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Calling All Economists: Challenging the Status Quo

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In recent times, economic consensus has been that a weaker currency either directly leads to inflation or, for a debtor, exports it to creditor nations. Also, in developed markets, it is harder for companies to raise prices, so inflation remains tepid. This can be seen in the wake of the Fed embarking on QE2 in 2010; inflation was prevalent but not as strong as it was in other countries such as China and India, who's central banks had to hike rates repeatedly to fight the inflation threat. The question becomes: is this dynamic of exported inflation unique to the US or is it a real effect for all developed/debtor nations?

Let's take Europe now as a case study. The European Central Bank has expanded its balance sheet tremendously through crisis fighting measures and recently the euro has fallen to levels not seen since 2010, when the debt crisis first flared up. As I wrote here, Europe has not seen this. There are lots of pressures across the continent, and yet inflation continues to rage, with ECB President Draghi saying that he expects inflation between 2.3-2.5% this year. The inflationary pressures of ECB balance sheet expansion are conflicting with the deflationary pressures of bank deleveraging.

In 2010, banks around the world were still deleveraging following the financial crisis. The deflationary pressures in each country offset each other, but inflationary pressures due to uncoordinated central bank action (QE2) sent inflation abroad. In 2012, it is really only European banks deleveraging. Inflation remains in Europe, and yet the US has seen disinflationary, if not deflationary, pressures recently. So here is my theory: in the wake of global bank deleveraging, central banks can export inflation, but in the wake of unilateral bank deleveraging, the deflationary effects of deleveraging and the contraction of the shadow banking system has a larger impact on inflation than does central bank balance sheet expansion. In this scenario, inflationary pressures caused by the expansionary policy stay domestic as foreign bondholders continue to dump bonds and the inflation is not passed on through the currency exchanges that foreigners would require.

I'm no tenured economist, I'm just highlighting what is blatantly visible in the market. I could be correct, or it could just be that nothing matters except for Bernanke. As an academic, I like to think that there is a rational explanation for things. I hope that the Bernanke effect isn't true, even though evidence argues the contrary. All in all, the current situation in Europe is challenging current economic theory, and this is exactly what I am calling into question.

Posted-In: Broad U.S. Equity ETFs Currency ETFs Forex Economics Markets ETFs


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