D.A. Holdsworth, May 2021
[City AM published my first piece warning about inflation back in February '21. In May '21, I then wrote this follow-up article, which I wasn't able to place at the time. Having recently re-read it, I thought it was well worth posting to the blog now (January '22) in the spirit of better-late-than-never. Here it is, unchanged since I first wrote it.]
Right now, it seems like every second article in the financial press is addressing the risk of inflation – a bit like characters in Game of Thrones warning that ‘winter is coming’. But this change of mood is relatively recent.
When I first wrote a piece about inflation back in February '21 (Runaway inflation might not happen – but what if it does?), I wasn’t sure if City AM would take the article. There was much less talk about the inflationary risk at the time. Bitcoin and gold enthusiasts were certainly all over it, and economists were talking about it a bit – but generally in order to dismiss it. They were dampening concerns about inflation with a downward gesture of their palms and a general message of ‘Calm down, dear’.
And, to be fair, you can see why. Since the credit crunch, Governments have increased their borrowing by trillions, and central banks have printed similar amounts, with no visible evidence of inflation. If we haven’t had inflation in the last decade, why should we now?
In this article I’m going to try to tussle out why inflation went missing for so long. I’ll then show what I believe is different about the post-pandemic world – and why the inflation genie is likely to escape the bottle.
Let’s start with some stats.
It’s well known that, in the aftermath of the credit crunch, printed money rained down like manna. By 2014, the four major central banks (the Fed, the BoJ, the ECB and the BoE) had generated $10tn of ‘quantitative easing’ (QE). The pandemic turbo-charged this trend: by the end of 2020, their balance sheets were pushing $25tn. All of this had a predictable impact on money supply (the amount of cash circulating in the economy). ‘M2’, the most common measure of money supply, increased in the US by 25% in 2020 alone.
At this point, economists will observe that money supply decoupled from inflation in the late 1980s and that inflation was tamed. And that’s true, it was. But why – and how?
The answer is relatively straightforward. Most obviously, the Chinese manufacturing miracle has been exporting deflation for years. At the same time, in the West, most of the additional money supply of recent years found its way into asset markets and not into what you might call the real economy. So we’ve seen bond prices, share prices, and property prices increase – but not retail prices. This process became even more pronounced after the credit crunch, when the money-printing started in earnest. Asset prices in the last decade have continued to go up and up, even though the yield on those assets was increasing much more slowly. To put it bluntly: there has been inflation, but it’s been asset-price inflation, not monetary (currency) inflation.
This is the uncomfortable secret of central bankers and governments alike. All that QE kept the wheels turning, but it did so by lining the pockets of asset owners. Essentially, the wealthy got wealthier.
The further acceleration of QE during the pandemic put this same process on steroids. To take one measure: the number of billionaires in the world rose during the year to April 2021 by a gravity-defying 35% to 2,700. The wealth of those same billionaires rose by 63% to $13tn – even as millions were losing their jobs and economies around the world were shrinking.
So the answer to why inflation went missing for so long is this: it didn’t go missing – we just had asset-price inflation instead of retail-price inflation. If the basket of goods on which RPI is based included Bugatti 35s, or Chateau Petrus 1982, or Tesla shares, or prime London penthouses, then inflation over the last decade would look a lot higher. But it doesn’t, so it doesn’t.
So now to our next question: what’s different this time?
As we’ve just seen, the pandemic has been good to billionaires. But in a change with recent tradition, a lot of the additional money supply during the pandemic has made its way into the real economy. Trillions worldwide has been spent on furlough schemes and small business support to help ordinary people.
Let’s unpack this process for a moment.
In a furlough scheme, people are being paid even though they are not doing productive work. This means the demand side of the economy is supported (salaries are being paid), but the supply side of the economy is being battered (firms have lower staff numbers and produce less). So if you have roughly the same amount of money (ie the same amount of demand) chasing a reduced amount of goods and services, the net result is – logically – inflation.
Let’s take a step back and look at the pandemic economy in the round. This economic crisis is, above all, a supply-side crisis. People have wanted to travel – but they couldn’t. People have wanted to eat out, get a haircut, or visit attractions – but they couldn’t. Shops have been shut. The demand has been there, but not the supply. In the services sector, homeworking has been a godsend to some, but has created inefficiencies and has likely been a net negative to productivity. In the manufacturing sector, reports are coming in daily from China and elsewhere of serious supply-chain bottlenecks. All in all, the seesaw of supply and demand has been tilted against the former. Plenty of demand chasing limited supply. That’s not just likely to cause inflation, that is literally the definition of inflation.
Of course, people were hoarding their cash during the pandemic, so inflation hasn’t manifested immediately. But the risk was never then, the risk is now – as we emerge from lockdown. The stored-up cash will likely be released into an economy whose productive capacity is greatly damaged.
The future is, of course, unknowable. Maybe the genie will remain in the bottle. But if there are any simple precautions that can be taken against an inflationary spike, I’d take them now.
D.A. Holdsworth is a former fund manager and author of 'How to Buy a Planet' - a financial & political satire. "Echoes of Douglas Adams... Lots of fun." Tim Harford, The Undercover Economist