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When inflation refuses to appear

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Inflation casts a long shadow over the political economy of the modern world.  So much so that the threat of its return is still given much more weight in governing circles than the fact of its absence for more than a decade.  The reason is best understood through the eyes of Germany’s politicians and bankers; still consumed with guilt for their grandparents’ role in the events of the 1930s and 1940s.  Although mostly untrue, the received narrative is that the 1924 hyperinflation gave birth to the Nazis, who then took advantage of economic mismanagement to seize power in the early 1930s.  The result was the Second World War, the Holocaust and the eventual partition of Germany into capitalist west and communist east.  The memory of those events goes a long way to explaining the European sovereign debt crisis of 2011-12 in which counterproductive and extreme austerity was imposed on the economies of southern Europe – and especially Greece – by German bankers at the European Central Bank.

In the aftermath of the war though, most western governments viewed unemployment as the main driver of political extremism.  According to this view, it was the unemployment which followed the 1929 Wall Street Crash, rather than the 1924 hyperinflation, which had turned the National Socialist German Workers’ Party from a fringe sect into a national party capable of winning elections.  It followed that the primary goal of post-war governments was to maintain full-employment.  And the main mechanism by which this was to be achieved was the printing and public spending of new currency.

The reasoning behind money printing for public investment was that in an economic downturn, private investors would move their money into unproductive assets, thereby starving the real economy of the capital it needed to modernise and begin a new round of growth.  Government could act as a counterweight by using its power to create new currency both to invest directly in the economy through programmes of public works and by providing benefits and pensions at a level that maintained wages and thus purchasing power across the economy.

Taken to extremes though – as the Austrian School’s economists had witnessed in the 1930s – the result of this approach would be over-powerful and increasingly authoritarian governments driven by vested interest such as closed shop trade unions and corporations in receipt of state handouts (what we would today call “corporate welfare”).  As this situation developed, government spending would cease having the desired effect.  Instead, at a certain point money printing would generate inflation at so high a rate that it would undermine the economy.

This appeared to be borne out by the crisis of the 1970s.  Instead of generating growth, government spending created its opposite; mass unemployment.  Even as inflation rose to double digits, private sector employees were losing their jobs.  Meanwhile an aristocracy of labour in strategic industries propped up with state spending continued to command above inflation pay rises, while pensioners and others on fixed incomes saw their living standards crumble.

Supporters of the post-war consensus had no answers.  Into the vacuum stepped the embryonic neoliberals around Thatcher in the UK, Mitterand in France and Reagan in the USA.  Their prescription was a dramatic cut to the money supply via government spending cuts and eye-watering interest rate rises, together with the withdrawal of state support for unprofitable industries.  In the course of the first Thatcher administration (1979-1983) Britain lost more than two million jobs as its manufacturing base was allowed to go to the wall.  Even publicly-owned industries were made to operate as if they were private concerns (and the few who managed the trick – such as British Telecom, British Gas and British Petroleum – were sold off to the highest bidder).

It was not until 1993 – in the aftermath of Black Wednesday – that UK inflation dropped into the 1%-3% band considered optimal by today’s economists and central bankers.  Since then inflation has only broken out of that band on two occasions – 2008 and 2011; the greater concern in recent years being that inflation keeps trending downward, falling to 0.37% in 2015 and again to 1.74% last year.  Nevertheless, contemporary politicians are so inculcated in neoliberal economics that even in the midst of the worst peacetime crisis of the industrial age, they are still focussed on curbing imagined inflation even as the spectre of a deflationary collapse looms ever larger.

Typical of this way of thinking is former US Treasury Secretary Larry Summers, who courted a social media shitstorm by opposing increasing the pandemic relief to ordinary Americans from $600 to $2,000:

“Some argue that while $2,000 checks may not be optimal support for the post-Covid economy, taking stimulus from $600 to $2,000 is better than nothing. They need to ask themselves whether they would favor $5,000, or $10,000 — or more. There must be a limiting principle…

“I am all for a far more expansive approach to fiscal policy. But that does not mean indiscriminate support for universal giveaways at a time when household income losses are being fully replaced and checking account balances (at least as of October) were above pre-Covid levels.”

