Why inflation looks set to return in the wake of coronavirus

Amid all the questions about Covid-19 – when will the lockdown be over? How quickly will we discover a vaccine? Will there be second waves or mutations? – we know two things for sure. One is that the scale of the economic downturn caused by both the pandemic and the measures to contain it is unprecedented in the modern era.

The precise figures are unimportant – we all know that forecasts are virtually always wrong – but to give a sense of just how bad things are, the International Monetary Fund (IMF) reckons that global economic output will fall by 3% for the whole of 2020 (for perspective, it fell by just 0.1% in 2009, during the global financial crisis). Meanwhile, in the UK the Office for Budget Responsibility – the UK’s fiscal watchdog – has warned that we are looking at a 35% plunge in GDP in the second quarter, assuming the lockdown stays in place for the full three months.

The other thing we know is that the scale of the government and central bank reaction to this downturn has been equally unprecedented. It’s really not an exaggeration to argue that free-market capitalism has been suspended. At the end of last week the Federal Reserve – the US central bank – declared that it would print money to buy a wider range of assets than it ever has before. Forget boring old US government bonds. The Fed is now buying not only investment-grade corporate debt, but also exchange-traded funds (ETFs) that own junk bonds. In other words, some of the dodgiest credit risks in the global market (they’re not all US companies) now have the Fed standing behind them.

An explosion in moral hazard

This is encouraging “moral hazard on a grand scale”, says Jonathan Tepper in the Financial Times. As an editorial in The Wall Street Journal put it, “The Fed will in effect buy the worst shopping malls in the country and some of the most indebted companies. The opportunities for losses will be that much greater... the taxpayer risks here are greater than what the Fed took on in 2008-2009.”

This made the news that the Bank of England has decided to give the UK government an unlimited overdraft in the form of its “Ways and Means facility” – in other words, it will give money directly to the Treasury if markets are too clogged up to allow the smooth issuance of gilts – almost seem like a minor administrative matter, rather than the next step towards full-blown deficit financing that it really is. 

It’s not just the Fed and the Bank of England. Stefan Schneider, Deutsche Bank’s German chief economist, sent out a note this week on Germany’s reaction to the crisis headlined: “Are we on our way to state capitalism?” Schneider warns that “the misallocations of capital, misdirected employment incentives and the spread of moral hazard” that will result from Germany’s efforts to prevent any healthy business from going bankrupt due to coronavirus will both weaken productivity and, in time, “further exacerbate the conflicts about allocation of resources sparked by the ageing of society”. Or as Howard Marks of Oaktree Capital puts it: “Markets work best when participants have a healthy fear of loss. It shouldn’t be the role of the Fed or the government to eradicate it”.

But eradicate it they have. And partly as a result, government spending as a proportion of the UK economy rose to 52% of GDP in March (from below 45% last year) and it’s expected to hit similar levels in Germany. Governments may argue that these measures are temporary and that they will be unwound as the economy recovers. But we heard that in 2008 and 2009 and those measures are still in place. Will there ever be a good time to unwind the “emergency measures” being put in place today? We wouldn’t like to bet on it. 

How do we pay for all this?

So that raises the obvious question: how do we pay for all this and who ends up footing the bill? There are lots of rumblings about a new era of austerity being imposed to pay the money back via higher taxes and reduced public services, but this seems highly unlikely. A simplistic but not entirely inaccurate view of the 2008 crisis is that banks and asset owners were bailed out and workers paid for it with suppressed wages and diminished public services. If that gave rise to today’s populism, then how will people react now that the same appears to be happening again? 

The problem is that moral hazard – the risk that cushioning individuals against negative consequences encourages the very behaviour that leads to disaster in the first place – isn’t just restricted to markets. It undermines the whole idea of free markets. For example, we (rightly, I believe) largely disagree with the notion of price controls or rent controls because they favour select political groups, encourage corruption and have hugely damaging side-effects. And yet what else are central banks, with their moves to support financial markets with effectively unlimited amounts of money, doing for asset prices? Why do price controls make sense for junk bonds, for example, but not for rents, or wages?

Those are hard questions to answer because there is no good answer – if you agree that the Fed should bail out not only big banks, but also big companies, private-equity investors and owners of ropey real estate, then why shouldn’t it bail out small companies and individuals too? And if you think that politicians can resist that idea at a time when entire wings of the economics profession are lining up behind them to endorse it as a valid option (generally under the umbrella of modern monetary theory – MMT), then you are living in a parallel universe. As a result, there is only one obvious and politically acceptable solution to all this – the debt has to be, and will be, destroyed via inflation or default. 

Given the spectacular collapse in activity, you might ask – how can inflation possibly arise?

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