LONDON (Reuters Breakingviews) - After Covid-19 is tamed, inflation rates are going to rise fast and far. Or maybe lockdowns will be followed by years of global deflation. The pandemic has unleashed a furious debate between extremists on either side of the monetary divide. Policy and habit suggest they’re both wrong.
Inflationists and deflationists have had several rough decades. In every developed economy, inflation rates have been on a declining trend since about 1980, but nowhere have prices and wages tumbled into serious deflation. Still, monetary gloom springs eternal in some human hearts.
For the inflationists, the big threat is the money supply. If prices are the amount of money in circulation divided by the things it pays for, as monetarist economics basically argue, then recent increases in the money supply should push prices upwards.
Look at the M2 measure of easily spendable money in the United States. Since 1985, it has never increased at more than an 11% annual rate. Yet thanks to ample government spending and central bank stimulus, M2 is now 23% higher than a year ago. True, the inflationists have been disappointed before. Growth in M2 last hit double digits back in early 2009, yet the disinflationary momentum remained unbroken. But this time, they say, it is much worse.
America’s GDP is likely to shrink by 7% in 2020, the Conference Board forecasts. That means there will be a lot more money to pay for less stuff. And that is a recipe for the beginning of an inflationary run, just as soon as consumers get their shopping mojo back.
Quite the reverse, say the deflationists. Never mind that the last sustained deflation was in the Great Depression, almost a century ago. Never mind that Japan, which is often described as deflationary, has had stable prices since 1997, with the consumer price index bobbling between 95.7 and 102.3. This time will be much worse.
Deflationists accept that governments are passing out money now. But the U.S. unemployment rate reached 14.7% in April. Fear and restrictions are likely to keep activity depressed for months, and a string of bankrupt retailers will be liquidating inventories and depressing moods. That is a recipe for hoarding money and cutting spending and hiring. If the monetary taps are turned off, prices are going to fall sharply, bringing wages down behind them.
Monetary extremists have to be impervious to evidence, because the facts have been against them for so long. But anyone worried that one side or the other might be right can take comfort. Neither the fire of rapid inflation nor the ice of deflation is very likely. The most plausible next chapter of monetary history is probably going to be more like slush.
Start with deflation. A sustained drop in prices requires a sharp monetary squeeze. The great deflations of the 19th century arrived when production was increasing much faster than the money supply, which was constrained by the gold standard. The great deflation of the 1930s was caused by a string of bank failures sucking money out of the economy.
As the aftermath of the 2008 financial crisis showed, central banks and governments have learned from those dark experiences. They rescued troubled banks and created money with abandon. This time around, even in the midst of fear and doubt, there will be enough government benefits and ultra-cheap bank loans to prevent desperate price and wage cuts – no matter how long GDP takes to recover.
The return of too-high inflation rates is a bit more plausible. After years of failing to keep prices rising by the desired level of around 2% a year, central banks might be too complacent if inflation picks up. They could conceivably dawdle into a new inflationary momentum. Governments eager to devalue their pandemic-related debts might provide encouragement.
But it takes years of official incompetence to get a serious wage-price spiral going. Banks, central banks and governments would all have to keep on creating more money long after prices and wages started increasing faster than they want. And both workers and producers would have to become absolutely certain that they will always need more money to keep up with the trend.
That incompetence threshold was crossed in the 1960s and 1970s, but there were some good excuses. The old Bretton Woods monetary order was unravelling and underlying GDP growth was strong. A repeat now is hard to imagine. Central banks have more independence and growth trends are tepid. Besides, high inflation is a lot less popular now, especially with ageing voters.
Sure, the M2 expansion could well go on longer than necessary. The expert consensus is that not enough money was pumped into the economy in 2009, so there may be some overcorrection this time. But as the Japanese authorities have discovered, unneeded money tends to go into savings accounts and financial markets, not into bidding up overall prices and wages.
Managing the post-Covid recovery won’t be easy. At least dramatic price instability – in either direction – need not be on the list of major worries.
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