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Tuesday, 11 October 2011

Economic Crisis: What Is The End Game?

The cycle of woe and uncertainty surrounding the economic crisis continues, with gloomy surveys predicting a double dip, and even fears of a ‘Great Depression'. Sir Mervyn King, Governor of the Bank of England, believes this could be the worst financial crisis ever - even beating the 1930s for gloom - and the economy is in breakdown, so what we want to know is:

How grim are things going to get?

Yesterday various reports told us the UK was bottom of the global confidence league, 43% of finance directors were preparing for a second recession while companies had delayed or cancelled £4.7bn of spending, reports the Daily Telegraph. "Today we report the OECD's leading indicator falling for the seventh month in a row, pointing to a slowdown, and the British Chambers of Commerce warning on stagflation."

Mindful Money asks commentators what they think will happen:

While we don't know if the recent injection of more QE will do any good, we do know that it automatically invites stagflation into our economy by pushing the pound down, say commentators.

According to Mindful Money economist blogger Shaun Richards, the most likely outcome if both politicians and central banks continue with the policies that they have now is, indeed, stagflation.

But he adds: "Those who look at the past I think miss an important point which is that it doesn't have to be 10% inflation to hurt people. A continuation of 5% a year combined with wages only rising say 2% will gradually turn the screw. Let's face it this has been happening already for the last couple of years so in general people are poorer."

Investors Chronicle says that Andrew Sentence, a former member of the BofE MPC believes that inflation is a bigger concern for the UK economy than a recession."High inflation and slow growth are inextricably linked."

What happens if stagflation hit?

Stagflation is a term which is formed by joining the words stagnation and inflation. It is used in modern macroeconomics to give a description of a period of uncontrollable price inflation combined with sluggish output growth. Stagflation raises unemployment.

The last time stagflation held the western world in a seemingly lethal grip was 30 years ago in the 70s and 80s, and it is threatening to emerge from the shadows again. Such fears are dismissed as irrelevant by those in favour of pumping money into the economy through quantative easing (QE), which they think will stimulate growth and avoid the dreaded ‘double-dip' recession. But so far, this policy has failed to prompt the necessary growth.

Thursday's announcement of another £75billion worth of QE played well with the stock market, but it is unlikely to cause much cheer for long. On the contrary it threatens to stoke inflation even higher, and meanwhile, there is the threat that growth stagnates.

"Stagflation" remains a word not uttered in the polite company of the financial world.

"But there remain only a few more tumblers to fall into place for a return to that awful word that conjures up images of the "malaise days" of the late 1970's and early ‘80s, where rising inflation and slumping employment tramped down economic growth," says CNBC,

However, some economists believe stagflation isn't something to fear at present.

Azad Zangana, European economist at Schroders, says: "While the current environment feels like a typical stagflationary environment, this is set to be temporary. The outlook is more positive as we expect inflation to fall from its current level back down to below 3%, mainly due to the passing of the VAT effect from the start of 2011.

"Meanwhile, we forecast growth to improve in the second half of 2012, and so the balance between real and nominal growth will improve. To conclude that we are entering a fully fledged stagflationary period, we would need to see significantly stronger inflation and wage inflation, and a continuation of weaker growth as seen in the 1970's. In our view, this is unlikely to occur."

What other threats may there be?

Another danger, however, is the rising threat of hyper-inflation. Shaun Richards says: "Whilst the self proclaimed "financial geniuses" persist in buying every gilt they can find there is a danger of this. Also it is the nature of things that when problems happen these days with the speed of trading it happens so fast that it is better not to run the risk at all. But I see this as rising but still low.

"So for now the danger is the silent drip drip of inflation and this is the enemy. The biggest problem of all is that as I keep pointing out it should not be a problem at this stage of the economic cycle and furthermore is being inflicted on us by individuals whose own contracts protect them against it.."

And if we're being warned that this crisis beats the 1930s, what happened then?

What happened in the 1930s, given the governor believes the gloom beats this decade? This was the ‘Great Depression', where in America millions were genuinely destitute, and unemployment hit a staggering 25%. Two million Americans tramped the country, sleeping rough as they looked for nonexistent work, and malnutrition was widespread.

Southern England escaped reasonably lightly, but in the North there were pockets of extreme hardship. On Tyneside the collapse of shipbuilding left unemployment standing at 70%, prompting the famous Jarrow march.

There were soup kitchens on the streets and millions of families were subsisting on bread and margarine. In Germany, economic misery that had begun with hyperinflation in 1923 helped another world leader to power in 1933: Adolf Hitler.

So is there any cause for hope with growth and falling inflation?

Henderson's chief economist Simon Ward gives his opinion: "Assuming that an EMU break-up is avoided, the global economy may start to regain momentum from early 2012. Such a scenario depends on the US economy doing better next year, as suggested by recent money supply strength...

"Another reason for thinking global growth could revive from early next year is a fall in headline inflation due to recent weakness in food and energy commodity prices. Rising inflation has been a major contributor to the recent economic slowdown by squeezing consumer spending power and forcing monetary policy restriction in emerging economies."

And anyway, nobody knows.

Mindful Money's resident psychologist Kim Stephenson says: "Let's assume that Shaun's right..

"Afterwards, lots of people who said that we wouldn't get stagflation but something else (hyperinflation or whatever) will say - "ah, well, it depends on how you define stagflation (or hyperinflation, or whatever)", they'll twist it round to show that they were right when they were actually wrong. Or they will point to some action or event - from the Bank of England, IMF, German Government, something, and say "if that hadn't happened, it would have gone the way I predicted". Human beings don't like being wrong and they will selectively remember what they want to remember to avoid having to admit they were wrong.

"Similarly, human beings like being able to predict and control their world . The economy isn't just out of our personal control, it's clearly out of control (or even prediction) of anybody like the Chancellor, the EU etc. that are supposed to be able to control it. That is very scary. It's like when you're a child and you realise for the first time that your parents don't know everything, can't solve every problem, can't ease the pain, stop the bully or get you on the team every time. It hurts and it makes us afraid, so we desperately cling to the belief that somebody can predict it (if not control it) and that we can have some measure of understanding of what is going on. To contemplate the fact that actually nobody controls it, nobody really understands it or can predict it and that most of our predictions are going to be wrong is simply too much to take."

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