How Britain becomes a basket case

A couple of weeks ago, I suggested you keep your eyes peeled for four inflationary warning signs.

We talked about the 'inflation indicators' energy and precious metals. We talked about volatility in the market. We talked about a rupture in a Western currency. And I finished by talking about the velocity of money the speed with which money races around an economy.

The picture that emerges is one of central planners damaging faith in cash. The question is: how quickly could the central planners destroy a currency?

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Well, let's look at a country where the central planners did exactly that. I'm talking about Argentina.

This week the Argentinian government announced that the large supermarket groups must freeze prices for two months. They've even urged shoppers to keep receipts and report any non-compliance to a government hotline. Remarkable! This is classic interference by the central planners. And if we are not careful, we could end up going down the same path ourselves...

The UK is already following in Argentina's footsteps

The crucial thing about Argentina is that the public is rapidly losing faith in the peso. And that's only going to be exacerbated as the government leans on supermarkets to freeze prices. This latest measure will almost certainly lead to food shortages... I mean, everyone's going to hit the streets and buy up all they can before higher prices kick in, aren't they? Not only that, but the supermarkets aren't going to be in a hurry to restock shelves only to make a loss on everything they sell!

Freezing food prices for a limited period is likely to stoke what the economists call money velocity. That is, people will dump money and buy... well, just about anything, as faith in their money collapses.

Of course, here in the UK we're nowhere near a total loss of faith. But it's interesting to note some broad similarities between how Argentina wound up in this mess and where we stand today.

How to cook the books

In recent years, the IMF has repeatedly castigated the official Argentine data collectors. Basically, the planners are telling the public that inflation is running at just under 11%. And yet, Bloomberg reports the real figure is probably somewhere over 25%.

There are many ways to cook the inflation books putting together a consumer price index is, after all, more of an art than a science. And we're not above using the same tricks here in the UK!

First, you ignore any prices that are rising. Especially things like commodities and energy. Fair enough, maybe some of these things are knock-ons from the financial markets they don't represent entrenched inflation. And maybe we don't want to make too much of a meal out of these volatile things.

Second, if the price of beef steak goes up, then assume the punters will buy more of something else that hasn't gone up... turkey steaks maybe? Again, I'm sure there's a lot of truth in the principle of substitution but there's no doubt, it's a darned good inflation fudge too.

The third way to cook the books is through 'hedonic' adjustments. That is, the argument that if the quality of a computer, for example,goes up and yet, prices remain the same, then you've effectively had a price drop. Once again, it's difficult to argue with the logic... but do the statisticians similarly inflate prices when quality goes down? Of course not. To my mind, much of the useless tat sold today is absolute rubbish but this loss of quality isn't reflected in the stats.

The inflation truth will out in the end

But you can only pull the wool over the eyes of the public for so long.

Argentinian stocks have been doing rather well over recent years. At least, in terms of the peso they have. A falling currency tends to lift stock markets. Just look at Japan! International companiessuch asSony are reporting far better results now that the yen has finally started toweaken. The benefit is two-fold. First, the weak currency helps sales that's because your products are cheaper for foreign buyers. Second, foreign earnings are worth more (in yen terms) earnings therefore tend to go up.

Of course, much of this is illusory. After all, if the yen falls, then measured in terms of, say, dollars, earnings may not have gone up at all. But nonetheless stock markets go up.

It's a similar story here in the UK. Before the financial crisis, you'd have got aboutone and a half euros for your pound. Remember all those cheap holidays abroad? Yet now, despite the significant headwinds in Europe, the euro is much stronger. Today, all you'll get for your quid is something like 1.15 euros. It's the same with the dollar. Before the crisis we were getting around $2 to the pound. Today, it's less than $1.60.

So the pound has taken a pasting. And that's undoubtedly helped spur the FTSE and coveted London house prices too! But none of this helps your average Brit. The weakened pound has induced inflation at home. And despite what the planners say, the guy in the street is paying the bill.

The thing is, your average Brit isn't quite as savvy as the average Argentinian. We're not used to inflation and as a nation we tend to believe the figures as they're presented by the planners.

It'll take quite a while to whittle down the British public's faith in the pound. So for the moment, let's just enjoy the effects of inflation on the FTSE.

For many, the rising stock market has been good news. But let's not forget, much of this is down to inflation. Not reported price inflation, but inflation in the amount of money circulating in the financial markets.

And let's not confuse the feel good factor of a rising stock market with a healthy economy. Remember, Argentina is closing in on basket-case territory yet stocks are doing just fine!

This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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