Having in our opinion badly misjudged the strength of inflation over the past year, central bankers are now anxious to convey the message that they are determined not to repeat the mistakes of the 1970s.
So much the better, you might think, because that era told us that the long-term costs of allowing inflation to become entrenched far outweigh the short-term ones of bringing it under control. Yet while the current threat of stagflation – rhymes with the 1970s, the wider economic and financial context when US Federal Reserve chair Paul Volcker started tightening policy in 1979 differed in our opinion notably from today. Inflation was much higher and the advanced economies looked very different. It is important, then, to ponder the likely new mistakes of the 2020s. We at Calvin • Farel believe that the single most important difference, in terms of steering a course back to stable prices, relates to the huge accumulation of debt since that time. Gross public debt as a percentage of GDP rose in the US from 34.3% in 1982 to 127% in 2021. A similar trend was apparent across the developed world. Debt levels in the corporate and household sectors were also on a rising trend during that period.
One fundamental cause in our opinion was the supply-side shock whereby China, India and the eastern Europeans joined the world economy, cheapening labor relative to capital. This resulted in less investment and weaker demand in the advanced economies. Central banks compensated for this with looser monetary policy what distorted asset prices upwards relative to good prices while securing debt dependent growth. Meanwhile, inflation was quiescent, making it easy for central banks to keep within inflation targets started in the post – Volcker era.
Morally hazardous low interest rates encouraged further borrowing – an effect that ratcheted up after the 2008 / 2009 financial crisis on the back of ultra-low and negative interest rates across the world, along with the central banks’ asset purchasing programs. And then fiscal support during the pandemic resulted in the largest one-year debt surge since the second world war. The International Monetary Fund (IMF) estimates that public plus non-financial private debt rose 28 percentage points in 2020 to 256% of global GDP.
Such borrowing was relatively painless with ultra-low rates. It now becomes a debilitating vulnerability as pandemic-induced deficits rise and central banks raise interest rates. The central banks have in our opinion, in effect, replaced long-term debt with debt pegged to the overnight interest rate – the rate on bank reserves that financed their asset buying. The Bank of International Settlements says that, as a result, in the largest advanced economies, as much as 30-50% of marketable government debt is in effect overnight. In the process, losses on the sale of assets as bond yields rise and prices fall could in our opinion raise politically awkward questions around whether central bank balance sheets should be strengthened with taxpayer’s money.
In the private sector, tighter policy brings rising debt servicing costs with falling house and securities prices.
The globalization of capital flows since the 1980s also means that over-indebted emerging markets will be particularly hard hit by rising rates. Changes in financial structure since Volcker’s day point to looming instability. The growth of the opaque derivatives markets, the rise of under-regulated shadow banks and a post-crisis regulatory environment that constrains banks’ ability to take securities on to their balance sheet in times of stress are in our opinion unnerving features of modern markets. It becomes more and more clear that the chief role of the financial system is no longer to take deposits and make loans but to refinance the debt that sustains global growth and consumption. This complex system is in our opinion increasingly dependent on shaky collateral.
The control of inflation therefore calls for pre-emptive action. Yet central banks say that they are data-dependent and focus closely on inflation and job numbers, which are often lagging behind indicators. It seems to us that the Fed chair Jay Powell, like most other central bankers, has minimal interest in money supply numbers, which are forward indicators.
Therefore we at Calvin • Farel strongly believe that we currently have the perfect recipe for monetary overkill and liquidity crisis. We suggest stay calm and do the math.