The economics of the pandemic: don’t panic

One of my favourite subjects in ten years of blogging has been economics. But for the last year I have hesitated. There has been a lot to write about, but somehow I did not have the confidence to say anything. A couple of weeks ago I got as far as writing an article, but it just meandered. But this week I have been bombarded with different opinions on the impact of the pandemic and what to do next, so I feel I must try to make some sense of it.

Most recently there were a couple of articles in the FT. There was an interview with economist Dani Rodrick, in which he urged that the left should make up for its attachment to neoliberalism in the 1990s and 2000s and meet the challenge of right-wing populism with a sort of left-wing populism. The focus of this should be the creation of decent jobs (the populism bit being the blaming of everything on plutocrats and bankers). He has certainly hit on something important, but to me left-wing populism brings to mind the late Hugo Chavez, and the creation of useless jobs given to political cronies, the running down of productive industries and bankrupting the economy on welfare programmes used to shore up politically compliant communities. This is where the policies of Labour’s former leader Jeremy Corbyn would have led in my view (he is a fan of Chavez after all). On the same day the neoliberals fought back with a piece by Ruchir Sharma, a banker, who claims that emerging market economies have responded to the crisis by pressing forward with supply-side policies, rather than splurging on stimulus. These are IMF-style programmes without the IMF – he points to China and India, amongst others. With developed economies resisting such reforms, he says these emerging economies will be better placed to overcome the shock. This is an interesting take on what is happening, but the conclusion is facile. Developed economies are at the productivity frontier, and they are not in need of many neoliberal reforms (with some exceptions such as Italy) – I agree with Mr Rodrick here, even if his picture of left-wing populism sends shivers down my spine.

And then we have some writing about President Joe Biden’s proposed massive stimulus for the US economy (£1.9trn is the headline). Left-wing commentator Robert Reich launched into enthusiastic support on Facebook. The Economist thinks it goes too far, and should be better targeted, echoing criticism from former adviser to President Clinton, Larry Summers. They fear that it will trigger inflation, and then rising interest rates, and a financial crisis. Meanwhile, also in FT, Gillian Tett has written about the remarkable stance of Chairman of the Federal Reserve Jay Powell, whom she thinks is being far to aggressive on the length of time he suggests interest rates should stay low. Meanwhile there is a lot of fretting about signs of overheated financial markets, with the popularity of crypto “currencies” like Bitcoin eliciting much angst.

There is quite a lot of agreement that governments are right to spend to support the economy, but a big concern on how far this should go. Critics of stimulus worry about setting off inflation. But conservatives have cried wolf on inflation many times in the last few years, and yet it remains stubbornly low. Most commentary on inflation misses the mark.

What is inflation? It is a devaluation of the currency, so that the same nominal units income or savings buy less, but that a fixed nominal amount of debt becomes easier to pay off. The focus of commentary tends to be almost entirely on the first, measured by overall movement in consumer prices. But if wages do not rise to match prices, then debts are not depreciated. It isn’t really inflation, in my books, but a structural adjustment. The three main reasons for this can be worsening terms of trade (i.e. imports becoming more expensive, usually because the exchange rate is depreciating), a decline in productivity, or a shift of bargaining power from labour to capital. None of these require the same policy response as inflation proper (i.e. higher taxes or reduced public spending, or higher interest rates). And in the 21st Century consumer prices and wages have rarely moved in line with each other in developed economies. Before the financial crisis of 2007-2009, wages trended ahead, largely because of improving terms of trade from cheap imports, mainly from China. After the crisis wages have usually failed to keep pace with prices, as the terms of trade moved against developed countries (Chinese products stopped getting cheaper), unmasking a steady process of the balance of advantage moving from labour to capital. All this is very different from the later 20th century, when most of the current theories of economic management were developed. Then wages and consumer prices usually moved in lockstep. The breaking of the link between prices and wages is one of the critical things to understand about the modern economy.

So what happens when demand runs ahead of supply? Inflation remains stuck because rising prices choke off demand, because wages for most people do not keep up. The typical response is for imports to rise. At least that is what I suspect from the limited times where this has happened in the 21st Century (I believe Britain in the mid noughties was a case in point). But a feature of modern developed economies, especially since 2007, has been a chronic lack of demand, while conservative government fiscal policies were the accepted wisdom.

So what will happen if President Biden’s stimulus gets going, with the Fed minded to keep interest rates low? I don’t think it will lead to more than a slight increase in inflation, largely because of the disconnect between prices and pay, but also because of the nature of the recovery. The Economist refers to some supply bottlenecks, such as in microchips, but these relate to distortions in demand arising from lockdowns. Assuming that the US comes out of lockdown, then the main rise in demand will be for services, rather than such manufactured goods, where there seems to be quite a deep pool of unemployed or underemployed labour. And doubtless imports will rise too, and the US dollar will strengthen relative to other currencies. Also much of the excess demand will be funnelled into asset markets, so the current distinctly bubbly markets could well continue. If there is trouble it will come from some kind of breakdown in financial markets. But they do not seem to be as vulnerable as they were in 2007. All this rather supports Mr Reich’s optimistic outlook. As the stimulus plays out things become a lot less predicable, but that is a couple of years away and not necessarily unmanageable.

What should the British government do? It has run up an astonishing budget deficit in its largely successful attempt to keep the show on the road in the crisis – unemployment is remarkably low I the circumstances. According the Economist the deficit is nearly 20% of GDP, the largest of any of the economies it follows. But the same statistical table shows something rather interesting: that the current account deficit to has fallen to 1.3%, and is unremarkable by international standards. Not long ago it was one of the highest. This, together with very low interest rates, suggests that there is no financial crisis, and therefore no need to panic, as the country did in 2010, when the budget deficit was 11%, though the current account deficit was a bit higher at 2 to 2.5%. The government’s main problem is its own rhetoric about government finances.

How quickly could things turn nasty in the UK? We are much more vulnerable to a financial crisis than the US, because we lack financial clout. But again we look much less vulnerable than in 2007. A big question is what happens if the current account goes sharply negative again. That is not necessarily unsustainable (it can be financed by selling property to foreigners). But if world interest rates should start to rise then problems might spiral. But my guess is that the country is safe for a couple of years at least.

There are some much deeper economic questions emerging from the covid crisis, which point to a major change in direction for economic management. These should occupy us more than short term government finances.