Will stagflation come?

US, WASHINGTON (ORDO NEWS) — The respected economist believes it is likely that inflation will rise steadily after the covid-19 recession. He points out the factors that make this growth almost inevitable. But it would be even worse if the situation begins to develop in the direction of stagflation, he warns, and explains the possible risks.

There is an increasing debate over whether inflation over the next few months will become temporary, reflecting the sharp recovery from the covid-19 recession, or permanent, reflecting both demand and cost factors.

Several factors point to the sustained sustained rise in inflation, which has remained below the annual target of most central banks of 2% for more than a decade. According to the first, the United States has imposed excessive fiscal stimulus on an economy that appears to have already begun to recover faster than expected. In March, $ 1.9 trillion in additional spending was approved, which was set aside for the $ 3 trillion package approved last spring and the $ 900 billion December stimulus, with a $ 2 trillion infrastructure bill to follow shortly. Thus, the response of the United States to this crisis is by an order of magnitude greater than its response to the global financial crisis of 2008.

The counter-argument is that this stimulus will not cause prolonged inflation, as households will save most of the money to pay off debt. Moreover, by increasing the amount of public capital that increases productivity, investment in infrastructure will increase not only demand, but also supply. But of course, even with this dynamic, stimulus-driven growth in private saving implies that there will be some inflationary release of constrained demand.

A second related factor is that the US Federal Reserve and other major central banks are overly flexible in pursuing policies that combine financial and credit easing. Liquidity provided by central banks has already driven asset inflation in the short term and will spur inflationary credit growth as well as real spending as the economy accelerates and economic activity resumes. Some will argue that when the time comes, central banks can simply liquidate excess liquidity by shrinking their balance sheets and raising interest rates from zero or negative. But this statement is becoming more and more difficult to accept.

Central banks have monetized large budget deficits as reflected by “helicopter money” or the application of Modern Monetary Theory. At a time when public and private debt is growing from an already high base level (425% of GDP in advanced economies and 356% globally), only a combination of low short-term and long-term interest rates can keep the debt burden at an acceptable level. … The normalization of monetary policy at this stage will lead to the collapse of bonds and credit markets, and then the stock markets, which will provoke a recession. Central banks have effectively lost their independence.

The counterargument here is that when the economy reaches full capacity and full employment, central banks will do their best to maintain their credibility and independence. An alternative would be to de-anchor inflationary expectations, which would destroy their reputation and lead to a runaway rise in prices.

The third claim is that the monetization of the budget deficit will not be inflationary; rather, it will simply prevent deflation. However, this suggests that the shock hitting the global economy is similar to the shock of 2008, when the collapse of the asset bubble triggered the credit crunch and hence the aggregate demand shock.

The problem today is that we are recovering from a negative aggregate supply shock. Thus, overly loose monetary and fiscal policies could indeed lead to inflation, or worse, stagflation (high inflation along with recession). Ultimately, the 1970s stagflation came after two negative oil supply shocks following the 1973 Yom Kippur War and the 1979 Iranian Revolution.

In today’s environment, we need to worry about a range of potential negative supply-side shocks, both as threats to potential growth and as possible drivers of production costs. These include trade barriers such as de-globalization and growing protectionism; post-pandemic supply problems; exacerbation of the Sino-American Cold War; and the subsequent balkanization of global supply chains and the redirection of foreign direct investment from inexpensive China to more expensive countries.

Equally worrisome is the demographic structure in both advanced and emerging economies. It is when older cohorts increase consumption by spending their savings that new restrictions on migration will put upward pressure on labor costs.

Moreover, rising inequality in income and wealth means that the threat of a populist backlash will remain in place. On the one hand, this could take the form of fiscal and regulatory policies to support workers and unions – another source of pressure on labor costs. On the other hand, the concentration of oligopolistic power in the corporate sector can also be inflationary, as it increases the price formation of producers. And, of course, the backlash against Big Tech and capital-intensive labor-saving technologies can lead to a reduction in innovation in general.

There is a counter-narrative to this stagflationary thesis. Despite public backlash, technological innovations in artificial intelligence, machine learning and robotics could continue to weaken the workforce, and the demographic effects could be offset by higher retirement ages (which implies an increase in labor supply).

Likewise, today’s reversal of globalization could be reversed as regional integration deepens in many parts of the world, and as service outsourcing provides workarounds to remove barriers to labor migration (a programmer from India should not move to Silicon Valley for developing an application for the USA). Finally, any reduction in income inequality could simply counter sluggish demand and secular deflationary stagnation, without causing serious inflation.

In the short term, sluggishness in commodity, labor and raw materials markets, as well as in some real estate markets, will prevent a sustained inflationary surge. But over the next several years, loose monetary and fiscal policies will generate persistent inflationary – and ultimately stagflationary – pressures due to any number of persistent negative supply shocks.

You can be sure that the return of inflation will have serious economic and financial consequences. We would move from Great Moderation to a new period of macro-instability. The secular bond bull market will finally come to an end, and rising nominal and real bond yields will make today’s debt unacceptable, causing global stock markets to crash. Over time, we might even witness a 1970s-style sickness return.

Nouriel Roubini is Professor of Economics at New York University’s Stern School of Business and Chairman of Roubini Macro Associates. He was a senior international affairs economist on the White House Council of Economic Advisers during the Clinton administration. He has worked for the International Monetary Fund, the US Federal Reserve, and the World Bank.


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