Holding it together
The experts got 2014 wrong. As Barclays points out in its latest Global Outlook for investors, the consensus at the beginning of the year was that GDP growth would pick up fairly strongly in developed economies, government bond yields would finally rise and commodity prices would hold steady at elevated levels. Wrong, wrong and wrong.
Predictions are notoriously difficult. Still, it is hard to excuse this comprehensive failure as fate or bad luck. It looks like most economists made a fundamental error. They underestimated the power of one of the great economic forces of the epoch – disinflation.
In almost all developed economies, and also in China, prices and wages have been rising less quickly than expected for several years. In a surprising number of countries, and now for a surprisingly large collection of commodities, prices are actually falling. The disinflationary wave has even extended into the previously highly inflationary London and Paris housing markets.
However, there is significant doubt about whether disinflation is an effect or a cause. Some see it as a symptom of slow GDP growth and high unemployment. Others view it as an original force, which dampens bond yields and slows down growth. The majority of economists are in the former camp. But I think it is better to see disinflation as a cause, something like a tide, gathering momentum as it rises. That is why wage and price rises have become increasingly more difficult. As disinflation waxes, it reshapes the economy in ways that are mostly unexpected.
The transmission mechanism may go something like this. Weak wages reduce demand, and the prospect of weak prices discourages hiring. Low inflation rates push central banks into stimulative policies, which depress bond yields. And a tolerance for disinflation leads commodity producers to keep on drilling and mining even when a fairly minor shortage of demand starts to push prices down. The result is a sharp drop in prices.
If this is indeed the way it works, then the Bank of Japan’s gigantic new money-printing project and the programmes promised by Mario Draghi at the European Central Bank are highly unlikely to have a great reflationary effect.
Of course, even if disinflation really is more cause than effect, something must nevertheless kick it off. Monetary policy and output gaps are the usual suspects. But it would be better to point the finger at a profound and almost irreversible social trend: demographics. Disinflation is bred by stable or declining workforces and falling numbers of young people.
In quantitative terms, each year a relatively large generation of people in their sixties move from peak earnings to a much reduced retirement income, while a smaller generation starts work at lower pay. In qualitative terms, the old are more cautious than the young, more likely to be on fixed incomes and less willing to borrow. As society ages, the social bias becomes more averse to inflation.
Rather than trying to fight even harder against the metaphorical tide, central bankers could learn from the earliest recorded version of the story of King Canute and the literal tide. The tale is well known. The 11th century English monarch attempted to tell the incoming sea what to do, but the waters refused to obey. However, the point of the story is often missed. Henry of Huntingdon, who wrote it down, did not want to chastise Canute or his courtiers for having grandiose notions. He wanted to show that Canute recognised “how empty and worthless is the power of kings,” and that the sea obeyed a higher power.
In the same way, demographic trends may well make disinflation too overwhelming to fight. Central bankers, along with politicians, employers and voters, might try to emulate Canute’s response. He “leaped backwards” to keep from getting too wet.
The big leap for the authorities is to rethink their horror of gently declining wages and prices. There is actually not that much to be afraid of. Workers, shoppers, companies and investors are not stupid. They can easily adjust to a new but basically stable monetary order.
Central bankers aren’t stupid either. When they warn about deflation, for the most part they are actually worried about a different but related problem: the excessive levels of leverage in many economies. Deflation automatically increases the ratio of debt to GDP, while managed inflation gently and helpfully erodes it.
After years of wanton debt expansion, the 2 percent inflation rate currently considered optimal by the authorities is too low to really be much assistance. Central bankers and their political bosses will have to figure out ways to deal with debt other than shrinking it by inflating wages and prices. In the meantime, a more realistic and less fearful appraisal of the disinflationary tide would lead to better predictions, more appropriate monetary and fiscal policies – and a healthier economy.