Wednesday, 19 May 2010

Inflation - The Governments Free Lunch

"While our case has been aggravated by the illegal sanctions imposed by the Western powers, rising food prices are a world phenomenon because of the use of biofuel"
Zimbabwe's Finance Minister, Samuel Mumbengegwi 

Recent figures for inflation have been released for the UK yesterday and it doesn't make pretty reading for the Government. CPI up to an annualised rate of 3.7% with RPI standing at 5.3%. Again Mervyn King blames the increase on VAT, the fall in the pound or the rise in oil prices. Hate to break it to him but these are just symptoms not causes. The causes can be laid directly at the Governments monetary policy, that is printing money, record peacetime deficits and artificially low interest rates. Thats what he should have told the new Chancellor George Osbourne. Scepticism amongst the city seemed to be the other part of the story, that is they are not buying the above reasons anymore. How long will it be before the general public cottons on that inflation is going to be a real problem going forward. The only way inflation is going to come down, as the Governer would have us believe, is if the government stops printing money, hikes interest rates and gets their books in order. But none of this will occur.

Continued debates regarding which algorithm to use have resurfaced. RPI-X, RPI, RPI-Y? What about using a tool we all know works, the free market. Supply and Demand. Prices. But that would be all too easy. The Keynesian witch doctors couldn't promote their economic religion of the 20th Century. 

There are a lot of common myths surrounding inflation in most instances, the symptoms are portrayed as the causes. Symptoms such as unions, 'overheating', OPEC, speculators - the list goes on. In a nutshell inflation is actually created by making more money, its that simple. Zimbabwe hasn't got inflation because of their stock market or the Unions or OPEC, its got price problems because Robert Mugabe ran out of money and turned to a printing press instead of balancing the books. Of course he lists the same reasons as all governments do. Zimbabwe shut down their stock market recently by stating it was helping to cause runaway inflation. The best stock market in the world is there, along with the best housing market, gains we could only dream of. However there is a catch. The Zimbabwe dollar, in which these assets are valued, is worthless. Same policy as our current Governments are pursuing only with more moderation.

Excess Capacity? Now theres something Zimababwe knows about. But yet the well versed lines we are told is that we can't get inflation because of this excess capacity. People can't demand pay rises, again a symptom, because of this fact. When in history did a country sucumb to high rates on inflation when their economy was strong? Excess Capacity exacerbates inflation, it doesn't dampen it. So while the deflationist scream 'excess capacity', I say 'look at history' (Remember Stagflation?). Incorrect lessons are learnt, fallacies are drawn from history. By the same logic, Zimbabwe should have solved their inflation problem. I have been tracking events there from around 2006 when their inflation stood at a 'mere' 1,000-2,000%, and continuously there has been more and more slack in the economy but yet inflation has gone through the roof, it can't even be measured anymore. People stopped turning up to work because the price of the bus fare was more than they got paid at work. People get confused that the unemployment caused during Thatchers Policies in the early eighties helped dampen inflation when in fact all she stopped doing is spending money the Government didn't have and buying her way out of trouble like previous Governments had. She let market forces take over which lowed consumer prices, and let inefficient state entities fail. It wasn't excess capacity, it was a combination of market forces and the relative restraint of money creation.

Oil keeps going up and up. It does in Zimbabwe. So much so that they put price controls in place. Mugabe blamed oil speculators or OPEC, again the symptoms. It was caused in exactly the same manner as we have now, excessive monetary expansion. Supply and demand issues will occur at some point in the future as we hit peak, but not now. Global demand is weak and people are struggling to buy as much of it. So that price of £1.22 a litre in the UK, we can thank our MPC and our government. Not the oil companies as the Government would have you believe.

Unions or the lack of them. We won't get inflation because we don't have unions due to the wage price spiral they cause, again its a symptom. As more money gets created the publics demand for money becomes greater as it takes more money to buy the same goods and services. However pay demands can equally occur in the free market, for example people move jobs similar to India where they have greater inflation expectations as their Government is weak thus creates too much money. People can just as easily drive up their own wages. We will see more unions and strikes in the future, but don't confuse this with a cause of inflation. I disagree with the concept of unions but there is one point I agree with them, they don't cause inflation, they just play catch up to rising prices caused by weak incompetent Governments. Suggestions of public sector pay freezes does not bode well for future industrial relations, when inflation is on the rise.

