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A dangerous misunderstanding

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How much money should there be in the world?  It is an interesting question; to which, at any time, there is a correct answer that is unknown to anyone.  It is the amount at which money is able to perfectly perform its two key functions – being a medium of exchange and a store of value.  Too little money in circulation and it would cease being a fair store of value because its value would be increasing – something that hasn’t occurred in half a century.  Most often, money ceases to be a store of value on the downside – losing its value – because it is far easier for states and banks to create new currency than it is to destroy it.

In practice, whether there is too much, or not enough money in the system is largely a matter of political economy rather than science.  There are two broad economic camps – Monetarists and Keynesians – which largely correspond to conservative and liberal politics.  The conservative-monetarist camp has been arguing for more than a decade that there is too much money in a system which should have been allowed to fail back in 2008.  The liberal-Keynesian camp in contrast, argues that the absence of productivity gains, inflation and wage growth pressure show that there is too little money in circulation.

The liberal-Keynesian camp appears to be winning the argument for now.  This is because the economic fallout from the pandemic and the response to it would – at least in the short-term – have been devastating were it not for the various grants, loans, bailouts, stimulus payments and public services spending embarked upon by states and central banks around the world.  Moreover, by pumping trillions of newly created dollars into the system, the Biden administration may well create a short-term post-pandemic bounce which will prevent the immediate onset of depression.

The conservative-monetarist camp may though, have the last laugh – albeit for the wrong reasons – when the inevitable increase in the cost of living arrives, as all of that new currency seeks somewhere to land.  Hopes that we will witness an immediate consumer boom are likely to be dashed by ongoing public cautiousness in the face of a pandemic which refuses to go away.  Saving rather than spending may well continue until a responsible adult finally arrives to declare the pandemic to have ended.

The bigger worry is that we experience an “elastic band effect” – that, rather like trying to lift a brick with an elastic band, you pull and pull and nothing seems to happen; but suddenly the brick flies upward and hits you in the face.  In an economic context, states and central banks may pump trillions and trillions again of dollars, euros, pounds and yen into the economy with no apparent effect; and then suddenly everyone begins trying to spend currency at the same time, driving prices through the stratosphere.

For the moment, states are being cautious about bringing financial support packages to an end.  Moreover, political pressure to build critical infrastructure, re-localise supply chains, to support businesses and to maintain increased support to those on the lowest incomes may make it impossible to withdraw currency from the system for several years to come.  Central banks, too, have pledged not to raise interest rates, even if inflation rises above the theoretical two percent ceiling.

The issue is compounded by a contemporary misunderstanding of what inflation is.  Ask most people – including most economists – what inflation is, and they will likely reply, “rising prices.”  And for most ordinary people, this is, indeed, how inflation is experienced.  The loaf of bread that cost £1.00 last April is £1.50 today.  Economists will explain it differently though.  They will point out that there is nothing different about the loaf of bread.  It is made with the same ingredients in exactly the same way as last year.  What has changed is the quantity of money in circulation together with the rate – “velocity” – at which it is being spent.  More money chasing the same supply of goods and services will cause the value of each unit of currency to decrease; giving the impression that prices are rising.

Problems begin because economists, journalists and politicians have grown up believing that inflation and price rises are the same thing.  As Tim McMahon explained in his article – What is the Real Definition of Inflation? – in the course of the neoliberal revolution (1983-2000) the definition of inflation was radically changed.  In 1983 inflation was defined as:

“An increase in the amount of currency in circulation, resulting in a relatively sharp and sudden fall in its value and rise in prices: it may be caused by an increase in the volume of paper money issued or of gold mined, or a relative increase in expenditures as when the supply of goods fails to meet the demand.”

By 2000, this had changed to:

“A persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money, caused by an increase in available currency and credit beyond the proportion of available goods and services.”

As McMahon notes, by 2000 cause had been replaced by effect.  And this had far more reaching effects than mere semantics among economists.  In 2005, conventional oil extraction peaked.  The need to fall back on unconventional resources such as deep water, tar sands and later fracking, drove the energy cost of energy above five percent; the point at which prosperity began to decline in the western economies.  Britain was particularly badly affected because it had also become a net oil and gas importer in 2004-5. 

The immediate effect though, was an increase in global oil prices which was interpreted as inflation.  And since neoliberal economists, central bankers, politicians and journalists understood inflation as being rising prices, as increased oil costs filtered through to everything made from or transported using oil, they interpreted the situation as one of general inflation.

