There's been a sort of rough consensus among American, British, and ECB central bankers about what levels of inflation are acceptable. Suddenly, however, we're looking like the profligate wastrels on M1 Street. Even during the big German and French slowdown, and the Italian recession (these are Europe's three biggest economies), the ECB held a hard line on inflation. Britain, too, has kept interest rates quite, er, bracing. Right now, the Bank of England is holding stat despite growth worries, and the ECB is talking about a rise next month. Bernanke, on the other hand, is tolerating quite a bit of core inflation in order to stave off recession.
It's rather a delicate question of monetary policy. The inflationary seventies gave rise the the conviction in the 1980s and 1990s that only an iron fist on the throat of inflationary expectations could hold back the beast. But Japan's experience proved that inflation isn't the worst thing in the world, and since the 1990's, the US has been inching towards more focus on growth. In a couple of years, we'll be able to look at US inflation and growth and see whether Bernanke managed to skirt recession without any worrying entrenchment of inflationary expectations, or rekindled an inflationary sentiment that will have to be ruthlessly and painfully extinguished.
Right now, all we--and the central bankers--can really do is try not to bite our fingernails all the way down to the quick.
Japan was able to weather their inflation in the 90s because they are a country of savers; their debt was not as massive as the current US deficits. Given our current public debt of some 60 trillion dollars, not to mention unprecedented personal debt, I would say the US economy is in for a rough ride.
Agreed that the winner remains to be seen. Still, the different philosophies and emphases are significant.
Beware the Moral Hazard Trivializers
The current financial crisis is the result of longstanding political interventionism. In what follows we argue that our monetary system creates incentives for irresponsible behavior (moral hazard) and is therefore an important cause of recurrent crises. Then we discuss two recent articles purporting to downplay the significance of this fact.
Moral Hazard and Financial Crises: Two Views
Virtually all economists agree on the proximate cause of the current financial world crisis: institutionalized moral hazard in the financial industries. Banks and other firms operating as financial intermediaries have a tendency to behave irresponsibly. They display an exuberant bias in their investment decisions, often taking risks out of proportion with possible returns on investment. Most notably they have reduced their equity ratios to extremely low levels, typically to less than ten percent. Equity being the economic buffer for losses, it follows that financial firms are more vulnerable the smaller their equity ratio. If such vulnerable firms dominate the market — as is presently the case — then there is an increased likelihood of contagion, as the liabilities of any one firm are more than often the assets of other financial firms. The bankruptcy of just one sufficiently large firm can then trigger a domino effect of subsequent bankruptcies. The entire financial market melts down.
While economists agree on this basic fact, they disagree about its causes and remedies. Some seem to believe that the bias toward irresponsible investment decisions is a fact of nature such as bad weather and death. Financial markets are unstable by their very nature because the agents on these markets profit from superior knowledge as compared to their customers ("information asymmetries") and therefore can enrich themselves at the expense of the latter.
While this theory is very widespread, it lacks any foundation in fact. If financial agents really had a bias to rip off their customers, there would soon be no clientele for them. Common people might be less informed than their bankers about the technicalities of financial instruments and investment strategies, but they can read a bottom line. They can also compare bottom lines and abandon their agent if they feel other people might take better care of their money.
The true cause of moral hazard in the financial sector is to be seen elsewhere, namely, in monetary policy and especially in the current monetary system.
Paper Money and Moral Hazard
Central banks function as lenders of last resort, that is, they lend money to financial firms and others who are unable to find creditors on the market. The salient point is that they can provide this service without any technical or economic limitations. Indeed, the money they lend does not cost them anything at all. Central banks do not have to borrow money; rather they make the money of the nation. Because paper notes ("greenbacks") and electronic accounts ("liquidities") are virtually costless to make, it follows that the amount central banks can lend is basically unlimited. This allows them not only to provide virtually unlimited credit to governments and similar institutions, but also to bail out market participants on the verge of bankruptcy. Thus they can prevent financial contagions and meltdowns.
"The problem is that the financial firms know that the central banks are there to help them out in times of trouble."
