June 2, 2008 | posted by Michael Baxter in inflation |

That Ben Bernanke knows a thing or two about depressions.  If there is anyone alive today who has studied the US economic depression of the 1930s more than the current chairman of the US Federal Reserve, then it would be a surprise.

That is why many have been saying we will never see a repeat of that saga, nor will we see a repeat of the lost decade suffered in Japan, not while Ben is in charge anyway.

There is one snag with that argument – not all downturns are the same.  The 1930s, and Japan’s lost decade, saw a crash in asset prices followed by deflation.  And Mr B has been doing his best to ensure those characteristics are not repeated here.

But, and this is the danger, supposing it is not like that.  Supposing the real threat is a return of 1970s style inflation, combined with sluggish growth – stagflation.   The danger has to be that Ben, by slashing interest rates, is making things much worse.

Think of it this way.  Imagine the economy is like a shower.  A shower in which the water supply only responds slowly to a turn on the tap.  So, one moment it is too cold, you turn up the hot tap, but it is still too cold.  What do you do?  Wait a little longer to see what happens, or turn up the hot tap some more?

The danger is that Ben Bernanke has turned up the hot tap before his previous tweakings had been given sufficient time to work. The result – well, very shortly scolding water might come flooding out.

But the analogy ends there. The economy is not like a shower – you can’t turn the inflation and growth taps on and off  like that.  Inflation doesn’t come pouring out one moment, and reduce to a trickle the next.  Instead, it has been likened to a tube of toothpaste.  Stopping inflation is the equivalent of squeezing toothpaste back into its tube.

It is an important point, because right now is a crucial moment.   It is possible that inflation is being allowed to build, and that down the line it will come gushing out – across the world.  The signs are certainly there to suggest this may happen.

Alternatively,  if you believe oil and food prices are displaying all the hallmarks of a bubble, which will burst, sending prices spiralling down, we may re-discover deflation, after all.   In which case Ben will seem like a genius – and may go down in history as the Fed’s best chairman to date.

Which scenario is right? In today’s issue we take a look at both sides of the debate. And to start with, let’s take a look at oil. Which way next for the black stuff – read the next article.