Reemergence of stagflation

Milton Friedman warned that high inflation would only worsen unemployment. Countries on both sides of the Atlantic are proving him right.

Jim Young/Reuters
The Federal Reserve held its key benchmark US interest rate steady on Tuesday, opting to soothe rattled financial markets with central bank lending facilities rather than cut rates.

In the United States, the Federal Reserve has doubled its balance sheet by buying up dodgy-looking securities. In the United Kingdom, the Bank of England has injected £200 billion into the economy by buying up equally dodgy securities, namely government bonds (well, that has been the effect, at least). And people on both sides of the Atlantic worry: does all this new cash that the authorities have created and spent mean that inflation is going to go through the roof? Already, the numbers look bad. In the UK, inflation is well over its 2% target. In both countries we see the classic 1970s stagflation of high unemployment and high inflation that Milton Friedman warned us about. Inflation, he said, would not mop up unemployment; rather, the uncertainties, distortions and investment mistakes caused by inflation would actually make unemployment worse.

Meanwhile, everyone is complaining that the banks aren't lending enough of all this new cash that has come into their hands. Small businesses in particular have folded as the banks finally pull the overdraft rug from under them. But larger businesses are not exempt either, particularly those producing the luxuries that people don't feel they can afford right now.

As usual the banks get all the blame, but then the politicians put them in an impossible dilemma. First they were told they had to 'strengthen their balance sheets' – that is, keep more rainy-day cash in their vaults so they won't run out of money like they did in 2007 and 2008. Then they have been told to lend more to boost business and preserve jobs. Well, they can't do both.

And tough though it is on businesses, and on those who have had to take pay cuts or who have been laid off, it is probably just as well for our general economic health that the banks aren't lending so much. Normally, injections of new cash allow the banks to lend, at the stroke of a pen, many times more than they get in, such are the joys of fractional-reserve banking. Right now, though, the banks are running scared and the new cash is going straight into their reserves.

So my guess is that inflation will be less of a problem than most of my monetarist friends believe. Indeed, raising interest rates right now would cut into businesses' faltering recovery, rather than spare us from inflation. The question, however, is whether the Fed and the Bank will be brave enough to start reining in borrowing once the recovery is sufficiently solid. Central bankers love booms; but let us hope that this time, they have learnt their lesson.

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