The story of inflation: balloons, bubbles, and baubles
The way inflation works in an economy has been compared to an expanding balloon. Blow too softly, the balloon looks flaccid and wrinkly, blow too hard, the balloon pops. The meaning of the image is intuitive. Inflation operates in an economy the same way as blowing into a balloon, it works well as long as it is steady and kept in moderation.
Such was the case in the 1990s. Inflation rates were benign and gave us the Goldilocks economy, where inflation was not too hot, not too cold. In 1998 that came to an end when the hedge fund Long Term Capital Management sank and threatened to take Wall Street with it. Goldilocks nearly came a cropper. So acute was the risk that the Federal Reserve dropped interest rates to keep the financial markets going. From then on, the Fed made it known it could be relied on. A new phrase entered financial jargon: “the Greenspan Put”. It meant that central banks would never let interest rates be a tripwire for markets.
Ever since, inflation has been kept low, to the point where it’s tempting to see it as a thing of the past. It’s a tempting thought — but is it true?
The economy of the Noughties was characterised by a different, more concerning image — the bubble. It was a distinct change from the idea of the inflationary balloon. The difference is that balloons can avoid bursting. But not bubbles. They always pop. Around 2008, just in time for that year’s market collapse, a new phrase started doing the rounds, “Irrational Exuberance”. The idea this time was that, once Central Banks had made sure interest rates suited the financial markets, there was nothing irrational about market exuberance. In fact it would have been irrational not to jump on the bandwagon of rising equity markets. But by 2008 the bubble popped, the financial crisis gripped global markets and lowering interest rates — even to zero — no longer spurred economic activity.
The remedy was Quantitative Easing. A interest rates were at zero and still economic activity was at a standstill, central banks borrowed an idea first tried by the Japanese central bank to stimulate the economy — they effectively printed money. The net result was a recapitalisation of the banks and an increase in lending. To be sure, there were some detractors of this measure — but faced with the threat of a collapse of the banking system, this fudge seemed the lesser of two evils.
In 2008 it was thought that bank rescues would restore business activity and so, further down the line, wealth would spread out through society. A decade later, these forecasts have not worked out. In theory, low interest rates encourage investment, which should create jobs and raise wages. But in fact incomes have stayed level, and the plight of the many is in stark contrast to buoyant prosperity of the few. The outcome of each new instalment of QE has mirrored the outcome of each new drop in interest rates, namely, a weaker booster effect on the economy overall. Wealth differentials have widened not narrowed.
There is a phrase that comes to mind to describe the present economy: bauble inflation. Differentials in interest rates are all but wiped out and hence no longer tell levels of risk. Consequently, it becomes harder to distinguish the relative worth of assets that are productive compared to those that are not. For example, low interest rates make it easier for a company to propel a share price up by buying back shares than by investing in gains to productivity; low interest rates encourage house buyers to pay over the odds for a new home; low interest rates enable consumers to pay for their holiday through their overdraft rather than through a salary increase. In 2020, leverage in the economy is higher than it was in 2008. However, a squeezed balloon compresses where pressure is applied but elsewhere bulges. And all the while inflation indexes are low, meanwhile, inflation has been rising in sections of the economy that are brazenly unproductive: check out the last few years’ price rises for a Bentley, a Breguet, or Manolo Blahnik shoes.
A critic tut-tutting at conspicuous consumption might appear a killjoy. But once inflation distorts the relationship between values and prices, inevitable repercussions follow. Some examples are plain to see. The run on gold has a flip side, namely a flight from cash. Another is negative interest rates, as seen on recent issues of government securities: when savers get back less than they handed over — such is inflation by another name. Discontent simmers in sections of the population that feel left behind. The balloon and the bubble economy came to abrupt ends; one hopes the bauble economy is not succeeded by something worse.
