Beware of central bankers on the way to monetarist war

The state of the world economy is reminiscent of the period following the First World War in Europe. The three episodes of high inflation in people’s minds – the early 1920s, 1970s and 2020s – are all 50 years apart. Back when I was a student, we called this (after the eponymous Russian economist) a long Kondratieff cycle. If the world is in one of these cases, short-term policy changes aggravate the crisis. So don’t be surprised if central banks trigger a recession by adopting a macho attitude of raising interest rates.

In 1919-23, Europe suffered from shortages and runaway inflation, with the worst example in Germany (caused above all by the fledgling Weimar Republic which resisted payment of reparations). The European economy took a long time to return to pre-1914 prosperity. In many cases, it never was. The Great Depression was one of the signs of no return to normality. In the meantime, the pursuit of technological innovation has worsened unemployment. It took another war and the Keynesian revolution to bring Europe’s economies back to ‘normality’

There are parallels with today’s global economy. For two pandemic years, economies suffered an unforeseen and totally exogenous shock with a collapse in supply. There was no comparable prior economic framework. Governments have therefore turned to the simple principle of preserving lives and livelihoods. They improvised. They spent money. They violated the normal canons of sound finance, hoping that everything would be corrected when times improved.

This was comparable to government behavior in 1914-18 and 1939-45. Production was oriented towards war material that had to be spent in battle. The demand was large but financed by printing money. Labor supply has changed structurally with the entry of women into the labor market.

Somehow the world has now gotten through Covid-19. We are more or less back to pre-pandemic normalcy as measured by gross domestic product. We hope that no new virulent variant will follow omicron. But no one knows how to approach the next double crisis. Given this uncertainty, it is surprising that over the past three or four months developed countries have shown signs of a hasty return to the “old normal”.

Central banks are bracing for a tightening, pushed by diehard monetarists blaming the pandemic measures for excessive money creation. The debate is sharpening between the opposing camps who believe that inflation is either transitory or permanent. Central banks seem ready to embark on the path of monetarist war. Yet if they do, they may face significant problems.

Current energy price-induced inflation reflects the oil shock of 1973. This followed the end of the gold-dollar link on August 15, 1971 when President Richard Nixon reneged on a US promise to convert surplus dollars from golden country.

This sequence shows that the inflation of the early 1970s was not a purely monetary phenomenon, whatever Milton Friedman may say. The sharp rise in prices reflected the end of the dollar’s role as a global anchor and its massive devaluation against gold. The rise in oil prices was just a simple “indexation” of Brent to reflect the new world.

Yet the monetarists have won the argument. Economies were squeezed causing high unemployment with high inflation. Stagflation has become the buzzword. Eventually, inflation was cured – not by a smart central bank but by Western capital migrating to Asia in search of cheap labour. As the West deindustrialized, in some cases scaling up high tech and services, cheap Asian production drove down manufacturing prices and with it drove inflation away. The instigators were not “rational expectations” or monetary targeting, but the economies of South Korea, Singapore, Taiwan and China.

What does this tell us, 50 years later? We are facing a new spike in energy prices. Yet the root cause cannot be excess demand. After all, overall economic activity has been below normal in 2020 and 2021. The cause must be a supply shock, with three main components. People (young and old) are refusing to re-enter the post-pandemic labor market, for life cycle reasons. There are difficulties in global supply chains, especially for container ships. And parts shortages in many high-tech fields are fueling a wide range of industries.

All of this clearly shows that the global economy has not yet returned to the “old normal”. Indeed, it may never happen. We could be in a transition to a different economy. GDP figures are misleading even though they signal a V-shaped recovery. Full recovery is still a long way off as changes in supply chains are felt through the system. This carries important messages for central banks. Consider Kondratieff. Be careful before you reach for monetarist war paint. You may be making a historic mistake.

Meghnad Desai is Emeritus Professor of Economics at the London School of Economics and Political Science and Chair of the OMFIF Advisory Board.