There always seems to be some wonderful irony in macroeconomics.
Like Minsky's "stability breeds collapse" and Goodhart's law of failure,[1] economic rulers eventually face the troubles they create.
In the 70s of the 20th century, Keynesianism was defeated by stagflation; Fifty years later, central banks and negative interest rates were defeated by supply-side inflation.
As the supercycle of neoliberalism and globalization recedes, the focus of economic policy will shift from demand management to supply management. The structure of money and finance will be reshaped, and the era of tight money + loose fiscal may come.
It also means higher inflation, higher interest rates, and larger deficits.
The "rules" of the pre-pandemic era - what's wrong with throwing money?
In the 70s of the 20th century, after Keynesian policymakers were defeated by the great stagflation brought about by themselves, inflation became the main stubborn disease facing the economies of various countries, and rational expectations and monetarism began to come to the stage. The independence of monetary policy has increased, while fiscal policy has become conservative, focusing on redistribution and budgetary constraints and weakening stimulus responsibilities (neo-Keynesianism).
However, when policymakers think they can rely on monetary policy to solve more problems, they always fall into a liquidity trap of their own making.
In the 90s of the 20th century, the savings and loan crisis broke out, and 3,234 savings and loan institutions in the United States were either restructured or closed by the Federal Reserve and Loan Insurance Corporation. The public and private sectors paid more than $300 billion, equivalent to 4.2 percent of U.S. GDP at the time. As a result, the United States has reformed the regulatory structure of banks.
But financial markets are like a virus, the more controlled they are, the more distorted they become.
After regulating banks, the flood of liquidity caused by monetary easing pushed financial bubbles to shadow banks and institutional investors. In 2005, in order to obtain funds, mortgage loan companies packaged their mortgages into mortgage securities (MBS), debt-backed securities (CDOs), credit default swaps (CDS) and other financial innovation products through "asset securitization". After these products have been repackaged and resold many times, it is difficult to distinguish the risks behind them, and they are held by domestic and foreign financial institutions.
So the outbreak of the subprime mortgage crisis in 2007 shocked everyone again.
New Century Financial, the second largest subprime mortgage company in the United States, filed for bankruptcy. The world's famous investment bank Lehman Brothers went bankrupt and Merrill Lynch was acquired. 140 banks in the United States collapsed, the commercial banking giant RBS was nationalized, and the insurance company AIG was taken over by the government. The collapse of the financial system also ultimately harmed the real economy. There was a crack in physical financing, production activity fell sharply, and companies laid off a large number of employees.
Since then, financial markets have suffered from post-traumatic stress disorder. Investors spent the next decade searching for a black swan that had yet to come. The European debt crisis of 2010, the US debt ceiling in 2011, the oil crisis in 2014 and the repo crisis in 2019. Sell-side economists analyze every potential threat in extreme detail to avoid the investment falling into "another Lehman moment."
And monetary policy has also entered the era of "bailout". Central banks respond in a highly sensitive manner to every potential market threat. After all, no one wants to fall back into the chaos of '08 when the rescue plan was finalized at 4 a.m.
They seized every opportunity to lower interest rates and increase quantitative easing. Thanks to the credit crunch, even if this does not help the real economy in recession, it is at least very effective in supporting asset prices. Anyway, inflation is no longer resurgence, so what's wrong with unlimited money?
But inflation isn't really dead.
In the words of Mark Twain, "What gets you into trouble is not what you don't know, but what you are sure is right but it is not." ”
There is nothing to be done about supply-side inflation – it has to create a recession
So black swans always come in ways that everyone can't imagine, such as the outbreak of the new crown epidemic.
By that time, policymakers and markets had already taken the "rule" of the 2010s – low inflation for granted. It is impossible that prices will rise by "double digits". So, they put everything they learned into practice. Central banks have quickly provided unprecedented liquidity support, and the Federal Reserve has expanded its global dollar swap quota.
The government also knew that monetary policy alone was not enough for the economy, so it launched the largest financial support program since World War II. The debt ceiling and the Maastricht treaty are scrap paper. The treasury only borrows, the central bank buys, and MMT (deficit monetization) is popular. And inflation? That's just a concern in the "baby boom era."
The policy response also appears to have been very successful. The market quickly recovered, the bankruptcy rate fell to a new low, and the depression was effectively stifled.
Yet inflation isn't really dead.
The greatest irony is that the coronavirus crisis is completely different from previous financial crises. It's a shock from supply, not just demand. The combination of pandemic-induced production stagnation and policy-induced income increases has pushed up inflation, which has been further exacerbated by disruptions and reflexivity (strategic inventories) in international supply chains.
Over the past decade, inflation may have been lifted by policy stimulus, but once stimulus is reversed, short-lived inflation will quickly disappear. So the central bank believes that this time as well, inflation is only "transitory".
