Inflation is a bigger danger than deflation
By Tim Lee Financial Times May 27 2003
The writer is an economist. He is author of the forthcoming Why the Markets Went Crazy

The risk of global deflation has become a preoccupation of economic commentators. The Federal Reserve's latest statement on US economic conditions, and a sharp fall in the dollar, have raised concerns once again. Yet those who forecast deflation rarely explain how deflation as a monetary phenomenon can be consistent with developments in money and credit.

Deflation, like hyperinflation, involves a marked shift in the value of money and therefore must have a monetary dimension. Can the world really be standing on the brink of deflation when by the vital measures - such as real short-term interest rates, the slope of yield curves and money and credit growth - monetary conditions in the western economies have been loose for most of the time since 1996?

Most discussion of the subject implicitly fails to distinguish between monetary policy influences on the economy and the ongoing, slow structural adjustment that has been the inevitable result of the collapsing of the giant financial bubble of the 1990s. The bubble was liquidity driven but became so big that it had structural consequences for the world economy. The financial imbalances in the US, particularly the low personal savings rate and enormous current account deficit, are well known symptoms.

What is less well understood is that, as long as these imbalances remain, the asset bubble cannot truly have burst. There is a gradual slackening but a full deflation of the bubble is impossible while financial conditions remain loose. Technology stocks have collapsed but the bubble has been transferred elsewhere, like a partially deflated balloon that is squeezed on one side only to bulge out on the other. This is why government bond yields are inexplicably low and why US equity valuations even now remain above historic norms.

A complete deflation of the bubble will occur only when financial conditions tighten globally, particularly in the US. A "financial" tightening can be either the result of higher inflation, or overt monetary policy tightening by central banks. Either outcome would reduce the real liquidity available to support financial asset prices. In the current context, no overt monetary policy tightening is imminent. Nor is it likely as long as economies remain subdued. Logically, therefore, the asset bubble will fully collapse only when inflation becomes a factor, however unlikely such an occurrence may seem to most observers at present.

The high level of the dollar has been another manifestation of the remains of the "bubble mentality" in financial markets. The US economy's apparent resilience has, in large part, been due to the Fed's monetary policy aggressiveness. At other times, or in other countries facing similar circumstances, the monetary policy that has been implemented by the Fed would have been impossible. The combination of monetary laxity and weak growth, against the background of the large imbalances, would have resulted in currency collapse. The Fed has got away with it up to now because of the financial markets' irrational attachment to the dollar, helped out both by the Asian central banks' willingness to accumulate dollar reserves and by US fiscal policy.

These factors could not have supported the dollar indefinitely. Investors should now be prepared for the dollar's fall to go much further than they might have thought possible. This is because it must eventually suffer both a nominal depreciation and a real depreciation. The real depreciation will be part of the process through which the US economic imbalances correct. The nominal depreciation is the part of the dollar's fall that will ultimately prove inflationary. It is this nominal element of the prospective dollar depreciation that is not expected by mainstream economists or commentators. Yet it is surely an inevitable consequence of the many years' accumulation of excess liquidity in the US economy. The existence of the bubble economy, through supporting the dollar and also through other mechanisms, has helped repress inflation and inflationary expectations. The final collapse of the bubble and of the dollar must be associated with the release of this "repressed" inflation.

The US will not be exporting deflation because it will not have deflation to export. A dollar collapse will suppress inflation in Europe, in the first instance. But there will be an obvious central bank response in Europe. In the long term, this could accommodate the dispersion of US inflationary pressures to the rest of the globe. This process could take years to work through but the early indications are already apparent both in the currency markets and in the gradual uptrend in the gold price in dollar terms. These are early signs of the loss of value of dollar money, which is a symptom of incipient monetary inflation.