Inflation is about demand, not supply
About 90 years ago, British economist Keynes already knew that at times when demand for real resources (land, labour, physical capital) compared to supply is low, DEMAND, and hence the economy can and needs to be stimulated by spending more financial capital on activities making use of those real resources. It is safe (under these circumstances, the fiscal stimulus will not cause excessive inflation) and effective. Moreover, it is ONLY demand-stimulus that will work — no demand, no economy. Don’t listen to your capital-guided politicians, no matter how much supply-side stimulus is provided or money is created — the great depression was not going to be ended by giving investors tax breaks. This episode of economic history became intensely political because the key to demand-stimulus is to do it in ways that mainly simulate demand for REAL resources (for example, increase the welfare spending or start labour-intensive public infrastructure projects — clearly the policies of the left), but not in mainly inequality-exacerbating, financial asset-inflating ways (buying up toxic loans or junk bonds, paying the payroll of businesses in tough times or subsidising real-estate investors — clear policies of the right). Fiscal stimulus (money actually spent) that is well-timed and mainly stimulates demand has to be done from time to time if growing the economy and smoothing out economic cycles is the aim (as central banks claim theirs is), but simply creating money will not do anything if there is no demand — it is as useful as “pushing on a string”, to quote the often used phrase.
No-one will dispute that it is possible to cause inflation by badly-timed and/or badly-directed spending. If a particular real resource is already scarce, extra spending stimulating more demand for it will indeed simply cause inflation — this may create individual winners and losers, but does not help at the aggregate level. Any spending that just inflates assets will not help with demand (apart from a possible, small, undirected stimulus as a byproduct of the wealth-effect), just increase inequality, as noted earlier. Spending is like anything — done too little or too much, on wrong things or in the wrong time will cause problems. But if the mere possibility of misusing something and causing problems would stop us doing things, we’d have stopped doing anything long time ago.
The Milton Friedman hallmarked small government drive of the 70s declared fatwah on governments’ ability to do many things, and that included control over money supply too. In terms of PR, this was a good moment: the world did indeed have an inflation-problem caused by irresponsible fiscal policies. Economic historians will probably correct me, but my working theory is: the US economy, already at full tilt, got the extra tasks of fighting on dual fronts of Vietnam War and the War on Poverty (the guns and butter wars), and has done all that with printed money (so, a Martian looking down could reasonably summarise the situation as follows: the “Great Society” committed domestically to elimination of poverty/injustice was also spraying napalm on foreign villages, with both undertakings financed by the whole world). The mis-timed Great society spending and the not only misdirected but wholly immoral Vietnam spending, coupled with rising energy prices washing through the economy HAD TO result in inflation, which then promptly got exported to the rest of the world. But the abuse of Keynes’ insight doesn’t mean Keynes was wrong. Even doing the right thing in the wrong way or wrong time is still a wrong thing to do.
At that opportune moment, Friedman argued that excessive money-supply is the root of inflation, always and forever. Because of this, he argued for strict targets in growth of money supply and to ensure that happens, taking money supply further out of the hands of unreliable elected governments, and giving it to central banks. Bond-holders of his day, enjoying more stable real returns once more, could breathe easier, but the economy doesn’t exist for them — bond holders exist for the economy. Today we know Friedman left out the obvious and crucial factor identified by Keynes, that all-important demand for real resources, and thus his solution of direct control of money supply is patently wrong. For an easy refutation of “printing money causes inflation”, just note the trillions of dollars of quantitative easing since the last two crises of GFC and Covid19: because much of that money ends up sitting on bank accounts, or if spent, was spent on assets (which is not demand-stimulating, only inequality-exacerbating), QE failed to lift inflation and more importantly, growth. Once again: inflation is largely demand-determined. Because of this fundamental mistake, nowadays all countries switched from controlled money supply to using targeted interest rates, using the level of unemployment as a proxy as means of controlling inflation rates.
Why unemployment? The real, but rarely stated idea of Friedmanites was to keep demand for labour low, therefore to keep the bargaining power of labour in check.
When inflation was bad, the famous, and by now completely discredited Phillips curve cemented the false idea of “low unemployment causes inflation” (and therefore implied that we should be happy about a fair bit of unemployment) in many heads. To see this, just consider how much of our monetary policies (the control of short-term and now with “yield curve control”, increasingly long-term interest rates) are naturally tied to the real resource of labour: if unemployment became “too low” (below a convenient but bogus, ideology-driven “NAIRU” rate), the bogeyman price inflation supposedly would inevitably begin to lift, so to prevent that “overheating”, central banks would raise rates and vice versa.
