Will inflation return post-COVID?
By Henning Vöpel, courtesy of HWWI
How stable will the global economy be macroeconomically after the COVID-19 pandemic? In addition to a few reasons to be able to relax, there are increasing signs that adversity is looming in the medium term. Inflation could return and that would change the situation suddenly.
The two economists Larry Summers and Olivier Blanchard, both better known for giving preference to an expansive fiscal policy, recently expressed concern that one could not only do too little of a good thing in the COVID-19 pandemic, but also too much. What was meant was the trillion dollar fiscal package in the U.S. Too much overheating could generate inflation and trigger inflation processes, thus their warning.
Another interesting remark came in the last few days from Thomas Piketty, who, along with other economists, called for debt relief for Italy. The European Central Bank can and should simply refrain from having to repay Italy’s debt that it financed itself. A demand that is extremely explosive, especially in the context of the euro zone, where the lack of fiscal union and on the other hand and a stronger economic divergence after the corona crisis could be poison for the cohesion of a currency union with structurally very different member countries.
And then a “theory” is currently haunting the public debate: the Modern Monetary Theory (MMT). Its most prominent protagonist at the moment, Stephanie Kelton, sees almost unlimited possibilities for more or less direct state financing by the central banks. The state can even do without taxes, because as long as there is no inflation and the state does not crowd out private investments, the state can and must ensure full employment, so the argument goes. The MMT is therefore less of a monetary theory than of a fiscal theory. The certainly not uninteresting arguments that go back to post-Keynesian approaches are not a real theory, but apply under certain conditions.
If you put all three statements together, those of Summers and Blanchard and Piketty and Kelton, it becomes clear that the discussion about macroeconomic stability is back. And precisely at a time when the question arises as to whether we can afford all of this with the almost unlimited help in the COVID-19 crisis. The answer is first of all: Yes, we can and we must afford it. The COVID-related debts mean a redistribution today and imply a redistribution in the future, but the real burden of the crisis is borne by the economies and societies today, and there is hardly any redistribution between the generations.
The current favorable macroeconomic constellation offers fiscal policy leeway that should be used for aid and investments. Any discussion of quick consolidation or tax increases after the pandemic would be counterproductive. Generating a fiscal shock after the pandemic shock would not make sense in the middle of the recovery. And yet be careful! Fiscal and monetary policy could all too easily get used to the whatever-it-takes attitude that has been practiced since the global financial crisis in 2008. Today, however, it is not just a question of a demand shock. Rather, the pandemic triggered a combined supply and demand shock. At the same time, almost all economies are in a state of multiple structural upheaval: climate change, digitization and also the geopolitical upheavals in the global economy could massively change the global supply side. Distribution conflicts could also return after the COVID-19 crisis, not to mention the demographics, which will slowly but surely lead to rising interest rates. So if monetary imbalances build up now, it is all the more important to reduce real economic imbalances. Accelerated structural change and a stronger reallocation of labor and capital must take place after the pandemic so that a sclerotic economy does not become the long legacy of the crisis. But this will certainly lead to rising interest rates. So if monetary imbalances build up now, it is all the more important to reduce real economic imbalances.
In other words: The macroeconomic constellation that is so favorable today, which has induced quite a few to even proclaim a new paradigm of macroeconomics, can and will change at some point, perhaps soon. The combination of very low interest rates, low product price inflation (and high asset price inflation), and high employment can change faster than many might think today. It is never just one cause that triggers crises, there are almost always combinations of causes, macroeconomic dependencies that occur in certain constellations and are mutually exacerbated: rising inflation leads to rising interest rates, the sustainability of national debt falls, the risk of currency crises increases. Monetary and fiscal policy leeway is never static, but always dynamic.
Stability is always long-term, but it is decided by the discipline of short-term action. Whenever what is done is what is possible and convenient in the short term, the effects can accumulate negatively and in the end threaten stability. In this respect, the independence of the central banks to avoid long-term dependence on monetary and fiscal policy (financial repression) and the debt brake to ward off unlimited spending requests by politicians are important institutional restrictions on political action, especially today. The time consistency problem between short-term opportune action and long-term stability almost always applies in political-economic contexts.
This time is different. In a crisis, it is often said that everything will be different this time. And yet, after crises, you had to find out again and again that everything wasn’t different after all, that certain patterns, constellations and dynamics were repeated. People and markets are and will remain prone to exaggeration. It is no coincidence that overconfidence is one of the most valid findings in behavioral economics. Inflation and currency crises cannot be ruled out in the future. On the contrary: it has existed again and again historically and there is no reason to assume that it will not also exist in the future. Even if the data does not (yet) show it, the theory and, above all, historical experience suggest it. It will take a lot of statecraft after the crisis.
Henning Vöpel is director of the HWWI.