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Why inflation could be on the way back

Are we about to enter a new era of surprisingly high inflation, rather than below target inflation to which we are accustomed? Many reject this point of view. But the boy who cried wolf was right last time. A book which has just come out cries wolf with insistence. He indicates in particular that, because of the fiscal and monetary largesse of today, “as in the aftermath of many wars, there will be a surge in inflation, probably above 5%, or even of the order of 10%. in 2021 ”. It would change everything.

The prediction comes from The great demographic shift by Charles Goodhart, a respected scholar, and Manoj Pradhan, formerly at Morgan Stanley. Its prophecy of impending inflationary catastrophe is, in fact, less significant than its analytical framework. These authors argue that the global economy is on the verge of regime change. The last time this happened was in the 1980s. The big changes of four decades ago were not so much the desire to control inflation, but globalization and the entry of China in the world economy. This era, they argue, which was marked by low inflation and high and growing debt, is coming to an end. Its reverse will follow soon.

In the 1980s and 1990s, the economies of China, the former Soviet empire, and other developing countries opened up. the The Uruguay Round has been approved, which led to the birth of the World Trade Organization, which China joined in 2001. International economic integration has progressed rapidly, notably through trade, but also through direct investment from high-income countries. The global supply of labor for the production of tradable goods has increased dramatically. Large market economies had declining birth rates and still young populations, bolstered by the entry of women into their workforce. Thus, the labor force has grown faster than the population and output per capita has exceeded that per worker.

Line graph of the working-age population (aged 15-64, in millions) showing that the growth of the working-age population is slowing in the heart of the global economy

All of this together, say MM. Goodhart and Pradhan, caused a decline in labor market power in high-income countries, an increase in profit shares in gross domestic product, an increase in national inequalities, a decrease in global inequalities, a “glut of savings ”, low inflationary pressures and falling real interest rates. There has been an increase in debt.

Now, they say, this is all in reverse. Globalization is under attack and no other economy can replicate what China has done. Aging hinders the growth of the labor force and exacerbates budgetary pressures. Most importantly, they argue, as the number of consumers increases relative to that of producers, inflationary pressure will increase. Moreover, as the labor force shrinks and globalization weakens, labor market power will reappear, exacerbating these inflationary pressures.

Line graph of Chinese working age population (15-64 years as% of total population) showing The demographic shift to aging is underway in China

These changes will, they add, create huge political dilemmas, especially given the extensive balance sheets of governments and non-financial corporations. If the relationship between unemployment and inflation were to evolve as negatively as the authors suggest, would central banks tighten as much as they should in order to contain inflation? How would the authorities deal with the waves of defaults? How could governments bring their deficits under control in a world of structurally low growth (in part due to aging), higher interest rates and pressures to increase spending? If they didn’t, would central banks continue to print money or would they allow domestic insolvency? In short, are we facing a 1970s revival, under worse circumstances?

Line graph of American wages as a multiple of Chinese wages showing the increase in wages in China relative to the United States in the era of globalization

The authors are correct that the global economy is undergoing major structural changes. Aging and a weakening of the globalization of goods production are well advanced. In addition, this process includes China. This combination will transform our economies.

Yet it is also essential to remember how little we know about how such changes might happen in the real world. What if we had known in 1980 that China was going to open its economy to the world and launch the biggest investment boom in world history, resulting in an investment rate of 50% of GDP? How many would have predicted that the macroeconomic situation a few decades later would be one of excess savings, low real interest rates, ultra-flexible monetary policies and over-indebtedness? Most surely would have assumed that booming China was on the verge of import massive savings and so raise real interest rates and export net demand, instead.

Line graph of UK gilt real yield and implied inflation expectations (10 year maturity,%) showing the UK shows how real interest rates have been declining generically, while inflation expectations are falling. are stabilized

Likewise, MM. Goodhart and Pradhan may be right that in their brave new world the desire to save will tend to decline faster than the desire to invest, the glut of savings will turn into a shortage, and interest rates real ones will fly away. But the difference between desired savings and investment is narrow. It is quite possible, on the contrary, that with slow economic growth and a continuing decline in the relative price of capital goods, retained earnings of firms will continue to exceed investments in high-income economies. The Chinese business sector could also follow suit. If this is the case, demand could remain weak and real interest rates low for a long time, reinforced by the enormous private sector debt distress in all of these economies.

Column chart of developed economies, debt as% of GDP showing the debt burden of developed countries has stabilized at a high level

It is not even clear that globalization has been the main historical driver of changes in labor markets. It was only one part of a set of transformations – new technologies, the corporate governance model maximizing shareholder value, the growing role of finance, and growing monopoly power.

Doubts about these theses are justified. But it is also dangerous to extrapolate the present into the future. In 1965, few imagined that postwar Keynesianism would soon die. The world of “lower longer” can also disappear. Big changes are underway. We need to think hard about how our future may differ from our past.

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