Economic history is marked by a series of paradigm changing moments. The response to the Great Depression saw Keynesianism triumph, the collapse of Bretton-Woods system of exchange rates marked the transition to fiat money and decades of high inflation and in 2008, central banks took centre stage with hitherto unprecedented ZIPR and QE policies, inflating asset prices and changing the dynamics of financial markets forever. The way governments have responded to the Covid-19 pandemic represents another such moment of systemic change. Some of these changes are already apparent, others lurk in the shadows. All are unwelcome.
Most conspicuous is the way the pandemic has seen a hitherto unprecedented level of state interference in the economy. Large swathes of private sector employees have been transferred to the public sector payroll and governments decide by decree which businesses are allowed to operate or are worthy of grants and subsidies. This enlarged role for the state will encourage cronyism and further distort free capital allocation and will inevitably have a long term drag on economic growth, as protected industries are shielded from the consequences of changing consumer preferences and allowed to tie up resources in suboptimal use.
Also already obvious is the explosion in already record levels of government debt. To pay for the decisions to lock down their economies, governments across the globe have turned to borrowing unprecedented amounts. The IMF predicts that rich countries will borrow 17% of GDP in 2020 and countercyclical spending in response to the inevitable recession will ensure that large deficits are here to stay for many years to come. To finance the spending bonanza, governments have again had to rely their financier-of-last-resort, the central banks, who have stretched further than merely expanding their QE programmes to accommodate. The European Union, after years of debate, finally coerced Germany into accepting common borrowing; the European Commission will now borrow EUR 750bn, roughly 5% of the union’s GDP, and disperse it to needy economies as loans and even partly as grants. Central banks such as Bank of England and the US Federal Reserve have begun lending directly to ‘deserving’ private companies. In return for all this debt, central banks have been printing new reserves, and count on it not being reflected in higher inflation, a traditional worry when the money supply expands. So far, QE has not been accompanied by higher consumer prices.
But the return of inflation could be the next paradigm shift. Some fear that the ‘secular’ nature of this round of deficit spending, where freshly minted money is handed directly to citizens and not to banks, could finally be reflected in consumer prices and spark the feared price-wage spiral. Of course, the notion that inflation has been absent is contentious. With global bond, stock and housing markets at record levels, it is hard to argue that the ultra-loose monetary policies have had no effect on prices just because consumer prices have not risen much, . This problem with definition leads Austrian economists to resist the usual definition of inflation as rising prices, focussing instead on the rate of increase in the money supply. The logic is that a growing economy should, with a constant money supply, experience falling prices. Therefore, measuring inflation as the rise in prices disregards the deflationary contribution from economic growth.
Of all potential consequences, the most ominous is the adoption of what has so far largely been derided as voodoo economics, namely Modern Monetary Theory, which essentially claims that if there is sufficient spare capacity in the economy, the government can spend as much as it likes without withdrawing resources from the production of other outputs. Controversially, the theory claims that as long as a country borrows only in its own sovereign currency, it can simply issue new money to pay for the expenditure and not worry about such matters as raising taxes to pay for it. Governments keen to find theoretical backing for their unhinged spending plans could embrace MMT, much like Keynesianism proved a convenient crotch to support the move away from fiscal prudence in the 1930s. But the obvious flaw in MMT is of course that government spending inevitably does divert resources from the private sector. Government spending in any form is taxation as taxes is the only means the government has to pay for its expenditure. Deficit spending is merely deferred taxation, paid for via future taxes or indeed by stealth via inflation, if the spending is paid for by expanding the money supply. In any case, the resources used in the public sector has to be transferred from the private sector. Should MMT gain mainstream recognition, the consequences would be catastrophic.
A larger role for the state and even more prominence for the hegemonic and unaccountable central banks and the risk of increased inflation and the final abandonment of even lip service to fiscal prudence paints an ominous picture. While the world has been focussed on alarming death rates and human tragedy in the wake of the pandemic, a much wider reaching catastrophe is in the making and the origin of this one is no mystery; it’s the government.