A great amount of the work economists do ultimately comes back to the question of inflation: how to anticipate it before it arrives, and how to deal with its threat once it materialises.
Such is the centrality of price growth that when the Bank of England was granted independence from the government in 1997, it was given a mandate linked to controlling inflation at or near 2 per cent. Unemployment, GDP growth and other similar preoccupations were deemed secondary, or at least outside its remit.
Those who believe in monetarism, the economic system which prevailed under the Thatcher government, take the view that the velocity of money – that is, the speed at which it moves through the economy – is constant, and that the supply of money (the amount circulated by banks via loans) is variable.
This means, to a monetarist, that higher inflation is caused by there being too much money circulating in the economy, leading to excess inflation and an economic crash. Those who subscribe to this view believe that the correct response to a recession is to reduce the supply of money in the economy. That should push inflation downwards, increasing the spending power of consumers, raising the level of demand in the economy, and lifting the country out of recession. To monetarists, therefore, inflation is always an evil to be combated.
Followers of the economist John Maynard Keynes attribute far more weight to the idea that the velocity of money is not constant, and that speed is what influences its supply. Advocates of this argument take the view that velocity is more important than supply.
If consumers, banks and businesses lack confidence in their individual economic prospects, then they will horde the capital they have, rather than spend it. Such hoarding slows down the pace at which money moves in an economy, and if economic participants are hoarding, then banks have little need to increase the supply of money by issuing new debt.
The Keynesian response to a recession is to have the government increase the supply of money by borrowing, and its velocity by spending quickly, to stimulate growth. Spending should, in theory, increase the velocity because it would help reduce unemployment, causing individual spending power to rise.
Keynesians would then treat the subsequent inflation as a temporary phenomenon to be managed by reducing government spending in times of plenty. Consequently, this approach is more relaxed about inflation.
Theory behind QE
Since the global financial crisis of 2007-08, the consensus pursued by policymakers around the world has been that of quantitative easing, an attempt to merge the concerns of both of the above theories.
Advocates of QE argue that the great depression of the 1930s happened because failing banks reduced the money supply, and that the solution was for a rapid injection of excess supply into the banking system.
This theory supposes that by directing the extra capital to banks, the velocity of money will also rise because banks make a profit by lending. Interest rates are kept low to ensure the velocity of money also increases, as this should improve help velocity by making the hoarding of cash less attractive.
Traditional monetarists dislike QE as they feel a rapid expansion of the money supply simply creates inflation without growth. Keynesians are wary of this policy because they believe it doesn’t stop hoarding. As Standard Life Aberdeen fund manager and ardent critic of QE Bruce Stout puts it: “You can take a horse to water, but you cannot make it drink.”
A decade after the policy was implemented, the Keynesians would argue that the tepid growth and inflation rates of the past decade show that the velocity of money is more important than supply. Monetarists will point to the inflation in asset prices since then, without a concordant rise in economic growth, as evidence that their view of the effect of a rapid expansion of the money supply on the real economy is vindicated. Others who subscribe to a broadly monetarist view of the policy believe that inflation will arrive, sharply, in the near future.
Secular stagnation
The reason inflation has not become more pronounced may be, according to former US treasury secretary Lawrence Summers, because the world is in the grip of what he calls “secular stagnation”. This is the idea that a combination of ageing populations, elevated debt levels, and the disinflationary forces pressing into the economy from technological change mean that inflation will remain lower than has historically been the case, as will economic growth.
But while there is broad consensus that the trends identified by Mr Summers are real, views vary on what their outcomes will be. The difference of opinion largely comes down to a judgement on what type of disinflation we get, and how people react to it.
Britain experienced strong economic growth for the majority of the 19th century, with negative inflation, as a result of technological advances. For investors such as Nick Train, this is because technology makes most goods and services cheaper for the consumer, allowing them to buy more, which increases demand in the economy without overall inflation rising.
As a result, Mr Train has loaded his funds with financial services shares, as he believes the lower interest rates justified by lower inflation will mean more investors pile into stocks for return. He is also heavily invested in consumer and luxury goods companies as he believes long-term disinflation will increase spending power on luxury items, boosting economic growth.
Meeting this wave of technological innovation are the threats of ageing populations and debt, which drive down inflation without adding to growth.
Policymakers try to understand the origin and outcome of particular bouts of inflation by examining the trend rate of growth. If an economy is expanding much faster than its natural potential, then inflation will occur, and interest rates will need to rise. If growth is taking place, but only at below-trend levels, then it can continue without inflation becoming an issue.
James Thomson, manager of the Rathbone Global Opportunities fund, says a major issue at present is that estimates of the trend level of growth in major economies are being revised downwards – while at the same time central banks (most clearly in the US) have raised rates for fear that economic growth has continued for long enough to mean inflation is around the corner.
He notes that global purchasing manager index surveys, which are regarded as a leading indicator of future growth, have weakened in recent months across the world.
The political angle
Just as the data seems determined to defy the consensus view by not producing inflation when expected, so the rise of populist politics has created more mud in the waters of the global economy.
Populist politicians of the left tend to pursue policies that create inflation as they pursue higher government spending. Populist politicians of the right tend to create inflation by increasing barriers to the movement of goods and services, via immigration controls or tariffs. This creates the net opposite of the gains Mr Train sees from technology, with inflation rising faster than growth. The effect of the heightened barriers to trade can be longer lasting than that able to be produced by Keynesian stimulus, leaving the world in a position where inflation is persistently higher than the economy can sustain. This prevents economies from achieving a stable trend level of growth.
One of the more interesting alternative theories to emerge in recent years is modern monetary theory. Among its principal advocates in the UK is Richard Murphy, an economist at City University London. The idea is that the government, as the sole authority capable of printing money, can therefore control its supply and use this money to pay its debts.
According to Mr Murphy, and others, this means that there is no limit to how much a government can borrow. Advocates of this theory take the view that any resultant inflation from the increase in the money supply would be offset by raised taxes. Higher taxes reduce the spending power of individuals and so should be disinflationary.
Jonathan Portes, a professor at King’s College London and longstanding critic of the government’s economic policy, says such an approach is unsustainable, because eventually there would either be nothing left to tax, or inflation would take hold in the conventional way. But it continues to gain advocates, including in some quarters of the Democratic party in the US.
The battle between the deflationary pressures of technology and the inflationary pressures of populism could define economic thinking, and investment performance, for years to come.
David Thorpe is investment reporter at FTAdviser.com
