The Wrong War

The Financial Times

Like generals preparing to fight the old war, the world's central bankers are
still obsessed with inflation. They should be looking forward to the real
enemy: deflation.

Look around the world and what you see are identical policies in favour of
trimming public spending, cutting debt, raising interest rates and squeezing
money supply.

Euroland has made deficit reduction the ticket to admission. The
International Monetary Fund still screams "austerity!" at any hint that capital
may flee a developing nation. And in the US, the Delphic and venerable Alan
Greenspan, the US Federal Reserve chairman, told the Senate banking
committee last month that the Fed would continue to evaluate "whether the
full extent of the policy easings undertaken last fall to address the seizing-up
of financial markets remains appropriate as those disturbances abate".
Translated: If we do anything over the next few months, it will be to raise
short-term interest rates.

The US bond market responded by pushing up long-term rates by nearly
one-tenth of a percentage point.

What we have here is a perfect example of the generational Law of Living
Memory. The current generation of world leaders was traumatised by
double-digit inflation in the 1970s. This occurred when they were young
adults (Bill Clinton, Gerhard Schroder, Tony Blair), or middle-aged fogeys (Mr

None of them has a living memory of the early 1930s, when deflation and
depression haunted the world. The generation that directly experienced the
Depression fell under the sway of John Maynard Keynes - "We are all
Keynesians now," Richard Nixon famously proclaimed - because Keynes
understood the proclivity of businesses to underinvest, from time to time,
relative to the productive capacity of a nation. Inadequate demand was a
greater threat than excessive demand.

It should not be surprising, then, that the Law of Living Memory should bias
this generation towards wanting to pre-empt inflation rather than deflation.
Yet the latter condition is as dangerous as the former, and arguably more so
under current circumstances.

It was not long ago that Mr Greenspan was warning Americans that the US
could not remain prosperous if the rest of the world was in trouble - but that
was then.

Now, Mr Greenspan says that while the Fed must take into account the
impact of global problems on the US economy, interest rates should not be
set for the benefit of other countries. As long as things are chugging right
along here, the Fed will continue to watch out for inflation, not deflation, and
the rest of the world be damned.

This is dangerous talk. The average inflation rate in the Group of Seven
leading industrial economies is 1 per cent, the lowest in half a century.
Inflation in most of Europe is close to zero, but unemployment among the
Euro-11 is 10.7 per cent. Japan's economy is turning into a shrivelled raisin.
Prices are dropping across much of east Asia, including China. Russia remains
a basket case, and the outlook in Latin America is poor to bad.

American consumers are about the only large group of people left in the
world who are diligently buying. It would be only a slight exaggeration to say
that American consumers have become the engine of the world economy. Mr
Greenspan is thinking about throwing less coal into the engine box.

Even if the rest of the world were fine, a case could be made for continuing
to pile coal on the US locomotive.

Inflation in the US is at its lowest for more than a generation, and there is no
sign of it accelerating. More to the point, the US economy is more vulnerable
than Mr Greenspan may think (or publicly concede). US consumers are
deliriously happy about what has been happening on Wall Street, as the
value of their stock portfolios has soared over the last three years. But apart
from their paper holdings, no one is saving a thing. Consumer and credit card
debt is at record levels and personal bankruptcies are legion. Because of all
the buying, unemployment is also down to record low levels, which
encourages consumers to buy even more.

This virtuous circle - consumer ebullience fired by soaring stock values, which
continue to soar because consumers are buying so much, which lowers
unemployment and thus fires more ebullience - could turn vicious. Such was
the danger last August and September when the US stock market plunged
on news of Russia's default and Brazil's troubles.

Mr Greenspan and company wisely lowered short-term rates by 1 1/2 points
and got the wheels spinning in the right direction again. They now fear they
may have gone too far. But raising rates any time soon - even proclaiming
the likelihood of a rate rise - could cause the locomotive to slow, and thus
stop the global economy dead in its tracks.

Mr Greenspan is only one member of the Federal Reserve Board's
12-member Open Market Committee, albeit the most influential member.
Even if he wished to ease up on short-term rates, Mr Greenspan would have
to convince a majority of his colleagues of the wisdom of doing so. Some
members, like Jerry Jordan and William Poole, are extreme inflation hawks.
They worry about little else.

If the US still possessed a fiscal policy capable of counterbalancing the Fed's
inflation hawkishness, there would be less reason for concern. But US fiscal
policy has vanished. Mr Clinton is now arguing that the US federal budget's
projected surpluses should be used to pay down America's public debt over
the next 15 years, reducing it from 45 per cent of gross national product to 7
per cent. Republicans prefer a tax cut. Republicans thus have become the
party of Keynes; the president, the lineal descendant of Republican Calvin

But the world economy is more intertwined than it has been in a century.
Asia and Latin America (aided by global companies) have built significant
productive capacity, much of which now lies dormant. At the same time,
advanced economies depend to a greater extent than ever before on
exports to developing nations, which are rapidly declining.

Deflation in one major part of the global economy will surely lead to deflation
in the rest.

At the very least, the US needs a clearer view of the whole, and a greater
willingness to accept the risk of the new threat of global deflation.

Fiscal and monetary policies in all major economies, along with policies
promoted by the IMF for developing nations in distress, must consider the
totality of global supply and demand - and do so without a generational bias.
Even Mr Greenspan would be wise to widen his sights.

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