Are we headed for deflation or inflation?

Will world governments' "quantitative easing" trump the contraction in the world economy, or are we all headed for a Japan-style deflationary slump? Martin Spring weighs up the arguments.

Is the massive 'quantitative easing' essentially, 'printing' money in the US and UK to buy government and high-grade corporate bonds, both to finance massive state spending to support domestic demand, and to depress long-term interest rates going to lead to the explosion in inflation that many investors fear?

That's very difficult to know.

The inflation pessimists base their arguments on the assumption that those with cash will flee from paper into tangible products or real assets, with or without a global economic recovery.

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As Edward Chancellor (one of the few experts to warn of the danger of the credit crisis well before it happened) explains: "The continued hoarding of money depends on people believing that a fiat currency, such as the US dollar, will remain a store of value in future.

"If this confidence dissipates due to excessive measures by the Fed, then cash would be considered a hot potato. The velocity of circulation would rise and inflation surge.

"Inflation expectations might also shift if the markets lose confidence in the state of the public finances. Washington is set to produce a deficit this year of $1,800 billion. The cost of bailing out Wall Street runs to several thousand billion dollars more

"If market participants come to suspect the US government faces insuperable financial burdens and that the Fed is losing its political independence, inflation expectations are liable to change rapidly."

Consumers will come to prefer goods they can enjoy or will need to replace, such as cars, rather than cash; investors will come to prefer real assets such as gold and property to paper claims.

Although some experts argue that inflation won't pick up until the current 'output gap' - the extent to which demand falls below supply closes up, Chancellor warns: "There are times when inflation and economic activity move in the opposite direction." One obvious current example (not one he gives) is the situation in Zimbabwe.

British economist Peter Warburton thinks the output gap now estimated at a huge 8% of the world economy - has been exaggerated, as the credit crisis has done so much damage to global supply - companies have gone bust, working capital has been hard to come by, and inventories have been run down.

As the productive capacity of the global economy has shrunk, aggressive stimulation of demand is likely to trigger a surge in inflation.

In theory, when that threat seems to be about to become a reality, governments will stop printing money and cut back on their fiscal stimuli. To me, that seems hopelessly optimistic.

It will be politically impossible for governments to revert to conservative finances because of fears that doing so would plunge economies back into recession and because politicians are always keener to spend lavishly rather than cut back on spending, raise taxes, and see interest rates rise.

A friend who is a retired central banker said to me: "Quantitative easing is like a drug! Once started, central banks can't resist carrying on with it. Also, they know that stopping its use could create a major crisis and set back economic recovery catastrophically."

The inflation optimists hold a very different view of the future, basing their opinions not so much on theory as on the lesson of what actually happened in Japan after its (property-based) credit bubble burst in the 90s.

The imbalance that produces inflation does not come about if an increase in the supply of money is neutralised by a fall in the velocity, or actual use of money. This comes about when banks are unwilling to pass on increased money supply through lending, and/or borrowers are unwilling to take on more debt.

That's certainly the situation in the global economy now, although we're in the early years of the crisis.

Doubling money supply didn't kick-start Japan

Analyst and investment guru James Ferguson, who spent some time in Japan, says there, although the authorities ran a steady double-digit growth in money supply for over a decade, and then injected nearly 10% of GDP into banks' capital bases, "even after money supply as a proportion of GDP had doubled, Japan's banks were still shrinking lending."

In other words, their principal concern was to strengthen their balance sheets because of the load of bad debt they were carrying.

So the central bank doubled M1 money supply again over a period of just two or three years. "This would be like the UK boosting quantitative easing not by £75 billion or £150 billion but by £1 trillion and then by the same again," Ferguson says.

"Yet the impact on Japanese bank lending was nothing." Lending continued to fall.

The Japanese economy was rescued, not by mind-boggling amounts of money, but by a recovery in global demand for Japanese exports.

Ferguson asks: "Heard about the rampant hyperinflation in Japan recently? No? Exactly."

The Japanese experience suggests that quantitative easing won't lift economies out of their plunge into deflation because it won't be very effective in underpinning domestic demand.

My conclusion? I don't know which of these opposing viewpoints will be right about inflation longer-term.

However, I suspect that inflation won't be the problem for quite some time, because the contraction in the world economy will be worse than generally expected, and the recovery will be sluggish and protracted.

If inflation does eventually become the problem, it could be particularly nasty, because governments will be far too tardy and timid about taking the hard decisions needed to curb money supply as aggressively as they are currently expanding it.

This article was written byMartin Spring in On Target, a private newsletter on global strategy. Email to be included on the recipient list.