In 1997 when Labour granted 'independence' to the BoE for controlling interest rates this was hailed in the city and by many economists, but I disagree. Their targets are still set by the Government. It's laughable that the BoE is independent with it's main remit to target inflation however this figure is now nearly twice as high as what they target, it's not even within their bounds. The 'recovery' or 'it will subside' are reasons given to not take action, but the bank doesn't have a remit on these issues. Its aim is to take steps once inflation goes outside its bounds of 1-3% that the Government dictates. So while Mervyn King and Co. sit on their hands it won't be long before the creditability of the central bank is called into question. A year ago the bank predicted that inflation would now be 0.7%. A 3% margin or error is quite large if you ask me. The record reads quite clearly - it didn't take until 2011 for inflation to rise above 1.2%.

Frustrated savers sit and wait, questioning the policies officials take. Of course its one great moral hazard and the Central Banks are masters at setting up future disasters. The reason savings rates are so low is because commercial banks can lend from central banks for virtually nothing. Unlike genuine savings (capital) this is just pure inflation, so why pay retail savers with real capital more than the central banks rate? The commercial banks can then take this money and lend it for the long term, a common trade is to borrow short term at 0.5% and take this money to buy long dated bonds, say 10 year gilts, which have a higher return (inflating the bond bubble). The difference becomes the profit, money for nothing. Of course the problem occurs when Central Banks have to raise rates. How will the banks deal with this sudden shock to funding? Bailout Mark II? Private Banks then lend to the public and the Government at higher rates because of inflation and default risks in the future. So unless the Government and Central Banks step into the place of private banks then they will never ultimately set market interest rates. 

Media types will have you believe that this is not a plan, that is to inflate away the debts, and its Central Banks believing that inflation will subside. Don't believe everything you read in the news, like I mentioned above there is a remit on the bank which they are quite clearly ignoring. Much damage will be done by trying to inflate, its not just a case that the prudent among society are punished to bailout the irresponsible. The prudent peoples savings erode, incentives are lost to save and capital begins to flee, into foreign assets or Precious Metals. Keynesian's would have you believe we have a liquidity problem, when it fact its a capital deficiency issue. If you have a printing press liquidity is never an issue, so by inflating all officials are doing is adding gasoline to the fire. It compounds the problem. I think people are aware something is not quite right with the monetary system, printing money, giving away free money, people are asking "isn't this what Banana Republics do?".

I warned that we can't devalue our way out of trouble, making the point that prices always catch up with you. The UK is now beginning to find this out. Companies and individuals get lazy but when prices come back to bite, suddenly that purchasing power has gone. Capital gets eroded, saving rates come under pressure as people's demand for money rises to buy the same goods for more - two building blocks for prosperity. Peoples inflation expectations grow. Capital becomes harder to form as prices rise and people struggle to forgo consumption. Company profit margins come under pressure. A vicious cycle can occur without action from a strong Government. Could we have a fall in inflation? In the short term I don't dispute this, when cuts are enacted we could have some slowdown but we won't go the distance and take our full dose. If we couldn't take the pain in 2008 why do you think our leaders will take it going forward with the economy in worse shape. 

There is only one trend and that is expect more inflation, but not the relative calm inflation we have seen over the previous decade. Over the new decade inflation will get out of control, the policy makers will go to far. With the same deflationary market forces relatively subdued it's going to get messy. Inflation, its historically the Government great free lunch.

"Inflationism, however, is not an isolated phenomenon. It is only one piece in the total framework of politico-economic and socio-philosophical ideas of our time. Just as the sound money policy of gold standard advocates went hand in hand with liberalism, free trade, capitalism and peace, so is inflationism part and parcel of imperialism, militarism, protectionism, statism and socialism."
Ludwig Von Mises

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