Can inflation occur during the recession?

Economy: Stagflation could drive the global economy into recession

Nouriel Roubini is CEO of Roubini Macro Associates and Professor of Economics at the Stern School of Business at New York University. Roubini became known because he warned early and precisely about the risks that led to the financial crisis in 2008.

For some time now, economists and investors have been discussing intensively whether prices will only rise for a short time after the corona crisis has been overcome or whether the world is facing a new era of inflation. Because there are price-driving factors on both the demand and the cost side.

The fact that the US launched gigantic government spending programs at a time when the economy is recovering faster than expected suggests a sustained secular rise in inflation. In addition to a $ 3 trillion package from last spring and a $ 900 billion stimulus package in December, government spending of $ 1.9 trillion was passed in March. A $ 2 trillion infrastructure package will follow shortly. The US fiscal reaction to the corona crisis thus exceeds the measures taken against the global financial crisis of 2008 by a factor of ten.

Concerns that fiscal oversizing could sustainably accelerate inflation are often countered by the fact that the measures will not trigger permanent inflation because private households are putting a large part of the money aside to pay off debts. In addition, investments in infrastructure increased not only demand but also supply. The growing public capital stock increases productivity. However, it is questionable whether these arguments can be used. The lavish fiscal transfers by the government to the citizens and their backed-up demand suggest that consumer spending will soon rise sharply and will lead to higher price inflation.



The course of monetary policy is decisive for the inflation outlook. The US Federal Reserve and other major central banks opened the money locks when the corona pandemic broke out. The liquidity made available has caused asset prices to rise sharply. As the economy picks up, private lending should also get going. The additional demand will gradually drive up goods prices as well.

Inflation skeptics object that the central banks can reduce their balance sheets if necessary, raise key interest rates and thus siphon off excess liquidity. However, it is difficult to believe this claim.

At a time when public and private debt continues to grow from an already high starting level (425 percent of gross domestic product in advanced economies and 356 percent worldwide), only a combination of low short-term and long-term interest rates can keep the debt burden at a sustainable level hold. In this environment, normalization of monetary policy would cause the bond and stock markets to crash and trigger a recession. The central banks have long since lost their independence.

Everyone is staring at the rising consumer prices. The producer prices for industrial goods are currently rising even more sharply. When and where consumers will feel this.

Defenders of current monetary policy suggest that central banks will do whatever they can to maintain their credibility and independence once full utilization and full employment are reached and inflation threats rise. Because they have no interest in inflation expectations unanchoring. That would destroy the reputation of the central banks and result in a sustained inflation process.

In addition, it is claimed that the monetization of budget deficits avoids an otherwise threatening deflation. This argument would only be valid if the shock that is currently affecting the global economy was similar to that of 2008, when the bursting of the housing price bubble led to a credit crunch and a loss of demand.

Demographic turning point

The problem today, however, is that we are recovering from a negative macroeconomic supply shock. In this respect, too loose monetary and fiscal policy could lead to inflation or, even worse, stagflation (high inflation combined with a simultaneous recession). Finally, the 1970s stagflation set in after two oil supply shocks as a result of the 1973 Yom Kippur War and the 1979 Iranian Revolution.

Even today there are factors that are depressing the long-term growth trend, driving up production costs and thus promoting stagflation. These include deglobalization and growing protectionism, supply bottlenecks due to the pandemic, the intensification of the Sino-American Cold War and the resulting fragmentation of global supply chains. This also includes the relocation of foreign direct investment from the low-cost country of China to places that are characterized by higher costs.

Another factor is demographic development, both in the industrialized countries and in the emerging economies. The growing number of older people who want to consume more towards the end of their lives will boost consumer spending. As these people are no longer available as labor on the labor market, the upward pressure on labor costs increases. Government measures to curb cross-border migration also drive wages up.

Technological opposing forces

In addition, growing income and wealth inequality increases the risk of populist backlash. These could be reflected in regulatory measures to support wages and incomes and drive labor costs further up. In the corporate sector, the concentration of oligopoly power could also prove to be inflationary. Because it strengthens the pricing power of manufacturers. Regulations directed against the big tech companies, on the other hand, could slow down the innovation process.

The thesis of the return of stagflation has sparked opposition. The critics point out that technological innovations in the areas of artificial intelligence, machine learning and robotics save labor and thus weaken the bargaining power of the unions. That counteracts a rise in wages. In addition, the shortage of labor could be mitigated by a higher retirement age.

The trend towards deglobalization could be reversed again, as regional integration is deepening in many parts of the world. In the service sector, thanks to modern technologies, it is also possible to keep wage costs low without allowing mass immigration. A programmer in India doesn't have to move to Silicon Valley to design an app for the USA. Political measures to reduce income inequality, it is argued, did not fuel inflation, but acted as a demand-stimulating corrective against deflationary secular stagnation.

What is the conclusion of all these arguments? Well, in the short term, the slack in the labor markets should prevent a sustained surge in inflation. As soon as the labor market stabilizes, however, the loose monetary and fiscal policy will unfold its effects and set in motion a sustained inflationary and ultimately stagflationary process.

The return of inflation will have serious economic and financial consequences. The world then enters a phase of macroeconomic instability. The secular bull market in bonds will draw to a close, rising nominal and real bond yields will make the debt increasingly unsustainable and the stock markets crash. At the end of the process, the world could slide into stagflation - just as it did in the 1970s.

More on the subject: The cost of living is increasing, probably in the longer term. The world economy is facing a long period of higher inflation. The reasons for this cannot only be found in the pandemic lockdowns.

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