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If you thought inflation was bad

Cast your mind back two years.  It seemed then that we were at the start of an economic renaissance.  The pandemic was all but over – even if the power-crazed public health technocrats were desperate to keep it going.  Bars, restaurants, theatres and cinemas were reopening, and for the first time since the election of “Call-me-Dave” Cameron, people had money to spend.  As had happened the year before, the unlocking of the economy led to a consumer spending spree.  And even when prices began to rise, the economists, central bankers and politicians were convinced that this was but a “temporary” adjustment as the economy restarted.

Some of us were unconvinced.  Lockdowns around the world had shattered the fragile just-in-time supply chains which had saved us from catastrophe after the 2008 crash.  Shipping costs had risen tenfold, as ships and containers were stuck in the wrong places.  And even if they hadn’t been, port facilities were already backed-up and had no spare capacity to deal with the sudden increase in demand.

And then there was energy.  First there was the media-inspired fake fuel shortage.  Which demonstrated that fuel supplies were just as vulnerable as banks:

“That is, this weekend’s ‘shortages’ are largely the product of a multinational oil company launching a media campaign aimed at avoiding having to improve the pay and conditions of its drivers.  From past experience – including your rush to get toilet paper last March – you didn’t have to be a genius to realise that publicising a faux shortage of fuel would lead to a run on the country’s filling stations.  They are, after all, just like banks in that if we all turn up at the same time, they break.  And so, in a matter of hours fuel shortages became a self-fulfilling prophesy; aided by ministers taking to the airwaves to urge people not to panic.”

The real thing was gradual and far more pernicious.  In the autumn of 2021, both gas and oil prices began to spiral upward as global demand far exceeded global supply.  This was a particular problem in the UK, where the attempt to create a pseudo-market in energy had been based upon the assumption that cheap North Sea gas would flow forever, and so there was no real need to worry about storage facilities to cushion market fluctuations.  As if this wasn’t bad enough, the political class, chose to disconnect Europe from the last cheap gas exporter on the planet – eschewing Russian oil and Kazakhstani coal too.  Indeed, one reason why diesel prices have remained high in the UK is because of George Osborne’s hare-brained idea that it would be best for Britain if we closed our diesel refinery, and offshored production to Russia… what could possibly go wrong?

In short, by the spring of 2022, the UK – along with consumer economies around the world – faced a combination of additional spending (demand-pull) and supply-shortages (cost-push) which had forced prices first of essentials like energy, food and fuel, and later general consumer goods and services to rise higher and faster than anything we had witnessed since the 1980s.  Ironically, it was that previous inflation – which was entirely different to today’s circumstances – which caused the central bankers’ mood swing away from their correct initial diagnosis of a temporary inflation… so long as we understand that in the real economy, “temporary” might mean several years.

The evil which the central bankers decided that they had to exorcise, was a psychological phenomenon witnessed in its extreme in the German inflation in 1924 – which is often credited as a cause of the rise to notoriety of a certain failed Austrian painter.  It is also worth noting that this was a largely cash-based economy, which meant that a sizable portion of the cash in existence was “out there” beyond the formal banking system.  And, of course, the inflation was a deliberate government policy aimed at devaluing the reparations imposed at the end of the First World War.  Nevertheless, the psychology was simple enough.  With a stable currency, people could keep cash under the proverbial mattress – in the same way as a large volume of bank credit is kept within people’s current accounts today – as a buffer between income and expenditure.  But when prices begin to increase, people turn to that cash buffer to meet the extra cost.  And while this makes sense to each individual, the collective consequence is a large cash injection into an economy which cannot increase supply accordingly.  And so, prices rise even further, causing even more of the cash buffer to be drawn down… and so on in a vicious inflationary spiral.

By the 1970s, two additional problems had been added.  The post-war growth and acceptance of trades unions provided workers with a means to respond to rising prices by demanding increased wages.  At the same time, wider access to credit provided a means to – as it were – draw additional cash from the future.  For example, if you knew that you were going to need a new car, a new refrigerator or a new washing machine, but you were also aware that the price of these goods was rising fast, you might turn to hire purchase or a bank loan so as to buy them before the price rises even further.  Indeed, so long as prices rose faster than the interest on the loan, you were better off doing so.  But again, the collective impact of this was to drive prices even higher.

