Stagflation: a demand or supply side story?

The semi-annual meetings of the IMF and World Bank start today where finance ministers and central bankers will meet in slimmed-down but in-person gatherings in Washington.  This meeting is likely to be overshadowed by the scandal involving the IMF chief Kristalina Georgieva, who may well have been forced to resign as I write after a devastating report on the machinations of senior World Bank officials several years ago.  Georgieva has been accused of manipulating data on ‘Doing Business’ to favour China, Saudi Arabia and other states while she was at the World Bank several years ago. The scandal has divided IMF members, with the US pushing for her to go and European powers wanting her to stay.

But more important than even whether we can ever rely on the scientific honesty of the World Bank and the IMF is what is happening to the world economy as these international agencies meet to review progress on the recovery from the pandemic slump in 2020.

Earlier in the year, most mainstream forecasts for growth, employment, investment and inflation were bullish, with hopes for a V-shaped recovery based on the COVID vaccination rollout, the ebbing of the virus cases and the boost to many economies from fiscal spending by governments and injections of credit by central banks.  But in recent months, that unabashed optimism has begun to fade.  Just before IMF-World Bank meeting, Georgieva reported that “We face a global recovery that remains “hobbled” by the pandemic and its impact. We are unable to walk forward properly—it is like walking with stones in our shoes!”

She outlined the three stones in her shoes. The first was growth.  At the meeting, the IMF is set to lower its forecasts for global growth in 2021 and expects the divergence between the richer Global North and the poorer Global South to widen.  The second was inflation: “One particular concern with inflation is the rise in global food prices—up by more than 30 percent over the past year.”  And the third was debt: “we estimate that global public debt has increased to almost 100 percent of GDP.” (No mention of private sector debt, which is much more important and at historic highs).

Georgieva posed the risk of what is called ‘stagflation’, ie low or zero growth alongside high or rising inflation.  This is the ultimate nightmare for the major capitalist economies – and of course, the worst possible scenario for working people who would bear the brunt of rising prices for households while income growth remains weak; leading a fall in real incomes. 

This was the story of the 1970s.  So is stagflation coming back in 2022? Let’s look at the GDP growth side first.  The evidence is building up that the ‘sugar rush’ recovery in the major economies after the end of the pandemic lockdowns and after the impact of fiscal spending and easy money is flagging.  For example, in Q3 2021 just ended, the Atlanta Fed GDP Now! forecast for the US economy suggests a sharp slowdown (compared to consensus calls) to just 1.3% annual rate.  And Q4 is likely to be worse. After the ‘sugar rush’ comes the fatigue.

The ‘high frequency’ business activity surveys called the Purchasing Manager’s Indexes (PMIs) are also showing a distinct slowdown in most regions from the peaks of the summer. 

And in the US, the latest official data showed the jobs recovery stalled for a second consecutive month in September.  Coupled with lower business and consumer confidence, this suggests the ‘sugar rush’ there is also over.  In China, the government is grappling with sporadic outbreaks of the Delta coronavirus variant and the risk of a property debt implosion along with an energy shortage. Strong growth over the summer appears to have slowed sharply in the eurozone and UK.

Also, there is the Brookings-FT Tracking Index for the Global Economic Recovery (Tiger) which compares indicators of real activity, financial markets and confidence with their historical averages, both for the global economy and individual countries, capturing the extent to which data in the current period is normal. The latest twice-yearly update shows a sharp snapback in growth since March across advanced and emerging economies.

On the other side of the stagflation scenario, inflation rates are rising everywhere.  Back in December last year the US Fed’s median forecast for inflation in 2021 was 1.8%. In March that was nudged up to 2.4% and then in June up to 3.4%. It is now 4.2%. Over the same period their median forecast for 2022 has risen from 1.9% to 2.2%. The Bank of England’s and the ECB’s numbers have followed a similar path.

Global grocery bills are rocketing.

And energy prices have taken off.

