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Wednesday, March 3, 2010

Inflation in the US ? Judging By The Situation in Europe, Not Too Likely

It seems inconsistent to me that the same people that argue the most that the US economy is headed the way of Europe seem to think inflation is coming soon. I think they forget the quantity theory of money equation from the monetary from their macoeconomics 101 class (or never took it) This is despite the fact that many who think inflation is coming around the corner are arch conservatives and the major advocate of this view in recent history was Milton Friedman. The basic equaltion is this:

 MV= PT (the Fisher Equation)

Each variable denotes the following:
M = Money Supply
V = Velocity of Circulation (the number of times money changes hands)
P = Average Price Level
T = Volume of Transactions of Goods and Services  

.... merely raising the money supply by taking interest rates low is not sufficient to cause inflation. Without velocity from increased circulation of money through bank loans use of those loans to hire and start new business and increased consumer purchases means no velocity and hence no inflation. While I won't argue Keynes had the answer here he certainly had a good characterization of this situation. Without the "animal spirits" of businessmen and consumers there is no increase economic activity and hence no economic recovery and certainly no inflation. With the fed having interest rates near zero many  the fed is pushing on a string a phrase also attributed to Keynes simply put thing of the difference between pulling a rubber band and pushing on a ball of string

inflation or a double dip recession. Judging my this description by columnist David Leonardt of the NYT it looks like the greater risk is for the latter. In fact he notes that pushing on a string may well be what is happening

 ...the economy’s biggest problem has not changed. When bubbles pop, they wreak enormous, lasting damage. Credit stays hard to get for years because banks need to rebuild their balance sheets. Families and businesses, whose net worth isn’t what they thought it was, have debts to pay off.

Over the last two years, households have been paying down their debts at a fairly good pace. But they aren’t yet close to being finished.

The average household still has debt that eats up roughly 17.5 percent of its disposable income — in mortgage payments, minimum credit card payments and the like. That’s down from a peak of 18.9 percent in 2008. It is still above the 1980-95 average of about 16.6 percent, according to the Federal Reserve. So debt payments will continue to hold down spending in the months ahead. the fed is pushing on a string a phrase also attributed to Keynes simply put thing of the difference between pulling a rubber band and pushing on a ball of string

I wont't be as extreme as some to say the US is about to become the next Greece but the description below of the eurozone might well apply here albeit perhaps to a lesser degree. From the wsj (my bolds, my comments in  blue) In Europe and quite possibly in the US the constraint on economic growth is more likely to be deflation not inflation.

Deflation Threat Is Latest Headache for Euro Zone

FRANKFURT—European countries struggling to plug gaping holes in their state finances face an additional headache: not enough inflation.
A prolonged fall in prices, which economists call deflation, are a real possibility in some euro-zone countries including Spain and Ireland, analysts say. Others, including Greece, face years of very weak inflation. Such an outcome could make it even harder for the euro zone's weakest economies to escape the downturn, and for their governments to repair their budgets and reduce their public debts.
"It's a very strong risk that Spain and Ireland will face a very long period of deflation," as collapsing housing bubbles continue to ripple through their economies, says Jennifer McKeown, economist at London consultancy Capital Economics.
The combination of high debt and falling prices on the once fast-growing fringe of the euro zone would complicate hopes for a wider recovery in the euro zone. Spain and other countries on the bloc's periphery have been a key driver of the region's growth in the past decade.,,,

Consumer prices are already falling in Ireland. They risk doing so in Spain, many economists say, where unemployment is at the highest level in the euro zone. Consumer prices in Ireland are down 2.6% from a year ago, the biggest drop in the euro zone. ....
hat could complicate the already fragile calculations of Greece, Ireland and others as they try to rein in their bFor businesses, lower prices of consumer goods and services often mean lower profits. For governments, they mean less tax revenue, especially in European countries where sales or value-added taxes make up a large share of tax receipts......
Deflation occurs when falling prices become embedded in the mindsets of households and businesses, causing them to delay spending, investing and hiring because they believe goods, services and labor will cost less in future. Such expectations and the cautious behavior they lead to can trap an economy in a kind of malaise that has gripped Japan for the better part of two decades.

with the interest rates at near lows, lower tax revenues and stimulative govt spending reaching its limits due to budget deficits the picture is quite gloomy. And supply side myths to the contrary lower taxes might spur some economic activity but they will increase deficits. And with consumers and businesses in deflationary mode it seems unlikely they will use the lower tax rates to spend and expand. In short not pretty and certainly not inflationary. 

in fact.... 
Economists generally agree that a bit of inflation is a good thing: In moderation, rising prices help fill government coffers through greater tax revenues, and can make it easier to pay off public debts by shrinking them as a share of government revenue. More than a little inflation, however, is a menace, most economists and policy makers say, based on bitter experiences like the 1970s, when inflation in many industrialized countries undermined economic growth and employment, and required a painful spell of high interest rates to curtail....

ECB President Jean-Claude Trichet cites survey data showing professional forecasters expect inflation to be right around the central bank's target of just below 2% in five years' time.
That's true for the euro zone overall. However, the roughly 20% of the euro zone made up by Portugal, Ireland, Greece and Spain could face much lower inflation than the euro average, and possibly declining prices in coming years, many analysts say.
Note the forecasts above: the countries with the highest deficits are forecast to have the lowest infation.
 It is unlikely tax cuts would change this kind of outlook on spending:

Cost-cutting at companies is spreading to the rest of the economy. Mr. Ballantine now saves up all his spare cash; he canceled his usual family vacation, and shops more than ever at discount stores.....

"People are spending less," says Ana Ordóñez, owner of Meva, a womens' shoes and complements shop in an upscale Madrid suburb....
Many more Spanish households expect consumer prices to fall in the next 12 months than to rise, according to a survey by the European Commission, the European Union's executive arm.


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