Spotting trends of Inflation

by | Jul 5, 2004 | Archives

The recent rising of U.S. dollar interest rates by the Fed confirms the answer to the question of what will happen next-inflation or deflation? The answer is inflation. This can have a profound effect on how we invest. The Fed finally feels that the economy is heating up. Many economists believe they are behind in this trend.

The global economy has many economic conditions that are similar to those in the 70s that caused rampant inflation and a U.S. dollar crash. The main inflationary force was a government that tried to wage a war and expand social spending all at once. (Does this sound familiar?) The huge deficit created by this undisciplined behavior caused the U.S. dollar to crash and prices to rise.

At that time fortunes were made by simply shifting out of the U.S. dollar into German marks, Japanese yen, Swiss francs and other European currencies.

This will not be the case this time around.

First, most European governments have abandoned their currency for the Euro. The, strong German mark, French franc and Dutch Guilder that offered inflation options in the 70s are gone. No evidence in history suggests that a currency such as the Euro can survive, much less do well.

One can learn a great deal about this problem from a British website which was set up to stop Britains from voting to replace the British currency with Euro.This site says:

“No one knows for sure what will happen. It is an unprecedented experiment in recent times for 12 states to have a single currency. There have been such experiments in the past century. In Germany there were several abortive monetary unions before Bismarck united Germany under Prussia. There was also a Latin Monetary Union in 1865 using the French Franc, and comprising France, Italy, Belgium, Switzerland, Greece and the Papal States; this ran into trouble quickly and was formally dissolved 30 years later. People say the Gold Standard, from which modern currencies evolved and which was formally ended after the second world war, is a parallel; but in fact any state could at any time withdraw or change the Gold Standard rules, relating the amount of its own coinage or currency it circulated to the gold it held in state vaults. So it was a voluntary, malleable arrangement- unlike monetary union from which there is supposedly no exit. Of course monetary union could in practice be dissolved or a country could leave it; no one expects the other members to force it back into the union by force, as the North of the USA forced the South back during the Civil War. This means that in the absence of a single state to enforce participation the euro is vulnerable to instability and uncertainty; a single currency really does need a single state.

“The biggest practical problem for the euro is managing monetary policy, in other words setting interest rates and so by implication the level of the euro's exchange rate against other currencies, especially the dollar. By having a single currency the 12 members must also have a single interest rate and of course a fixed unit of exchange against each others. Since an Italian Euro is the same as a Belgian euro, the interest rate you will get on an Italian bank deposit will be the same as what you will get on a Belgian bank deposit; if it were not people would switch between them massively until the banks were forced to offer the same. But having the same interest rate and exchange rate for all the very disparate parts of the euro area, from relatively fast-growing parts (like Ireland in 1999) to stagnant East Germany, is full of problems.

“It is bad enough managing the different regional needs of a single country with a single currency; think of the way that in the late 1990s the North of the UK attacked the strong pound and high interest rates because of their effect on manufacturing while the South was enjoying a service-dominated consumer boom which needed those things to control it. We cope with these strains in the UK in a lot of complicated ways; we help regions in trouble by a national system of taxes and benefits that automatically transfers more money to them, their MPs scrutinize policy generally to see how else they can be helped, then people are free to move from region to region, and finally we have developed a flexible, competitive labor market so that wages respond flexibly to regional problems.

“Are any of these mechanisms available in the euro area? In fact, basically none of them. When these strains develop in response to shocks, like regional recessions, the burden will entirely be on the European Central Bank to adjust the euro-wide interest rate and exchange rate. This adjustment could be right for the average region but it will be too tight for the regions in recession and too loose for the regions that are still doing well. The lack of regional monetary flexibility will add to the size of recessions and of booms in every region”

So the euro may not be a great escape from inflation and a falling U.S. dollar. More on why this is the case in our next message. Until then, good investing!