What is causing this rise in inflation generally and in food and energy, in particular?  The standard macroeconomics view is that there is ‘excess demand’.  During COVID, consumers built up huge stashes of savings that they could not spend.  But now that economies are opening up again, households are spending heavily at a time when global supply chains have been disrupted by the COVID pandemic. 

This is the view of financial analysts, Jefferies: “the $2.5tn in excess household cash is an important buffer against stagflation, and we show that excess savings are distributed across the entire income distribution. To date, there has been very little evidence of demand destruction. Real spending is still close to cycle highs for most discretionary spending categories, despite significant price increases…A more rigorous analysis of price and volume changes by the San Francisco Fed shows that demand effects are the dominant driver of inflation at the moment, contributing 1.1% to y/y core PCE as of August. In contrast, supply-side effects contributed only 0.2%. This flies in the face of the prevailing narrative which attributes most of the price increases to supply chain disruptions. Yes, product shortages and supply bottlenecks are real, but they are largely a function of excess demand, rather than supply outages.”

So the Jefferies view is that this situation is just temporary or ‘transitional’, to use Fed Chair Powell’s expression.  Once production, employment and investment get going and international supply chain blockages ease, then inflation pressure will also ease and things will get back to ‘normal’.

There are serious doubts about this rosy scenario.  First on the demand side, is it really true that released pent up demand is the cause of rising prices?  The idea that ‘excess cash’ will simply ‘sop up’ the extra costs of gas and food prices seems unlikely.  After all, in the major economies this ‘excess cash’ is mostly in the pockets of the rich, who tend to save rather than spend.  Higher prices are more likely to lead to reductions in spending in so-called ‘discretionary items’ as working-class households try to meet the rising costs of food and energy. 

Moreover, accelerating inflation in essential goods and services is more likely to be the result of a ‘supply-side’ shock rather than excess demand.  “We are not dealing with demand-push inflation. What we are really going through right now is a massive supply shock,” said Jean Boivin, a former Bank of Canada deputy governor now at the BlackRock Investment Institute. “The way to deal with this is not as straightforward as just dealing with inflation.”   

On the supply side, there are those who argue that the 2020s are not like the 1970s with its stagflation, but more like the 1950s, when inflation incurred from the disruption and spending during the Korean war gave way to rising investment and profitability, so that industrial output and real GDP growth rates rose and inflation subsided.  “With supply shortages set to persist for the next 6 to 12 months, the current period of “stagflation-lite” will persist a while longer. But it is likely to remain a pale imitation of the 1970s stagflation episode. Meanwhile, we do not share the pessimism of those who think that the current supply shortages are just one of a series of stagflationary shocks likely to hit the economy in the coming years.”

But are the 2020s going to be a new ‘golden age’ for capitalism like the 1950s with high profit rates and investment, real wage rises, full employment and low inflation?  I doubt it; first, because the current supply-side ‘shock’ is really a continuation of the slowdown in industrial output, international trade, business investment and real GDP growth that was setting in in 2019 before the pandemic broke.  That was happening because the profitability of capitalist investment in the major economies had dropped to near historic lows, and as readers of this blog know, it is profitability that ultimately drives investment and growth in capitalist economies.

In previous posts, I have provided the evidence of the decline in profitability in the US and elsewhere.  Brian Green has a new analysis of UK business profitability which gets a similar result “before the UK entered the pandemic, the rate of profit had fallen sharply to stand 20% below the last mini peak in 2015.”

Again, you could even argue that the supply-side shock will remain not just because of low profitability and investment, but also because of the hugely increasing costs of dealing with climate change.  This has led to sharp cutbacks in investment in fossil fuel energy exploration and production, putting many economies at risk of an energy supply crisis.  This is the irony of market solutions to the global warming problem: driving up carbon emission prices and taxes merely causes a severe reduction in energy production because planning for the replacement of fossil fuel production with alternatives is non-existent.

