Inflation in the world economy – 07/06/2023 – Why? Economês in good Portuguese

Since the 1980s, the world economy has not faced such a serious inflationary problem. What brought us here? What should be done? Finally: where does the thing go or go?

Before unrolling the ball, a clarification. In general, with the small exceptions that prove the rule, inflation in developed countries was defeated in the 1980s and, in developing or emerging countries, about a decade later. In the emerging countries, here and there, it also got its claws out in the most recent period. In Turkey and Argentina, for example, it is around 75%, while in Sudan the value is around 150% and in Zimbabwe at almost 300%.

Milton Friedman used to say that inflation is always and everywhere a monetary phenomenon, but this explanation is incomplete. First of all, it is necessary to understand the reason for the excessive monetary expansion! And every 99 times out of 100 a country has had to resort to printing money it has been to cover a fiscal deficit. Very difficult to have very high inflation at the same time, let’s say above 20% a year, with the fiscal house in full order.

After the great financial crisis of 2008-9, world inflation was reduced and was stuck close to 2%, in the case of advanced countries, even with monetary policy, in many of them, in full expansion mode (that is, with zero interest). It already seemed to some a strange balance, possibly temporary. But the majority view was that the economy’s natural interest rate had actually been reduced and that many countries could live with interest rates close to zero without inflationary problems. Then came Covid.

With the pandemic and the risk of a new depression, fiscal and monetary policy action was quick, brusque and decisive: those with interest rates slightly above zero, like the United States, quickly dropped the rate to that level. What’s more, central banks began to engage in a myriad of other operations of an expansionary nature, such as the purchase of public and private bonds to support the credit market and downward pressure on longer-term interest rates. Fiscal expansions were also brutal. Several countries increased public spending (mainly transfers) by more than 10% of GDP in a few months (throwing down the old hypothesis that fiscal policy is not fast enough). A coordinated action to prevent the worst. And more: on a global scale.

The bright side of the story is this: after just a few months, the economies started to recover. The downside: governments fell asleep on the spot and/or did not have enough political strength to withdraw the bulk of the stimuli even after the arrival of the vaccine and the clear downward trend in unemployment. Result: inflation, dormant for a decade, has awakened. He roared, but Saint George pretended not to hear. In the meantime, a war came with its unfailing adverse supply shock, pushing energy and food prices hard. The dragon rose confidently, breathing fire. São Jorge then drew his sword and went up, stunned, but the animal had gained confidence.

Interest rates finally rose, but apparently not enough so far. Core inflation — in theory more correlated to demand pressures than the headline index — has dropped since the peaks of 2022, but remains close to 5% in Europe and the United States and around 7% in England. In short, accelerated fiscal policy, late interest rates, an adverse supply shock and, finally, a shift towards consumption of services (which had fallen sharply during 2020 and part of 2021), formed the perfect inflationary storm.

And now, Saint George? Higher inflation for longer and tighter monetary policy for longer. A bad combination for the private sector of the economy and complicated for public finances. The ideal solution to reduce suffering and risk of sustainability issues? A fiscal policy with a contractionary bias for a few years at least. The real solution: something far from it.

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