Inflation eats away at the purchasing power of the poorest and at the savings of the middle classes, increasing social tensions.
A specter from the 1970s has come back to haunt developed countries: inflation. The Covid epidemic has given rise to fears of huge numbers of bankruptcies and unemployment, but inflation has suddenly returned – except to Japan – reaching 7.1% per annum in the USA, 5% in the Euro zone, 5.7% in Germany, and 6.6% in Spain.
Governments and central banks first said that rising prices were temporary, linked to the singular nature of a recovery that combines, on the one hand, frenetic consumption on the part of households fattened with forced savings, and, on the other hand, shortages due to a lack of materials, energy and labor. In fact, inflation will be long-lasting, as shown by underlying inflation which has reached 5.5% in the USA, where a price/salary spiral has come about, and 2.6% in the Euro zone. First and foremost, inflation is being caused by the economic policies introduced in response to the Covid epidemic, and to compensate for health restrictions by guaranteeing people’s income, jobs, and company revenue. The principle behind these policies is unquestionable. However, they have been excessive, as in the USA where, even before the 2022 budget, $5,200 billion of budgetary expenditure was mobilized, and the Fed’s budget was doubled from $4,000 billion to $8,000 billion, i.e. an injection of liquidity equivalent to half of GDP over two years. Milton Friedman was right when he said that inflation is always a monetary phenomenon, as opposed to new monetary theory which claimed that public deficits and debt had no limits. The massive injections of cash together with restricted production have naturally caused very high price rises.
The problems caused by inflation underline the fact that it is never a good thing. One is always tempted to use it as a painless remedy for public and private indebtedness. But the damage it creates is considerable, as shown by the implosion in Venezuela, huge numbers of bankruptcies in Argentina, and Turkey’s insolvency. Inflation eats away at the purchasing power of the poorest and at the savings of the middle classes, sharpening social tensions. It squeezes company profit margins and reduces investment. It leads countries and companies to default on debt repayment, particularly when their debt is in a foreign currency.
It has visible, perverse consequences. It is badly slowing down recovery, forcing the IMF to lower its growth prediction for 2022 to 4.4% – as opposed to its initial forecast of 4.9% – and to 3.8% for 2023. It is creating a risk of recession and is destabilizing stock markets, where values are undergoing severe correction – notably technological and crypto-currency values. In the world that is now emerging, it will reduce 100 million more people to extreme poverty because of soaring food prices, and will threaten the stability of the poorest countries.
It seems highly unlikely that, after energy prices have peaked in 2022, inflation will disappear, given salary increases and changes in expectations in the USA. It is perfectly true that central banks find themselves facing a formidable dilemma: it is either to have recovery choked by a fall in purchasing power, or to risk recession or a crash because of rises in interest rates. But, having extended their tasks to managing systemic financial risks, with the objective of full employment or the reconfiguration of the production machine in order to combat global warming, they now find themselves reduced to their raison d’être, i.e. guaranteeing a stable currency.
In the USA; a consensus of opinion wants the Fed to act on and eradicate inflation. In Europe, the situation is far more ambiguous, for the ECB’s mandate has evolved (outside treaty requirements), and now prioritizes Euro zone stability over price stability. But there is a widening gap between the Northern countries – where industry and the middle classes are bearing the full brunt of the rising prices of raw materials and energy – and the heavily indebted Southern countries.
The scenario of a return to the stagflation of the 1970s, against a background of increased strategic risks, can be avoided. But only on condition that we end the illusion that public money is free and unlimited. The central banks are going to having to walk a tightrope: to bring inflation down to about 2% in developed countries without causing a violent recession and avoiding another devastating crash.
(Column published in Le Figaro, 31st January 2022)