Remember Stagflation?

It appears increasingly likely that the world's central bankers are going to have to pay back decades of monetary mismanagement during which they flooded markets with newly printed money and low interest rates instead of allowing recessions to wring distortions out of the global economic system. Many are now starting to tighten. But if they tighten too much, they could throw the world into a global depression.

Despite U.S. Federal Reserve Chairman Ben Bernanke's soothing July 20 testimony before the Senate Banking Committee, there are serious questions whether world inflation is anywhere near reined in. Increasingly sluggish U.S. economic growth, coupled with rising unemployment, will also be accompanied by persistent inflation - a condition known as stagflation. This is a risk that extends to Asia in no uncertain terms

A global tide of hot money has resulted in the creation of dubious financial instruments, produced vast amounts of debt and ominously rising wages -- and enriched an entire class of bankers.

Debt has reached unprecedented levels only made possible by years of easy liquidity, says Geoffrey Barker of Ballingal Investment Advisors of Hong Kong. "Technology and globalization are taking jobs away from the people who have the most debt. Credit extension and spending have become increasingly dependent on asset price inflation that is now threatened by the liquidity squeeze."

On July 26, Chinese Prime Minister Wen Jiabao told the State Council, China’s cabinet, that China would take “forceful measures” to cool the country’s surging economy, which recorded 11.3 percent growth in the second quarter of 2006 and appeared to be veering out of control. The speech was a signal that China’s top leaders are increasingly dissatisfied with lackluster efforts by the People’s Bank of China, the country’s central bank, to slow the economy.

In addition, Australia's Reserve Bank is also expected to raise interest rates as early as the first week of August week in the wake of consumer price reports indicating accelerating inflation. Just three months ago, in May, Australian Treasurer Peter Costello announced A$37 billion in tax cuts over four years, which appeared certain to push up consumer spending by already deeply indebted households. And New Zealand, whose current account deficit now has hit 9.3% of GDP accompanied with inflation at a 16-year high also appears to be in trouble.

This tide of hot money across much of the planet has resulted in the creation of dubious financial instruments, produced vast amounts of debt, resulted in ominously rising wages in such traditional low-income countries as China and India—and enriched an entire class of bankers. These are dislocations that now must be dealt with, not least in the United States, where the U.S. Federal Reserve has continued to raise interest rates 25 basis points at a time for 17 consecutive quarters.

Global Money Growth Less Nominal GDP Growth 1973-2006

Courtesy Robert Rountree, Prudential Asset Management

Nonetheless, many economists believe the Fed has not acted decisively enough. In the face of expected U.S. average fed funds growth of 4.65% for the entire year of 2006, growth is already at 5.5% with half a year to go. U.S. household debt is now 131% of income, built on a continuing burst of easy credit.

Nor have either the European Central Bank or the Bank of Japan been eager to follow suit. Japan’s 25-basis point rise on July 14, in the face of eight straight months of rising consumer prices, was immediately met not only by criticism Japanese politicians but from the International Monetary Fund, which fears rising interest rates could snuff the nascent recovery of the world’s second-biggest economy.

In Asia, only Singapore, Thailand and Korea have been even willing to follow the U.S. Fed’s measured stance. Despite Wen’s statement, China’s policymakers particularly have been loath to curb the country’s torrid growth. Provincial bureaucrats still regard fast growth as the path to political success and they continue to push for investment, much of it in dubious projects on money borrowed from state banks even in the face of attempts to separate lending from politics. Nor has the People’s Bank been aggressive. Monetary conditions in China remain easier today than they were when the U.S. Fed began its tightening more than two years ago. That has started an investment spree that appears inevitably headed for disaster.

The Reserve Bank of India belatedly began to tighten on July 26, raising key interest rates by 25 basis points and warned that Indian consumers would face rising inflation, particularly in global crude oil prices. The Congress Party-led government heavily subsidizes prices for both gasoline and cooking fuels and faces opposition from communist allies in the ruling coalition. The rupee remains soft, however, loosening monetary conditions despite the rising interest rates. It appears the RBI has considerable room to tighten beyond the rise.

Many critics say that for better or worse, the now-retired U.S. Federal Reserve chairman Alan Greenspan is responsible for much of this loose-money philosophy

Hong Kong, Malaysia and Korea fall somewhere in between, with rates rising in Hong Kong by 300 basis points over the last two years, Korea tightening by 320 bp in the last 12 months and Malaysia allowing its currency and market interest rates to take up the slack. Taiwan, hampered by a weak domestic economy, has eased monetary conditions by nearly 300 basis points since the second half of 2005, suggesting that inflation will begin to rise.

In the Philippines, of course, the party goes on. Buoyed by healthy inward remittances from millions of Philippine workers overseas and by a strengthening peso, falling domestic rates have continued to ease monetary conditions. But it is questionable how long the party is going to last. With predictions of slowing world growth, inward remittances can be expected to slow as well since overseas jobs will start to dry up as well. Most observers now believe the peso to be overvalued against the U.S. dollar. As usual with the Philippines, the question is whether the government, facing continued unrest, has the will or the wherewithal to take steps to correct the situation.

