Path Dependency in the EU and U.S. Economies

This quote from a Deutsche Bank report on the differing approaches to rate-setting in the EU and in the U.S. is fascinating and instructive:

Recent and prospective differences between the Fed and the ECB in the conduct of monetary policy have been striking. The ECB has launched a Martian frontal assault on inflation while the Fed has opted for a more cautious and patient Venusian approach.

The historical experience of deflation and depression in the U.S., and of German hyperinflation and currency reform in Europe, plays a key role in shaping different responses.

I hadn't thought of it that way, but it strikes me as correct. Both regions see the current market problems through the prism of their most traumatic similar economic experience -- and in the U.S. that's the Great Depression, and in the EU that is German hyperinflation. It is a lovely example of path dependency in the economy, with policy approaches differing not on where we're going, but on how we got here.

[DB via Bloomberg]

Comments

[shareholdersunite]

It's not really that surprising. Some path-dependency perhaps, yes, but two factors are more important:
1) The EU financial system was not close to melt-down, like that in the US.
2) Real-wage resistance is generally much higher in Europe, which makes tackling inflation in it's early stages particularly important.

[mdmrjsds]

I agree that there are different responses, and your viewpoint probably has some validity. But the other factor here is the different perception of what inflation is. Within the general public, and it seems for some economists and central bankers, any price rise is inflation. I think this is a flawed definition. "Inflation is always and only a monetary phenomenon". That is, only the debasement of a currency yields inflation.

For example, imagine there are two farmers living next door to each other. One produces milk and eggs, the other produces bacon. They barter with each other and trade 2 gallons of milk and 2 dozen eggs for 5 pounds of bacon. At the farm gate each can sell the bartered produce for 10 dollars.

First scenario. The government doubles the amount of money in circulation with all other things being equal (that famous economic caveat :-) ). The two farmers still barter at the same level, but now they sell at the farm gate for 20 dollars. This is inflation, a monetary phenomenon.

Second scenario. The money supply remains the same, but an article comes out in a scientific journal that bacon is an aphrodisiac. Demand for bacon increases dramatically, and the bacon farmer can sell his bacon at the farm gate for 30 dollars. The barter is now changed as well. The milk and eggs farmer has to trade 6 gallons of milk and 6 dozen eggs for 5 pounds of bacon. This isn't inflation, it is demand shift. The value that people place on bacon has shifted. The extra money being spent on bacon is money that isn't being spent on other goods.

What has this to do with central bank interest rates. Well, many central banks are mistaking the second scenario for the first scenario. They see rising prices and immediately assume there is inflation of the monetary sort. So they raise interest rates to slow the growth of the money supply (what an inefficient mechanism, but that is another explanation for another time). However, they are crippling their economies for nothing. What is occurring is a shift in demand that is causing a reallocation of resource distribution and thus a price increase. In the example above, they are trying to prevent the price of bacon from tripling because of an increase in demand. This is counterproductive and will be ineffective in curbing price increases, while unfortunately being effective at slowing growth in the economy.

Scarcity of supply or increase in demand is not inflation. If they persist in the folly of treating it as such, it won't end well for the world economy, and in particular it won't end well for their economy.

There is a special case, the countries that have their currency pegged to the US dollar. They are importing the inflation of the US dollar, and there is really nothing they can do in monetary terms to counter that. Their only effective recourse is to decouple their currency from the US dollar.

And in truth, there is really little the US central bank can do about it either. The US dollar is finding its market equilibrium as the distortion of being the world's reserve currency is slowly removed because the US economy is slowly losing its dominance in the world economy. It is difficult to tell the actual rate that the US central bank is debasing the US dollar because they have stopped publishing statistics about the growth of the money supply that would show it clearly, but it is clear that there is some level of debasement going on as well as the equilibrium adjustment.

