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Sunday, April 20, 2008

"The Princess’s Cake"

Wolfgang Münchau says monetary policy shows "contempt for the poor":

The princess’s cake gets an added crunch, by Wolfgang Münchau, Commentary, Financial Times: “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...

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. ... 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 ... 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. ... Too much money is ... chasing too few goods –... 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. ...

Second, financial market indicators do not show any strong evidence of a rise in long-term inflationary expectations. ... 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. ... 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. ... 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. ...

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.

A key part of this story is that monetary policy caused the increase in food and oil prices. I'll just add this:

Commodities and speculation: metallic evidence, by Paul Krugman: We’ve had a huge runup in commodity prices — fuels, food, metals. But why? Broadly, the debate is between those who see it as a speculative phenomenon, driven by some combination of low interest rates and irrational exuberance, and those who see it as a collision of rapidly growing demand with constrained supply.

My problem with the speculative stories is that they all depend on something that holds production — or at least potential production — off the market. The key point is that the spot price equalizes the demand and supply of a commodity; speculation can drive up the futures price, but the spot price will only follow if the higher futures prices somehow reduces the quantity available for final consumers. The usual channel for this is an increase in inventories, as investors hoard the stuff in expectation of a higher price down the road. If this doesn’t happen — if the spot price doesn’t follow the futures price — then futures will presumably come down, as it turns out that buying futures produces losses.

Which brings me to this chart, from the IMF’s World Economic Outlook:

Bubble, bubble, where’ the bubble?

As far as I can see, this creates real problems for any claim that high metal prices are speculatively driven. Food inventories are also historically low. I just don’t see how a low-interest-rate or bubble story works here.

    Posted by on Sunday, April 20, 2008 at 01:05 PM in Economics, Monetary Policy | Permalink  TrackBack (0)  Comments (12)


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