Conversely Thailand and Indonesia have both acted aggressively, with Indonesia driving up the price of subsidized fuel and drying up demand in the face of political opposition. The government of Susilo Bambang Yudhoyono is also credited with attempting to push through tax and customs reforms, although they too have met with considerable opposition. In Thailand, where political infighting has stalled the government of Thaksin Shinawatra for months, the country’s technocrats have nonetheless run a surprisingly tight fiscal ship, with monetary conditions now much tighter than they were two years ago.

For better or worse, the now-retired U.S. Federal Reserve chairman Alan Greenspan is responsible for much of this loose-money philosophy. Two months into his reign as Fed chairman in 1987, the U.S. market lost 22% of its value in a single hour. Greenspan’s answer was a written pledge to flood the market with as much liquidity as necessary until the crisis was over. From that time on, Greenspan’s answer to any crisis, including the Asian Financial Crisis of 1997 and the stock market crash and recession of 2001, was more liquidity and low interest rates.

It was William McChesney Martin, selected Fed chairman by U.S. President Harry Truman in 1951, who famously said the job of the Federal Reserve “is to take away the punch bowl just when the party starts getting interesting." But with the exception of Paul Volcker under Ronald Reagan, few Fed bosses have been willing to do that—and Volcker, who wrung inflation out of the U.S. economic system through a series of rate rises in the wake of 1970s oil shocks, faced enormous criticism for doing so.

"The central bankers that have tightened have been way too cautious and are going to have to tighten more than people expected," says Sean Darby, Head of Asian Regional Strategy for Nomura. "No central banker has the compunction or character to start a recession."Central bankers, he says, are basically politicians, and "politicians never want to see pain administered during their period on power."

"A widespread perception exists that inflation will ease as the base effect of higher commodity prices washes out," Darby wrote in a recent report. " We believe inflation appears with a lag in an economy and the longer the energy price is high, the greater the chance it will percolate through the economy via higher transport costs, petrochemical prices, fertilizer costs and, in turn, food. The higher oil price is stimulating demand for lower-cost bio-fuel. As soft commodities are thus sucked out of the food supply, a bump-up in the headline inflation rate seems certain - making it harder for policy makers to cut interest rates."

Inflation normally lags economic performance by about a year and a half. With skyrocketing fuel and other commodity prices, and rising wages not only in the developed economies but in China and India as well, the timing to both raise interest rates and tighten the printing of money is a kind of art: too early and it snuffs nascent recoveries; too late and inflation explodes. This is the dilemma that faces not just the Fed but the European Central Bank, the Bank of Japan and others as they seek to act in concert to dry up liquidity and tame inflation

Darby's nomination for the best central banker since Volcker is Zhou Rongji, China’s iron prime minister of the mid 1990s—who wasn’t a central banker at all. Zhou wrung excess liquidity out of the Chinese system, in particular driving many of the country’s high-flying state-owned international trust and investment corporations (ITICs) to the wall and distressing foreign investors, who used them to gain entrée into China’s economy. Zhou stood his ground in the face of opposition from considerable numbers of top Chinese officials who had their own financial interests in the ITICs. In the end, Zhou won out. The economic distortions in the Chinese system were dramatically reduced.

Now they are growing again, and hardly just in China. Indeed, it appears inevitable that, especially in economies like the U.S., given the rising amounts of consumer debt across the world interest rates are going to have to rise to keep inflation in check, and monetary aggregates are going to have to fall. As interest rates rise, consumers will be increasingly imperiled. As Barker writes, it is a scenario that should keep most of the world’s central bankers awake nights.

After all, it was Greenspan, the maestro himself, who wrote in 1966 the following much-repeated passage, quoted in full, probably to the chairman’s distress:

"When business in the United States underwent a mild contraction in 1927, the Federal Reserve created more paper reserves in the hope of forestalling any possible bank reserve shortage. More disastrous, however, was the Federal Reserve's attempt to assist Great Britain who had been losing gold to us because the Bank of England refused to allow interest rates to rise when market forces dictated (it was politically unpalatable). The reasoning of the authorities involved was as follows: if the Federal Reserve pumped excessive paper reserves into American banks, interest rates in the United States would fall to a level comparable with those in Great Britain; this would act to stop Britain's gold loss and avoid the political embarrassment of having to raise interest rates.

"The "Fed" succeeded; it stopped the gold loss, but it nearly destroyed the economies of the world, in the process. The excess credit which the Fed pumped into the economy spilled over into the stock market—triggering a fantastic speculative boom. Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in braking the boom. But it was too late: by 1929 the speculative imbalances had become so overwhelming that the attempt precipitated a sharp retrenching and a consequent demoralizing of business confidence.

"As a result, the American economy collapsed. Great Britain fared even worse, and rather than absorb the full consequences of her previous folly, she abandoned the gold standard completely in 1931, tearing asunder what remained of the fabric of confidence and inducing a world-wide series of bank failures. The world economies plunged into the Great Depression of the 1930's."

That passage appeared in an essay titled “Gold and Economic Freedom” which was published in a book of essays by Libertarian icon Ayn Rand. Greenspan, progressively more embarrassed by those comments, ultimately repudiated them and began nearly two decades of pumping money into the American economic system.

But he may have been right all along.