WIll the ECB incite the Armageddon scenario?

Update 4 Jul 2008: see a fuller answer to this question at my new post: The ECB is right and the Fed is wrong

That’s the question Ambrose Evans-Pritchard addressed in his blog yesterday. I am firmly in the deflationist camp, meaning systemic risk from credit contraction is the most frightening risk for our economies. However, I believe that allowing inflation to rise exponentially does risk a potentially greater collapse once central banks are forced to react. Better to put the inflation genie back in the bottle now.

Evans-Pritchard takes a different view, praising the easy money policy of the Fed and criticising the ECB. I agree with him that this is not that 70s Show. It is more like that Japanese show or that 30s show. But, I don’t agree with him about the Fed being the better central bank here. Nevertheless, I do respect his arguments and he has shown great insight in previous posts.

Below is the beginning of Evans-Pritchard’s post.

Sadly, we are witnessing the sort of strategic errors that turned the recession of 1930 into a global catastrophe.

The European Central Bank is now hell-bent on a course of action that will have a knock-on effect across the world and risk a dangerous implosion of the credit system.

The ECB’s Jean-Claude Trichet told Die Zeit today that “there is a risk of inflation exploding.”

Let me put it differently: there is a grave risk of social and political disorder “exploding” if the logic of his argument is followed to its grim conclusion, that is to say if the ECB charges ahead with a string of rate rises through the autumn after its move to 4.25 per cent today.

The ECB mantra is that Europe and the world is on the cusp of a wage-price spiral along the lines of the 1970s. This directly contradicts Ben Bernanke at the Fed, who insists — correctly — that today’s conditions are not remotely like the 1970s.

(Perhaps this is uncivil, but I might add that Bernanke is one of the greatest economists of our age. Trichet studied political administration at ENA. He is a fine and honourable man, but he is a politician, not an economic historian)

The Telegraph, 2 Jul 2008

Yves Smith over at naked capitalism makes a more compelling argument regarding the Fed and ECB policy. She says:

Readers have taken to throwing brickbats when I post material that suggests that raising interest rates (at least in advanced economies) might not be a good move right now.

We’ve said before that the reason the Fed kept rates too low too long was it looked at inflation as strictly a domestic phenomenon and ignored the inflation-suppressing effects of cheap imports. That process has gone into reverse due to high oil prices and rising import prices. Remember, the reason high interest rates kill inflation is by slowing economic activity. That’s already happening, and I am highly confident things will get worse all by themselves if the Fed and ECB merely stand pat.

The problem is inflation in emerging economies, particularly China. The Chinese stock market (not a perfect indicator, to be sure) says growth is slowing big time. We noted in a post yesterday that there are other indicators, such as significant factory closings, that say Chinese growth may be about to downgear fast. We’ve noted in passing, and reader Independent Accountant noted longer form, that an increase in fuel prices is having the same effect as tariffs. Hello, Smoot Hawley?
naked capitalism, 3 Jul 2008

I suggest you read her post. My own view is that we have a pseudo Peak Oil situation. That is to say the available cheap oil given previous exploration and production is less than the total demand for oil. As a result, prices are going to go through the roof until the economy responds with demand destruction. Investment in the oil sector cannot take place quickly enough to be a relief valve for this situation.

(Whether we will ever be able to produce enough light, sweet to meet demand is questionable. I believe productive capacity has peaked and we need to find alternative sources or use technology to better extract the residual oil in existing fields. That will be expensive. But that’s a debate for another day.)

In my view, this is the reason for oil prices rising so high and is behind much of the inflation we see in oil and food. While I do believe this is temporary due to demand destruction, we do risk a wage-price spiral if this situation remains ‘temporary’ for too long. A few years ago, Stephen Roach thought you might have seen demand destruction at $70 a barrel. But here we are at double that level.

As credit contraction is the main economic worry over the long-term, raising rates once the inflation genie is out of the bottle and a wage price spiral has taken form is a recipe for disaster. The ECB, the BoE, the Fed, and other central banks are, therefore, faced with the unpleasant dilemma of deciding whether the wage-price spiral is likely to happen and to make their bets accordingly now. Waiting could be disastrous.

