Greenspan-Bernanke Cycle (2)

By Christopher Lingle

BANGKOK ― Stagflation arises from economic theories that induce policymakers to ignore the real (supply) side of the economy and focus on aggregate demand and price levels. As such, the way that loose monetary policy interferes with the coordination of real economic activities is not anticipated by most economists.

Conventional macroeconomic analysis assumes that prices are rigid in both absolute and relative terms so that the effect upon the structure of relative prices is assumed away. As such, changes in the structural composition of production are ignored or deemed unimportant.

In turn, unemployment and excess capacity are assumed to appear in a uniform manner throughout the economy as the business cycle enters a trough.

An abiding belief emerges from this analysis that the level of output and employment can be boosted by raising the rate of increase of monetary expenditures. But loose monetary policy causes discoordination and maladjustments in economic activity that affect the structure of prices and output.

In the first instance, imposed increases in the availability of money and credit lead to inequitable transfers of wealth. Those that first receive it will have higher purchasing power than those further down the chain of spending.

Secondly, artificially-cheap credit creates misleading information needed for economic decision making by consumers, entrepreneurs, and resource owners. As such, monetary pumping reduces the stock of potential and realized wealth while weakening currency values on international markets, as seen with the U.S. dollar.

In the end, what initially appears to be prosperity will eventually morph into excess productive capacity before it all disappears in a flurry of bankruptcies and liquidations.

Faced with these prospects, politicians tend to ``socialize'' losses from poor business judgments. These moves contribute to larger public-sector budget deficits as seen in the U.S. in reaction to the subprime issue.

Populist pressures to avoid policies that worsen short-run unemployment and stagnation problems that lead to continued monetary expansion will contribute to inflation. Since inflation-driven prosperity feeds on continued inflation, increases in prices less than expected will have a depressing effect on the economy and will lead to recession.

The primary lesson to be learnt here is that more credit expansion is wrongly being seen as the remedy for the economic ills that were caused by loose monetary policy.

Instead of blaming irresponsible monetary and fiscal policies for creating an artificial boom leading to a recession, false accusations will be pointed at capitalism and globalization.

Now, the U.S. is in an unenviable position. While America was a net creditor in the 70s, it is now a debtor, owing vast sums of money to much of the rest of the world. Also, during the 1970s the U.S. had a strong manufacturing base that depended on imports only for raw materials.

Stagflation can be avoided if central banks stop inflating money supplies to allow interest rates to move back up toward market-determined levels. This requires tighter money supply growth to dampen expectations of rising prices while living with lower nominal GDP growth rates and restructuring of troubled businesses.

But the prognosis for the future is not very good. It may be politically impossible for the Fed to follow a Volcker-style monetary squeeze to stop the monetary expansion. Such a decisive reversal in monetary policy might trigger economic collapse and force much of the financial sector into bankruptcy.

It turns out that monetary expansion and recession are inseparable aspects of business cycles. The halting of the expansion by reversing expansionary monetary policy precipitates the recession that it set into motion.

And so it is that stagflation and the Great Depression should not be seen to be a crisis of capitalism. Instead, disastrously-loose monetary policy during the 1920s set into motion an inevitable recession and the Roaring Twenties collapsed in a paroxysm of economic stagnation. It seems that similar circumstances are in place today to set off another round of stagflation.

This new round of stagflation provides a cautionary tale for those that would divine the future stock markets around the world. And it can be summed up in a simple phrase. Stock markets hate nothing more than inflation. As such, it is the moment to remember, caveat emptor.

Christopher Lingle is research scholar at the Centre for Civil Society in New Delhi and Visiting Professor of Economics at Universidad Francisco Marroquin in Guatemala. He can be reached at clingle@ufm.edu.