Aug 13, 2008

World Inflation Soon to Fall

Andy Xie recently wrote in the South China Morning Post that the world is now facing a decade of inflation fire. The reason is that the central banks around the world, especially the Fed, have been overly expansionary. According to him the US has been engulfed in piles of debt, and asset values are declining to the extent that “the US financial system may be bankrupt as a whole.”

It is true that the US has been engulfed in piles of debt. In fact, the corporate sector, the household sector, and the government sector are all net debtors. It is also true that the Fed has been very aggressive in providing liquidity to the financial system since August last year. However, I had determined that the Fed had been overly slow in responding to signs of trouble. If the Fed had started easing early last summer, the calamity would have been scaled down considerably. But better late than never: thanks to the Fed’s aggressive actions, the financial system has been saved. If the Fed had set its eyes on containing inflation single-mindedly instead as some analysts had advised, a repeat of the Great Depression in the 1930s could not be ruled out. Inflation would be contained, and deflation would set in, and unemployment from 15 to 25% could become reality, with tens of millions of people around the world falling into bankruptcy.

Although the Fed has been aggressive in injecting liquidity to the financial system, the assumption that this would cause inflation is wrong. The liquidity served mainly to counteract a contraction, so that the economy could continue to grow. The Central Bank has acted wisely, and has taken its lessons from the Great Depression. Thanks to Ben Bernanke, the humble student of the Great Depression, this time around the Fed will not take any chances.

It is true that many speculators had placed their bets on oil and commodities, and thus fueling a spectacular price surge. But speculative demand cannot go against the law of supply and demand forever. Speculative demand in the final analysis has to be supported by concrete demand for the hard commodities. With a slowing economy, the required buoyancy of demand was simply not there. Consequently commodity prices including oil prices have fallen sharply in recent weeks.

In the final analysis, inflation is a phenomenon of supply against demand. It is true that if money expansion keeps pulling demand beyond supply, inflation will flare up. But demand depends on many factors. The major declines in asset prices is in itself a demand-suppressing force. The rise in unemployment is another demand-suppressing force. The surge in the pricing of risk is yet another demand-suppressing force. Investment is slowing down; consumption is slowing down. US exports have been strong so far, but are expected to weaken considerably with the European and Asian economies slowing and the US dollar strengthening. With the strong RMB the Chinese economy will slow down very rapidly over the next few quarters. All of these factors are eroding aggregate demand, so that real growth has slowed down and will remain very mild over the next few quarters. The injection of liquidity is only preventing the slow-down from aggravating into a fully-fledged recession or even depression.

Three cheers for Ben Bernanke! His innovative and bold ways of lending support to the fast weakening financial system are needed. His proposals to tighten up regulations especially in the lending practices and to improve the governance of financial institutions are both required. He has my full support, and I am positive inflation will not flare up as Xie predicted. Instead, inflation is going to ease considerably. The world economy has been saved!

2 comments:

Trader101 said...

Hi

I am puzzled about if it should be inflation or deflation coming and your article I think provide helpful points. Thanks.

Wonder what do you think of the possibility of deflation (in asset prices) and inflation(commodity driven especially food and energy) at the same time? Seems like Jim Rogers is seeing inflation and Marc Faber seeing deflation more likely.

Lok Sang Ho said...

The correction of asset prices reflects the rise in risk aversion, which deters buyers and sometimes leads to forced sales. I think this is only temporary.

One thing that I can be certain about is that over the longer run asset prices will move up again.