Handing out billions of pounds and dollars to already wealthy corporations in the form of quantitative easing, in contrast, is just the price we all have to pay to keep the economy functioning.  As journalist Matt Taibbi points out:

“The operating principle in most of those cases was that financial institutions must not be allowed to take crippling losses, even if those losses were the fault of the companies in question, because such a decision might trigger (pick one or more) ‘a chain reaction,’ ‘catastrophic losses throughout the system,’ ‘graver economic consequences,’ the ‘spread’ of investor ‘flu,’ etc., etc.

“The thinking of these experts changes, however, the instant the question shifts to rescuing individuals affected by something like the 2008 crash, or the current pandemic. Suddenly we learn that resources are scarce, and the commitment of public money to rescue mere People With Problems risks ‘moral hazard’…

“Such people are also quick to remind us that mass aid to people from central banking systems carries a terrifying inflationary risk that somehow didn’t exist when they were arguing in favor of trillion-dollar financial-services bailouts, or Quantitative Easing, or whatever other ‘liquidity’ injection plan to save the macroeconomy they were trumpeting five minutes ago.”

Summers refers euphemistically to the danger of the economy “overheating” – generating more demand for goods and services than the economy can supply; particularly given that large swathes of the economy are either shut down or operating minimally because of the pandemic restrictions.  But part of his concern can also be cited as evidence for why deflation may be the greater danger:

“[F]urther adding to earnings when losses are being replaced seven times over seems hard to justify — especially at a time when pent-up savings totals $1.6 trillion and is rising.”

The American people didn’t save that $1.6 trillion after March 2020; although savings did grow by 33% during lockdown when there was little to spend on.  But this masks the huge inequality between rich and poor:

Before the global pandemic, we know that Americans as a whole don’t save a lot of money. Up until May 2020, the average saving rate was only around 7.7%.  In other words, it takes the average American 13 years to save just one year’s worth of living expenses. That is a disaster!

“When you’re 60-something years old and only have several years’ worth of living expenses to buttress your declining Social Security checks, life isn’t going to be very leisurely. You’ll probably be mad at the government for lying to you and mad at yourself for not saving more when you still had a chance.”

Most of that $1.6 trillion in savings belongs to those at the very top of the wealth and income ladder.  And if you want to understand where the inflation went, just consider where those people saved it.  As Tim Morgan explains:

“…current incumbents of office cannot be blamed for a historic convention which decrees that, whilst rising food prices are evidence of inflation, rising stock or property prices are not. Logic may tell us that neither high house prices nor low wages are economically beneficial, but both fallacies are deeply embedded in established (though mistaken) lines of thinking.”

Despite living through the worst peacetime economic shock of the industrial age, stock markets around the world – and particularly those in the USA – have been hitting all-time highs on the back of the kind of corporate welfare handouts that neoliberals like Summers happily turn a blind eye to.  But this is part of the reason why inflation is not – or at least not for now – a problem which need concern us.

In part, the ever rising price of shares is a consequence of savers having nowhere else (“safe”) to go.  The mass of zombie firms and households that make up an increasing part of the real economy renders traditional forms of investment in industry too risky for most.  Only those with cash to spare or those (like pension and insurance funds) whose business model is based on the kind of returns last seen in the mid-1990s will gamble on so-called “junk bonds” such as those issued by unsustainable US fracking companies.  You might… just… be fortunate enough to invest in some new technology that genuinely becomes profitable.  But it is more likely that you’re going to lose your shirt.

Behind this, though, is a more deflationary practice.  A large part of the rise in share prices since 2008 has been the result of corporate share buy-backs.  When this occurs, those shares simply evaporate into the ether, so that there are ever fewer shares in circulation.  But institutional investors such as pension funds are required to hold a sizable part of their funds in supposedly safe assets such as US Dow Jones and Nasdaq or UK FTSE-100 listed companies.  And with fewer shares to go around, this drives stock prices ever higher in the same way as oil shortages inflate the price of goods and services.

Something else is going on here too.  Remember how commercial banks create currency out of thin air when they issue loans?  Well when currency meets debt it is the financial equivalent of matter meeting anti-matter – the two cancel each other out.  And while a share might be considered an asset to you and me, it is a form of debt to a corporation.  And so it was in their interest to borrow the QE currency and use it to buy back shares from investors as fast as the central banks could spirit it into existence.  And while this might have been inflationary if investors used the income from the sale of shares to spend on goods and services, for the most part they, too, used it to pay down debt or to invest in alternative non-productive assets.

