Inflation has not been around in western countries for some decades but now there is concern that inflation could return. Governments are printing unprecedented sums of money to pay for COVID recovery plans. 

Meanwhile there have been disruptions caused by supply chains being damaged, and so there are global shortages of food, electrical components, resources and fuel. Some staff have resigned and so employers will need to pay more wages to attract new workers (in the US this is being called “The Great Resignation”).

But the bottom line is that there is nothing new in this debate. Those of us who have been around for a few decades will remember previous concerns about inflation.

“Inflation” means that too much money is chasing too few goods and services. One of the most well known examples come from the early 16th century, with the influx of gold from the Spanish Latin American colonies. The gold poured in but there was not a corresponding increase in food and other items to soak up all the extra purchasing power and so, ironically, despite its new wealth Spain was actually damaged by stealing the Latin American wealth.

The opposite term is “deflation”. This is where the prices of goods and services fall. Customers defer expenditure expecting prices to fall even lower and so a recession is thereby triggered.

The current system of coping with COVID in western countries has been influenced by the 2008 Global Financial Crisis (GFC). The US was the source of that crisis, rather than the backstop to solve it, and the US banking system’s contagion spread to other countries.

The US Federal Reserve’s eventual response was “whatever it takes”. This was different from the “hands off” approach that characterised the Great Depression of the 1930s (which meant letting the market sort itself out because recessions were then seen a natural part of life, like floods and droughts, in which government had only a limited role).

Luckily Australia was already on that path in 2008 with “go early, go hard, go household”. Therefore, Australia avoided the early austerity policies in UK, Europe and US, and so escaped largely unscathed that crisis (the UK magazine The Economist called Australia the “wonder downunder” because of its having the longest continuous economic boom in western history).

But can governments be trusted with money? 

There has been a change in mindset with the rise of “Keynesian economics” (named after British economist John Maynard Keynes, 1883-1946). He argued (i) government does have a responsibility in the economy and (ii) individuals should shrug off Victorian notions of thrift, and instead go out and spend.

His critics warned that government would debase the currency and that the British Empire would go the way of the Roman Empire: debt destroys empires.

Ironically, the 2008 GFC showed that the financial regulatory system had been overwhelmed by the markets it was supposed to supervise. Therefore, can we trust politicians (and bureaucrats) with money? Should the market be left to work its magic? This may mean short-term pain but it will be better in the long-term.

Keynes called gold a “barbarous relic”. He wanted a currency that avoided being based on gold.

The gold standard was in effect invented by Sir Isaac Newton (1642-1727) who was Master of the Royal Mint in London. He said in 1717 that gold standard was “financial gravity” (he had earlier sorted out some of the problems of gravity in physics).

After all, the Wise Men who brought Jesus gifts 2,000 years ago included gold. That gold could in theory buy the same amount today as then: it has kept its value: financial gravity.

The UK set an example for the rest of the world. But it came off the gold standard in the early 20th century because of World War I and the financial problems the UK encountered.

There was a return of sorts to the gold standard in 1944. The Bretton Woods Conference worked out the post-World War II international financial structure. There was agreement (opposed by Keynes, who was shortly to die) that US$35 would buy a reserve bank one ounce of gold.

The Bretton Woods System gave us an economic miracle. Boomer Australians (born between 1946 and 1966) won the lottery of life. This includes purchasing homes cheaply – and which now makes many older Australians “millionaires” (at least on paper).

But success breeds a disregard for the possibility of failure. The US debased the US$ with the war in Vietnam and other high government expenditures in the 1960s. The US came off the standard in July 1971. Gold is now just another tradeable commodity.

Currencies are now not backed by precious metals: they are “fiat” currency (“I command you to treat this sheet of paper as currency”). Governments can print extra money because the money is not based on any reserve or other benchmark.

Inflation returned. There was far more lending. In 1973 OPEC (Organization of Petroleum Exporting Countries) increased oil prices.

The western world was hit by “stagflation”: mixture of stagnation and inflation. There was even speculation that “capitalism is dead” (the Soviet economy was not too healthy either but that was not so obvious at the time). In Australia, the Whitlam Government was besieged with economic turmoil.

And then the inflation was tamed. US Federal Reserve chair Paul Volcker (1927-2019) pushed up interest rates. They reached 20 per cent in June 1981. There was widespread economic dislocation and a dramatic increase in unemployment (all of which helped cost Jimmy Carter his 1980 re-election and put Ronald Reagan in the White House). The new president did not reappoint Volcker given his reputation for toughness!

Additionally, there was China’s greatest gift to the world. Post-1979 China was the “factory of the world”. It made many very cheap goods to soak up all the credit sloshing around in the global financial system. This too helped keep inflation low. 

The world entered the “Great Moderation”. The Bank of England said we were living in a unique time: “NICE”: Non-inflationary Continuous Expansion.

Inflation is now largely forgotten (except among elderly economists). But with the onset of COVID expenditure programmes a new economic crisis could be emerging. 

The US and other governments are back to Keynesian thinking and they have learned from the 2008 GFC. Huge government expenditure is underway.

Australia has very low interest rates to protect economic growth but this has led to a housing bubble. In economic life, one problem is “solved” at the cost of creating another one.

At some point, the Australian Reserve Bank may start to fear the onset of inflation above the target (of around 2%) and increase the interest rate, thereby adding to “mortgage stress”. The Bank’s Dr Lowe still reckons that won’t be before 2024.

Managing debt and paying for all the COVID programmes will be a chief worry for Australian governments for many years to come (and there will probably have to be expenditure cutbacks and so more social dislocation).

Keith Suter

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