The Great Reversal into a higher inflation environment
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This is not the 1970s, or so we are confidently assured by respectable economists. Granted, as we confront soaring levels of inflation, there are nuanced differences between then and now.
But the UK’s strikes in rail, mail and rubbish collection point to one overwhelming similarity — namely, that stagflation creates winners and losers. When national real income is squeezed by oil price shocks as in the 1970s or the current food and energy price shocks, rival claimants in the economy compete ferociously to reclaim lost income. A wage price spiral results.
Milton Friedman remarked that inflation is “always and everywhere a monetary phenomenon”. Clearly, money is an important component in the inflationary process. Yet strikes in the UK and the tightness of labour markets around the developed world suggest that no explanation of inflation can be complete without reference to the distributional power struggle between labour and capital.
While central bankers congratulated themselves on delivering low and stable inflation during the so-called Great Moderation in the three decades before the financial crisis of 2007-09, disinflation was in reality the result of the global labour market shock arising from bringing China, India and the eastern Europeans into the global economy.
This ensured a long-term downward trend in labour’s share of national income. Productivity gains were seized entirely by capital. The disinflationary impetus was reinforced by demographics and the wider ramifications of globalisation.
Weakness in returns to labour held back consumption and output because workers have a higher propensity to consume than owners of capital who have higher savings rates. This prompted endemically expansionary monetary policies.
As economists at the Bank for International Settlements have long pointed out, the central banks did not lean against the booms but eased aggressively and persistently during busts. This bias to loose policy was further entrenched after the financial crisis by the asset purchasing programmes of the central banks.
William White, former head of the monetary and economic department in the BIS, argues that central banks have systematically ignored supply-side shocks and in the Covid-19 pandemic failed to grasp how much supply potential had been reduced by illness and lockdowns.
In effect, they have repeated the mistake of Federal Reserve chair Arthur Burns, who in the 1970s argued that the oil price shock was merely transitory while ignoring the second-round impact, notably in the labour market.
In his speech at the central bankers’ annual jamboree at Jackson Hole last month, Fed chair Jay Powell indicated that the Fed was belatedly on the case, saying that the employment costs of bringing down inflation were likely to increase with delay, adding that “we must keep at it until the job is done”. The difficulty here is that both private and public sector debt are at higher levels than before the financial crisis so the output and employment costs of sharply rising interest rates will be very high.
This debt trap raises in acute form the longstanding question about the politics of central banking: how to persuade politicians and the public that a modest recession now is a price worth paying to avoid a much worse recession later. At risk is central banking independence.
The Fed’s harder line suggests that the bond bear market has much further to run. And the summer bounceback in equities looks to have been quixotic. Steven Blitz of TS Lombard points out that it is equities that Fed policy must have an impact on rather than credit creation because the expansions of 2010-19 and post-coronavirus amount to an asset cycle, not a credit cycle. Richly priced financial assets, he adds, have been this cycle’s source of economic distortions.
Righting those distortions will mean some marked contrasts with the 1970s. Today, the shrinking of the workforce and deglobalisation are tilting the balance of power from capital back to labour. We have moved from the Great Moderation via the Great Financial Crisis to a Great Reversal into a higher inflation environment.
It is also a world in which the toxic combination of the debt trap and the shrinkage of central bank balance sheets will greatly increase the risk of financial crises. While commercial bank balance sheets are in better shape than in 2008, under-regulated, opaque non-banks are a potential systemic threat as the collapse last year of the Archegos family office indicated. A vital lesson of history is that after an “everything bubble” leverage, or borrowing, turns out to be far greater than everyone assumed at the time.