Possibly the most important economic question to emanate out of the global financial crisis is the choice between two evils.
For the United States and to a lesser degree, continental Europe policy makers, a decision may need to be made between deflation or hyper-inflation. At the moment, the vast majority of experts, from ‘Helicopter’ Ben Bernanke to Nobel prize-winning Joseph Stiglitz to the usually excellent Niall Ferguson are suggesting another round of quantitative easing in the United States to prevent deflation from occurring.
Most of the same economists claim that the Great Depression was exacerbated by the decision of the US Fed to exacerbate the reduction in money supply in the early 1930s. The only problem with this path is that it may lead to the worse situation of hyper-inflation.
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As Karen Maley reported last week, voting member of the Federal Reserve, James Bullard, last week warned that “the U.S. is closer to a Japanese-style outcome today than at any time in recent history…a better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities.”
Bullard’s comments raise two questions: first, is a Japanese-style outcome a good or bad result from the current predicament, and second, what is worse for living standards — deflation caused by collapsing asset values or hyperinflation caused by irresponsible governments?
In relation to the Japanese question, while Japanese asset prices have been in a near 30 year malaise, the actual living standards of the Japanese have remained relatively stable. The Nikkei is trading at the same level as back in 1983 –- that means that in 27 years, an investment in the overall Japanese share market has made no money at all (by comparison, the Dow Jones has risen by almost 900 percent during that time). Remarkably, the Japanese share market remains at less than a quarter of its 1989 peak.
Similarly, Japanese property encountered a monumental boom and bust –- as Steve Keen notes, “Japan’s real house price index rose by 54 per cent between 1986 and 1991 during its Bubble Economy phase, peaked at 154.75 in February 1991 in the early days of the Bubble’s bursting. By March 2009 had fallen to 63.961 – a fall of 58 per cent over 18 years.”
So while Japanese asset values have fallen, so too have prices –- that means the actual living standards in Japan haven’t slumped like they did in the United States during the Great Depression (which also suffered falling prices, but coincided with a general liquidation and higher unemployment). In some cases, deflation actually benefited parts of Japanese society. Whereas purchasing a property in Japan was out of the reach of many in 1989, after the property correction, buying a dwelling has become far more affordable. Japanese life expectancy (for women) is also the highest globally.
In 1989, Japan’s economy faced a similar predicament to what the US is encountering (and what Europe most likely will face) –- too much debt supporting asset prices which have become far removed from their intrinsic values. When the asset bubbles popped, the Japanese didn’t allow the market to properly clear and the creative destruction process to fully complete. Instead, it undertook decades of fiscal stimulus and easy monetary policy. This has led Japan, once a nation of savers, to amass a debt which is equivalent to 200 percent of GDP.
While the Japanese have witnessed assets and price deflation, it never undertook widespread quantitative easing (other than an unsuccessful attempt during the early 2000s) as suggested by Bullard and friends. As a result, while Japan has seen two ‘lost decades’, the living standards of Japanese people have remained relatively stable.
It is therefore somewhat strange that many financial journalists warn of the evils of deflation, when the alternative, rampant quantitative easing, may lead to the far less satisfactory scenario: hyper-inflation. (Deflation is feared because it leads people to delay purchases in anticipation of falling prices – this has the unfortunate side effect of stunting economic growth given the importance of consumer spending on the economy, and higher unemployment.)
“What we in the Western world are about to learn is that there is no such thing as a Keynesian free lunch. Deficits did not ‘save’ us half so much as monetary policy — zero interest rates plus quantitative easing — did. First, the impact of government spending (the hallowed ‘multiplier’) has been much less than the proponents of stimulus hoped. Second, there is a good deal of ‘leakage’ from open economies in a globalised world. Last, crucially, explosions of public debt incur bills that fall due much sooner than we expect.”
While Ferguson was most likely correct in his criticism of a Keynesian free lunch (there is certainly no such thing) – his support for QE should not go unnoticed.
The problem with quantitative easing, or ‘printing money’, is that in essence it remains the purest form of theft from the general population (inflation allows Governments to pay for their fiscal spending by simply printing money, rather than raising money from taxation or issuing bonds). While an initial period of quantitative easing (like what the US undertook in 2009) may have a negligible real effect on price levels (due to deflationary expectations of the population), eventually, if not controlled, it may lead to hyperinflation as people adjust their expectations from falling to increasing prices.
As German citizens found out in 1923 (or the people of Zimbabwe are still tragically discovering), the onset of hyper-inflation destroys the middle class and the livelihoods of those on fixed income (like pensioners). For example, German hyper-inflation caused such depreciation that one required 4.2 trillion German marks to purchase one dollar. Hyper-inflation, like deflation, is not necessarily bad for every person but is a negative for the economy as a whole.
So while quantitative easing may seem like the lesser of available evils, in reality, it may be the most evil path of all.
There is of course the sensible, yet politically difficult option of living for the United States and Europe — the outlandish notion of living within one’s means. Of not spending more on government programs (such as military or social security or fiscal ‘stimulus’) than the economy will be able to generate in taxation revenue. But no one ever seems to seriously suggest that.