Inflation is a very hot topic at the moment, and everyone is wondering if it will reach levels comparable to 1970's. This is the first in a long time when well developed countries experience inflation, as they've rather been used to fight deflation in their economies.
Last year, many economists argued that inflation is transitory, and it won't run hot. And yet it happened, and inflation exceeded expectations in many countries. It looks like it might not be transitory after all, and economics historian Niall Ferguson believes high inflation will persist for the next 5 years.
As Harvard professor Jason Furman explained in one of his recent articles, macroeconomic modelling is needed to forecast inflation and many US economists failed to predict it because they "didn't take economic models seriously enough."
Furman believes the error was forecasting using extrapolation from the recent past based on the thinking that this is almost as good as, or even better than using more sophisticated modelling. However, there were significant economic inputs that were outside the realm of recent experience, for example the $2.5 trillion fiscal support for the US economy in 2021 - around 11% of GDP - which was the largest fiscal package since WWII.
"A simple fiscal multiplier model would have predicted that average output in the last three quarters of 2021 would be 2-5% above pre pandemic estimates of potential," he said. "To think that a stimulus of this magnitude would not cause inflation required believing either that such a huge adjustment was possible within a matter of months, or that fiscal policy is ineffective and does not increase aggregate demand. Both views are implausible.”
Economics is not a science. That’s why it's important for both economists and policymakers to dive back into financial history. Economic models may work in 90% of cases, but in 10% they will fail, Ferguson said.
The influential historian has always argued that making good comparisons with similar events from the past can lead to good decision making and dealing with crises in a better way. Even if it's almost impossible to know exactly what the future holds, having good knowledge of financial history in their arsenal can help investors and economists alike.
As far as inflation is concerned, Ferguson thinks the US won't experience the runaway inflation of the 70s, but there is a chance we could be rerunning the late 60s when the Fed lost control of inflation expectations. Big inflations are usually triggered by a geopolitical crisis, usually a war, which is why watching the cold war between the US and China, as he described it, is concerning. If this escalates into a hot war over Taiwan, we can have serious problems.
An oversight of policymakers has also been that they treated the current pandemic as an economic crisis and acted like it was one.
"It's been hard to explain to people that a pandemic has a completely different dynamic from a financial crisis and that the recovery from it is different and more rapid because, unlike the last financial crisis, when households and banks' balance sheets were terribly impaired, coming out from the pandemic, particularly in the US, balance sheets were extraordinarily strong," Ferguson told CNBC in an interview in September. "And so you have the phenomenon of this very rapid V-shaped recovery, which has only slightly been dampened by the Delta variant and we are now into a new set of problems which economists have been talking about since February [...]" - the danger of overheating.
But while at this point things are not very concerning and it's too early to say if we'll see a repeat of the '70s, economist Nouriel Roubini has a more pessimistic and grimmer look about the future. He believes we will enter a period of stagflation - a period of economic stagnation with persistent high inflation and high unemployment.
Roubini, who predicted the great financial crisis of 2008, is known for his doom opinions, but many of them turned out to be true in the past. He believes that rising inflation will be more persistent, and that growth will slow down for two reasons:
"On the demand side we have very loose monetary policy and very loose fiscal policies that are also unconventional," he said last year at the 47th edition of the Cernobbio Forum “Intelligence on the World, Europe and Italy”. "We are moving to a world of debt monetisation on a permanent basis as we have large stocks of private and public debt and central banks are in a debt trap and they cannot exit [the] unconventional policies so easily."
"On the supply side the bottlenecks to supply on the goods market and labour market are not just transitory, but more persistent," Roubini said. "I fear that like in the ‘70s we could have permanent negative supply shocks. I identified several of them: Globalization and protectionism; the balkanization of global supply chains; the aging of the population in advanced economies and emerging markets; restrictions to migration from poor to rich counties; decoupling between the US and China on technology, trade data information and investments. We also have global climate change damaging production, agriculture and increasing both energy prices and food prices."
Roubini also thinks that pandemics will be permanent which will lead to self-reliance and export controls and that cyberwars could damage production in the future, being expensive to protect against. Finally, the backlash against income and wealth inequality and the fiscal policies that will result from that can raise the labour share in the GDP and lead to a wage price spiral. If monetary and fiscal policies remain loose that can lead to de-anchoring of inflation expectations and high inflation.
In the '70s we had the stagflation problem, but the debt ratio was low, but after the global financial crises we had the debt problem with too much private debt. The worst in the future is that we could have the worst of the '70s with stagflation combined with the post-great financial crisis situation with high debt ratio. "I worry about the stagflationary debt crisis," Roubini said.
This article was written by Gina Constantin.
