the bad news is that given half a chance politicians could yet strangle such hopes with red tape. Here’s to hope.
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