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The Great Reversal into a higher inflation environment

These are not the 1970s, at least that is assured by respectable economists. Admittedly, as we face rising levels of inflation, there are nuanced differences between then and now.

But the UK’s rail, mail and waste collection strikes point to one overwhelming similarity: that stagflation creates winners and losers. When national real incomes are under pressure from oil price shocks like in the 1970s or the current food and energy price shocks, rival claimants in the economy compete fiercely to recover lost revenues. A wage price spiral is created.

Milton Friedman noted that inflation is “always and everywhere a monetary phenomenon”. It is clear that money is an important part of the inflation process. Yet strikes in the UK and tight labor markets in the developed world suggest that no explanation for inflation can be complete without reference to the power struggle between labor and capital.

While central bankers congratulated themselves on delivering low and stable inflation during the so-called Great Moderation in the three decades leading up to the 2007-2009 financial crisis, disinflation was in reality the result of the global labor market shock caused by the bringing in China, India and the Eastern Europeans into the world economy.

This caused a prolonged downward trend in the share of labor in national income. Productivity gains were completely taken up by capital. The disinflationary impulse was exacerbated by demographics and the wider ramifications of globalization.

A weak return on labor inhibited consumption and output because workers have a greater propensity to consume than capital owners with a higher savings rate. This led to an endemic expansionary monetary policy.

As economists at the Bank for International Settlements have long noted, central banks did not back down against the boom, but relaxed aggressively and persistently during failures. This preference for loose policy was further anchored after the financial crisis by the asset purchase programs of the central banks.

William White, former head of the Monetary and Economic Department of the BIS, argues that central banks have systematically ignored supply-side shocks and failed to understand in the Covid-19 pandemic how much supply potential had been reduced by disease and lockdowns.

In fact, they have repeated the mistake of Federal Reserve Chairman Arthur Burns who argued in the 1970s that the oil price shock was only transient, ignoring its second-round impact, particularly on the labor market.

Speaking at the annual central bankers’ jamboree in Jackson Hole last month, Fed Chair Jay Powell indicated that the Fed was late on the matter, saying that labor costs to curb inflation would likely be delayed. , adding that “we have to hold on until the job is done”. The difficulty here is that both private and public sector debt is higher than before the financial crisis, so the production and employment costs of soaring interest rates will be very high.

This debt trap, in acute form, raises the long-standing question about central bank politics: how to convince politicians and the public that a modest recession now is a price worth paying to avoid a much worse recession later on. The independence of central banks is at stake.

The Fed’s harder line suggests that the bond market has much further to go. And the summer rebound in stocks appears to have been quichotic. Steven Blitz from TS Lombard points out that the Fed’s policies should have an impact on equities rather than credit creation, because the 2010-19 and post-coronavirus expansions amount to an asset cycle, not a credit cycle. Richly priced financial assets, he adds, are the source of economic disruptions to this cycle.

Correcting those distortions will produce some clear contrasts with the 1970s. Today, the shrinking workforce and deglobalization are shifting the balance of power from capital to labour. We have moved from the Great Moderation through the Great Financial Crisis to a Great Reversal to a higher inflation environment.

It is also a world in which the toxic combination of the debt trap and the contraction of central bank balance sheets will greatly increase the risk of financial crises. While commercial bank balance sheets are in better shape than they were in 2008, underregulated, opaque non-banks pose a potential systemic threat, as indicated last year’s collapse of the Archegos family office. An important lesson from history is that after an “everything bubble” leverage, or borrowing, turns out to be much greater than everyone assumed at the time.


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