  1. Sobers says

    I’m a monetarist. Inflation is caused by an excess of money in the system. The only way to control inflation is to reduce liquidity and availability of credit. Traditionally this has been via increased central bank interest rates. However in the current situation the change in attitudes of the banks to credit risk has effectively increased interest rates and reduced credit to consumers and industry above and beyond anything dreamed of by the central banks.

    The current spike in inflation will rapidly fall when the effects of the reduction in credit availability kick in. When (and not if) the Chinese and Indian economies blow up due to their rampant inflation, the reduction in demand for commodities will reduce their price to a fraction of current prices. All the economic pointers are showing demand/consumption reduction ahead. It is therefore unneccessary to increase central bank rates. I’m am unsure as to whether doing so risks a 1930s style depression – on balance I think not. That may happen anyway, but not due to raised rates.

    The current financial situation is going to run it’s course, whatever the central bankers and governments do. It’s too big to stop, or change the course of significantly.

  2. Edward Harrison says

    I agree with you in general about the credit contraction being deflationary. However, I am not so sure things will run their course. As I indicated in the post, most people probably thought an oil induced inflationary spike might create demand destruction at $70 a barrel. Yet, here we are way above that level. To me, this suggests that inflation can and will do temporary damage to the economy before the scenario you envisage occurs.

  3. Anonymous says

    I agree with sobers comments. What is going to happen is already written. To much on and off the books to stop this boat from running aground.

  4. Worried says

    I think you put the cart before the horse surely?

    CB’s defend a target rate. To do that they provide liquidity or take it away.

    When the point comes when they are no longer willing to provide unlimited liquidity then they raise rates.

    Right now it seems the CB’s are going to exstraordinary lengths to ensure there is unlimited liquidity provided to the market at the target rates. It is a very inflationary scenario. Meanwhile of course there is massive delationary pressure.

    But it is a bit like being in a submarine. There is massive deflationary pressure and yet you can inflate and rise to the surface once again providing there is no system wide breakdown.

    Unlike in a submarine where it takes time to pressurise depressurised areas in an economy no time is really needed to produce instant liquidity for collapsed areas.

    The deflationary scenario myth is that money is debt. I think that one has been sponsored by the banks!

    But there are no magic answers here. Eventually one area of the world becomes poorer and has to compete for money with richer countries. This surely is now what is happening? It is manageable I think.

  5. Edward Harrison says

    worried, I share your believe that there are no magic answers here and that is just my cause for concern.

    The case I am making is this.

    1. Credit contraction is deflationary in a bad way as it increases debt burdens.

    2. However, the rise in commodities is causing consumer inflation.

    Given these two preconditions, what is a central bank to do?

    As you have stated, they can provide liquidity in order to stop the credit contraction to specific lending institutions who need it. However, that liquidity to stop the credit contraction does not have to be inflationary, because they can always sterilize their activities by selling treasuries. This liquidity is purely to grease the skids and not to inflate.

    Further, comes the question as to whether to inflate by not sterilizing open market activities. And then there’s the question of providing easy money by lower interest rates.

    In my view, liquidity is fine as it makes the markets liquid when liquidity is an issue. Inflation and easy money are not fine.

  6. Worried says


    >In my view, liquidity is fine as it makes the markets liquid when liquidity is an issue. Inflation and easy money are not fine.

    But is that not the deflationists argument in a nutshell? Ie it is not fine so it wont happen?

    But what is happening?

    You mention ‘consumer inflation’ is rising.

    Obviously our paper money is being devalued. Debt is being devalued.

    So the debt burdon is being reduced.

    The missing ingredient is rising wages.

    Its all a game. CB’s want inflation and they want rising wages. But they dont want too much inflation and they dont want too much rising wages.

  7. Edward Harrison says

    You and I are on the same track. The Fed does want inflation.

    Read my post here:

  8. Kent Nelson says

    Just stumbled across your site. Very informative, well thought out. I lived in Japan during/thru their bubble years. It took awhile before they came clean with how deep the problems were. I don’t think we’ve seen how deep this iceberg goes yet. But I don’t know how it will play out. Even when the Japanese central bank lowered rates to under one percent-banks still wouldn’t lend. What happens if U.S. banks close their doors to lenders even if the Federal government does back them? I’m still having a difficult time getting my arms wrapped around the current situation. Not even sure quite yet which facets of the problem I need to focus on most.

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