Inflation - A fine and fitting thing? 2

In my previous post, I pointed to what I feel is the real cause of the ongoing/oncoming inflation

http://rogueboysrants.blogspot.com/2011/06/inflation-fine-and-fitting-thing.html

I’d like to now look a the angle of government/markets, and assuming my theory is accurate why they haven’t picked up on this or if they have what the consequences have been/would be. This is from a UK perspective, but you can probably mirror most of it to similar economies.

Labour

Taking this back to when the issue arose, Labour were in Government. Labour are historically a left-leaning party who aim to redistribute wealth among their citizens by taking money from those who’ve got some and giving it to those who haven’t. I wouldn’t say that Labour were a socialist party, as it’s difficult to follow a socialist agenda in a capitalist Britain which is where we were in the 90s and where we are today, but they effected their ideologies during their tenure by increasing welfare payments and increasing the numbers of people working for the state.

This kept the majority of public support, who were working class or below, on their side. During this time, we experienced decent growth and by delegating responsibility for interest rates to the Bank of England, the inflation numbers were deemed to be good. Housing inflation was ignored of course, despite it increasing the money supply at consolidated level.

Essentially, during this period where housing inflation was increasing, but inflation was low, people were magically seeing their standards of living increase at a faster rate than we’ve tended to see historically. People put this down to good government, but as I pointed out in the first blog post, effectively they weren’t ‘carrying the one’ forward in the sums. This worked for them though, as it also increased indirectly the numbers they were dealing with in budgets and gave them the opportunity to redistribute on indexed taxation levels (using GDP as a base). Meanwhile the right-leaning in society saw their net wealth increase due to their abodes tripling in price. Everyone was a winner. This is odd of course, because the money supply was only increasing by true growth and true inflation or so we’re told. Interest rates were greater than inflation (not an exact science here – indicative only), so how were we all able to get rich at such a quick rate otherwise.

Labour must have known that housing inflation was the missing link – they had some smart people in there in Brown, Darling and Balls. At the BoE we had Ed George and Mervyn King during that time, both were Economists by trade. I think they all knew, but chose to ignore it because of the benefits, rather than lack of understanding of the bubble. To assume that none of these individuals were ‘Monetarists’ and never put forward this concern I find a little difficult to believe.

Of course, come 2007 when bluff was called on this money, Labour’s reputation was in tatters and at the next election Conservatives were put in power (with Lib Dems). Labour have never admitted to knowing this, and instead like to blame the bankers. For me, bankers will arbitrage differences. Whether that’s lending at a higher rate than then borrow, or whether that’s though repackaging mortgages and selling them on at a rate they can lend above – it’s all the same. The fractional reserve system will lead to exponential levels of exposure if you allow it and don’t regulate, but if you pretend account for more money than their actually is, that lie will come back to bite you. I don’t blame the bankers in any of this, the market was the market, so all are to blame for the price of ABN Amro, the belief that Lehmans were good for their debts, and the belief that Northern Rock had enough money in the vaults to pay back the deposits. We all shared the joys and the risk of this indexed position. Some ended up losing, some ended up winning – but it was a distorted baseline.

Market Reaction

Then came the ‘crisis’. Gordon Brown was quick to point out that this was a ‘Global problem, requiring a Global solution’. He had to say that. If he had come clean about the true cause and effect, the markets would have lost confidence in the money system. Essentially, the pound had become a concept like Time, where it has been defined but only so that others can benchmark against it. The reality is money had been created over and above what was disclosed. The economy had been inflated through the backdoor. Gordon Brown had no alternative, but to tell the world this concept was still valid and it wasn’t a UK issue but a global one. In many respects he was right, the same had happened across most of the Western World. Many economies had bluffed the world by creating more money and not telling anyone about it, and thus were in the same position. This is why I believe Gordon Brown knew what was happening all along, and when bluff was called he played this political Ace. This was backed by governments across the world who also pointed to it being a Global issue (some pointed the finger directly at America, but their fingers were stubbed by the door being closed on that opinion).

Gordon Brown then looked at Keynesian policies to try and spend his way out of the recession – it was never going to work, the money supply was depleting back to its true base and given his 40% spending had to be maintained in real terms, he would have ended up with a true socialist government spending closer to 60% or 70% of a rebased GDP. He did give it a go for a while, but Keynes himself often said the problem with people is that they always look to solve previous economic issues by using the previous solution, when every situation is different (I haven’t quoted him directly, as he said this repeatedly phrasing it differently each time).

Gordon soon realised with the help of the BoE, that the only way out of it was to print the money to cover the gap. In return the markets diluted the pound down to a reasonable level to reflect this, but no-one ever had to admit that the concept of the UK economy and the money supply wasn’t what they thought it was. In many ways, you have to admire Gordon Brown for this, he got the press blaming the bankers to further drag us away from the truth (an easy sell to the core Labour support who don’t like capitalism). Bad Bankers. They caused it through arbitrage of constants. Hmm, OK Gordon.

What if house price inflation was accounted for back then

There’s a lot of variables in that scenario, but let’s assume the BoE included house price inflation in their core inflation numbers. What would have happened is that interest rates would have been set a lot higher initially. This would have had the knock on effect of reducing the demand for borrowing, which would have kept housing price inflation in line with general inflation and growth (if they managed to get it right). Subsequently, unsecured debt would have been lower also as interest rates would have been higher too. Impact of this, is that we would have bought less, and this would have led to lower increases in GDP over the time period, but we wouldn’t have seen a recession as a result of it, even if it was marginally wrong.

Other options such as taxing gains on property wouldn’t have achieved the desired results, demand would have outstripped supply further and caused prices to rise to account for the tax in order to reach an equilibrium. Of course, selling a 200k flat at 180k to move into another 200k flat wouldn’t be desirable. I just don’t think this was the best measure at keeping costs down. Targeting the price of money seems the only direct-ish way.

What if we had come clean about the increase in the money supply during the crisis

Given it was a crisis and people were looking for any reason to sell, I think it’s fairly inevitable that market players would have sold everything British, from the pound to shares in our companies. People wouldn’t have wanted to hold anything denominated in Sterling and this would have caused a run on the pound. Selling the pound would have meant that people get more pounds to their currency and thus our exports would be cheaper, but it would cost us more to import. Given that we are a net importing nation, this would have caused inflation which would lead to further devaluation of the pound.

There would be a floor in this however, as exports would be desirable to other countries, but internal consumption would drop. It might end up leading to an equalisation of our balance of payments, but our standards of living would definitely drop. Government Bonds, you would think, wouldn’t be desirable if everyone was selling the pound, but given a return of say 8%, people would take that bet and hedge out with a currency swap/forward. I’m not so certain corporate would have survived given the uncertainty in the underlying economy. Any printing of money would have been analysed and frowned upon by the markets, given they were in the know at this point.

I think the knock on effect of announcing this overall ‘truth’ to the market is that they would take a greater look at other western economies and the dollar and euro would collapse also. Net effect, if Gordon Brown had told the truth – a shift in wealth from west to east?

Best keep schtum for Queen and Country.