Let them eat cake...

By: Wolfgang Münchau

“I remembered the way out suggested by a great princess when told that the peasants had no bread: ‘Well, let them eat cake.’”

Jean-Jacques Rousseau, Confessions

When I saw reports of food riots, I was reminded of these immortal words, often attributed to Marie Antoinette, although there is no evidence that she used them. The modern equivalent to “let them eat cake” is: “Core inflation is well contained.” Core inflation is a measure that excludes goods whose prices are currently rising the most – food and oil. It is a popular concept among some central bankers and academics, and an insult to consumers: let them eat refrigerators.

The global rate of headline inflation is 4.5 per cent and rising. Some economists had us believe a year ago that the rise in inflation was just a blip. But it kept on blipping. They predicted it would fall back in 2008. Now, they say it will fall next year.

We can waste a lot of time talking about the mechanics of the oil market or about speculators. Persistent inflation is not caused by oil sheikhs, ethanol producers or retailers, but by monetary authorities. A point Milton Friedman once made, and accepted even by many of his detractors, is that “inflation is always and everywhere a monetary phenomenon”. The rise in commodity prices is the consequence of a credit-financed economic expansion that has hit natural supply constraints. It is a very familiar story, except for geography. This time it is truly global.

In a recent empirical study using data from the Organisation for Economic Co-operation and Development, the economists Ansgar Belke, Walter Orth and Ralph Setser* claim to have found a statistical link between the global liquidity glut, the real estate boom and inflation. The emphasis here is on global. The key result is that both house and consumer prices are determined by global monetary conditions – but at different speeds: the housing market reacts first, with consumer prices following after some delay. Too much money is still chasing too few goods – except that it creates an asset price bubble on the way.

Unsurprisingly, not everybody agrees. There are four common, and not very convincing, arguments. First, core inflation is under control. Yes, incredibly, people are actually making that argument. There is an economic theory that says core inflation is leading headline inflation. If the two diverge, headline should adjust to core. Unfortunately, the opposite is happening now. Higher oil prices are pushing up prices of final goods, and workers are demanding higher wages, as they sensibly ignore core inflation.

Second, financial market indicators do not show any strong evidence of a rise in long-term inflationary expectations. These indicators include the yield difference between Treasury inflation-protected securities and ordinary Treasuries and their respective European equivalents. In fact, some of these indicators have actually gone up a little. But more importantly, they are not really forward-looking. The yield difference tells us more about liquidity conditions in those markets than about future inflation.

Third, the expected slowdown of US and global economic growth will take care of the inflation problem. A devastating global depression would probably have that effect. But fortunately, the world economy will be spared this calamity. There is no reason to suspect that Asia will suffer a recession, rather than a moderate slowdown. As I explained last week, the eurozone may also be a little stronger than the consensus forecasts suggest. The US recession will put a temporary lid on US inflation but, once the recession is over, prices will go up.

Finally, there is an argument I have been hearing a lot more recently: why bother? Let inflation go up a little. It oils the wheels of the adjustment, in particular for house owners.

Unfortunately, this may work for people with high levels of mortgage debt, but not for the poor and those on fixed incomes. In Europe, and especially in the south, there are people who have difficulty paying the vastly increased prices for bread and grains. Since poorer people spend a higher proportion of income on food and petrol than middle-class people, the inflation rise hits them hard. Higher inflation is the transfer of wealth from the poor to the middle classes. You might as well say: if you cannot afford the bread, let me eat the cake.

What about the fact that the US has a negative savings rate? Surely the country would be better off with higher inflation, as this transfers wealth from foreign creditors to US debtors? My guess would be that under such a scenario the US bond market would implode, the current account deficit would become impossible to finance, the dollar would collapse, inflation would rise even more and the Federal Reserve would have to raise interest rates to high single digits or higher. In that scenario, nobody eats cake anywhere.

I expect that the biggest danger to global economic stability will be not the credit crisis, but the way we are overreacting to it. Both in the US, and increasingly in Europe as well, monetary policies are no longer consistent with price stability. Since a pre-revolutionary contempt for the poor is a side effect of this policy, I suspect Rousseau’s unnamed princess would have found our early 21st century most congenial.

*Global Liquidity drives House Prices, www.eurointelligence.com

© The Financial Times Limited 2008

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