At first sight, it appears that the activity of central banks is wholly beneficial. However, the exact opposite is the case. The problem is that the financial firms know that the central banks are there to help them out in times of trouble. They know that these institutions can make and lend as much money as they wish, at any price they wish, without being subject to physical or economic constraints. As a consequence, financial agents have the incentive to reckon with this kind of assistance. Rather than making their business plans and investment decisions in a responsible way, relying on other people only through contracts and other voluntary agreements, they now rely on publicly sponsored bailouts.
Who pays for such bailouts? Not the customers of the banks and other financial agents. Rather, these groups belong to the net beneficiaries of this policy. The true paymasters are citizens as a whole, in their capacity as money users...
http://mises.org/story/2987
Your article carries two suggestions which are not at all certain. The most important one is the suggestion that the US Fed is acting in the best interests of the nation. Cutting interest rates in the face of a sharp upswing in inflation is inconsistent with such a notion. Rate-cutting by bank presidents whose banks are walking a balance beam above a yawning chasm of loan defaults and insolvency is a much more rational concept. The second suggestion, more an implication is this: why would the US bankers suddenly stop protecting their own interests because everyone else has to pay more for stuff? It is far easier to pay down debts in inflated dollars than the reverse, so inflation is clearly the path of least resistance for them.
A Volker-style interest adjustment is fully merited to restore some strength to the dollar and bring the economy back into line, but this type of action would seal the fate of the large lenders by tipping all of the ARM loans and potential refinance deals into the dustbin. It simply will not happen. The bankers will continue to attempt to use the power of invocation to manipulate the market while dithering on actually adjusting rates.
When workers are getting double digit pay hikes built into longer term contracts, like back in the 70's, then I'll start worrying about inflation. Before that - not so much...
"Not after we demonstrate the power of this central bank" ...
One other point that hasn't been raised, and which Megan doesn't want to write about is the mission of the different central banks. The mission of the ECB and most, if not all, other European central banks is price stability. It's in their charter. They take their mandate more seriously than "B-52" Ben. Bernanke is trying to save the IB's. We'll see if he can do it with out wrecking the economy(and this country).
I'm not too worried because of how we seem to be handling inflation as well as what kind of it we're getting. Inflation is hitting profits and disposable income, rather than leading to a push for wage increases & price increases. So It's segregated.
Then there's the inflation that we're getting - food inflation thanks to secular commodity pressure and idiotic energy subsidies, energy inflation thanks to increased perceived risk and secular demand increase, and a currency adjustment. The dollar isn't plummeting like a 3rd world currency, just adjusting downward (probably too much) from a period of being overbought. That causes price increases for imported goods (lots of manufactured stuff and oil) but is a step function rather than a trendline. Nearly all the inflation that we're seeing is step-function reactions to exogenous factors rather than endemic trend-line inflation.
ECB is running higher interest rates to prove their independence (germany and france REALLY want lower rates, so ECB can show who's in charge by doing the opposite), to balance eurozone performance (huge area means germany + france don't dominate economic stats like they used to, and economic performance in other parts of the EZ are rather different), and to shore up the Euro (for the first few years of it's existence the Euro had pathetic performance and they really want to switch that, since they're supposd to be competing with the $ and the pound for hard currency status). Most of the reasons for running a very high interest rate have nothing to do with any economic indicator, and demonstrate the dissociation of the ECB from the economy of the EuroZone.
KIA is on crack - we're nowhere near Volker territory.
Inflation expectations ... when my not exactly economically aware fifteen year old daughter tells me I should buy her the fashion-widget now because it will just be more expensive a year from now, then I think if Bernanke had better start being a whole lot more inflation-frightened than he seems to be.
Megan,
Let me first say kudos on the Star Wars reference. Next I'd like to just observe the correlation between high inflation rates, low growth, and high oil prices. If you examine the stagflation era, it coincided with the quadrupling of the price of oil and then oil embargos. The roaring 90s that people pine nostalgically for was, not coincidentally, a time when interest rates were low (comparatively), inflation was low, growth was high, and...oil prices were low.
It stands to reason that the price of oil is as much a driver of growth and inflation as interest rates. Or in other words it doesn't matter if Helicopter Ben and the Green Genie wheel out the dumptruck of money, or Volker slams on the brakes. The choice is either recession or stagflation until energy prices come back down.