BU's Emeritus Professor Nigel Jump writes the next in a series of economic blogs looking at the impact of covid-19 on the economy.
In my early days as an economist, most of the profession’s macro analysis was centred on addressing high inflation. Inflation is a generalised rise in prices that imposes real costs; effectively acting as a tax on fixed incomes and the low paid, and distorting price signals for all.
UK consumer inflation built up steadily from the mid-1960s onwards, peaking at over 22.5% in 1975 and continuing at higher than optimal rates until the late 1980s. Since 1992, however, inflation has been below 5% per annum and often at rates commensurate with, or below, the official 2% target. Consequently, inflation has been less of a concern for applied and policy economists.
In the high inflation years, the leading theory was that ongoing excess inflation was “always and everywhere” a monetary phenomenon – a symptom of “too much money chasing too few goods”. Excess monetary growth devalued money relative to other goods and assets. It was only with better control of the UK money supply, (and after global output was boosted by China’s ‘low wage’ opening to world trade), that inflation became less of an issue.
In 2021, however, some economists fear that 2-3 decades of more stable inflation rates are now at risk. As well as globalisation running down and monetary expansion accelerating (for and after the debt recession 2008/9), the Covid19 pandemic has added a new potential inflationary twist to the economic tale. Inflation expectations may be rising.
The unprecedented, 2020 “shutdown” of the world economy to address the impact of the Covid19 virus, and the consequent explosion of public spending to minimise the unemployment effects of that shutdown, mean that government spending and borrowing have surged whilst supply chains have been disrupted.
- Modern monetary theorists suggest this is not a problem. As long as we have our own floating currency, the debt is manageable and cheap. Public debt is different from private debt. Governments can always print money to cover the public finances. The state does not “compete” with the private sector for access to funds.
- Classical monetary economists, believing that inflation is always caused by excess money supply, disagree strongly and argue that devaluing a currency (domestic and foreign exchange) by excess production of money has real impact on business and household choices. Moreover, the signs of higher inflation to come are already in evidence in the monetary figures, thanks to quantitative easing, fiscal largesse and supply blockages.
Even though the latest recorded consumer inflation measures remain low (CPIH +1% year to March), with the balance between aggregate demand and aggregate supply disrupted, the inflation chain from input through producer to consumer prices has started to accelerate. The resulting ‘cost push’ is starting with commodities: many, including corn, lumber, aluminium and oil, show double digit price rises over the last twelve months. It may be that this is a transitory effect. Some Euro area experts, for example, claim that once the lockdown supply-side logjams are removed, cost push will diminish. But there is a risk that cost pressures will build, particularly for a post-Brexit Britain.
What about the (“always and everywhere”) money supply? Classical monetarists argue that the ‘price pull’ from excess monetary growth is a vital and growing factor. This can be seen in booming house and car prices, rising stock markets and other asset values. US M2 (an important measure of money, including cash and current accounts) growth was 27% in the last twelve months – the highest growth rate for decades. Similarly, UK M2 growth is more than 16% year-on-year. (Over a cycle, M2 growth should be commensurate with nominal growth - real output plus inflation - normally more like 4-5% per annum.)
This excess money supply growth, fuelled by central bank quantitative easing in an effort to keep economies afloat, means the price of money (interest rates) are extremely low. In some cases, base interest rates are negative. This is a worrying distortion for financial management and investment incentives in any post-pandemic recovery. (The recent surge in demand for crypto currencies may suggest investors are already making a partial hedge against future inflation through money devaluation.)
Other distortions exist. Notably, household savings ratios have doubled (or more) and these funds could be released into demand quickly, fuelling higher prices in response to relative supply bottlenecks. Also, business supply capacity has been lost due to pandemic bankruptcies and labour mismatches exist. We have spare capacity but is it the kind (skills and physical investment) and in the places (spatially or sectorally) where it will be needed?
If ‘old’ money theory is right, inflation may be heading back towards 5% plus in the next few years. Interest rates will have to respond – indeed, arguably, should get ahead of the game to head off persistent inflation. Until the pandemic is over, however, higher interest rates risk turning a major downturn into depression. At this point and for the foreseeable future, the Bank of England and the Federal Reserve (et al) say they are reluctant to move early. The central banks have signalled a “wait and see” approach which could mean the inflation genie is out of the bottle before the authorities act appropriately. In time, (as recently acknowledged by Janet Yellen – President Biden’s Treasury Secretary and a former Federal Reserve central banker) base rates may have to increase, dampening the speed of any post-pandemic recovery. The danger is of slower growth and higher inflation to come: get out those textbooks and revise memories of ‘stagflation’.
The underlying theme of these blogs is that regional economic progress is driven by increasing productivity. Robust productivity growth is the only way of securing better real (net of inflation) economic performance and avoiding ‘stagflation’. This is important for a world in which the economy has to make the shift from fossil fuels to low carbon at the same time as recovering from the pandemic. The principles of sustainable regional economic development remain unchanged even if the backdrop for growth and inflation shifts.
Ideally, by the mid-2020s, central bankers, will get the money supply under better control and will have raised interest rates to more sustainable levels; treasuries will be adjusting to more sustainable public finances; and businesses will be reacting logically to higher interest rates and prices. The search for positive real investment returns, driven by productivity gains and positive real growth, will be underway.
It is too soon to say high inflation is back or imminent and, therefore, will be a problem for future development, by distorting price and income signals. Indeed, some will argue that a bit more inflation would grease the wheels of an economy trying to recover whilst achieving structural change. Still, whilst aiming and preparing for a productivity led, (investment and innovation driven), revival through the 2020s, we must remember the damage uncontrolled inflation can do. As the pandemic shows us, forewarned is forearmed: early action is usually better than delay.