[icandoitdon]

mdmrjsds.....

nice explanation of inflation as a monetary phenomena. but there is much more to our economic problems than inflation/deflation and it is unprecedented in modern history.

the loss of confidence in the u.s. dollar has extraordinary implications, some of which we've seen as of late...specifically the price of oil. oil is no longer trading as a raw commodity. it is trading as a financial instrument. holding dollars is getting increasingly unattractive due to negative real interest rates, which seem to have become institutionalized under federal reserve policy, and the steady decline of our currency, which the federal reserve and treasury are virtually ignoring.

imagine this scenario:

china decides to let it's currency float against the dollar in order to help contain their inflation problem. but they become fed up with our fiscal/monetary mismangement and tell us that they will no longer purchase our treasury securities to fund our structural debt. they insist that we borrow and repay in their own currency to protect themselves from the our dysfunctional economic policies.

what is u.s. inflation going to look like under that scenario? under the current policies of artificially low interest rates and never ending budget and trade deficits it will go parabolic and utterly bring ruin the u.s. economy. for those who believe it cannot happen because the world "needs" the u.s. consumer, i beg to differ. it's just another version of the bogus "too big to fail" argument.

alternatively, what if the arab states decide to decouple from the dollar and price their oil in some other currency. we're lucky that oil is priced in dollars today...if it were priced in euros, all other things being equal, we'd all be walking.

we are a nation that relys on imports and we cannot afford to have a weak dollar. this "weak dollar helps exports" nonsense doesn't hold up. countries cannot devalue or borrow their way to prosperity and we're trying to do both.

current u.s. fiscal/monetary policy is dysfunctional and must be changed regardless of the short term pain it brings, which will be substantial.

[billp37]

Paul Kedrosky has gotten more visible since he got involved with Iran in Jim Rogers interview.

www.theoildrum.com/nod...

[fran]

to varying extents we are all creatures of our past.

the disappointing fact with many living today is either their lack of historical knowledge or their blindness to current circumstances; or in some[many?] cases, both.

such is the basis for invention/progress or repetition/failure. what will the future wrought?

if we had the occasion to return at some far distant time, would history show anything new???

[theinvestingspeculator]

I think our Fed is to political. Ever since daddy Bush blamed Greenspan for his election loss. Fed is scared to let the economy clean itself out.

[James V]

Oil can not be priced in Euros because the European Bond Market is too small to cater for the volumes. It is also does not make sense for the Arab oil producing nations to unpeg the dollar because there economies are based primarily on selling oil (which is priced in USD). They can and are making adjustments for the USD debasement by pushing up the price of oil.

There are s few factors behind the surging oil price (apart from s+d):

China is trying to buy as much oil as possible as a means of flight to quality out of the USD. China is not stupid, they can see that the US is effectively devaluing their dollar and pumping up inflation to export their monetary problems. China is also aware that a contingency for a dollar crash is already in place which involves the a financial Treaty between Mexico/Canada/USA and involved the creation of a new currency to replace USD - the Amero. All debt owed to China will be devalued and priced in Ameros at whatever price Canada/Mexico/USA decide. If the Amero is put into circulation.
This incidently is how USA is going to write off it debt if the worse comes to the worse.

The speculators everyone is blaming for pushing up the price is actually an agency arm of the Chinese government. They are buying paper oil with their useless USD. The other speculators are the oil producing nations buying paper oil, restricting supply to drive the price ever higher. It could be argued that the Oil producing nations have waged an economic war with the USA covertly. Or it could be argued that they dont want to be holding devalued USD monopoly money and so are manipulating the price of oil to reflect loss of USD purchasing power. **REAL INFLATION**

For those who want to look at the real numbers go to:
shadowstats.com

[Dan Walker]

icandoitdon, you are right about large investors holding (hoarding) oil which is causing our current problems. And you are, of course right about the FED debasing out currency. You shanked one into the woods with the part about China letting their currency float. That sinks the dollar and we can no longer afford to buy their output. We have to re-start producing our own goods. Great scenario for the US (after a couple of years of severe pain which will happen anyway), but the Chinese leadership is not populated by fools and they will not allow that to happen. Just think in terms of 'if I were in charge of that kind of cash inflow' to see which direction they may go.

