Wednesday, May 19, 2010

Is the world headed for Inflation or Deflation?

This is a tough one. Ever since central banks started creating money from nothing, Austrian school economists have been crying themselves hoarse about potential inflation. And yet it hasn’t been that much of an issue since Paul Volcker supposedly tamed the beast. Theory supports these economists, but experience doesn’t. So what’s really going on?

For one, theory often makes assumptions which don’t hold true in reality. “Ceteris Paribus”, a Latin phrase meaning “ other things remaining constant” is often used in economic theory but doesn’t really work in real life because almost nothing remains constant.

So when central banks started conjuring money, they not only added to the amount available for consumption, but also to the amount available for lending. This in turn led to the creation of capacities, which are now far in excess of consumption demand. Consumption demand should have risen as well, and it did, but looking at the scale of unemployment in all major economies, not enough to offset increased capacity.

This should ideally result in deflation and if one were to look at core inflation numbers (excluding food & energy) across the world, it has. On the other hand, sectors in which capacities haven’t really kept pace like food-grains, and those where natural limitations exist, like minerals, oil, metals etc., prices have been rising all through this period.

Rising prices of necessities, when coupled with falling prices for almost all other items, does not impact all nations equally. This differential impact is really a function of  the consumption pattern in these nations, which in turn is a function of their average per capita income. In high income nations, a lower proportion of income is spent on necessities when compared to low income nations. So increasing prices of necessities are more than balanced by deflation in other items as far as consumers in high income nations are concerned. On the other hand, in low income nations, necessities form a large part of the consumption basket and despite deflation in other items, perceived and experienced inflation remains high.

Average global inflation is, per force, GDP weighted while actual inflation is ‘per capita GDP’ weighted. This implies that while average global inflation will remain low and inflation experienced by consumers in high income nations will be slightly below this average, inflation experienced by consumers in low income nations will be significantly higher. Looks like the rich are getting richer and the poor, poorer.

Food for thought?

A version of this post appeared on my Business Standard Blog on May 18, 2010

2 comments:

  1. "Looks like the rich are getting richer and the poor, poorer."

    great stuff.looks like fiat money is achieving what it set out to do.

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