Why Inflation Could Become Our Worst Nightmare
In the post-Covid, we may experience a long period of cost-push inflation if institutions do not intervene with innovative and hard measures
Inflation does to the economy, or better, to money what age does to the body. We may or may not perceive its effects in the short term, but it affects our life in the long term. However, in this period of economic instability we may see inflation rising suddenly to unexpected levels. Since the topic of inflation is wide and complex, I will use the Italian economy to contextualize the phenomenon and describe my hypothesis. In addition, I will tackle a few arguments that go against mainstream economics with real life examples.
A brief introduction to inflation
The concept of inflation may be summarized in a general and long-lasting raise in prices which should not be confused with a short term change in prices. For example, if a rainy season comes and half of the harvest goes to waste, it’s normal to see a general raise in fruit and vegetable prices since sales volumes are decreased. However, this doesn’t properly mean that the fruit and vegetable market is experiencing permanent inflation since, in the following season, prices will most certainly decrease and adjust to normal sales volumes. The “real” inflation we need to consider is the permanent raise in prices which affects our purchasing power in the long term. Hence, inflation always comes to stay, while sudden raises usually go away.
If you are not familiar with inflation you are now probably asking yourself “Why do we need inflation?”. This is a good question and some economists would probably tell you that we don’t need it and it’s actually bad for the economy. However, mainstream economic theories state that inflation is needed in the economy in order to drive up consumption. The concept behind this assumption is that money should always lose its value otherwise we would keep it forever, waiting for higher purchasing power in the future. Instead, almost everybody knows that a dollar tomorrow does not buy a dollar today.
When we read, watch or hear discussions about inflation, these generally refer to the so-called demand-pull inflation theory, which asserts that a raise in prices is inevitable when the money supply exceeds the real supply of goods and services. In a few words, when money is excessively available and supply cannot keep up with demand, prices rise because consumers are willing to spend more money to purchase a product or service. You may have heard statements such as “there are too many dollars for too few goods” or “we are printing too much money”, which both refer to demand-pull inflation.
On the opposite side of demand-pull inflation, we find cost-push inflation which is a raise in prices caused by an increase in production costs that diminishes the available supply in the market. While demand-pull inflation is caused by an excess of money supply, cost-push inflation is caused by higher production costs which may be due to higher costs of raw materials, higher wages, etc.
Concluding this very brief introduction on inflation, I want to emphasize the fact that in this period of economic instability we should take a careful look at cost-push inflation and leave aside demand-pull inflation. In a few paragraphs you will understand why.
The control of inflation
There is a specific reason why institutions control and constantly analyze inflation: by monitoring inflation, institutions can intervene and regulate inflation rates with specific tools like quantitative easing (QE) or interest rates. With an injection of money supply in the market thanks to quantitative easing or reduced interest rates, institutions may boost economies, but they need to be careful with inflation spikes. The opposite holds true. In times of inflation peaks, interest rates are increased and QE is stopped.
I think this is a very interesting topic, but it’s very complex and the main takeaway that should get your attention is that inflation can be controlled by institutions. For now, we have the necessary tools to understand the context and the discussion below.
The context for our discussion
As I mentioned before, I will use the Italian economy as an example to demonstrate why inflation may become our worst nightmare and why institutions need to be prepared to fight it with the right tools.
First of all, the Italian economy has been stagnant for many years with a Gross Domestic Product (GDP) growth of 0.2 to 0.4 percent (check data here). Before Covid-19 had impacted the whole country, GDP growth reached -0.2 percent (negative), which signifies a very important economic stagnation. Hence, inflation levels remained very stable below 1% (check data here). Italy is a country with very high taxation levels and its monetary policy is controlled by the European Central Bank (ECB), which, in the last years, kept interest rates low and strengthened its QE program to fight the economic crisis of 2008/2009. Hence, we could say that Italians have a lot of money and purchasing power, but in reality the average net wage in Italy is approximately 16.500€, which, trust me, it’s not a big salary if compared to the cost of living. It’s true that Italy has one of the highest levels of private wealth, but this is very concentrated and mostly spent outside of the country.
What is happening now in Italy
As you may know, Italy has been one of the most affected countries by Covid-19 and the government imposed a lockdown for almost 3 months. Exact data are not yet available, but it is supposed that 80–90% of businesses stopped operations and relied on government support in order to pay employees. However, government support has been very limited and many workers did not receive a salary for more than 3 months. You may imagine that this economic crisis has significantly shortened the money supply, leaving people and businesses with uncertainty and cash flow issues.
Despite the Italian government offered support to businesses by guaranteeing bank loans up to 90% of the full amount, banks are not lending money because they do not trust the government guarantee. You may think that this is a joke, but other countries (check for example India) are affected by the same issues and many, many businesses are closing for good, forever.
The effects of the economic crisis on inflation
The worst nightmare of economists is deflation, which is the opposite of inflation. During a deflation period, prices decrease and the main fear is that consumers will not buy goods or services because it is more convenient to keep cash in their pockets with the expectation that prices will continue to fall. In fact, why should we buy a car today when it will be less expensive tomorrow?