However, as the policy declined, the employment gap has been difficult to repair, wages have been rising, inflation has become more and more sticky, and after the dream of "transitory" was awakened, the central bank found that it could not do anything about supply-side management, and the specter of stagflation in the 70s was looming.
This is an unacceptable "nightmare" for the central bank.
Since there is nothing to do about supply-side management, the only thing central banks can do is to suppress demand and tame inflation by creating a recession.
From a central bank's perspective, a recession is really bad. People will lose their jobs, and the job market will take longer to recover. But recessions do occur, and they rarely undermine the credibility of central banks.
Uncontrolled inflation, however, can cast a darker shadow over central banks. In the short term, inflation expectations are de-anchored, and the central bank's credibility is undermined. Along with Arthur Burns, Powell, Lagarde and others will be included in the university curriculum of "Classic Cases of Monetary Policy Failure in History". Forty years later, economists are still repeatedly discussing how they made the 1970s happen again.
No central bank wants this, which is why they have suddenly become tougher than everyone thought a year ago - Jerome Powell's constant touting of Paul Volks' legacy, and Europe, the Bank of England, despite the threat of recession, widening interest rate spreads, and pension blowouts, have to defend "credibility".
The tighter the central bank, the more fiscal expansion
But fiscal policy has a different idea. The more central banks raise interest rates to squeeze demand and reduce inflation, the more the government will need to spend more to protect households and businesses from inflation and recession.
Supply problems remain, and the outbreak of the epidemic shortens long-term problems. The labor force participation gap remains significant, the ongoing energy shortage caused by the Russia-Ukraine conflict, and the retreat of the globalization supercycle. The balance of power in the economy is shifting from capital to labor.
For fiscal policy, the cost of living crisis requires more financial subsidies; The need for a new round of expansion when central banks push the economy into recession, as well as additional chain reshaping, decarbonization, defense spending, and so on, will all put pressure on fiscal policy.
There is a clear divergence between the two policies to regulate the macroeconomy, which did not exist in the decade before the pandemic. The position of fiscal and monetary policy has taken a 180-degree turn. The result is a very different situation from the previous decade of monetary easing and balanced fiscal relations – tight money and loose fiscal.
Such a combination not only reminds us of "Reaganomics," the "supply-side school" that dominated economic policy after the Great Stagflation of the '70s.
After Keynes's demand management failed miserably in the 70s, the conservative Reagan became president of the United States, and his supply management mobilized business operators and investors by reducing taxes, controlling the money supply, and deregulating the market, and freed the economy from stagnation and inflation, resulting in economic growth after the 80s.
In order to balance the fiscal Reagan also drastically cut social welfare spending, some people accused the policy of "robbing the poor and helping the rich." This is where the 1980 and 2022 versions of the fiscal policy structure are very different. The tax cuts + welfare cuts of the 80s were based on the surplus of the labor market and the creation of jobs. At present, under the background of labor gap, serious resource shortage and anti-globalization, increasing taxes + increasing welfare + industrial protection has become the mainstream idea of fiscal policy.
We will (already) see higher taxes, broader aid and relief, and stronger (not more liberal) industrial protections and support – those that are considered to be chain security and strategic competitive advantage (trams, energy, chips, etc.).
Conversely, of course, every dollar that fiscal pours into the economy only makes central banks more hawkish. Supply gaps and government spending support the economy as well as inflation, while central bank interest rates have to chase inflation. This meant higher average inflation, higher neutral interest rates, and larger deficits (the so-called balanced fiscal balance of the Reagan economy eventually led to the US fiscal deficit rising to $240 billion in 1992, the highest in the postwar period).
What about the huge public debt problem?
Yes, this will be something that the market needs to worry about in the future, the sustainability of government finances. How will they pay off the huge public debt of the past three years and beyond?
History shows that there are two ways to address public debt: the "orthodox" approach (austerity, structural reforms, etc.) and the "unorthodox" approach (inflation, perpetuity, default, and financial repression). The government has been following the orthodox approach since 2008, which has failed (see European and American debt balances), and now the "unorthodox" approach is beckoning.
So inflation is a way out that Europe and the United States are on the march and can see in the medium term. Tight money + easy fiscal is by no means a stable state. With the supply-side repair, global economic growth will return to the deflationary spiral caused by insufficient demand, bringing down inflation and economic stagnation.
Perhaps the only thing that can truly repair the daunting balance sheets of central banks and governments may be a new industrial-technological revolution.
Note: This article is based on Dario Perkins' Inflation was always the Endgame. Dario Perkins is Managing Director of TS Lombard's Global Macro Business. He has extensive economics experience in both the public and private sectors.
1) Goodhart's law of failure: Named after Charles Goodhart, this is a very famous theorem: when a policy becomes a goal, it will no longer be a good policy. As a former Bank of England advisor, he argued that when governments try to manage these financial assets with special markers, they cease to be credible economic bellwethers.
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