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THE ROAD TO HYPERINFLATION, Part 3
Inflation targeting
By Henry C K Liu
Global inflation outlook for 2008 does not justify an accommodating monetary
policy stance for any central bank. Risk of a recession in the US looms larger
by the day from the collapse of the debt bubble, yet monetary policy is not an
effective tool to prevent that prospect. A debt bubble will eventually have to
burst to allow overblown asset prices to self-correct. If a central bank, as
Greenspan claims, should not and cannot intervene on asset prices on the way
up, but starts to target them on the way down, it fuels inflationary
expectations. Low interest rates had caused the price bubble; and resorting to
lowering interest rates to keep prices up after the bubble burst risks
hyperinflation.
If higher inflation to the level needed to sustain the expanding debt
bubble is tolerated, serious convulsions in global bond markets and the foreign
exchange market and serious disruption to the global flows of funds can be
expected. If high inflation is not tolerated, a violent burst of the debt
bubble may be the outcome. While the market pushes the Fed to allow inflation
to moderate price correction, it is far from clear that the damage to the
global economy from inflation will be less than that from market price
correction.
Inflation expectations in emerging markets
Measuring inflation expectations in emerging markets requires different methods
since competition for export market share has neutralized wage-price spirals
common for the developed economies. This is so despite the fact that food and
energy account for a much larger share of total spending in poorer countries
than in rich ones, making it harder for workers to absorb price increases
without demanding higher wages to compensate. The core rate of inflation,
excluding food and energy, is moderate in most parts of the world and
strikingly low in some of the fastest-growing economies in the world, including
Saudi Arabia and even China, where core inflation was just 1.1% in October,
2007. Headline inflation in China was 6.5% in August, 2007 with food prices
leading the rise.
The food prices increase was exacerbated by an outbreak of porcine reproductive
and respiratory syndrome ("blue-ear" disease) that has affected pig supplies,
pushing the year-on-year increase in meat and poultry product prices to 49% in
August 2007. Pork alone accounts for around 4% of the basket used for the
consumer price index, so movements in its price have a direct feed-through into
inflation. The cost of eggs rose by 23.6% year on year in August, moderating
from a peak of 34.8% in June. Vegetable prices were up 22.5% over a year ago.
Aquatic-product prices are also gaining momentum. Food accounted for 37% of the
average total spending of a Chinese urban household in 2005.
The Fed and global stagflation
While inflation expectations remain locked at moderate rates, food and energy
prices will continue rising at above-average rates because of an anticipated
decline in the purchasing power of the dollar, causing overall inflation to
escalate globally as the global economy slows. The Fed is betting on its
aggressive rate cutting moves to turn 1970s'-style stagflation into mere
inflation.
Until the end of 2007, many financial executives, market participants,
influential commentators and government policymakers had insisted publicly that
last summer’s credit squeeze would prove short-lived and containable. Suddenly,
in the course of a few weeks, bankers and regulators have been forced to face
reality and to admit that the shock that began in August was merely the first
sign of widespread financial collapse that would take years to unwind.
Market confidence fell abruptly off a cliff, with banks became wary of lending
to each other while investors stopped buying new securitized debt instruments.
Borrowing costs in the money markets rose dramatically to put pressure on
corporate borrowers, private equity acquisition and commercial real estate
finance.
Fear has spread to the entire global market, partly due to lack of transparency
behind the credit crisis that began in the US. Projected losses continue to
rise with no end in sight. The problem is made worse by the self-inflicted loss
of credibility on the part of top government officials and leading financial
executives.
For example, Bernanke first suggested that the subprime mortgage crisis would
result in a manageable $50 billion in losses. Less than three months later, he
tripled the projected loss to $150 billion while still denying any threat of
systemic contagion. Speaking after the February 9 meeting of Group of Seven
finance ministers, Peer Steinbrck of Germany said the G7 now feared
that write-offs of losses on securities linked to US subprime mortgages could
reach $400 billion, sharply higher than the $150 billion credit losses that the
Fed, Wall Street banks and other institutions have revealed in recent weeks.
The latest panic-stricken Fed interest rate cuts are telling market
participants to expect losses that could amount to trillions.
AIG, the world’s biggest insurance company by assets, sent tremors through the
markets on February 12 when the insurance company raised its estimate of losses
in October and November from insuring mortgage-related instruments from about
$1 billion to $5 billion. AIG shares tumbled 11%, wiping $14 billion off its
market value. AIG has written $78 billion of credit default swaps on CDOs,
which protect the purchaser from a CDO’s failure to pay. The primary providers
of the hedges are bond insurers such as MBIA and Ambac, whose ability to pay
claims is causing deep anxiety in global markets. These have written about $125
billion of protection on "senior tranches" of CDOs. Catherine Seifert, analyst
at Standard & Poor’s, was quoted in the Financial Times saying that AIG
would "have an extremely difficult time regaining investor confidence".
How many times can public figures be shown wrong by subsequent unfolding events
before losing total credibility? The overused truism is now flooding the media:
that credibility is like virginity - much easier to lose than to get it back.
Like the resourceful pimp who promotes the virgin-like freshness of his
prostitute by claiming that it is only her second sexual encounter, the "good
fundamentals" of the economy is touted over and over again by influential
public figures in the face of deepening systemic collapse and dwindling
confidence. Gratuitous advice that the market was temporarily oversold and that
every decline session presents a "buying opportunity" continues to be standard
pronouncement by those who are in the position to know better.
The faith-based Larry Kudlow & Company program on CNBC, where participants
are asked to declare with solemn piety: "I believe free market capitalism is
the best route to prosperity" as an article of faith, is increasingly
attracting viewers for its entertainment value rather than for the quality of
its analysis, particularly when the host continues to repeat with a straight
face his tiresome mantra that the Goldilocks economy is alive and well in the
face of serious systemic financial disaster.