Left to market forces, the rise in oil prices would have eventually settled out via a new pattern of spending across the economy.  In the absence of wage growth and rising profits, households and businesses would have simply adjusted their spending; cutting down on discretionary purchases in order to accommodate the rising cost of essentials.  Purchasing patterns would have changed, but inflation would not have increased.

This is not though, how central bankers chose to interpret the data.  To them, rising prices meant inflation.  And the cure for inflation – learned from the crisis of the 1970s and early 1980s – was to jack up interest rates.  But there was a huge difference between the money of 1980 and the money of 2006.  In 1980, almost all of the money in circulation came in the form of notes, coins and cheques.  Mobile phones and desktop computers had yet to put in an appearance, so transactions were still tallied by hand.  Credit cards were the preserve of the rich.  And in the UK at least, most people did not have bank accounts; and most wages were paid in brown envelopes containing cash.  More importantly, in those days, banks and central banks were heavily regulated whereas politicians made the decision about how much money to print.

By 2006, the situation had reversed.  Politicians had surrendered control of the money supply to central banks which had, in turn, surrendered the power to create new currency to private banks – which is why; incidentally, building societies began offering cash incentives to their members to allow them to convert to banks.  Following the deregulation of the banking and financial sector in 1986, the western economies embarked on one last debt-based binge before Planet Earth called time on the industrial economy.

Many readers will no doubt remember how difficult it was to open the front door when you arrived home from work because of all the credit card and loan offers posted through the letterbox.  Long after the banks had run out of AAA-rated borrowers to lend to, they used arms-length brokers to encourage far less credit-worthy borrowers to take on debt… including, of course, the now infamous sub-prime mortgage borrowers.  And so long as the system remained stable – the “Great Moderation” proclaimed by Ben Bernanke – what could possibly go wrong?

There is an important point here.  Throughout the 1990s, sub-prime borrowers had been able to manage.  For sure, it meant that people had to buy low-end housing as an investment; the aim being to sell for more than was paid in order to re-finance mortgages until rising house prices finally resulted in outright home ownership.  But for this to work, interest rates had to remain low.  It was thus the decision to begin raising interest rates rather than reckless borrowing, which brought the house down.  And it was the first oil shock since the 1970s that had triggered the rise in interest rates.

What followed was the 2008-9 crisis and a decade of stagnation in which prosperity continued to retreat into a handful of affluent enclaves, while the wider population saw their living standards decline.  Even before the pandemic, declining oil extraction, rising resource extraction costs and falling living standards had created a retail apocalypse which was already spreading to the commercial real estate sector (where most pension funds are invested).  Across the economy, businesses and public services were faltering.  The pandemic and the response to it merely accelerated these trends; causing a depression which might otherwise have been staved off to mid-decade.

We might have reset the system in 2008; allowing the banks to go bust and letting zombie businesses and households go to the wall.  It would have been painful, but it would have evaporated most of the excess financial claims upon the dwindling resources of the real world.  But a small group of wealthy and powerful men got together to oblige ordinary people to bail them out.  We have been playing a game of “extend and pretend” ever since – big corporations continue to get state handouts while ordinary people’s living standards fall far faster than might otherwise have been the case.  And the point is that we never did solve the crisis – it is still there in the shape of a massive debt overhang which can only be managed by ever lower interest rates, together with massively inflated asset bubbles everywhere you care to look.

From the viewpoint of those charged with managing economic affairs, it was no less insane to lockdown national economies and spend trillions keeping businesses and households on life support, than it would have been to allow the shock of the pandemic to burst all of the asset bubbles.  Either way, we face a far less prosperous future.  However, by printing and borrowing into existence all of the new bailout and stimulus currency, the inevitability of future inflation leaves us dangerously vulnerable to a global market which is desperately seeking to adjust to the late-pandemic and post-pandemic future.

The UK is particularly vulnerable because its current government is a late and reluctant convert to the Biden-style approach of spending money like a drunken sailor.  More than half of the government’s members were ardent supporters of the austerity policies of Cameron and May; and are only tempered by the needs of the red wall Tories, who understand that their seats will be lost if the government doesn’t keep the printing presses rolling.  Nevertheless, with the fallout from last year’s lockdowns and restrictions only now washing upon our shores, we are about to experience something that looks and smells for all the world like inflation… and the government’s response could make matters a lot worse.

