The Covid lockdown crisis has arguably been the most important global event since the fall of the Iron Curtain, perhaps since the Second World War. It has turned our lives upside down, devastated the economy and heralded a political paradigm of big government interventionism. It has made the world live day-to-day as data for infections and deaths drive panicked and authoritarian policy changes. But with vaccines being rolled out and lockdown fatigue setting in, we can slowly start turning our attention to what will come after Covid. Politically, big government paternalism is the order of the day, and likely to be with us for generations. But what about the economy?
Central banks reacted to the great financial crisis of 2008 in an unprecedented way, by cutting interest rates to almost zero and letting the printing presses roll out huge amounts of new money. Many thought that these policies – and in particular quantitative easing (QE), the practice of letting central banks purchase large quantities of government bonds – would be hyperinflationary: more money chasing the same amount of goods and services should, in theory, cause prices to rise. But inflation, as measured by the (flawed) RPI or CPI measures, has stayed very low. The reason behind this apparent paradox was that the new money never reached the wider economy, rather, it largely stayed in bank reserves: the expansion in base money did not result in an expansion of broad money. With banks curtailing lending and governments restraining spending to avoid exploding fiscal deficits, ordinary people didn’t see their disposable incomes rise. Instead of manifesting itself in price inflation, the new money stayed in the financial system where it chased ever diminishing returns on assets: new bubbles were created in bond and equity markets and in “real assets” like art and real estate. The world got asset price inflation instead of consumer price inflation.
But is it different this time? The reaction to the Covid lockdown crisis has once again been a massive dose of QE, but this time it is combined not with interest rate cuts (rates are already at zero) but with huge fiscal injections into the real economy in the form of state guaranteed loans to small businesses or, as is the case with the newly passed stimulus bill in the US, cheques sent directly to people to spend as they see fit. Admittedly, due to lockdown, many people do not spend the money because there is nothing to spend it on, so they’ve invested it instead, in everything form Bitcoin to baseball cards – for now. But once that money finds its way into the real economy, it is inevitably inflationary.
When the government starts putting money directly into people bank accounts and mandating banks to make state guaranteed loans, they are crossing a Rubicon: straying away from fiscal policy and into monetary policy, an area that has been the remit of central banks ever since they became independent. And the independence of central banks and their ability to continue to operate with a mandate to curtail inflation – most central banks in the West have a mandate to keep inflation close to 2% – is a key question going forward.
As inflation rises, central banks are supposed to react by increasing short term interest rates to curtail economic activity and prevent the economy from “overheating” and prices from rising out of control. The problem is, all western economies (but not just western economies) are extremely highly leveraged: both governments and the private sector have borrowed enormous amounts of money, something they have only been able to do because the cost of debt service has been at unprecedently low levels in this past decade of ultra-low interest rates. This puts a serious question mark around how independently central banks will be able to act and whether they will be able to raise interest rates as they are ostensibly mandated to do. Governments are very unlikely to allow central banks to create a solvency problem for themselves or the wider economy.
In a world where central banks are unable to raise nominal raise interest rates, which have already been manipulated to remain below the rate of price inflation for the past decade, we are facing a future of permanently negative real interest rates (defined as interest rate less inflation). Combine that with a political environment where any constraints on spending seem to have been abandoned, with unprecedented stimulus packages and a political paradigm where serious spending cuts are anathema. What does that mean for inflation and, more importantly, for our way of life?
The first consequence is what is know as financial repression: central banks allow inflation to run and as prices go up, the value of the government’s debt decreases in real terms, effectively bailing the government out by the stealth tax of inflation, and, alongside it, helping the private sector deal with their unsustainable levels of debt too. A related term is fiscal dominance, the phenomenon of monetary policy being dominated by fiscal policy and the central banks focusing almost exclusively on financing the government’s budget deficits.
A logical consequence of fiscal dominance is that price rises eventually get out of control, inviting hyperinflation, as we have seen it in for example Venezuela. And this is most certainly what would happen in a modern market economy. But what if governments start manipulating not just money markets but other parts of the economy too? What if we are no longer living in a market economy?
Fractional reserve banking, as is the system in all modern economies, is a model of banking in which only a small part of bank lending is backed by actual cash. In other words, most of what we call broad money – all liquid forms of money, including bank deposits – are created by commercial banks through lending. So, one way for governments to control broad money, and in turn inflation, is to control bank credit and the rate at which it grows. And if that does not work, to introduce price caps in other markets. Government can simply force price inflation down by curtailing bank lending and forcing nominal price stability. What this means, in all likelihood, is that governments will allow inflation to go somewhat higher, to help them pay back the enormous debts they have accumulated and which they cannot possibly hope to repay by turning budget deficits t surpluses. But they will intervene heavily in the economy to prevent inflation from rising too much, and it is a strategy that might well prove successful for some time.
That is a scenario almost as terrifying as hyperinflation: the abandonment of the largely free capitalist economy which has allowed unprecedented wealth creation to take place over the last couple of centuries, in favour of a system of state control where money doesn’t chase investment return but is allocated to favoured industries and well-connected people – crony capitalism. Free market capitalism has always been under attack, but in our lifetimes, the left has been much more successful in their efforts to grow the size of government than in challenging the fundamental paradigm of free markets. That started to change after the great financial crisis and the lockdown crisis will only accelerate this process – a process we can’t hope to hold back, because it isn’t just about political paradigm but driven by a grossly distorted economy that must eventually fail.