While it is relatively easy to predict that the postcorona economy will suffer from high unemployment, the outlook for price inflation is not so certain. On the one hand, there will be high government deficits and more public debt; on the other hand, given the weak economy, consumers and companies may refrain from taking on new debt and could begin to lower their debt burden.
Monetary Expansion Doesn’t Always Lead to Price Inflation
In contrast to common usage, the correct use of the term “inflation” refers to the money supply. Rising prices are not the cause, but the result of monetary expansion. However, not every rise of the money supply turns into price inflation. It can happen that the so-called price level remains stable when there are drastic shifts in the demand for goods and services that impact differently on their prices. The average will be deceiving when rising and falling prices cancel each other out and when certain goods and service vanish from the statistical basket because prices have risen so much that the demand has collapsed.
Due to the immense disruptions caused by the lockdown of the economy and because of social distancing, fundamental structural changes in business life are going on. More goods and services will be removed from the official price statistics than usual, and for those products that remain in the basket, prices may vary widely.
Problems with Measures of Price Inflation
Even more than in the past, the statistics of the price index will send wrong signals about the extent of price inflation. If the prices for some goods rise exorbitantly and, accordingly, there is less demand, they go into the statistical shopping basket with a lower weight, and these goods can drop out completely if they are hardly in demand because they have become too expensive for normal consumers. Even more than in the past, price inflation, measured by the statistical price index, will no longer be a reliable guide for monetary policy—if this has ever been the case.
Inasmuch as modern central banks follow the policy concept of “inflation targeting,” they will lose a reliable compass. Central bankers set the interest rates as if blindfolded.
More than in the past, depending on their personal demand structure, each individual will have a price inflation rate that differs from that of their fellow consumers. Different social groups will not only be affected differently by unemployment, but also by the price changes. The so-called price level stability directive is becoming less and less meaningful as an indicator of monetary policy. The same applies to official unemployment numbers. The upheavals that the lockdown has brought about affect the segments of the labor market in different ways. When persons leave the labor market for good, they no longer show up as unemployed.
As it did with the blow that came with the oil price shock in 1973, the economy after the lockdown confronts stagflation. When stagnation and recession show up together with price inflation, macroeconomic policy has hit the wall. Using Keynes as the guide for fighting the downturn of the economy after the lockdown would give an additional blow to the economy, which has already been weakened by the lockdown. The lockdown of the economy has also severely hurt the global system of supply chains that had been a major source of keeping prices low. Additionally, with the rupture of the trade with China that concerns not only the United States, the impact of cheap goods from overseas that had dampened global price inflation will recede. One of the consequences of more home production instead of global free trade will be higher production costs.
Monetary authorities have released a huge amount of money in the form of central bank money to mitigate the consequences of the economic slowdown and social isolation. Such a policy has already been implemented in response to the 2008 financial crisis and has been practiced as a so-called quantitative easing.
In response to the 2008 crisis, the assets of the balance sheet of the Federal Reserve System have expanded from $870 billion in August 2007 to $4.5 trillion in early 2015. The later attempts to trim the central bank’s asset sheet only slightly brought down the amount of assets to $3.8 trillion until August 2019, when monetary policy became expansive again. Beginning in September 2019, the assets of the Fed began to rise again, reaching over $4 trillion before an additional big boost due to the lockdown lifted the total assets to over $7 trillion dollars in June 2020.
The lockdown brought the economies all over the world almost to a standstill and affected production and supply chains. The International Monetary Fund currently expects global production to shrink by 3 percent in 2020. While the US government has refrained from an economic outlook for the rest of 2020 on the grounds that the preview is too uncertain, the Congressional Budget Office predicts a fall in the real GDP of 12 percent during the second quarter and an unemployment rate close to 14 percent.
In the face of the economic consequences of lockdown, the Fed is about to expand the scope of assets that it may buy. While in the past the range of assets that central banks were able to buy was limited to government bonds, the range of asset categories is in the process of being extended to go beyond public debt titles—not to mention the possibility of direct financing of government spending.
A Credit Contraction—until the Dam Breaks
What has happened so far is a steep increase of the money supply in the form of the so-called monetary base. This increase does not necessarily mean that the newly created money will end up in the hands of businesses and consumers. If the demand for credit is low and the commercial banks assume an increased risk of default, or if they are already in a precarious state, they will use the money offered by the central bank as a liquidity cushion instead of lending it. In this way, the commercial bank’s lending capacity exists only as potential and is not yet actually executed.
This phenomenon of a credit contraction emerged also in the 2008 financial crisis. Despite the massive monetary policy stimulus from the central banks, global price inflation failed to materialize. The base money did not flow into the production economy and the demand for goods, but remained largely in the financial sector and served as a reserve for commercial banks. The most significant effect of the monetary expansion in the wake of the crisis of 2008 was the hefty price increases for bonds and shares.
