February 27, 2008 | posted by Michael Baxter in UK economy, inflation | comments (0) |

Will the economy experience a Japanese-style decade of lost growth, or will the impact on the real economy be small and shallow? “History,” said Ms Lomax, “does not give a clear steer.”

Yesterday, she articulated the fear that must be running around in the heads of all central bankers during their waking hours – and maybe when they are dreaming too. Is inflation making a nasty return, in which case interest rates need to be pushed higher, or are we about to experience deflation, in which case it is essential that rates are slashed now to choke the beast of deflation before it can get a foothold.

Ms Lomax put it this way: “Going to the apocalyptic end of the spectrum – if the global macro economy does turn very sour, at what point might falling asset prices and mounting banking losses start to feed on each other to push economies into a deflationary downward spiral?”

“To take two extreme possibilities,” she added “is what we are seeing closer to a repeat of the US Savings and Loans crisis (whose real economy impact was small and shallow) or to Japan in the early 1990s (characterised as a ‘lost decade’ of growth)? Or is it something else again? How much does it matter that this is one of the first crises where a credit boom has died of ‘natural causes’, rather than being choked off by some external macroeconomic or policy shock?”

And just to keep the headline writers happy (including us – Ed), she said, “There have been financial and banking crises before, but not on the present global scale, and this must surely be the largest-ever peacetime liquidity crisis.”

It really seems as if Ms Lomax was actually discussing two problems.

First you have the fallout from US subprime disaster. That is bad, but surely not enough to send the global economy, or indeed even the US, into tailspin.

“Even the most pessimistic estimates of the total losses from sub-prime mortgages” said Rachel, of “around $400 billion – compare with total global financial assets of at least $110 trillion.” In other words, the global economy should be able to shake off this problem.

“But,” she added, “there may be more shocks to come. The focus of current concerns is how far other assets may be impaired, as a result of the broader economic impact of this period of financial stress.”

The second problem she referred to seems to be more serious. It relates to the sharp rises in commodity prices. And this provides the real dilemma.

Ms Lomax warned that the recent rises in commodity prices have not yet fully fed through into consumer prices, but that from next month CPI inflation is likely to rise more sharply.

In the press release accompanying the text of her speech, the Bank of England went to pains to emphasise that Ms Lomax said there is essentially nothing the MPC can do about this, and its remit does not require it to raise interest rates sharply to counteract this rise in inflation.

And that brings us to the nub of the speech, and, more importantly, to the central dilemma facing banks.

Is current inflation a one-off, or could it set in? If it is a one-off, then tight monetary policy could be very dangerous and lead to severe economic shocks down the line. On the other hand, if there is a danger it will set in, and monetary policy is too lax, like arguably it is in the US, then all kinds of problems could occur down the line.

The danger has to be that higher inflation could lead to banks raising rates, which could lead to a crash in asset prices, which could in turn to lead to deflation – do you see the paradox?

There is one massive potential flaw with all this reasoning.

The central assumption to all this handwringing, and problems revealed on central bankers’ sleeves, is that it is all based on one questionable assumption. The assumption that central bankers have made that much of a difference.

The reason why we have had such modest inflation for the last decade or two, goes the argument, is that central bankers know what they are doing now.

But there is a real possibility that, actually, we need to look further afield for the real factors that have led to such happy economic conditions.

Surely it has been improvements in technology leading to greater global capacity, the Internet ceding power to price-conscious consumers over suppliers, and of course cheap imports from developing countries such as China.

Actually, the last few years have seen governments follow all the policies that would normally lead to inflation. Low rates, high government expenditure. This has led to an unsustainable asset bubble, and an economy that has become used to consumer spending growing, even when that spending occurs instead of  saving -  that the economy just needs more and more growth.

Maybe Government policy, and the short-term targets it has given to central banks, has created a beast of an economy with an insatiable appetite for more spending.

For as long as China, and the Internet and changes in technology had created all those benign conditions referred to above, we could get away with it.

The good news, those benign forces may continue to work. The worry, the consequence of these powerful forces for real growth has been to create a global appetite for scarce natural resources that can not easily be met.