Back in the real world, Goldman Sachs analysts estimate that the total final
loss on US subprime mortgages would exceed 80% of its March 2007 face value of
$1.3 trillion, even if the meltdown does not spread throughout the $20 trillion
total residential mortgage outstanding and beyond the housing sector into
commercial real estate and corporate finance.
The bulk of this loss will ultimately be borne by pension funds whence the
average worker around the world expects to receive money to fund his/her
retirement needs. Market forces can resolve the financial crisis with a sharp
and quick price correction from bubble levels but the politically sensitive Fed
and Treasury are trying to engineering a "soft landing" by extending the debt
bubble, the penalty for which would be a decade or more of stagflation.
Pathetically, supply-side market fundamentalists are clamoring for more
government bail out of the market, with "damn the economy" frenzy. It is the
equivalent of the God-fearing faithful asking the Devil for help in easing the
ordeal of faith.
Dollar hegemony and loose monetary policy The benefits of a loose
monetary policy are by now proving to be dramatically short of what their
advocates have claimed. A protracted policy bias towards low interest rates led
the economy into its current debt quagmire, particularly when the unearned
profit of the debt-driven boom has gone to a select manipulating few, leaving
the masses with debts unsustainable by income. More low interest rates will
perhaps help the wayward financial institutions delay inevitable insolvency but
will not get the economy out of its debt crisis without pain. The argument that
subprime mortgages helped expand homeownership is false. Such mortgages only
put buyers into homes they cannot otherwise afford by distorting the happy
American dream into an unneeded financial nightmare.
Easy money has been one of the most tempting monetary fallacies for all
governments all through civilization. It has brought down the mightiest of
empires, from Rome to Dynastic China. But the one basic requirement for
sustaining the value of money is that must not be easy to come by without
equivalent input of value. In the current international architecture based on
fiat money, governments of trading nations justify inflationary monetary policy
with the need to lower currency exchange rates to compete for market share in
international trade. Inflation is driven by global trade.
The Bernanke Fed seems to have followed Greenspan’s pattern of adopting
traditional gradualism only when interest rates are on the way up to retrain
inflation, but always abandoning gradualism on the way down to stimulate
growth, thus introducing a long-term structural bias in favor of inflation. The
Fed then frequently finds itself behind the curve in fighting inflation
expectation and overshooting to combat deflation expectation. This unbalanced
proclivity has contributed to the long-term decline of the purchasing power of
the dollar on top of the fiscal and current account twin deficits. Yet the US
has been the privileged beneficiary of this easy fiat money fallacy through
dollar hegemony since 1971 when President Nixon abandoned the Bretton Woods
fixed exchange rate regime based on a gold-backed dollar. And this fallacy of
the benefits of easy fiat money is about to be exposed by hard data for even
the printer of the fiat dollar.
The Age of Worker Capitalism
There was a time in the past under industrial capitalism when in a class war
between capitalists and workers, moderate inflation could help workers keep
their jobs by keeping the economy expanding and make it easier for them to pay
off their debts to capitalists. But nowadays, under finance capitalism, when
capital comes mostly not from capitalists but from enforced savings held by
worker pension funds, inflation robs workers of their retirement resources
while stagflation lays them off from their current jobs.
Capital has been manipulated as a notional value on which derivative
transactions are calculated and profit and loss are realized. Finance
capitalism, through income disparity condoned by a supply-side ideology of
keeping profit for the rich in the name of capital formation and letting the
working poor be taken care of through trickling down from the rich, has
constructed a financial infrastructure that channels profits to a few and
assigns losses to the many. The inequity is mind-boggling. At least the
capitalists of industrial capitalism used their own money. In finance
capitalism, the retirement funds of workers are manipulated by financiers to
exploit workers.
In April 2002, the term dollar hegemony was put forth by me in Asia Times
OnLine in a critical analysis of a post-Cold-War geopolitical phenomenon in
which the US dollar, a fiat currency, continues to assume the status of primary
reserve currency in the international finance architecture that finances global
trade. Architecture is an art the aesthetics of which is based on moral
goodness, of which the current international finance architecture is visibly
deficient.
Thus dollar hegemony is objectionable not only because the dollar, as a fiat
currency, usurps a role it does not deserve, thus distorting the effects of
trade, but also because its impact on the world community is devoid of moral
goodness, because it destroys the ability of sovereign governments beside the
US to use sovereign credit to finance the development their domestic economies,
and forces them to export to earn dollar reserves to maintain the exchange
value of their own currencies. Exporting economies are forced to accumulate
dollars that cannot be spent domestically without severe monetary penalty and
must reinvest these dollars back into the dollar economy.
The Bretton Woods II theory fallacy
In 2003, economists Michael Dooley, David Folkerts-Landau and Peter Garber
proposed what has since become known as the Bretton Woods II theory. The theory
turns dollar hegemony from the destructive monetary scam that it is into an
assenting fantasy by applauding it as a happy win-win arrangement in which
newly industrialized countries peg their currencies to the fiat dollar at an
undervalued exchange rate in pursuit of export-led growth; and in return, they
reinvest their trade surplus dollars back into the US, which acts as an
economic anchor and consumer of last resort. This warped theory fed the
illusion that the US trade deficit can be reversed by merely forcing trade
surplus partners to upward revalue their currencies. The 1985 Plaza Accord
succeeded in pushing the Japanese yen up against the dollar and threw Japan
into a two-decade-long recession without reversing the US trade deficit.
By 2006, the US was running a current account deficit in excess of 6% of its
gross domestic product, a level that would normally be considered excessive and
unsustainable while the capital-
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