Something strange is happening to the American economy and the Fed may have to take some risks if it is to prevent a long, Japanese-style recession. It seems that the long-run relationship between broad monetary growth, inflation and economic growth in the US has broken down. It has become a ‘stylised fact’, sanctified by Milton Friedman and much economic opinion, that monetary growth is a major factor in determining inflation and national income.
In recent years broad money has grown rapidly, but it has not prevented the collapse in economic growth since last year and it has not been reflected in inflation, which has remained low and stable. The graph shows how broad money growth has accelerated to over 12% year-on-year while real US GDP growth has collapsed from over 5% to less than 1% and inflation is steady at around 2%.
Alarmingly, there are other examples of periods when increases in money supply have been absorbed without noticeable effect and very relaxed monetary policy has failed as an instrument of economic stimulation.
Economies in this state suffer from a ‘liquidity trap’ where demand for liquidity matches — and sometimes exceeds — that supplied by the banking system. Monetary policy ceases to have its usual effect as consumers pile up cash deposits as a precaution against evil tidings. A prime and ominous example has been the Japanese economy over the last decade.
Panicked reactions
There can be two motives for accumulating cash: first, as a generalised precautionary measure; and second, as a means of benefiting from falling prices. If prices are falling it makes sense to hold off buying until prices are lower. Currently in America, liquidity preference has increased as fears of recession have intensified, greatly exacerbated by the terrorist attacks on 11 September. In addition, prices in the US have threatened to fall. In the month to October wholesale prices in the US fell by 1.6%, the largest monthly drop since 1946, representing a yearon- year decline of 0.4%.
The threat of deflation and recession had prompted increasingly panicky rate reductions by the Federal Reserve. So far the American central bank has cut rates ten times this year and there are even expectations that the Fed Funds rate could be cut significantly below the current level of 2% to 1.5% — or even less. The experience of Japan suggests that interest rate cuts alone will be insufficient to ward off recession. Furthermore the Japanese have had very little success with massive fiscal stimulation and the economy remains in the doldrums, despite lengthy application of conventional monetary and fiscal treatments. But the one sure cure for deflation and a liquidity trap is inflation.
Learning from example
This was the cure engineered by the Nazis, who financed their rearmament programme with inflation, camouflaged by extensive price controls. However, the Nazis soon discovered they had caught a tiger by the tail and the recovery could only be sustained by increasingly draconian controls.
Japan’s recovery has been stifled by the reluctance of its central bank to permit sufficient inflation to escape the deflationary forces, and by resistance to the necessary painful restructuring of its banking system and its economy in general.
America, in contrast, has a sufficiently liberal economy to permit the bankruptcies and business failures that have so far proved impossible in Japan. Further, the determination of the Fed to cut interest rates so aggressively suggests it may be able to take the necessary risks with inflation. The problem for policy makers is to judge how much inflation is needed to kick-start the economy without setting off an inflationary spiral. America looks certain to face a serious recession that it can only escape at the risk of an inflationary surge. In the mean time, ultralow interest rates seem certain to continue for some time.
Closer to home
What about the UK? Although the British economy is slowing, it is not inevitable that the UK will follow the US into recession. The chances of a UK recession next year are put at around 15%. Moreover, for the liquidity trap to operate, there must be general expectation of falling prices and a desire to amass cash ahead of a looming contingency, such as redundancy. The UK is much further from these circumstances than the US, which is in turn, further from these conditions than Japan. It seems we are safe for now.
