IN PART FIVE of this series (link here) I wrote about the growing inflationary risk fuelled primarily by a perfect storm of massive fiscal expansion (greatly increased public spending) and continuing monetary easing, together with the duel stimulus of Quantitative Easing (QE- central bank money creation) and growing negative real bond yields (encouraging consumption over savings and effectively bankrolling public spending deficits) – with secondary drivers of the rather indulgent and costly impact of the woke agenda (forced power price rises etc etc) accidental savings (nought to spend your money on in lockdown) and supply shocks (either via furlough discouraging some back to work, or supply disruption post as a result of lockdown).
While the debate rages amongst professional economists I remain firmly in the camp that the inflation risks are material and growing particularly in the area of asset prices (residential property especially and not included in UK inflation definitions), wage costs, particularly for recreational, building and personal services and what I would describe as rarefied assets (luxuries, wine, unique products).
In normal circumstances we would be enjoying a period of price stability or even deflation. Consider the massive productivity gains from technology, the growing global labour supply as people continue to move from small holdings to cities with the deflationary impact of first China and now Vietnam and others making things for very little coupled with the greatly improved global logistics networks enabling product to flow.
If private enterprise had largely been left to its own devises, without consistent cajoling, regulation and distortion from government, both here and globally, this would, all other things being equal, be a golden age. Golden for prosperity in emerging markets and golden for the consumers in the West.
It should have been and with the right policy response, still could be a real win, win.
That technology and global free trade dividend described above kept a lid on global inflation over the last decade despite Governments’ attempts to re-float economies after the Global Financial Crisis (GFC) through both QE and arguably bond yield suppression over a true free market rate.
The Covid-19 global response however has changed everything and is of a different magnitude. The US has effectively announced a stimulus worth a staggering 40 per cent of GDP over the next four years, Britain has funded its £370bn+ of Covid-19 spending almost directly through the Bank of England printing a similar amount taking QE to a staggering £895bn.
The central bank now owns 40 per cent of its own debt with doubtless more to come. The ECB response has been even more extreme with often over 80 per cent of peripheral bonds (Italy/ Spain/ Portugal etc) being bought centrally. No serious commentator expects this ever to be unwound.
What is different about the central bank actions this time however is a) the scale globally; b) the purpose; and, c) the fiscal response. Arguably emboldened by the apparent success of QE round 1 post the GFC, this time the governments have designed round 2 to be so large it is without precedent.
What is perhaps more critical however, unlike the convoluted transmission mechanism post the GFC where the purpose was largely to re-float the banks and other financial service companies from insolvency with a fig leaf of fiscal constraint, this time the money has gone largely and directly into the economy.
Furlough has paid wages of the forcibly inactive and tens of billions have been spent on public services, the NHS in particular. This time the printed money has largely gone directly into the economy, not metaphorically into banks and insurance company vaults. The same is true in Biden’s America with direct cheques and to an extent (although perhaps in a more convoluted fashion) in much of the EU.
Further, this time in Biden’s America and Johnson’s Britain the continuing response will almost certainly continue to be spend, spend, spend. Austerity is now a dirty word (in my view it was an effective if largely inaccurate political slogan given it was never really implemented in the round) and we can be certain that much of the greatly increased public spending (up 32 per cent in 2020 alone in the UK) is now embedded. The British State is now well over half the economy, while perhaps of more note America has swapped a version of capitalism for managed socialism and outright political opportunism regarding public spending programmes.
In the UK, regardless of productivity, which in the public sector is largely lamentable and deteriorating, public sector wages are up 6 per cent this year, the so called levelling up agenda will be expensive and in my view counter-productive (see here), while the enforced net-zero drive already adds an estimated 40 per cent to electricity bills and seriously risks breaking confidence in price stability.
Throughout history from time-to-time monarchs and Governments have tried similar tricks. In Europe historically it was often to fund warfare, or sometimes by accident. In Latin America it was simply short-term populism and redistribution. Whatever the reason the result was always the same – disaster.
In England Henry VIII, now affectionately remembered as an overweight party-loving philanderer, was nicknamed ‘old copper nose.’ He was one of the first British monarchs to debase the royal mint. To pay for his foreign adventures he mixed copper with his former pure gold sovereigns. The result was not more coins to spend on feasting and war and untold wealth. It was simply inflation. He created an early wealth illusion. So disastrous was his policy that his debased coins were withdrawn in 1562.
More prosaically when the Spanish Conquistadors discovered silver by the barrow load in Bolivia initially some became fabulously rich. But it too was an illusion. The market was flooded and soon the price of silver collapsed.
Our current crop of politicians globally act in step. Be it on lockdown policy, fiscal stimulus or monetary response. While there remains some deflationary pressures – the technological, growing global labour market with still a couple of billion people globally earning very little who may leave their lands for the riches of the smoke stack factory floor – the idea the magic money tree can solve our ills has been tried before. It failed for the Conquistadors, it failed for Henry VIII and it failed in Argentina as well as many, many other places.
Yes, Modem Monetary Theory suggests that used carefully with moderate levels of QE and interest rate manipulation we can re-float the boat safely (no one is saying there is never a case) but we are in a whole new ball game now with short sighted politicians offering money for nothing, universal incomes, prizes for all and free money without productive gain. Worse, they are becoming addicted to spending and will find it nigh impossible to turn off the taps. We have moved a very long way from avoiding deflation and financial system collapse to funding current public spending and giving near direct payments.
The Central banks response so far has been entirely predictable. With the exception of one or two sane voices the cry is “it’s a blip”, “it is temporary”, the impact is “just a one off.” Don’t panic, don’t panic.
Well we will see, but US inflation is now above 5 per cent, UK wages are picking up apace, Governments are borrowing unprecedented sums. In the UK case £300bn of public debt in 2002, became £500bn by 2006, became £1000bn by 2011, became £2000bn by 2020 and will become almost £3000bn by 2025.
How does the Central Bank deliver a rise in interest rates in that environment? In the long term, with such debt even a poultry 1 per cent rise will add £25-30bn to government financing costs in the long term. A 5 per cent rise, to what would have been normal before 2010, would cost more than the entire VAT budget to finance.
Call me cynical but the response will be more “don’t panic chaps it is a blip”. Rates will stay low, spending will continue apace. The advocates of QE have got themselves on a treadmill they can’t easily get off. They will likely chose the path of least resistance, more of the same, but the risk is they are stoking an already simmering fire. We had better hope that technology and global market innovation that Brexit allows us to access dampen the tiger – but I wouldn’t bet on it.
Previous articles in Ewen Stewart’s ‘Hard Economic Reality’ series:
Photo of Bank of England in the City by schusterbauer.com from Adobe Stock.