The real answer to inflation that no one wants to hear: stop spending

Central banks are assuring markets they are dealing with spiralling inflation while doing nothing of the sort
That’s because the only solution is to cut the flow of money, but neither governments nor markets are ready to reform their high-spending and highly speculative habits

Andy Xie

Published: 10:00pm, 20 Jul, 2022

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The US Federal Reserve and other central banks are trying to convince financial markets that they will do everything possible to contain inflation.

To buy themselves time, the banks are playing psychological tricks on the market. While they are raising interest rates, they are not stemming the supply of new money that began when Covid-19 hit, which is the least that is required to contain inflation.

Stimulus spending has led to massive fiscal deficits and debt-fuelled housing inflation. Rolling it back would lead to a crisis bigger than that of 2008. The central banks intend to inflate away excess debt, but want to keep bondholders in the dark about it; as the Chinese saying goes, it’s best to boil frogs slowly, because they don’t jump.

Experts, central bankers and politicians are all talking about inflation. But they don’t talk about how we got here; instead, they emphasise the impact of the Ukrainian war. While there are many factors at play, the ultimate cause is excess monetary expansion since 2008 and its acceleration during the pandemic.

The US Federal Reserve building in Washington. Photo: Reuters

To deal with inflation properly, it’s important to understand why, for many years, the excess supply of money did not lead to inflation, what happened during this long lag, and why the dam separating money and inflation has now broken.

I have argued for the past 20 years that China’s entry into the world market was a one-time deflationary shock which kept inflation low despite rapid monetary expansion. The resulting excess liquidity kept interest rates artificially low and flowed into asset markets to create massive bubbles.

It allowed governments to run massive deficits during boom time and to escalate them to even higher levels during the pandemic. Yet China is no longer deflationary; it ran out of excess labour a long time ago and the government has done little to boost productivity.

Instead, China is trying to exterminate a virus, just as it tried to exterminate mosquitos, flies, rats and cockroaches in 1958, and the effects are both inflationary at home and across the rest of the world.

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If the West wants to contain inflation, it must cut the excesses built up during this free-lunch era. Fiscal deficits must come down quickly, and monetary policies normalise. Unfortunately, the long free lunch led to the build-up of economic and political practices that depend on free money, like government handouts and the rich getting richer on paper gains.

Normalising means, one, saying no to fairy-tale spending plans and, two, massive reduction in paper wealth. Politicians hate that. Their donors wouldn’t have the money to finance their careers, and the voters would throw rotten eggs at them. The pressure is all on central banks to keep the music going. That is why they must convince the market that they can handle inflation without actually meaning it.

The dollar is surging, thanks to financial wizards who arbitrage interest rate differences. As the US bond yield rises to 3 per cent – a pittance compared to an inflation rate of over 8 per cent – the wizards can borrow yen at near zero to buy dollar bonds. This force is crashing the yen and making the dollar pop. But it’s a trade based on fantasy.

Exchange rates fluctuate hugely. When the tide goes out again, the dollar-to-yen rate won’t go back to where it was; it will be much lower. But don’t tell that to the banks that finance such reckless trades.

A screen displaying the Japanese yen exchange rate against the US dollar in Tokyo on June 14. Photo: Reuters

The surging dollar is likely to tame US inflation for a bit. The rate may dip in the coming months. The Fed and the Wall Street cheerleaders will scream “it’s working”, disregarding that inflation is still way above interest rates.

This temporary illusion will bring back the bond buyers. The stock market cheerleaders will cry “buy, buy, buy” again. It will take many months for people to realise that the dip in inflation isn’t a long-term trend. Let’s see how long the Fed can fool the world.

Two decades of speculative bubbles have turned the world into a kind of Disneyland. Politicians no longer say “ask not what your country can do for you, ask what you can do for your country”. They always say that they can help. That means bigger and bigger budget deficits.

In three pandemic years, the US government has run up a deficit double the size of its spending during World War II to defeat both Germany and Japan. The world has become a crazy town. The people who run it don’t know and don’t want to know.

US President Joe Biden discusses his administration’s Covid-19 response at the White House in Washington on March 29, 2021. Photo: AFP

Western Europe is at war with Russia in Ukraine, even though it doesn’t say so. But it still pays Russia nearly US$1 billion a day for oil and gas. Russia uses the money to keep the war going.

As Russia threatens to cut off the gas supply, Europeans are talking about how to get through the next cold winter. Politicians don’t have the guts to tell them to wear more clothes to stay warm. They are trying to hang onto the last glass of champagne while the house is falling down.

The world is headed towards inflation and chaos, because people don’t want to accept the hard truth: you must earn money through hard work before you can pay for a good time.

Andy Xie is an independent economist