All that is solid melts into inflation

July 07, 2022 10:11
Photo: Reuters

Rich Western industrialized countries appear to be caught in a time loop, with unexpectedly higher inflation bringing back not just memories of the 1970s but also that era’s policy debates and the political insecurities. Is inflation always and everywhere a monetary phenomenon, as Milton Friedman insisted? Or is it a consequence of fiscal over-extension – or simply a symptom of a more general democratic malfunctioning?

The debates of the 1970s were not just about technical matters of macroeconomic management. They also raised doubts about the sustainability and legitimacy of the Western model of democracy. The world was beset by geopolitical instability, and the United Nations General Assembly endorsed calls for a New International Economic Order. And now that many of the same old political and geopolitical issues are heating up again, inflation is a thermometer. As more money chases fewer goods, prices rise – the economy becomes feverish.

During periods of monetary innovation, however, it becomes harder to tell what money even is. No one would dispute the fact that monetary innovation has been proceeding at a breakneck pace over the past decade. But it is worth remembering that the 1970s also featured a financial revolution, one that blurred previously hard distinctions between money and non-money. This was partly a consequence of inflation, which prompted bank customers to flee from non-interest-bearing checking accounts to alternatives such as certificates of deposit or accounts in non-traditional banks.

Friedman was contemptuous of all the conservative voters and politicians who thought that fiscal policy was to blame for inflation. But his disdain was misplaced, because there was indeed a connection between fiscal and monetary policy: high government deficits had been financed through the central bank. In both the United States and the United Kingdom, the treasury and the central bank had come to be seen as a unified “macroeconomic executive.” Regarding themselves as globally dominant powers, both countries aimed to use their monetary sovereignty to secure advantages at the expense of the rest of the world.

In the event, the US and UK ended up with higher inflation compared to most other industrialized countries, and this same distinction is apparent again in 2022. The US and the UK have the highest inflation rates in the G7, and they also both enacted massive central-bank-assisted fiscal-stimulus packages in response to the COVID-19 shock.

The UK is a particularly dramatic example of this. In the first financial year of COVID-19, the Bank of England bought up 99.5% of government debt – and over 100% the following year. Under these circumstances, it is not credible to argue that the central bank is independent.

The same logic applies in the US, where policymakers’ biggest mistake was to pin their hopes on higher inflation being “transitory.” This lasted until November 2021, with the Biden administration pressuring the US Federal Reserve to keep monetary policies loose by delaying the nomination or renomination of Fed officials. This political intervention was as obvious as Richard Nixon’s efforts to pressure Fed Chair Arthur Burns in the 1970s.

The upshot is that central banks are not as independent as they purport to be. In both the UK and the US, governments and central banks have been responding to the political pressures created by apparently intractable societal divisions. Such extreme polarization raises questions about whether the political union can continue. Hence, the 1970s-era debate about the UK’s ungovernability is reappearing, with both Scotland and Northern Ireland eying paths out so that they can rejoin the European Union. Even more ominously, a slew of recent books prophesy a civil war in the US.

Of course, Europe, too, faces threats of disintegration. The European Central Bank has been even slower than the Fed or the BOE to raise interest rates. This is partly because the character of the inflation is different, and because Russia’s war in Ukraine has driven up energy costs. European labor markets also have somewhat more slack (though some European economies are suffering the same dramatic shortages of skilled labor seen in the US and the UK).

But the ECB’s main reason for hesitating is its fear that markets will interpret higher borrowing costs as a threat to government and banking stability in the more highly indebted southern eurozone countries. An increase in government borrowing costs could deliver the double whammy (or “doom loop”) that many feared during the European debt crisis a decade ago. If indebted governments must pay higher risk premia and are threatened with insolvency, their bonds’ value will fall, undermining the balance sheets of the banks that hold them.

One of the mantras of the euro crisis was that the US and the UK were in a much stronger position than Europe because they had a single government and a single central bank. And though the eurozone’s structural fragility has since generated a tentative move toward a limited fiscal union, that work remains incomplete. Moreover, the pandemic and this year’s geopolitical crisis have reminded everyone that even fiscally unified states don’t have all the answers and can become vulnerable to disintegration.

History is replete with examples of high inflation driving systemic breakdowns. By trying to bind societies together with money, central banks have repeatedly sown the seeds of broader political and social dissolution. In federal states, such as Germany in the early 1920s or the Soviet Union and Yugoslavia in the late 1980s, inflation fueled a centrifugal dynamic and separatism. The public harbored a gnawing suspicion that the center (Berlin, Moscow, Belgrade) exercised unfair political control over the distributive levers. For the federated republics, secession and monetary autonomy became ever more attractive.

By breeding uncertainty, inflation can easily destroy large, complex political entities. We know that Russian President Vladimir Putin believes the breakup of the Soviet Union was the greatest political catastrophe of the twentieth century. He may also believe that energy- and food-price inflation – and government efforts to buffer the impact with even greater subsidization – will destroy the British, American, and European unions.

Copyright: Project Syndicate
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Professor of History at Princeton University and a senior fellow at the Center for International Governance Innovation.