As was widely predicted, disruption to the oil industry last year is finally manifesting in higher fuel prices as economies attempt to open up.  The WTI price is now above $60 per barrel and the Brent price looks set to go above $70; putting us in recessionary territory as, since 2008, prices above $60 have proved too high for consumers.  In the short-term though, rising oil prices spell higher fuel charges at the pumps… something that is already impacting the official measure of inflation here in the UK, and which may well impact the USA as the summer motoring season gets going.

Shipping, too, is proving a major headache.  Ultra-efficient, just-in-time global logistics chains were torn asunder by the various pandemic restrictions last year.  The result is that ships and containers are in the wrong places and, with no certainty about what the post-pandemic market will be like, for now at least there is no way of rebalancing the system.  And so, the cost of everything that is transported on ships will be rising.

The disruption to energy and transport has a knock on impact on almost everything else too.  Shortages of everything from wood pulp to computer chips have been popping up like paste bubbles on badly hung wallpaper.  And those shortages will also be feeding through as higher prices in the near future.  Indeed, reopening our economies looks set to be more traumatic than locking them down for months on end.

The big danger is that states and central bankers stick to the modern definition of inflation and assume that the price rises we are beginning to see – which are actually the result of the pandemic response 12 months ago – are evidence of inflation caused by all of the additional currency they created.  If they assume this, then the two policy responses – central bank interest rate rises and state austerity cuts – are going to make the consequences of the pandemic far worse than they need be; and will likely bring about a far bigger crash than would have happened in 2008.

What we are witnessing in 2021 is not the result of currency printing.  That will arrive soon enough.  But the increased prices today are a consequence of real economy shortages – some of which began before the pandemic – to which the economy will have to adapt.  With not enough energy to go around from here on in, the price of material goods and services will be rising anyway.  That means that people will be buying them less often; and that those at the bottom will no longer be buying them at all.  Allow this rebalancing to occur – as they should have done in 2006 – and the landing is going to be a lot less bumpy than if the rug is pulled out from beneath the economy before it has had chance to adjust.

In the longer term, we will have no choice than to deal with inflation; because the answer to the question I posed at the beginning is that there should be the same amount of money as there is value derived from our available useful energy… and, of course, nobody knows how much that is.  This is why historically humans have flipped between two types of money – money backed by some real commodity, most often precious metal; and fiat money backed by the writ of the state.  The advantage of the former is that it tends to reflect the available energy; especially in economies which run on renewable energy alone.  In fossil-fuel economies, though, commodity-backed money acts as a fetter on productivity because the energy supply in the growth phase expands far faster than the commodity backing the money supply.  This is where fiat currency has the advantage – you don’t need to wait for new gold mines to produce enough to catch up with the massive expansion in coal, oil and gas; you just print more currency out of thin air.  The downside, of course, is that when energy production stalls – as it did in the 1970s and after 2005 – the supply of fiat currency overshoots the real economy, creating massive asset bubbles which have to burst sooner or later.

The gold bugs can correctly claim that they would have never allowed the bubbles to grow in the first place.  But the supporters of fiat can just as correctly point out that left to the gold bugs we would never have grown beyond the economy of the nineteenth century.  Both though, are engaged in a superfluous debate, because both assume that a growing economy is the natural state of affairs.  What we face in the post-pandemic landscape though, is an economy which is visibly shrinking.

In the wake of the 1970s crises, prosperity remained the norm; while precariarity was limited to small minorities.  This allowed the political class to blame the victims.  Even as late as 2015, the narrative was that the only duty of the state was to provide places in educational facilities; it was up to the poor to go to the right universities and take the right courses to get along in life.  And if they failed?  Well that was their fault.  The 2016 political shocks seem to have shaken that narrative; and there is growing consensus that some degree of state intervention – such as greater infrastructure spending – is required to iron out unsustainable inequalities. 

Even this though, misses the point; because we are no longer in the age of industrial growth.  Wherever governments sit on the intervention v laissez faire continuum, and irrespective of whether they favour fiat or metal-backed currency, inflation – by its modern definition – is inevitable because the energy and resources available to the economy will be shrinking faster than the supply of currency.  The only serious question to be answered is whether governments should attempt to manage this inevitable process of de-growth – trying to leave as few people as possible behind – or whether they should allow nature, red in tooth and claw, to take its course.  Sadly though, they will do neither – at least until it is far too late – simply because the religion of progress has too great a grip on our collective psyches.  Governments will continue to treat each new crisis – including the post-pandemic rebalancing – as no more than a blip on the road back to the glory days of the 1953-1973 boom… even as that golden age passes from living memory to the dead pages of the history books.

As you made it to the end…

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