Since the COVID pandemic hit early last year, Fathom Consulting has produced a Recovery Watch blog —a way to help inform its clients and others in these uncertain times. Below is an extract from the latest post, which explores how massive fiscal stimulus financed through money creation right across the developed world has helped cushion the economic impact of the pandemic — but this fiscal dominance (with central banks financing fiscal expansions) is not without its consequences.
The response of macroeconomic policy to the pandemic has been colossal and extremely rapid. It has taken the form of monetary, financed, fiscal stimulus, aimed at supporting the incomes of those unable to work as a result of the restrictions on movement imposed by the government. That response is entirely appropriate. But it will have consequences, not all of them positive.
For example, central bank balance sheets across the major developed economies expanded by around $3 trillion as an immediate response to the Great Financial Crisis of 2008/09, in a move that was generally regarded as temporary and extreme at the time. They expanded by a further $8 trillion thereafter, as temporary measures became permanent, and by another $8 trillion in response to the pandemic. A trillion here, a trillion there: pretty soon you’re talking big numbers… The change this time around is that the latest tranche is straightforward monetary financing of the government deficit, with very little pretence to the contrary. For now, that is not problematic: that degree of monetary loosening is consistent with the inflation targets of the central banks. But if the day comes when the demands of the fiscal authority override the objectives of the monetary authority, it will mark the end of independent central banking. That day has not yet come.
Government debt to GDP ratios have hit or exceeded 100% in the major developed markets as a result of the pandemic (Japan was already a long way through that threshold when the pandemic struck). With government borrowing costs at or close to all-time lows, those debt ratios are not problematic in themselves, in the sense of creating a problem of government solvency. But, if they remain that high or (as is likely) increase, in the long term that will be a drag on growth, as previous Fathom research has discussed. And solvency will become a problem should inflation and interest rates ever pick up significantly.
In the UK, the supply of so-called ‘high-powered money’ (which includes reserves held at the Bank of England) has increased by some 15% of GDP as a result of the pandemic. That increase in high-powered money was nearly three times as large, as a share of GDP, as the entire stock of high-powered money as recently as 2006. This would matter if there were grounds for thinking that the stock of high-powered money had some systematic relationship with aggregate demand or with inflation. But such relationships as ever existed were bulldozed by the GFC and have now been steamrollered by COVID.
As a result of these brutal (though, on this occasion anyway, necessary) policy interventions, many of the old nostrums of monetary economics have been shattered. ‘Inflation is always and everywhere a monetary phenomenon.’ Is it? When? Where? Despite these record-breaking monetary injections, there is no sign of rising inflation in core prices across the developed world as yet. In fact, core inflation has fallen in most countries thanks to the steepest global recession of all time.
Fathom’s view from the beginning was that the medium-term impact of the crisis would be, if anything, inflationary. That is because, eventually, aggregate demand would come all the way back to where it otherwise would have been, while aggregate supply would remain persistently lower thanks to the impact of the disease on investment and on global supply chains. Early on, bond markets disagreed with that assessment, with even the thirty-year inflation expectation embedded in bond markets falling sharply. But those expectations have since recovered and now stand slightly higher than they were, at all maturities, ahead of the crisis. Bond markets see inflation coming, if only modestly for now. Fathom would agree.
Subscribe to join our upcoming event Climate economics: leading the way to net zero and beyond. Laura Eaton, Erik Britton and Brian Davidson from Fathom will be joined by Paul Fisher (Fellow, Cambridge Institute for Sustainability Leadership) and Leon Saunders Calvert (Head of Sustainable Investing, Lipper and I&A Insights, Refinitiv) to discuss crucial issues related to climate economics, including the economic consequences of global warming itself and the pathway to beyond net zero. For more on Fathom’s climate-related services please get in touch with Brian Davidson, Head of Climate Economics.
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