[bbzz24]

James V,
Your argument is total nonsense. I will liken it to: just because a baby is sucking on his mommy's *** it will never want to eat something else or suck on someone else's. So you argue that just because the Treasury prints so much bonds to finance fiscal irresponsibility, only it has the capability to accomodate the cash that oil sales generate. Really wise argument.

China does not care about the value of its reserves. If it did it will not keep it in currency that is being debased at 18% yoy. It wants to promote employment and increase urabnization which at 40% is about 2x lower than in the industrialized world. To achieve that it has to sell much more stuff to the U.S. and for that it can only receive worthless paper. If it changes its policy, then the U.S. dollar will be doomed and if it is not repriced on the terms of the creditor guess what: there will be no more sales on credit and that will lead to painfull due to the lack of productive resources in the U.S. change where all paperwork 'workers' will have to move to the fields and deal with agriculture as they have no skills to work on production lines.

[icandoitdon]

dan....

well, let me try to recover from my shank into the woods...

i understand your argument that it would not be in china's interests to let their currency float against the dollar because of the effects of "demand destruction" for their products on the part of the u.s. consumer, their biggest client. this not a given to me. consider the following:

1. the u.s. has long maintained that the chinese currency is undervalued against the u.s. dollar. they want the chinese currency to strengthen to help u.s. exports and our trade imbalance. my view: be careful what you wish for.

2. a stronger chinese currency will help transition china from "developing" to developed economic status on the world stage.

3. if the dollar gets weaker...a distinct possibility...china's inflation problem worsens. how much weakness is too much and how much inflation will china tolerate before it has to act? we don't know.

4. the crux of your argument...that the u.s. consumer would no longer be a lucerative market for chinese goods if they were to float their currency...is specious. the u.s. consumer is already on his back and it is likely to get worse. our disposable personal income is under severe pressure and it is likely to get worse. many countries will feel these effects whether their currencies are linked to the u.s.dollar or not. my view: look for a worldwide recession caused in part by a collapsing u.s. currency, higher oil/commodity prices and an overleveraged consumer and financial system. the u.s. economy is structurally flawed and there is no fix that will ease the pain of correcting its imbalances.

for the moment the world is stuck with the u.s. dollar as the reserve currency and that is unlikely to change any time soon. it might not change at all if the u.s. can slowly start to address and solve its structural problems. but if we can't...or don't...look for these changes to be forced on us by our creditors.

[iThinkBig]

Hmmm. Good arguments all - In March of 2008 I submitted to the Administration the only way out of our monetary crisis is energy independance, subsidized with $150 B, some spread into responsible i-Banks and some into the SBA. Job creation, national security interests and eventual return to wealth building is the purpose. There is no other asset class the U.S. could build to cushion the free-fall we are in. I agree with another poster saying eventually we'll have a manufacturing boom as we will have to begin producing much more of our own goods. But first things first, you need energy to power everything else. There is promising technology for plug-ins for the transportation sectore but NOT accelerating them now leaves the U.S. in a VERY vulnerable position.

Yeah, I believe other nations are now waging economic war. Nations are opportunists. They must not realize how childish our leadership is, because our current leadership would consider invasions and confiscations of oil fields as justified- oooops, we aleady did that in Iraq... Perhaps they are just not sure how our spoiled children in Washington will act next...

The time to become energy independant of course is now, but we'll no doubt wait for the next batch of mental dwarves in Washington and then get half of what is needed. Meanwhile, the transfer of wealth to new global economic anchors such as Russia and the ME are right around the corner. We know they'll treat us just swell, don't we?

[messy]

Has this author forgotten the hyper inflation of the 1970's in the USA with 15 to 18% rates of interest and inflation above that. How well i remember retirees making a COLA DOUBLE of what workers were getting. Now that we have "core inflation indexing", its just the opposite due to government manipulations of indexing. Core inflation says 2.4% per year, and actual inflation is above 8.0%