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The Economist: Austrian school provides the best explanation

July 31, 2005

I recently criticized The Economist for its very confused Keynesian analysis of monetary policy in Europe . Its analysis of China's impact on the global economy in its latest issue is however a lot more impressive. Apart from a few minor details, its provides a interesting and correct analysis of the subject.

Some of the more interesting paragraphs is when they point out that given a positive supply-side shock in terms of increased availability of cheap goods from China, positive consumer price inflation is not a good thing and in this context praises the Austrian school analysis.

"In its latest annual report, the Bank for International Settlements (BIS) asks whether it is really desirable to maintain positive inflation rates when China is boosting the world's productive potential so dramatically and thus reducing the prices of so many goods. In other words, are central banks targeting too high a rate of inflation now that China has joined the global market economy?

During the late 19th-century era of rapid globalisation, falling average prices were quite common. This "good deflation", which was accompanied by robust growth, is very different to the bad deflation experienced in the 1930s depression.

Today, we would again have had "good deflation"—but central banks have instead held interest rates low in order to meet their inflation targets. The BIS frets that this has encouraged excessive credit growth. This echoes a fierce debate in the 1920s.

At that time, a similar jump in the world's productive potential (then caused by technology-driven productivity growth) was reducing manufacturing costs. Some economists suggested that, in such circumstances, overall price stability might be the wrong policy goal. Instead, they argued, average prices should be allowed to fall to pass the productivity gains on to workers and consumers as higher real incomes. But just like today, monetary policy prevented prices from falling. And an overly loose policy then inflated the late-1920s stockmarket bubble.

The Austrian school of economics offers perhaps the best framework to understand what is going on. The entry of China's army of cheap labour into the global economy has increased the worldwide return on capital. That, in turn, should imply an increase in the equilibrium level of real interest rates. But, instead, central banks are holding real rates at historically low levels.

The result is a misallocation of capital, most obviously displayed at present in the shape of excessive mortgage borrowing and housing investment. If this analysis is correct, central banks, not China, are to blame for the excesses, but China's emergence is the root cause of the problem."

Good, very good. But why did they then just two weeks ago then call for the already inflationary ECB to aggravate these misallocations by becoming even more inflationary? Either they are schizophrenic or (more likely) their writers ( The Economist's articles are never signed and their writers are anonymous) disagree with each others, some being pure Keynesians and others being more or less Austrians.

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