Even after the lockdown, the effects of the central bank’s creation of base money over a longer period of time may not show up as lending, thus boosting aggregate demand. However, the current expansionary monetary policy harbors the danger that what has hitherto existed as mere potential could, as it were, become an avalanche overnight that swamps the real economy with liquidity. Until the dam breaks, it may appear to the superficial observer and to large sections of the population that there is nothing to fear and that the heads of the central banks have the situation under control.
One must fear that the national debt of the United States, which reached 107 percent of the nation’s gross domestic product in 2019, will rise sharply in 2020 and in the years thereafter. Deficit financing goes along with an increase of the money supply. Here, it comes in handy that the so-called modern money theory (MMT) explicitly provides a justification for direct government financing through the government’s own creation of money. Under the MMT model, a country’s central bank would become part of the Treasury. It does not take much effort to explain that following this theory of monetary mismanagement opens the door to hyperinflation and that it will be impossible to close this door once it has been opened.
The Importance of Sound Economics
Before the flood breaks loose, the central bank’s money creation may not significantly affect the real economy in terms of production, nor may it drive price inflation right away. A possible scenario could be that the central banks continue following their current policy model of “inflation targeting” and increase the money supply even further under the deception of an apparently “stable” price level. This way, the monetary authorities would ignore the inflationary potential and neglect the risk that hyperinflation exists as a clear and present danger. The monetary potential of price inflation that has accumulated in the past twelve years is so great that control has become unattainable once the avalanche starts.
Regardless of the differences in their details, the politically influential macroeconomic schools are interventionist. These doctrines are attractive to politicians, because they assume that the market economy is permanently dependent on government control. For these economists, the economy always needs leadership, control, and guidance. By declaring the market economy to be permanently ill, the interventionist economists are taking on the role of scientifically proven saviors. These social engineers then find coveted and highly paid jobs at the central banks and in the various ministries and regulatory bodies.
Austrian economics has a different perspective. For these thinkers, the economy is dynamically self-regulating. Consumers strive to improve their situation and entrepreneurs are vigilant in pursuit of these needs. In a competitive market, the price system provides control and guidance from consumers. Extensive intervention by the government and its central bank is not only not necessary, but harmful to prosperity.
More Intervention Will Bring Even More Economic Damage
Governments—not only in the United States—are about to make the same errors that were made in the 1930s, when economic policies deepened and prolonged the crisis. As Rothbard explained, America’s Great Depression came about because the policymakers encouraged the maintenance of high wage rates and implanted measures to stabilize the price level. They actively fought deflation through direct interventions. Instead of encouraging savings, the political decision-makers tried to stimulate consumption and discourage savings. Instead of promoting laissez-faire, policymakers expanded and deepened interventionism.
A new round of zero and negative interest rate policies (ZIRP and NIRP) would further deviate the price of financial assets from the fundamentals and sharpen wealth inequality at a time when social tensions have reached a revolutionary degree. What is needed in the face of an economic downturn is not more, but less government spending, and not more, but less monetary and interest rate stimuli.
The lockdown has resulted in the destruction of capital. The challenge ahead requires rebuilding the capital structure. This requires more savings and investment and less consumption. The government, Rothbard recommends, can only help positively if it lowers “its relative role in the economy, slashing its own expenditures and taxes, particularly taxes that interfere with saving and investment.” Stimulating consumption will prolong the time required to return to a prosperous economy.
Laissez-faire means freeing the multitude of economic actors from government impediments so that they can actively seek to improve their lives. Not more interventionism, but less taxes, less public debt, less inflation, less bureaucracy, and less regulations will open the way for entrepreneurial creativity and thus for the country’s prosperity. Getting the country out of the slump is not done with more alms, but with more productivity.
The lockdown of the economy and the imposition of social isolation have led to large-scale economic disruptions. Not only have jobs been destroyed, capital has also been consumed and the political measures have caused many cracks in the delicate network of the division of labor.
After the big mistake made with the ineffective lockdown, now another, maybe even larger mistake—not only in the United States but in Europe, too—is being made. The implementation of expansionary economic policies will mean that after the blow of the disease, and the smash of the lockdown, economic life will receive another major hit. More government spending and still lower interest rates will not accelerate the upswing but will paralyze the economy after a short flash in the pan.
The upcoming challenge requires the reconstruction of the capital structure and the restoration of global cooperation. This objective does not require more consumption but more savings and new investments. In order to overcome the economic impact of the lockdown, the Austrian school of economics recommends the opposite of the official economic policy that is in effect today. Instead of trying to get the economy going again with the futile means of low or negative interest rates, economic policy should provide a policy environment that promotes savings, encourages innovation, and gives room for private initiative.