But it turns out that the Phillips curve is essentially flat (i.e. low unemployment has actually very small effect on wage-inflation, therefore inflation as a whole), and so monetary policy is largely resting on false foundations. Think about this: we actually got to the point that in our accumulated wisdom, our universally accepted monetary governance framework instigates that interest rates largely respond to to changes in demand for just the one real resource (labour) that we know has little effect on inflation. You couldn’t make stuff like this up.
In any case, any price-rise due to wage-inflation is not really a problem for most of humanity predominantly living from wages (if over a period of time your wage doubles and prices double, are you any worse off?). But wage inflation is the enemy when wage-earners are the “others”. Federal Reserve resisted lifting interest rates during high-inflation 2020–2021, but when wages started going up, quickly “pivoted” to tightening. Oh, don’t worry, there is the necessary economic theory to make it acceptable: wage-spiral, the evil that caused the inflation in the 70s…not the Vietnam war, wages.
Having said all that, interest rates strongly influenced by unemployment are a somewhat better control mechanism than simple control of money supply, but keep your eyes where it is misdirected: it is a) fighting the part of inflation that is not a real problem and b) potentially mistimed as low unemployment doesn’t automatically mean high aggregate demand of real resources in general. In addition, monetary measures (rates and supply of money) are of limited potency even if deployed at the right time — in times of sub-par growth, fiscal policies that stimulate demand of real resources (and carefully deployed to only minimally inflate assets bubbles) can and should complement the monetary measures all the time, but especially so when monetary limits are reached (as they clearly are in 2020). Exactly as Keynes would have done. Exactly the opposite of the ruling class’ tendency for austerity.
How are developed countries different?
Developed countries are in a very different situation to the developing. Inflation has been very low for a long time now. There are many cited reason (globalisation is a big one), but the largest underlying factor in my opinion is technology-enabled productivity — demand-stimulation is getting harder as humans solve their material existential problems. When most households have a couple of cars, a few screens, yearly overseas trips and a couple of fridges full of food on average, getting a stimulus check or lower tax bill is not as strong an incentive to go out and spend as they would have been in older, poorer times. A lot will be saved, and the resulting savings glut will simply inflate asset prices (not part of inflation as currently defined) and lower interest rates. Productivity improvements mean the lucky developed countries don’t desperately need full deployment of all their real resources, so the demand for them is dropping. Because of this, their central banks try increasingly desperate measures, like ever-broader, ever-larger scale quantitative easing, to kickstart inflation for a decade. The old growth rates of second part of 20th century may never be repeated — largely because they don’t need to be (do we really need that third fridge full as well?). Welcome to the times of low rates, low growth, low inflation. Theoretical “output gaps” may be real but meaningless, but if for some reason GDP growth is still someone’s aim, demand (where it is still “stimulate-able”) is still the vehicle. If globalisation is going to be winded back (as it seems to be in the aftermath of Covid-19), inflation may turn up, but that increase won’t be the kind policymakers hope for.
Lastly, it is interesting to note opposing interests at lower level of aggregations, the groupings of winners and losers of various monetary and fiscal measures. Those with predominantly financial assets will welcome asset-inflating new money (say, grants to home-owners) and oppose new money aimed at general demand-stimulation (say, welfare cheques). Those with predominantly real resources (say, labourers) will do the opposite. Central bankers will defend their sizeable control over money supply to their last breath. Their mission statement will talk sustained growth and inflation targets, but in reality, instead of demand-stimulation, asset-preservation transpires to be more their game. They will hint that they are more dependable (code for “politicians can’t be trusted”), and will promise to keep interest rates low enough — but will not answer the questions like “why do the taxpayers need to pay interest at all on money they could be issuing themselves”. When banks’ powers to act in the societal interest are exhausted (“effective lower bound” of interests is reached), they will exhort the “unreliable” pollies to take on the burden of lifting demand by spending borrowed money with those unnecessary interests payable, even if pollies lose popular support (since the electorate has now been conditioned to expect fiscal responsibility, even if that is against society’s own interests of stability and growth). Aaagh…this PR, lobbying, legal manouvering, public arm-twisting of these various interest-centres around money is the most complex performance piece I know of, even if the subject (currency, a well-defined means of exchange and store of value) is so simple. When there is so much at stake, the games will be eternal, sophisticated and fascinating.