Meanwhile, back in the real world inflation has stalled for a related reason.  Currency printing – whether by states or commercial banks – does not, in and of itself, generate inflation.  Suppose, as a thought experiment, the government deposited £1 million into your bank account.  Wouldn’t that be fantastic?!  Now imagine that there was a clause in the small print which prevented you from withdrawing or spending more than £1 thousand in any year.  Not quite so fantastic now is it?  The point is that inflation depends not only on the total amount of currency in existence, but also on the rate – or “velocity” at which it is spent.  And here’s the problem, while both the supply of currency – the main means by which central banks have been trying to generate inflation since 2008 – and GDP have been trending upward for decades, and while 2020 has seen a massive expansion of the currency supply, the velocity of currencies continues to fall:

As a post on the This Time it is different site just prior to the Covid emergency explains:

“Money velocity in the United Kingdom is currently less than 1 which means that money being printed (even notionally) isn’t even circulating once…

“Given that money velocity is so low now implies

  1. Consumer and business confidence for spending isn’t particularly high.
  2. Consumers and businesses aren’t borrowing too much money either.
  3. There is ample (probably excessive) liquidity in the system.”

From a purely financial point of view, the reason for this is difficult to explain.  If there is “ample liquidity in the system,” why wouldn’t people spend it?  One reason is that the inequalities discussed above mean that the excess liquidity is in the hands of those with the lowest propensity to spend.  A handful of godzillionaires have seen their personal fortunes spiral up into the stratosphere even as thousands at the bottom are forced to turn to foodbanks to feed their families.  But individuals such as Amazon’s owner, Jeff Bezos, are unlikely to spend any of this additional income; and may even view it as a burden as they (or at least their investment portfolio managers) search desperately for somewhere safe to put it.

This, though, is not the only reason for the falling velocity of currencies.  Back down on planet Earth where the rest of us live, people have a hierarchy of spending commitments.  Sure, some spendthrift types will put alcohol, drugs and gambling ahead of putting food on the table.  But for the overwhelming majority, there is a heirarchy of essential payments that have to be made before any leisure or luxury spending can be made, including:

  • Paying the rent or mortgage
  • Paying local taxes
  • Buying food
  • Paying for utilities
  • Paying for essential transport (such as commuting)…

Indeed, many of these payments are made automatically because the consequences of not paying them can be devastating.  Failure to pay the rent can rapidly result in homelessness while failure to pay local taxes can end with a jail term.  Failing to pay the electricity bill may have a less immediate impact, but in the worst cases it can result in court action, bailiff’s taking your possessions and the end of your access to credit.

Less obviously, debt itself becomes a priority, non-discretionary payment; which is ironic as in many cases the initial borrowing was for an item of discretionary spending which, in an earlier age, we would have been told to save up for.  And in this change in attitudes we glimpse one of the key systemic changes over the past 50 years which drives our current crisis.

The Monetarist-Neoliberal “solution” to the oil shock-driven crisis of the 1970s involved mass unemployment to crush the collective income of workers together with ripping up capital controls to enhance the profits for investors.  One result was that large swathes of the manufacturing base of western states were decanted to Asian states where labour was cheap and regulation largely absent.

Making goods cheaply only takes you halfway along the road to profitability though.  The trick is to sell those goods in order to turn theoretical profit into hard cash.  But having trashed the western economies by destroying millions of jobs and decimating thousands of businesses, by the early 1980s there was little scope for discretionary consumption.  Credit provided the solution.

Anyone who lived through the period will remember the revolution in banking and finance.  As late as 1980 in the UK, most workers were paid in cash and were more likely to deposit it in a building society than a bank.  The few who did open bank accounts often found them highly restrictive.  Cheques, for example, could only be used for withdrawing cash; and there were limits on the amount of cash which could be withdrawn on any day.  Credit cards and bank loans were limited to the upper classes, while working people turned to hire purchase for items they could not afford to pay cash for.

By the late-1980s this had been turned on its head.  Wages were paid directly into bank accounts; and those accounts came with open cheque books and debit cards.  Credit cards became the common means of paying for things that couldn’t be afforded directly.  And pretty soon the building societies were resorting to bribing their members to permit them to convert into commercial banks.  Just a few years later, British householders struggled to open their front doors as a result of the mountains of “pre-approved” credit offers arriving through the post.

