As someone who came of age in the 1970s, I remember inflation very well. As a college student taking economics courses, I remember being taught many of the prevailing thoughts on inflation in the early 1970s. Since we are facing another inflationary period, it probably makes sense to revisit those thoughts.
Generally governments have two sets of tools to impact the economy -— monetary policy, undertaken by the central bank, and fiscal policy, undertaken by the government.
When the economy is in the recessionary phase of the business cycle, the central bank and government take steps to stimulate the economy. The key is to invigorate the economy just enough so that it does not overheat. When the economy recovers, central banks and governments are supposed to stop the stimulus and apply both fiscal and monetary restraint to prevent inflation.
Central banks stimulate the economy by increasing the money supply. The banks don’t literally print more money. Rather, they create money by making deposits in commercial banking institutions and by lowering interest rates to encourage debt-financed economic activity. After the economy recovers, central banks apply economic brakes by contracting the money supply and raising interest rates.
This is more of an art than a science as it is difficult to determine whether the measures taken were appropriately implemented until after the fact.
Governments, on the other hand, can stimulate the economy during economic downturns by increasing government spending and lowering taxes. Doing so typically results in deficits, which increase the national debt. Theoretically, when the economy has recovered, taxes are supposed to be raised and the resulting government surplus is used to repay debt.
Unfortunately, such actions are politically unpopular, so governments find this difficult.
There is one other historical note: Pandemics are typically followed by periods of inflation because the supply of goods is impaired by the pandemic. In the middle ages when plagues swept across Europe, the serfs who grew the crops suffered the brunt of the contagion and were unable to grow crops during the pandemic. Because so few survived the disease, there were not enough serfs to resume post-pandemic crop production. We see a similar problem today with the supply chain issues that make it impossible to obtain many goods and services.
But the current coronavirus pandemic is probably merely a catalyst for an inflationary period that is inevitable. Since the Great Recession about a dozen years ago, central banks and governments around the world continued to apply extraordinary stimulus to the global economy.
Ben Bernanke, the Federal Reserve Board chief at the time of the Great Recession, spent his career studying the Great Depression of the 1930s and believed that another similar-sized depression could be avoided by implementing unprecedented monetary and fiscal stimulus. He was right, as enormous monetary stimuli were provided to prevent a collapse of our banking system. Interest rates plunged as the money supply was increased by coordinated actions of central banks around the world.
It is interesting to note that the tax cuts at the time were generally modest, but governments spent like drunken sailors as the national debts of most nations grew to historically high levels. The economy slowly recovered, but the stimuli proved addictive and governments found it hard to wean themselves off the monetary and fiscal actions that were undertaken.
By 2012, governments were trying to take their foot off the pedal, but the global economy still exhibited underlying weaknesses. In the U.S., there was a measured tax increase and by 2016 the government reduced the annual deficit considerably.
The Fed was still keeping interest rates low, as the economy appeared to be recovering. Job creation was robust and the supply of goods and services kept pace with the demand.
In 2017, there was a major tax cut while the government sustained spending levels.
Many nations, including the U.S., incurred record levels of governmental debt. The economy was clearly approaching the peak of the economic cycle and by 2019 there were signs (such as increasing housing prices) that inflation was around the corner, until the pandemic hit the global economy.
We currently have a perfect storm for inflation: pandemic-induced shortages, an expansive money supply coupled with unprecedented levels of government spending.
I suspect that remediating inflation will be a long and painful process.
Jim de Bree is a Valencia resident.
