We risk a return to 1970s stagflation

The writer, a faculty member at Yale University and former Morgan Stanley Asia chair, is the author of ‘Unbalanced’

Back in the early 1970s, when I was a pup, my colleagues and I on the staff of the US Federal Reserve Board, analysed inflation from the cost-push or supply side. Global economic growth had unleashed a surge in commodity prices, reinforced by a quadrupling of oil prices after the 1973 Arab-Israeli Yom Kippur war. With labour markets already tight, productivity weakening, and US regulatory costs mounting, a wage-price spiral soon ensued. A stagflationary decade of double-digit inflation and slow growth followed. Financial market performance was atrocious.

Of course, that could never happen again, right? Central bankers insist that inflation expectations are anchored. The horror movie of the early 1970s is also running in reverse. Oil prices have collapsed, so too those of other commodities, and soaring un­employment has killed any chance of wage inflation. Demand will, meanwhile, remain under pressure as social distancing keeps consumers from shopping, eating out, travelling and other leisure activities.

But there is a catch. Consumer retrenchment will persist only until a Covid-19 vaccine arrives. If this takes another 12 to 18 months, as scientists believe, pent-up demand will build as never before. Assuming that governments continue to support worker incomes in the meantime, the release of this pent-up demand could spark an inflationary spiral that markets are not expecting.

The seeds for such an outcome are also being sown by the disruption of global supply chains. In the early 1970s — despite periodic pressure from globally traded commodities — inflation was primarily a local affair, driven by domestic labour markets, national regulatory regimes and relatively closed economies that did not depend much on cross-border trade. The advent of global supply chains changed all that.

They arose from Japan’s just-in-time production systems of the 1980s and took flight thanks to plunging transportation costs, new technologies and breakthroughs in supply logistics. The IMF estimates that almost three-quarters of the increase in trade between 1993 and 2013 was due to the growth of supply chains. With trade rising fivefold in those 20 years, the chains helped power global economic expansion.

As significantly, they were an important source of disinflation. Before Covid-19 hit, the Bank for International Settlements estimated that global inflation would have been about one percentage point higher were it not for the supply-chain enabled efficiencies of global production.

Therein lies the inflationary risk for the post-coronavirus world. As part of a growing backlash against globalisation in general, and China in particular, nations are threatening to bring their offshore platforms back home. Tokyo has set aside ¥243bn of its record ¥108tn rescue package to help Japanese companies pull their operations out of China. Larry Kudlow, economic policy chief to US President Donald Trump, has hinted at similar anti-China measures for American companies.

This reshoring flies in the face of everything we learnt about comparative advantage from David Ricardo. Reshoring may well increase the security of supplies. But it will also involve higher-cost domestic producers.

Moreover, the anti-China weaponisation of supply chains promises to riddle global production systems with bottlenecks. Inflation will not return while the recession deepens. But as recovery takes hold, a new world of fragmented, more expensive supply chains may tell a different story.

Soaring deficits and debt could compound the problem. For now, no one is worried about them because of a conviction that interest rates will stay at zero forever. But with fractured supplies set to push inflation higher, that assumption will be tested.

For the indebted US economy, an inflation-driven rise in interest rates would slow growth. Public debt is headed to about 120 per cent of gross domestic product by 2025, up from 79 per cent in 2019 and well above the post-second world war record of 106 per cent.

History suggests that inflation may be the only way out. After the second world war, the US escaped from its public debts by reflation. Public debt fell by 0.9 percentage points a year from 1947 to 1957, while nominal gross domestic product, helped by accelerating inflation, rose 7 per cent annually. The ratio of debt to GDP soon plunged to 47 per cent. Today, a comparable debt shrinkage would occur if inflation moved back to 5 per cent.

With rock-bottom interest rates, open-ended quantitative easing and a massive debt overhang, inflation may be the only way forward for the US and other indebted western economies. Even so, equity and bond markets will probably tremble in response.

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