A future of debt and inflation

There is much we do not know about the Covid-19 crisis and its consequences, but one enduring legacy is already under way — the return of Big Government. Before too long, we are likely to see the return of another familiar but forgotten, and related phenomenon — inflation. Don’t hold your breath, but it is lurking out there in the early 2020s.

Historically, sharp changes in the role of the state in the economy are associated with war, and with the expectations for change that it generates. No one is making the case that the fight against the Covid-19 pandemic isn’t, to all intents and purposes, a war. The surge in public debt and public spending will be a feature for a long time. The crisis allows people to see that a variety of financial and economic possibilities are open if push comes to shove. Solving homelessness, investment in public health and the green economy and other programmes might now be more firmly grounded, depoliticised expectations rather than cross-party political options.

These and other things are for another day. Right now, consider the sheer scale of what’s being done to compensate for, or offset, the policy-induced economic contraction. The UK, US and Germany have all announced economic programmes amounting to about 10 per cent of GDP. Other countries have also announced large programmes. On top of direct wage and salary or transfer income support for individuals, households and companies, governments have set out large programmes of loans and grants to firms, and for mortgage, utility bill and tax payment relief.

The Federal Reserve, European Central Bank, Bank of England and other central banks have put in place many hundreds of billions of dollars of quantitative easing (QE) and credit and financial system support. Interest rates, already at generational lows, have been cut to the bone. The recent G20 meeting set a goal of $5 trillion of support for the global economy, or nearly 6 per cent of GDP, which is about four times as much as in the global financial crisis (GFC). The US, UK and Germany have already stepped up to half of this.

So, not only is the quantity of official support much bigger than then, the quality is different too. During the GFC years and after, initial modest fiscal stimulus was scaled back quite quickly, except in China. The monetary and QE impetus from central banks was significant, but largely stayed inside the banking system, fuelling the excess reserves of banks in the hope that this might spur credit demand and economic growth. While there’s no question that QE did succeed in some respects, it couldn’t create credit demand, which remained largely lacklustre, and it also had unintended consequences in stoking up asset rather than goods price inflation, providing what’s been called “welfare for the rich”.

This time, it’s different. While central banks are still fulfilling their roles as lenders of last resort to stressed institutions, they are also taking on a role as buyers of last resort in some markets, especially those where companies raise funds. But the biggest point of difference this time is the direct fiscal spending to support income in households and companies. By now, I think, only hermits have failed to understand why this course of action is essential to stabilising the immediate economic outlook.

But what of the longer-run consequences, especially in the Big Government context referred earlier? Unlike the aftermath of the GFC, this time, there is a sporting chance it will entail both a pick up in inflation, and a willingness on the part of governments and central banks to tolerate this by raising inflation targets.

For the time being, there is nothing to see. The demand shock in the global economy is a powerful deflationary factor. Quite what the inflation figures will mean in the next months is anyone’s guess, bearing in mind that consumption patterns have been totally upended by the crisis. No one is consuming much of anything, apart from healthcare products and equipment, medicines, food, online delivery services, and video services and other things we need for isolation and being socially distant.

Oil prices would have fallen anyway, but a price war involving Saudi Arabia and Russia in the main has added a frisson to the market. Brent oil has plunged from almost $70 per barrel at the end of January to about $25. Some analysts expect it to slide further to about $10.

In its own time, this collapse in oil prices might turn out to have a healing impact on the global economy. When that time comes, it will almost certainly be joining an environment in which:

a.    global demand is picking up, aided and abetted by

b.    large government and monetary policy programmes gaining more traction as people get back to work, and restrictions are lifted

c.    the pandemic itself is truly behind us

d.    China’s global role has switched from being a source of deflation to inflation

Most major countries, including the UK, maintain inflation targets of about two per cent. It’s very likely this target will be raised, with the promise that it will be short-lived and designed to compensate for recent years of “low-flation”. Don’t believe a word of it.

It is, after all the way in which we traditionally try to deal with high debt burdens, and one of the main policy objectives of the next 20 years is going to be to lower the deadweight of private and public debt.

But who will assure us, and how, that a little bit of inflation, say three to four per cent, won’t become much more? And, as significantly, if we do bring debt burdens a lot lower in the 2020s, that we won’t then again use debt to create economic growth with the deleterious consequences with which we’ve all become too familiar?

One step at a time, though. First we have to get through the deflationary demand shock, and then look for prices to start rising again.