In the UK it was funded out of the ill-gotten gains of the City of London global money laundering operation.  But even that depended upon the oil and gas revenues to provide the pound with a stability that could not be gained from the wider UK economy.  As Guardian journalist Ian Jack remembers:

“I had the idea… when I was walking through a London square around the time of the City’s deregulatory ‘Big Bang’ and Peregrine Worsthorne coining the phrase ‘bourgeois triumphalism’ to describe the brash behaviour of the newly enriched: the boys who wore red braces and swore long and loud in restaurants. Champagne was becoming an unexceptional drink. The miners had been beaten. A little terraced house in an ordinary bit of London would buy 7.5 similar houses in Bradford. In the seven years since 1979, jobs in manufacturing had declined from about seven million to around five million, and more than nine in every 10 of all jobs lost were located north of the diagonal between the Bristol channel and the Wash . And yet it was also true that more people owned more things – tumble dryers and deep freezers – than ever before, and that the average household’s disposable income in 1985 was more than 10% higher than it had been in the last days of Jim Callaghan’s government.”

By then though, the nominal value of our houses was rising faster than wages.  And much of the supposed additional prosperity which carried us through the boom years of the late-1990s and early-2000s was a result of people using their homes like an ATM; extending mortgages (which have a much lower interest rate than credit cards) to pay for everything from holidays to home improvements.  And so long as the North Sea oil and gas kept flowing and provided nobody sought to regulate the City, the party could continue indefinitely.

The North Sea fields peaked in 1999 and production plummeted 66% in just a few years.  By 2005, Britain had become a net importer of oil and gas.  By then though, the entire world was experiencing the first symptoms of the peak of conventional oil extraction worldwide.  Prices were rising across the economy.  In response, central banks raised interest rates, creating the conditions for the debt defaults which brought down the global banking and financial system in 2008.

Inevitably, the banks were bailed out and the bill was handed to ordinary people in the shape of stagnating wages and austerity cuts.  But the debt didn’t go away.  Interest rate cuts made it easier to service the outstanding debt.  But in a near stagnant real economy, zombie firms and households had little chance of repaying their loans.  And so debt has become a major part of the non-discretionary hierarchy of payments that we have to make before we can even think about discretionary purchases:

At the very bottom, people have been forced to borrow still further just to keep a roof over their heads and to put food on the table.  Many failed to manage and joined the growing army of homeless people congregating in our declining town and city centres.  Others get by with the support of friends and family together with occasional income from zero-hours jobs or gig economy work.  Many in full-employment – particularly those earning below the median wage – struggle to balance the books since – as many discovered when they were forced to work from home in 2020 – simply having a job adds thousands of pounds to the cost of living via additional spending on transport, clothing, food, etc.

As the energy cost of energy increased after the oil shocks of the 1970s, then, debt became the mechanism for bridging the gap between the level of consumption we could afford and the level of consumption needed to prevent the economy from crashing into a depression.  What Marx (wrongly) called a “crisis of overproduction” – in reality a “crisis of under-consumption” had become a structural norm.  But while borrowing against the future could offset the problem – and, indeed, generate a debt-fuelled boom – it ultimately depended upon the energy cost of energy falling in the future.

In the real world that meant either discovering and extracting new sources of low-cost – so not fracking or tar sands – oil deposits, or discovering some new and even more energy-dense – so not wind turbines and solar panels – alternative source of energy.  Neither exists.  And so we have seen an increasing energy cost of energy translate into increased prices for those items that fall into the non-discretionary column of the things we purchase – electricity, transport, food, rent, etc.  Unfortunately, inflation calculations tend to down-play these non-discretionary items while focusing on the falling prices of discretionary goods and services – you might not be able to feed and clothe yourself but look on the bright side, the price of an i-phone or an aromatherapy massage has fallen!

Even this though, may be merely describing the latest iteration of a deflation that has plagued humanity for centuries.  There is a reason why most of the world’s religions regard usury as the greatest sin of all.  But in a usuristic (I made that word up) system, what we think of as usury is incorrect.  Today we are encouraged to think usury is the practice of loansharks and payday loan companies who charge exorbitant rates of interest.  But they are akin to a virus which kills its host before it has had time to spread the infection.  The truly successful usurers are the ones – like modern commercial banks – that set rates low enough that people will struggle to service their debts rather than go bankrupt.  That is, because of the power of compound interest, greater returns flow to those who wait patiently than to those who rush in for the kill.

