inflation

In some of my more gamesome moments I have challenged my students to produce an article about the equity risk premium, which made a useful contribution to our understanding of the way financial markets work. So far the challenge has not been met. This may reflect the modesty and good manners of those I teach but also, I hope and believe, the fact they are too sensible to wish to defend the way this often ill-defined and generally useless concept has been habitually discussed. In practice, comments on the ERP seem to me to have been a source of confusion and error rather than illumination.

The ERP can be defined in at least two ways. One is the historic difference between the returns on bonds and equities and another is the expected difference in these returns. Alternatively, the “risk-free rate” can be used in place of bonds. Read more

The Chinese government decided some years ago to keep its exchange rate undervalued by buying foreign currency and building up its foreign exchange reserves. The result has been dramatic. Reserves have risen by $3tn over the past seven years. This has occurred despite a strong rise in the exchange rate, as I show in chart one.

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Comments are flying around about whether inflation or deflation is the greater risk. This is almost invariably interpreted as asking which is the most likely and therefore misses the central point. Inflation is a much greater risk – not because it is more likely but because its consequences are far worse.

Deflation has been demonised. It has been harmless or even beneficial in Japan. While I think it would hurt the eurozone, its impact would be mild and easily reversed – or it would be if German economic policy was not so obstinately foolish. Inflation poses a much more serious problem, particularly in Japan, the UK and the US. Read more

Deflation provides a good example of economists’ bad habits. They assume that people behave in the same way even if they live in different countries and that their behaviour does not change over time. They are sometimes right. But deflation and inflation show how misleading this tendency to generalise can be. Today deflation is a danger for the eurozone, but not for Japan.

Deflation can cause problems, but not always. As I pointed out in my previous blog, since its market crashed in 1990, Japan’s gross domestic product grew more when prices fell than when they rose. Read more