If rising inflation is being driven by the weak supply-side rather than an excessively strong demand side, monetary policy won’t work.  Monetary policy works by trying to raise or lower demand. If spending is growing too fast and generating inflation, higher interest rates supposedly dampen the willingness of companies and households to consume or invest by increasing the cost of borrowing.  But even if this theory were correct, it does not apply when prices are rising because supply chains have broken, energy prices are increasing or there are labour shortages.  As Andrew Bailey, governor of the Bank of England, has said: “Monetary policy will not increase the supply of semiconductor chips, it will not increase the amount of wind (no, really), and nor will it produce more HGV drivers.” 

Indeed, as I have argued ad nauseum on this blog, pumping cash or credit into the financial system with ‘quantitative easing’ does not work to boost the economy if the ‘supply-side’ is not growing through lack of profitability.  You can take a horse to water, but you cannot make it drink.  That disconnection applies just as much when central banks tighten policy (ie withdraw credit and raise policy interest rates).  Reducing demand will do little if supply is stagnant for other reasons. 

Nevertheless, central banks are starting to tighten.  Interest rates have already risen in Norway and in many emerging economies, while the US Federal Reserve and the Bank of England have made moves to tighten monetary policy.  This won’t get inflation rates down, but merely increase the risk of a recession as debt servicing costs rise for companies already low on profits.  That’s the dilemma for central banks and governments as they debate the issue of stagflation this week in Washington.

But let me finish this long post by reminding readers that mainstream economics has no coherent theory of inflation.  As Charles Goodhart, a professor at the LSE and former member of the Bank of England’s monetary policy committee, remarked: “the world at the moment is in really a rather extraordinary state because we have no general theory of inflation”. The two main theories offered: the monetarist theory that money supply drives inflation; and the Keynesian theory that inflation is caused by tight labour markets driving up wage costs, have been debunked by the evidence. 

So the mainstream has fallen back on a theory of inflation based on ‘expectations’.  As Goodhart remarks, this is “a bootstrap theory of inflation”; that as long as inflation expectations remain anchored, inflation itself will remain anchored. But expectations depend on where inflation already is and so provide no predictive power.  Indeed, a new paper by Jeremy Rudd at the Federal Reserve concludes; “Economists and economic policymakers believe that households’ and firms’ expectations of future inflation are a key determinant of actual inflation. A review of the relevant theoretical and empirical literature suggests that this belief rests on extremely shaky foundations, and a case is made that adhering to it uncritically could easily lead to serious policy errors.”

As regular readers of this blog may know, G Carchedi and I have been developing an alternative Marxian theory of inflation. The gist of our theory is that inflation in modern capitalist economies has a long-term tendency to fall because wages decline as a share of total value-added; and profits are squeezed by a rising organic composition of capital (ie more investment in machinery and technology relative to employees).  But this tendency can be countered by the monetary authorities boosting the money supply so that money price of goods and services rise, even though there is a tendency for the growth in the value of goods and services to fall.

We have tested this theory during the COVID pandemic slump for US inflation. During the year of the COVID, corporate profitability and profits fell sharply. Wage bills also fell. As our theory predicted, the results were deflationary. But the Fed pumped in more money.  US M2 money supply was up 40% in 2020.  So US inflation, after dropping nearly to zero in the first half of 2020, moved back up to 1.5% by year end.

In slumps, the velocity of money, which is the pace of turnover of the existing money supply in an economy, falls.  People and businesses make fewer transactions and instead tend to ‘hoard’ money.  That was certainly the case in 2020, where the velocity fell to a 60-year low.  Such a fall is hugely deflationary.  But in 2021, the velocity of money stopped falling.

In 2021, all the factors that led to a near zero inflation rate in the US in mid-2020 began to reverse.  At that time last year, we made a forecast that if profits and wages began to rise (wages, say by 5-10%; money supply by about 10%, then our model suggested that US inflation of goods and services would rise, perhaps to about 3.0-3.5% by end 2021.  Actually, money supply has continued to rise faster than we forecast.  And so US inflation is now over 4%, not 3.0-3.5% as we forecast. 

Our theory of inflation suggests that the US economy over the next few years is more likely to suffer from stagflation ie 3%-plus inflation with less than 2% growth, than from either deflation or inflationary ‘overheating’ (4%-plus).