Inflation and Capacity Pressures Will Stifle Economic Growth in Trans-Atlantic Community

Dr Ivanovitch - MSI Global
Dr. Michael Ivanovitch

Official claims of “benign” and reversible price inflation dynamics in the U.S. and in the euro area are vacuous debating points among financial markets and short-term forecasters at the monetary authorities in Washington and Frankfurt.

For the time being, markets are gun-shy and following the Wall Street’s old adage: “Don’t fight the tape …” – i.e., go with the crowd, it’s unwise to be a contrarian.

A slightly humped U.S. yield curve is reflecting market unease about Federal Reserve’s expected credit tightening in the months ahead. But the bond market vigilantes don’t seem bothered by the Fed’s tough talk and look comfortable with the very long end of fixed-income assets.

The European bond markets – using the German “bunds” as a reference – are exhibiting the same term structure. Let’s see though what will happen when the Greens, who are in charge of the economic portfolio, begin raising hell about the country’s soaring 6% inflation rate.

Structural problems are obstacles to growth

People really interested in the trans-Atlantic economy, financial markets and geopolitics should stay away from the mug’s game of an essentially random walk asset price forecasting.

They should look instead at structural economic problems.

Start with the question, for example, of how sustainable is the current course of economic growth in the U.S. and in the euro area.

Our GDP charts nearby show that the huge output gap during last year was roughly compensated for by a 6 percent aggregate demand growth in the U.S. and the euro area in the first three quarters of this year.

But where do we go from here?

Can the U.S. and euro area economies continue to grow at average annual rates of 6% in the months and years ahead?

The answer is simple: That is impossible in economic systems whose potential and noninflationary growth is estimated at 1.8% (U.S.) and less than 1% (euro area)

To see the structural noninflationary growth constraints of those two economic systems, you just have to add the average labor productivity growth and the growth of the labor force.

And here is what you get.

The euro area with an average labor productivity growth of -0.3% over the last four years and a labor force growth of 0.4% (over the same period) is an essentially stagnant economy with a long-term noninflationary growth of 0.1%.

A similar calculation for the U.S. gives a long-term noninflationary growth potential of 2.2% (labor force growth of 0.4% plus a productivity growth of 1.8%) – but that is a far cry from wild forecasts of 3.5% and even 6%.

Keep an open world economy

Now, one can turbo-charge those economies with huge monetary and fiscal expansions – as is currently the case – and the nominal GDP growth will respond. But most of that growth will be in prices (i.e., inflation) rather than in the real output.

That’s a typical outcome of an inflationary monetary policy, and that’s what we expect to see in the months ahead.

A foretaste of that is already offered by U.S. numbers for the third quarter of this year. The nominal GDP growth of 9.5% consisted of a 4.6% price inflation (i.e., GDP deflator) and a 4.9% increase in real economic growth.

We can expect an even worse breakdown of inflation and real output in the euro zone.

That’s because strong monetary and fiscal stimuli are pushing that region’s virtually flat noninflationary growth potential to run at an average annual rate of 6% in the first nine months of this year. And unlike the Fed, the European Central Bank plans no meaningful credit tightening in the coming months. Indeed, the ECB firmly believes that the euro area inflation is a transitory phenomenon expected to vanish for statistical and other reasons.

The Fed is talking about a tough anti-inflationary action, but there is no sign of that yet. The Bank’s monetary base (the right-hand side of its balance sheet) at the end of October stood at $6.3 trillion, a virtually record-high level and a 30% increase from the year earlier. Excess reserves of the banking system (money that banks can readily lend) has reached an incredibly large $4.1 trillion and a 46% increase from the year earlier.

Things are hardly any better in the euro zone.

This is a situation that calls for an open world economy, unfettered free flows of trade and finance, and a buildup of real assets. That’s the only way the huge dollar and euro liquidity can be absorbed in productive investments to advance jobs, incomes and a universal social welfare.

Dividing the world, running a virtual cordon sanitaire around the western democracies and seeking containment and confrontation is a pathetic waste of global resources.