Towards an inflationary twilight zone
By Hossein Askari and Noureddine Krichene
At a time when commodity and consumer prices were rising modestly in 2002, the
media and academics falsely sounded the deflation alarm. As stated by former
Federal Reserve chairman Alan Greenspan in his October 2008 Congressional
testimony on the origins of the financial crisis, it was the deflationary scare
that made him open the throttle on monetary policy, pushing credit growth to
unsustainable rates, setting off housing and commodity bubbles, and culminating
in the worst financial and economic crisis since the Great Depression.
The fiscal cost of US bailouts has already exceeded US$1.5 trillion and public
debt has jumped to 90% of GDP. While the financial crisis continues to
adversely affect economic activity with
new orders and production measures in US manufacturing hitting their lowest
level since surveys began in 1948, leading financial media and academics have
again sounded the deflationary alarm, calling on the US Fed to intensify its
aggressive monetary policy.
Not conceding that monetary policy has failed to support economic growth, some
pundits are calling for a helicopter money drop. While for the first time in US
history the federal funds rate is at zero bound, the Fed has totally lost
control of monetary policy. If not prevented by the US Congress, the Fed is
inevitably moving on the path of inflating the dollar into the twilight zone,
as with Germany and its currency in 1920-23 and Zimbabwe similarly in 2008, not
to mention a number of countries over the years in Latin America. The myth that
hyperinflation can happen only to others could turn out surprising and costly.
Many academics, workers in the news media, and policymakers with little
economic modeling or principles, confuse historical events and rush into
tumultuous action. In this respect, soon after the crisis broke out in August,
Greenspan's successor at the Fed, Ben Bernanke, confused an in an incredible
act of armchair theorizing, the current financial crisis with the Great
Depression, a period on which he claims considerable knowledge.
He applied his own theory of the Great Depression, known as aggressive monetary
policy, sending off the US dollar to record lows, food prices sky high, and
energy prices to levels that wrecked havoc on the US and the rest of the world
US economic institutions, macroeconomic setting, including the size of the
public sector, and safeguards now have no resemblance to those in 1929, and
Bernanke's approach to the crisis has brought down the US economy from vigorous
growth to recession, precipitated the collapse of the banking system, and
inflicted the largest bailout cost on the US Treasury. While Hyman Minsky
correctly argued (1986) that risks for another Great Depression had become
slim, Bernanke's doctrine has made such a risks significant.
Deflation is not a simple topic. As there has been a disagreement on defining
inflation, so there is yet no agreement on defining deflation. While the Fed is
using core inflation, which excludes food and energy prices, others include
food and energy prices as well as commodity prices to measure inflation.
In the 1960s, many authors (for example Armen Alchian) proposed including asset
prices (such as housing and stocks) in an inflation index. When discussing
deflation, one has to be specific about which group of assets, commodities,
food, energy, goods and services, or factors (for example interest rates and
wages) are facing price deflation, or whether deflation is more pervasive.
If the price of gold, food, vegetables, fruits, and basic necessities
(transport, health and so on) are rising rapidly, while those of toys and video
games are falling, does this imply deflation? Does a month-to month drop in a
specific price index warrant a deflation scare, or should the trend persists
for several months, quarters, or years before a deflationary trend and its
underlying causes are identified? Is the adjustment of speculation in asset
prices to market fundamentals deflation? When the value of toxic assets goes to
zero, does it indicate deflation?
Taking 2002 as the benchmark year, food prices in the US have exhibited strong
upward tendencies for a large array of essential food products. By end-December
2008, bread prices have risen 2.5 times (that is a whopping 250%); cooking oil
2.5 times; flour 5 times; butter 2.5 times; eggs 3.5 times; potatoes 4 times;
bananas 3 times; apples 3 times; fish 2 times; poultry 3 times; meat 2 times;
milk, 2 times.
Notwithstanding the recent sharp drop in world commodity prices, food prices
continue to rise at a high rate and show no tendency of stabilizing, let alone
dropping. Such a high inflation in food prices, a clear indicator of rapidly
dwindling savings, has had two effects.
First, it has caused a major drop in per capita food consumption in the US.
Thanks to the strong rise in prices, supermarkets are selling lower quantities
of food, vegetables, and fruits, but are receiving larger sales figures.
Second, as a result of fast food and energy price inflation, real incomes of
pensioners and wage earners have fallen significantly leading to depressing
effect on non-essential consumption.
The drop in real demand for non-essential goods and services has triggered a
rise in unemployment and gradually an economic recession. Although a
stabilization of food prices, or a realignment of these prices with incomes, is
a prerequisite for economic recovery, claiming that there is food price
deflation in the context of world food deficits is incorrect.
