Old inflation never dies; it only fades away

As we all know, the rest of the world is crazy - and therefore wrong. Only each one of us is, in his or her view, NOT crazy - and, ipso facto, has the brilliant insight to be right.

On that basis, I have the "right" to tell those who have been contributing to the discussion of the United States trade deficit, that none of you has come even close to a true and reliable analysis of the dollar situation and that huge - should I say massive? - US dollar trade deficit.

So let me enlighten you.

The huge dollar trade deficit is not unique. It has its little-cousin equivalent down there in Australia - a country whose currency has never dominated world markets, never been a reserve currency, never done any of those grand things that are customarily attributed to its big cousin across the Pacific.

The huge US dollar deficit - and the smaller but still not inconsiderable Australian $ deficit - are both due to the inflation - domestic inflation which then spread internationally - the inflation that started in 1969 and whose "remedy" produced the even greater inflation and stagnation which followed throughout the 1970s and into the 1980s. The inflation plus stagnation came to be known, reasonably enough, as "stagflation".

Most people have come to believe that it was some sort of clever policy - possibly founded on some variant of monetarism - and the "discipline" of central banks, including the Fed, which brought about a cure to this inflation and stagnation and delivered us into the mind-bogglingly prosperous 1990s.

None of this is true.

First, anything resembling "monetarism" has been/is an unqualified disaster. Not only did it not cure inflation, it made inflation worse, indeed, made it chronic.

Second, there were no other clever policies that had anything to do with providing a cure for "stagflation." Almost without exception, US policies and the equivalent elsewhere, again for example in Australia, made things worse, if not in the short term, then not much later. The policies did result in a lowering of the living levels - or at least a stagnation of those levels - for the workers and the middle classes. This was accompanied by a stagnation or even an absolute reduction of social services, including such things as unemployment benefits, invalid and old-age pensions and so on.

Third, the reduction of social-services expenditure tended, ceteris paribus, to stabilise inflationary pressures. Unwillingness of governments to undertake essential infrastructure expenditures and eagerness to sell off the family silver to private enterprise also gave the impression that something closer to a match between demand and supply was being achieved. However, these savings were made in a context in which investment generally was limited, in which disinvestment took place through failure to replace depreciated assets, and in which the economy exported much of its industry overseas or across the national borders.

Fourth, while all this was going on, inflation in the US (and Australia, remember) was offering a juicy market to anyone who could get in there and sell. For a while, in the 1970s and 1980s, only countries like Japan and West Germany, who maintained their real investment and their export capacity, could help meet these needs but the Asian Tigers and their kin gradually and quite quickly came into their own. Their unprecedented economic growth was the other side of the United States coin, which, comfortingly, showed a decline in levels of domestic inflation. At the same time, there came into being those famous trade deficits - which have, after so many years, become chronic trade deficits.

That's a rough and brief outline.

I don't want to go on with this too long but I would just suggest that the above account confirms that inflation has never been conquered. All that has happened is that its superficial character has changed. It no longer looks like a duck, seems to walk like a duck or can be heard to quack like a duck. But, make no mistake, it is as it has always been - a duck. All that has happened is that a shift has occurred from domestic inflation to trade-deficit inflation.

Just to put that into very simple terms - I hope not into too simplistic terms: the excess demand over supply that caused domestic inflation after 1969 has been transformed into a continuing excess of demand over supply which has, over time, expressed itself in having the excess supplied from beyond the national borders.

Now, we can make all sorts of points about creditor countries being more willing to hold US dollars than Australian dollars or other people's currencies. Many of these points may well be valid but they have little or nothing to do with basic, underlying causes.

Neither for the United States nor for Australia is the position sustainable in any "permanent" way. Sooner or later the disequilibrium has to be corrected.

In Australia's case, one of the levers of correction has been a slide in the value of the Australian dollar. As late as 1973, the Australian dollar was worth more than the US dollar. Recently, it has been struggling to remain above 50 US cents. Right at this moment, it is worth, I think, about 54 cents.

I am writing this from Austria. About twenty years ago, the Australian dollar would buy between 25 and 30 Austrian schillings. Now we're using Euros but, to make the comparison easier, the Australian dollar would now buy between 7 and a half and 8 Austrian schillings.

I might just add that the US dollar is now lucky to buy 14 Austrian schillings, about half what it would buy twenty years ago.

So the chickens have come home to roost for Australia.

For the United States, the chickens are not yet quite roosting; but be patient. Those chickens might already be well on their way.

What will that mean?

Remember that the US deficit has been running recently at the rate of about $US500 billion, certainly well above $US400 billion. That is greater than the GDP or GNP of most of the countries, members of the United Nations or the WTO.

If there is a sudden reduction to, let's say, to $US250 billion, the impact on those dependent on the US market could, indeed will be severe. If the deficit is wiped out, it could be catastrophic, for example, for some Asian countries.

The complex of effects is quite simply too difficult for me - and I suppose for most of us - to define with any accuracy or in any detail.

The value of the US dollar would seem likely to fall, perhaps to something like the present level of the Australian dollar. However, anything that happens to or in or with the largest economy in the world has impacts elsewhere. So the Euro, for example, might not stand tall and strong when the US economy collapses. Similarly, while the Australian dollar has already fallen so far, it might still collapse further with the fall in the value of the US dollar, the reduction of US imports and the impact of those changes on Australia's major markets in Asia.

We cannot, in this account, go through all aspects of the situation which is with us now or which will confront us soon.

The first step to understanding the present situation - and in formulating "remedies," however belated and inadequate - is to acknowledge how the US deficits came about and the broad nature of their transition quality. In other words, we need to acknowledge that, with present policies, they cannot last and that the end of another glorious "bubble" may now be just about in sight.

If I have succeeded in advancing that understanding, that will be a giant leap forward. On the other hand, you might think that I am the only one who is crazy!!