Deflation usually happens during economic recessions when supply is greater than demand and businesses are forced to lower prices in order to increase sales. This is what happened to oil prices during Covid-19. The supply level was much higher than demand that barrel prices went below zero.
By following economic thinking we would expect a big deflation period in Italy. If people don’t have money to buy goods or services, businesses will be forced to lower their prices in order to meet the purchasing power of consumers. However, even though it is too soon to tell, consumers have been noticing price increases on many goods, even on the necessary ones like food. For example, a small cup of coffee used to cost 1.00€ pre-Covid, while now many bars price it at 1.30€ (23% increase). May’s Consumer Price Index reports inflation (in this case deflation) at -0.1%, but I believe we need to wait two or three months to see inflation kicking in since many businesses have just reopened and they may have kept pre-Covid prices to avoid disappointing customers. Moreover, as many businesses will fail and many others will be acquired by big players, many industries may become more concentrated with a concrete increase in prices due to a potential oligopoly (a market dominated by a small group of large firms).
I think there are two main reasons why inflation, and not deflation, will be our worst enemy in the near future. First, cost-push inflation is inevitable. Businesses have been facing huge losses and are forced to operate with more production costs (think about social distancing, purchase of new equipment like masks, etc.), but mostly they are selling (and producing) at lower volumes. For example, if a bar used to sell 100 coffees a day at 1.00€, now it will probably sell only 60–70% of those 100 coffees with higher production costs (if you understand Italian I suggest you read this article which shows how consumption has fallen by 30% in May 2020). Therefore, the price of a coffee may remain 1.00€ for a few weeks or months until the owner will notice that prices need to be increased in order to cover for higher production costs and lower sales volumes. Second, the money supply is inarguably lower than 4 months ago and consumers will buy less goods and services, concentrating their expenses on necessary items. This means that on a wide range of products demand will be much lower than it was pre-Covid.
It is inevitable that both these issues need to be addressed quickly by institutions in order to prevent a social disaster.
A possible solution
Despite it is very clear that the money supply must be increased and that the European Central Bank should print and distribute money like never before, the European Parliament’s discussions are centered about avoiding debt and a potential demand-pull inflation with a financial plan that reminds of austerity. Financial packages that have been announced by the ECB to help European countries are nowhere near the optimum amount of money that is needed to boost such big economies. We are not in the middle of a typical economic crisis and it is clear that protests around Italy (and the world) show that many people and businesses are close to a financial meltdown. Millions of workers may be left without a job and it has been estimated that Italy’s GDP will fall by 15 to 20 points this year (around 315 billion Euros).
I believe that in hard times there must be hard measures and one of them is Milton Friedman’s theory of Helicopter Money. Friedman theorized to distribute free money through an helicopter (yes that’s what he wrote on “The Optimum Quantity of Money” in 1969) in order to increase inflation and boost a devastated economy. Of course, the helicopter is just a metaphor to emphasize the need to distribute free money to everybody.
This theory has never been used in the real world, but, against Friedman’s beliefs, I believe that in this economic scenario it would be a great tool to reduce, not increase, inflation. In fact, by distributing free money to businesses, these will be able to keep prices to a decent level despite a decrease in sales, while, by distributing money to consumers, institutions may prevent a social meltdown and revitalize the economy. In addition, a potential demand-pull inflation is out of context if free currency is distributed with measure.
Distributing free money may not be the best solution, but it could be the only way to save countries like Italy from a meltdown, which could later impact the biggest economies of the world. There is just a major issue, many European countries do not want to create public debt. However, I must recall that fiat money (money issued by a government) is no longer backed by a gold standard. In fact, money may just be printed and debts erased. It wouldn’t be the first time in history that a debt gets erased. In 1953 Germany’s debt was erased by half in order to help the country revive its economy after the loss in World War II.
Mario Draghi, the former president of the European Central Bank, released in March a very interesting interview to the Financial Times. Mr. Draghi argues that during this present economic crisis “much higher public debt levels will become a permanent feature of our economies and will be accompanied by private debt cancellation”. His formula to save the economy is quite simple: we need to give free money to businesses by cancelling debts that they are not able to repay, while countries should not worry about increasing public debts. As he previously stated during the 2008/2009 crisis: “We must do whatever it takes”.
Conclusion
During difficult times we usually see great innovations. Institutions need to innovate as well in order to keep up with the economic environment. The economic crisis caused by Covid-19 is probably the most dangerous crisis our world has ever faced and institutions are the only actors that can change the course of this tragedy.
My hypothesis is that countries that will not adopt an abundant money supply injection, mostly in the form of free money, will experience a brief deflation period followed by high inflation period caused by a lack of demand and a shortage of supply. Businesses will be forced to increase prices due to higher production costs and many will fail doing so, while consumers will face hard financial times and will only buy necessary goods, causing an economic shrinkage that may lead to the worst recession in history. Moreover, I hypothesize that the increase in prices will not be a temporary inflation, but it will be a long term adjustment to a suffering economic outlook.
Will this hypothesis hold true? Only time and data will tell.