The underlying conditions in form of monumental fiscal deficits, overly
expansionary monetary policy, and severe short-run limitations on food
supplies, are supportive of an explosive pattern for food prices in the coming
years, which will in turn exert a crippling effect on economic growth.
Energy prices have exhibited a strong upward tendency since 2002, leaping from
$25 per barrel to $147 per barrel in July 2008. Since September 2008 and under
the cover of economic recession, de-leveraging by hedge funds, and strong
downward speculation, they fell rapidly to $40 per barrel. Production cuts
announced by the Organization of Petroleum Exporting Countries were never
implemented, keeping the oil market amply supplied. Could it be inferred safely
that oil prices are under deflation? Or could they again come under an even
stronger upward tendency than in the past? Would a stabilization of oil prices
around a non-speculative equilibrium consonant with market fundamentals be a
requisite for economic recovery?
A number of other consumer expenditures have leapt rapidly since 2002. For
instance, home property taxes have doubled, while healthcare expenditures,
insurance premiums, utility charges, transports expenditures and rents have
increased. Non-fuel commodity prices have also exhibited strong upward
tendencies since 2002, recording the highest commodity price inflation in
modern history, with price increases averaging 23% a year from 2002 until
Because of hedge funds de-leveraging and world economic recession, non-fuel
commodity prices plummeted rapidly in the second half of 2008. Again, could it
be inferred safely that commodity prices are under deflation? Or would they
become inflationary again under rising pressure? Would it be desirable that
commodity prices return to an equilibrium consonant with world economic growth?
Scaring policymakers about deflation and its dangers because the consumer price
index fell slightly in November 2008, and calling for massive money injections,
can only lead to economic ruin. Other than few episodes in the 19th century
(for example in 1873), the only serious deflation in the US was when prices
declined during 1929-1933. But in the post-World War II era there were only
inflationary trends in the US as the underlying conditions for deflation have
During 1929-1933, real gross domestic product fell by 30%, money supply by 35%,
the price level by 30%, and unemployment rose to 25%. The Roosevelt program in
1933 to stimulate the economy was appropriate for the prevailing conditions and
helped prices recover to the pre-crisis level. Eminent economists who lived
through the Great Depression called for restoring the circulating media, which
contracted sharply during 1929-1933, and stabilizing prices at pre-crisis level
consonant with economic recovery.
The authors of the Chicago Plan (1933), including Henry Simons as well as
Irving Fisher, while supportive for rebuilding money supply to the pre-crisis
level, were adamantly opposed to discretionary monetary policy and to
inflation, and all called for a quantitative fixed rule for monetary
aggregates. In the tradition of monetarism (see Henry Thornton 1802, Knut
Wicksell, 1896), Simons, Fisher, to be followed later by Milton Friedman,
Maurice Allais, and many others, rejected the use of interest rates as an
instrument for monetary policy and were staunch proponents of the fixed rule on
money supply growth.
John Maynard Keynes (1936) was even more extreme, and was adamantly against
using monetary policy to bring an economy suffering the conditions of the Great
Depression back to full employment. Keynes was also against inflationary
Fighting deflation in the midst of strong inflationary tendencies since 2002
underlines the wrong-headed policy approach in the US. Bernanke promised over
and over again to the US Congress that aggressive monetary policy would soon
bring economic recovery. His promises have not been born out by developments.
Bernanke has been bailing out almost all sectors of the economy (the auto
industry, insurance companies, finance companies, mortgage industry, banks, the
US Treasury, and on and on) with others to follow.
Bernanke's Fed has become a panacea for all. Along with a zero federal funds
rate, Bernanke has recently announced a purchase of $600 billion of mortgage
loans and securitization of consumer loans with the aim of reducing the
mortgage rate to 4-4.5% and re-launching consumer credit, respectively.
We should learn from recent history. Certainly mortgage rates fell to 4% during
2003-2006. Unfortunately, the average monthly mortgage jumped from an
affordable $600 per month to a prohibitive $3,000 per month, resulting in
millions of foreclosures, bank failures, and bailouts. Increasing consumer
loans would be tantamount to creating purchasing power against a zero increase
in goods and services. Besides certain default, such a policy will reduce
savings and investment.
Maintaining interest rates at zero bound will drive banks out of existence and
devastate the real economy. Intensifying inflation will deflate the real
economy. A central bank should have a strict mandate of managing liquidity and
should observe a fixed, extra-constitutional, rule regarding strict ceilings on
money and credit. If the Fed's role is not redefined within limits, the US
economy will continue to suffer huge economic distortions, financial disorder,
inflation, and economic recession. The dollar could collapse and the world
economy could be in turmoil for an extended time.
Hossein Askari is professor of international business and international
affairs at George Washington University. Noureddine Krichene is an
economist at the International Monetary Fund and a former advisor, Islamic
Development Bank, Jeddah.