Doomsday Stagflation?

08/02/2013 12:24 GMT | Updated 09/04/2013 10:12 BST

A quote of all times

"It took three years of muddling through crisis, near-panics in the financial markets, a million or so jobs lost in the US, social unrest in the developing world to recognize the debt crisis for what it is: a long-term economic and political barrier to development that is slowly strangling world economic growth."

Christine A. Bogdanowicz-Bindert

This quotation on the debt crisis seems apt. However, the words were uttered in 1985, when debt crises had erupted in Latin America and Africa. Eventually, the problems were addressed through international collaboration, debt restructuring, and social-economic reforms. Approximately 40 countries restructured their debts. Stagflation was a big problem. Inflation rates in Latin-America reached 117% in 1984.

Attentive readers may have noticed already that the quote has no bearing on the crisis that started in 2008. Europe (in particular) has been muddling through for five years while the US has lost millions of jobs, instead of a million. Western states are grappling with debt mountains whereas populations continue to age, so more money needs to be spent on pensions and healthcare.

Plus, in the 1980s, the US, Japan and Europe could extend a helping hand to the "small fry". Now they themselves are hit. And, unlike the troubled countries 30 years ago, they face a daunting and structural obstacle: demographic aging.

Fiat money fatally flawed?

Doom-mongers believe politicians will choose the easy way out and put pressure on central banks to crank up the printing presses. They often point to the weakness of the international monetary system, because it is based on fiat (soft) money, which is not backed by the value from tangible materials like gold. The pessimists think a monetary system based on fiat money will rarely, if ever, exist for long because hyperinflation is inevitable.

The first use of fiat money was chronicled as early as the 10th century AD with the Chinese Song Dynasty. Next, the Yuan Dynasty issued paper money on a large scale in the 13th century. Eventually, the regime printed far too many notes and hyperinflation reared its head. Still, the Yuan money was only abolished in 1455.

Fiat money made its entry into the western societies in the 17th century. First in Sweden and the Netherlands and later in America. The so-called Continentals, issued after the start of the American Revolutionary War, are a case in point for those who believe that fiat money is a nightmare. Owing to a lack of coordination between Congress and the states, not to mention sabotage by the British (who printed heaps of counterfeit money), within a few years the notes were 1/40th of their nominal value.

Yet such horror stories are but one side of the coin. At the end of the 17th century, the Amsterdam Wisselbank (AWB) created a successful fiat money regime that existed for over a century. It slowly bled to death as a result of the Fourth Anglo-Dutch War.

In 1862, the US Treasury introduced the US Notes, also known as Greenbacks, in order to fund the American Civil War and was printed until 1971. In other words, the idea that high inflation dooms fiat money quickly should be taken with a grain of salt.

Hard money far from perfect

Meanwhile, hard money is also far from plain sailing. Several experts indirectly blame the gold standard for both World Wars. The (indirect) gold standard introduced after World War II was abolished in 1971, when President Nixon decided that dollars could no longer be converted into gold.

Whatever the monetary system, rash political actions and waning investors and consumer confidence can prompt a spiral leading to hyperinflation, recessions and, in the worst case, war.

So far, we have not seen such a spiral. However, fears are growing that the West will crank up the money presses and opt for competitive devaluations. If so, political, economic, and social unrest could spread like wildfire.

Positivism will not last

Presently, it is still almost inconceivable that the markets would lose all faith in US, European and Japanese government securities. But that does not mean it couldn't happen. In 1914, entrepreneurs and markets were convinced war was out of the question because countries were interconnected economically and mutually dependent. And in 1961, Nobel Prize winner Robert Mundell wrote that "it hardly appears within the realm of political feasibility that national currencies would ever be abandoned in favor of any other agreement." Yet a few decades later European leaders did precisely that when they decided to introduce the euro.

Over the past century, the international financial system collapsed in the 1930s and the 1970s. The first time, the outcome was catastrophic. The second time, no world war broke out but inflation soared until it was contained, around the turn of the decade, by Fed chairman Volcker.

Should politicians decide to drive up inflation, this could result in a long period of high inflation that will be brought under control only after a very hard struggle. At worst, political tensions will rise quickly as states try to steal a march on each other through devaluations, inflation policies, and trade wars. If so, we can only hope that the calamities of the last century are still fresh in the collective memory...