I had lunch in London with an economist at a well-known global investment bank last week. I can’t tell you who it was, because our meal was off the record. But I can tell you about the most interesting bit of our conversation, because it’s not a secret if you are the kind of person — like me — who is obsessed with why capitalism is so dysfunctional right now, and you like to eat lunch with City analysts.
It’s the theory that central banks have a fundamental misunderstanding of inflation, and how it manifests itself in free markets. The misunderstanding explains why central banks in Denmark, Japan, Sweden, Switzerland and the ECB have set Alice in Wonderland-style negative interest rates, and the countries affected don’t show any signs of traditional monetary inflation. It also explains why inflation hasn’t showed up in dozens of countries — such as the UK and the US — where central banks have set rates that are at or near zero interest.
The theory says that central banks have actually caused inflation — tons of it, in all sorts of assets — but that they mistakenly don’t see it because they are looking for “traditional” inflation, which manifests itself as consumer price inflation (CPI): rising prices, rising wages, and everyone grumbling about the inflation rate.
The theory is attractive because it explains why the US Federal Reserve’s Alan Greenspan failed to do anything about the dot com bubble that collapsed 2000, why his successor Ben Bernanke failed to do anything about the real estate/credit bubble that collapsed in 2007, why his successor Janet Yellen has failed to do anything about the current boom in tech-startup valuations, and why Bank of England governor Mark Carney, and his counterparts in Sweden and in the European Central Bank, are doing nothing about the property booms that are distorting markets in Northern and Western Europe right now.
First, let’s do the history.
Every economist learns this basic lesson about inflation: If a central bank prints money — either by literally printing it or by lowering interest rates (cheap credit has the same effect) — then you get runaway inflation. The classic examples of this are the Weimar Republic and Zimbabwe, where people ended up carrying around wheelbarrows full of money just to pay for groceries. Russia is the most recent example of a traditional inflationary economy. As the Russian economy collapsed in 2015, prices there spiraled at an inflation rate of 17%. Russians began Instagramming food prices to show how ridiculous they were: Here is one showing a watermelon on sale for £24/$35. This equation — low interest rates = inflation — is drilled into every economist and central banker right from the beginning.
A small amount of inflation, like 2%, is a good thing. It devalues your currency a little bit, making your exports a little cheaper, and it encourages consumers and businesses to spend or invest money now rather than next year, when everything will be a little more expensive. That can make an economy grow. It’s like grease on an engine — helps things run smoother. Most central banks — like the BofE and the US Fed — have an inflation target rate of 2% for this reason.
Neither Europe nor the US has any traditional inflation right now, even though rates are below zero or near zero. Incredibly cheap oil has lowered the cost of everything, so deflation is more likely than inflation. So central banks are keeping their rates at rock bottom, hoping that all this cheap money somehow triggers the upward spiral on prices that they were always taught would happen.
Their mistake, of course, is that money is fungible. We already have inflation — just not in consumer prices. We are seeing it in asset prices instead. There are severe housing booms in London, Stockholm, Germany, Norway, and Sydney and San Francisco. Investors are pouring money into private tech startups that show scant profits. BofE chief Mark Carney thinks BTL mortgages have fuelled damaging excesses in the UK market, which has exceeded the peaks of the 2008 bubble.
Central banks see controlling traditional inflation as one of their core duties. it is this narrow focus that led them to miss the dot com bubble in 2000 and the real estate bubble in 2007. Now we’re looking at a housing bubble in Stockholm that “could ultimately be very costly for the national economy,” as the Riskbank admitted on February 11. And yet the Riksbank pushed its rate for the kroner down to -0.5%, because it is targeting a traditional CPI of +2%.
This is not the behaviour of a bank that believes modern inflation might manifest itself in assets. Yet asset crashes are just as damaging to the economy as regular inflation.
We’ll find out soon enough whether the theory is correct. If it is not, then everything will be fine — eventually inflation will show up and everyone will be happy.
But if the theory is right, then several Western economies are in for some unpleasantly bumpy landings once their inflated assets become revalued at more realistic prices, as they inevitably will. And at that point central banks will have no tools to ease the damage.
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