In 2022, none of these inflationary pressures was widespread.  Cash has all but disappeared – particularly in the UK, where it accounts for less than two percent of all transactions.  There may still be some cash under the mattress… but not enough to fuel a general inflation.  Trade unions have been reduced to a rump – mainly in public services where the state is under little pressure to concede above-inflation wage rises.  And the days when you couldn’t open your front door for piles of pre-approved loan junk mail, are but a fading memory from a by-gone age.  Lending standards have been tightened well beyond the point at which excess borrowing might fuel further inflation.  In short, the scope for demand-pull inflation is far lower today than it had been in the 1970s and was largely the result of the various – and temporary – government subsidies provided in response to lockdown.

So why are prices still rising?  The immediate answer is because the price of essential items like fuel, fertiliser and food have yet to settle following last year’s extreme shocks… although there is gathering evidence that food prices are beginning to fall.  The deeper issue is that economic change takes time.  Just as there was a time lag between governments doling out additional Covid cash and prices rising, so there is a time lag between price increases and the impact of changing consumer spending patterns.  For the most part, consumers responded to rising prices by switching spending from discretionary to essential items.  For example, pubs, gyms and cable TV networks have experienced a big decline in income as people have been obliged to spend more on rent, energy, fuel and food.  Crucially, and on a global scale, this has had a big impact on oil prices – which tend to drive general prices because just about everything we consume is made from and/or transported with oil.  The Brent Crude price today is $77 per barrel, compared to $122 per barrel a year ago, despite the sanctions on Russia and the recent OPEC+ production cuts.  And just as it took time for oil price increases to translate into rising prices, so it will take time for falling oil prices to manifest as deflation.  Nevertheless, deflation is on the way.

The reason for this is the mirror image of the post-lockdown inflation… and not in a good way.  Global demand has crashed as economies around the world rebalance to accommodate the higher energy cost environment.  Where 2021 was all about demand-pull, 2023 and 2024 are likely to be about demand-push, as consumer spending crashes, causing the discretionary side of the economy to collapse.  This is likely to be accompanied by a regionalisation and localisation of the economy as global supply chains continue to fragment – aided in large part by the growth of the BRICS trading system and the end of Eurodollar financial hegemony.  All of which results in an even bigger slump in demand for oil which, in turn, creates further deflationary pressure.

And so, we need to revisit the economic psychology models of the past… but this time to try to understand how people might respond to a deflation.  Certainly, when it comes to big ticket items like houses, cars and domestic white goods, the incentive will be to avoid purchases for as long as possible – not necessarily a bad thing in environmental terms but devastating for a debt-based economy in which there is always more debt than there is currency to repay it.

In a debt-based currency system, even a slowing of the rate of borrowing is sufficient to cause a recession.  But in a deflation, it is not just the rate which declines but the absolute volume of borrowing.  This, in turn, means business failures – and not just the small local ones but also some of the big corporations.  It signals bank failures on a scale far greater than we have seen so far.  And, of course, it means widespread job losses.  All of which put massive further downward pressure on prices.

Ironically, just as governments and central banks panicked when prices remained high for more than a few months in 2022, they are likely to look favourably on the early stages of a deflation – most likely seeing it as a vindication of the unprecedentedly rapid interest rate rises.  For example, as Lucy Fisher and Valentina Romei at the Financial Times reported last week:

“The UK chancellor signalled his support for Bank of England rate increases after a week when core inflation, which excludes energy and food, hit its highest level since March 1992.  Asked if he would be comfortable even if further interest rate rises precipitate a recession, Hunt said: ‘Yes, because in the end, the inflation is a source of instability.’”

Hunt – one of the least competent politicians ever to hold high office – likely lacks the imagination or even the memory to conceive of anything beyond the “soft landing” that the central bankers claim they are steering us to.  Whereas something akin to the recession of the early 1980s, when Britain lost more than two million manufacturing jobs in just two years is far more likely.  Indeed, given the ongoing collapse in global trade and the growing fragility of a western banking and finance system which is vital to the UK economy, a depression similar to the 1930s may well be unfolding.  But so long as the economists, central bankers and politicians continue to believe that depression is the cure for inflation, they are unlikely to respond until it is far too late.

Not, of course, that an easy response presents itself.  Despite the inflated claims of the central bankers, it was the second oil shock which followed the Iranian revolution which brought inflation down in the early 1980s.  And unlike the 1980s, when we could still develop the oil fields of the North Alaskan Slope, the North Sea and the Gulf of Mexico, there are no alternative sources of cheap(ish) oil left to us today.  Indeed, globally the quantity and the content of the oil remaining to us is in decline.  And this means that even if governments and central bankers were foolish enough to do helicopter money, the result would be another economy-crushing spike in prices – followed by yet another, deeper, deflation – rather than the ushering in of a new round of growth… damned if they do and damned if they don’t.

As you made it to the end…

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