A recent Bank of England research paper by Paul Schmelzing points to a general trend to ever lower interest rates between 1311 and 2018.  Moreover, Schmelzing – writing prior to the pandemic – anticipates a descent into negative rates in the early-2020s as the only means of keeping the system going:

“Against their long-term context, currently depressed sovereign real rates are in fact converging ‘back to historical trend’ — a trend that makes narratives about a ‘secular stagnation’ environment entirely misleading, and suggests that — irrespective of particular monetary and fiscal responses — real rates could soon enter permanently negative territory.”

In fact, the economic and political climate that we – in the developed western states – have been encouraged to regard as “normal” – mainly the post-war boom years – are actually the historical abnormal; while the periods we think of as crises – the 1970s and the years after 2008 – are actually the long-term norm.

In the long march of human history, growing prosperity of the kind we have been encouraged to think of as normal is an outlier of a kind that occurs for just a few years in a millennium.  As Schmelzing explains:

“One key empirical result analyzed here is that there is no evidence of a ‘virtual stability’ of real capital returns, either expressed in R or ‘R-G’ over the very long run: rather, – despite temporary stabilizations such as the period between 1550-1640, 1820-1850, or in fact 1950-1980 – global real rates have shown a persistent downward trend over the past five centuries, declining within a corridor of between -0.9 (safe asset provider basis) and -1.59 basis points (global basis) per annum, with the former displaying a continuous decline since the deep monetary crises of the late medieval ‘Bullion Famine’. This downward trend has persisted throughout the historical gold, silver, mixed bullion, and fiat monetary regimes, is visible across various asset classes, and long preceded the emergence of modern central banks. It appears not directly related to growth or demographic drivers, though capital accumulation trends may go some way in explaining the phenomenon.”

Those who regard the economy as a financial system will, like Schmelzing, struggle to understand what is going on here and will equally fail to understand the relevance of those temporary islands of stability.  Those who understand that the economy is primarily an energy system subject to the laws of thermodynamics, in contrast, will understand exactly what caused that “stability” in an otherwise entropic system.  The period 1550-1640 saw a massive energetic boost – based on the backs of African slaves and new calorific food crops – emerging from an Atlantic trading system which itself resulted from the technological harnessing of Atlantic gyres and trade winds; renewable energy at its technological peak.  1820 to 1850 marked the spread of the coal-based industrial revolution out of England and ultimately across the world.  1950 to 1980  marks the period when the developed states (excluding the USA) switched their economies from coal to oil; ushering in the biggest growth in output, wealth and prosperity the world has ever seen.

In the few periods when the energy available to the economy increased significantly, it was possible to expand the currency supply without generating inflation.  In such circumstances, interest rates far above the norm can be charged without triggering bankruptcy or causing investment to be switched from the real economy into unproductive asset speculation.  Once real economy growth outpaces the energy needed to maintain it, and once the energy supply itself begins to fall (such as the European timber shortages which also arose in the sixteenth and seventeenth century) growth, and thus interest rates, cannot be sustained and must ultimately trend downward.

Even without the pandemic, we were heading for negative interest rates as a result of the accelerating collapse of discretionary consumption across the developed states.  With energy costs rising and capital destruction gathering pace in response to the actions taken to deal with the pandemic, the situation can only worsen.  No amount of currency printing can restore growth because we lack the energy and material resources to ever return the economy even to its recessionary 2019 conditions.  Meanwhile, for an increasing number of households and firms, debt is becoming the largest item of non-discretionary spending; meaning nowhere near enough spare currency is available to increase velocity.  It follows that the only place where inflation can exist is in the shrinking pot of assets where pension fund managers and tech godzillionaires seek to hide their cash.

Welcome to 2021 and the “k-shaped” post-pandemic recovery in which the rich get richer, the poor get poorer, and the politicians and central bankers turn to increasingly outlandish policies in a vain attempt to convert currency into energy.  There will be neither a “Great Reset” nor a “back to normal,” just the permanent downward grind toward a less energetic, less material and more labour-intensive way of life.

As you made it to the end…

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