How Central bankers dropped the ball

By Neil Behrmann

December 2008:- Historians will narrate one day how central bankers were hopelessly out of touch with reality ahead of the greatest economic crisis since the thirties.

Despite numerous warnings, notably sliding US and European real estate prices, a worsening credit crisis and tumbling stock markets, most central bankers were mesmerised by inflation until only a few months ago. They kept interest rates at punitive levels for far too long. The US Federal Reserve Board was slow off the mark, but at least it acted a lot sooner than its European counterparts. The European Central Bank (ECB) and its Governor Jean-Claude Trichet, Merwyn King, Governor of the Bank of England and the UK Monetary Committee feared that inflation would accelerate. With few exceptions, central bankers and most economists didn’t appreciate that the inflation, caused by an unusual increase in energy, industrial raw material and food prices, had to be tackled in a different way. Since the inflation was not the result of a surge in money supply, excess credit and large wage demands, high interest rates were not the solution. It was ludicrous to keep interest rates high in a world economy that was already beginning to contract because of on going debt deflation crises.

The commodity inflation was initially caused by higher demand in the US, Europe, China, India, Latin America and other emerging nations and regions. Then hedge funds and pension funds caught the ball.  Prices soared following an extraordinary rise in so called “investment” i.e. speculative flows. That in turn led to fears of mostly nonexistent shortages and panic hoarding. Since global supplies were more than sufficient to satisfy normal consumer demand, the commodity bubble was bound to implode at any time. This in turn would be followed by a swift end to the global raw material and food price rises that had pushed up inflation.

Despite the evidence of rampant speculation, central bankers and their advisors chose to ignore warnings of experienced commodity traders. A collapse in shipping rates on the Baltic Exchange also indicated that global demand for commodities including coal, iron ore and steel was declining. Instead of inflation, the far greater danger was recession. Only one member of the Bank of England’s Monetary Policy Committee, David Blanchflower, stressed that inflation was not a problem.  He urgently advised from October 2007 that interest rates had to be slashed significantly and quickly. If rates were not cut aggressively the UK faced the prospect of a relatively deep and long-lasting recession. The European Central Bank, under the stewardship of its stubborn Governor and his economic advisors was even more blinkered in its approach and ignored worsening economic conditions first in Spain and Ireland and then in Italy, Germany, France and other members of the European Union.

The chart illustrates US deflation in the thirties, wartime inflation, mild deflation and steady prices in the fifties.  Then came the Vietnam and Yom Kippur wars causing runaway inflation. The Reagan Administration and Paul Volcker, head of the Fed brought down inflation and it has kept in a steady range from the eighties onwards.

Then it happened. Commodity prices collapsed. Crude oil, which was trading around $30 a barrel in 2004 and soared to $147 mid year has fallen back to $43. Copper, a good industrial raw materials indicator jumped from around $1300 a metric ton in 2004 to a peak of $8800 has since tumbled to around US$3000. Wheat surged from US$3.50 a bushel around 2004 to almost US$14 in 2008 before plunging to around US$5. Rice, which caused such traumas in Asia earlier in the year jumped from US$4 to US$25 on the Chicago Exchange has since declined to US$14. There are numerous other examples of extraordinary price increases followed by declines. And with global demand still weak and abundant stocks and supplies, prices could fall a lot lower. People tend to examine recent peaks rather than earlier lows. Most energy analysts used to oil prices of $20 to $30 a barrel in 2002 to 2004 neither predicted nor dreamt of oil quotes above $50, let alone $100 within four years of that time.

Can we trust central bankers' judgement?

So what should have the central bankers done? They should have called in the regulators to do something about excess speculation. The solution was simple and would not have interfered with the free market: Raise the margin deposits on commodity exchanges, every day, to force speculators to withdraw. Simultaneously central banks should have placed pressure on banks who were lending money to funds that were speculating in commodities on the over the counter market (OTC). Instead economic forces have taken hold pulling prices down.

At last central banks are acting. But had they cut sooner, the recession would probably have been shallower with bank bailouts a rarity.  The question is now is whether their judgement can be trusted.  They are pouring money into economies on the grounds that there will be deflation.  So far, however, only Japan is experiencing deflation.  If economies defy the pessimists and recover swiftly, will the central bankers be behind the curve in countering inflation?

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