On Tuesday 21st December, Chancellor Rishi Sunak announced a £1 billion package of support for firms in the leisure and hospitality sectors. Since the pandemic’s inception, the government has played midwife to the sickly UK economy, lathering it with some £410 billion (figures only current up until the 8th of December, and so excluding the Chancellor’s most recent announcement). In total, since the start of the pandemic, the money supply has increased by nearly 20%. Should we be worried?
In the late seventies, neoliberals accused policymakers of “government oversupply” - pushing the state into more and more areas of civil society and relying on central banks to print their deficits away, causing inflation to rocket in the process. This same accusation could be levelled now. In April and May 2020, policymakers established the precedent that central banks and treasuries would do “whatever it takes” to protect the economy from coronavirus - including business bailouts and wage supplements via furlough schemes. Far from midwives, they now find themselves playing the roles of hassled mothers, doling out cash on demand to angsty, impecunious teens. Since the pandemic’s start, thirteen separate economic support programs have been set up in the UK.
More broadly, the rapid spread of Omicron may suggest that we have reached a new, unstable equilibrium. Coronavirus will not disappear; for the next decade, governments will be locked in a vaccine arms race with successive waves of the latest variant. This has economic implications. As of January 6th 2022, there are no social restrictions in England, and yet it was still a given that the Chancellor could be counted on to throw businesses a lifeline on Tuesday. Now, the pandemic is endemic, and so is the economic support.
Is this a bad thing? Conventional macroeconomic theory holds, simplistically, that ceteris paribus, inflation is a function of money supply. As the Bank of England prints money and buys up government bonds to support Rishi’s latest scheme, and as this extra government support money trickles through the economy, more cash will be chasing the same amount of goods. Demand effectively increases, meaning that prices, in the long run, will go up. Jeremy Siegel, professor of finance at the University of Pennsylvania’s Wharton Business School, argues that the current “jump in money supply” will “inevitably cause higher inflation” around the world.
But the economy and policymakers have failed to play by this convention, through which increased money supply reliably triggers inflation, for over a decade now. In response to the financial crisis in 2008, the Bank of England increased the money supply by over 20%, inaugurating a decade of inflation that rarely rose above their target of 2%. After central banks around the world did the same in early 2020, on the other hand, inflation rose. It currently sits at around 5% in the UK. However, when inflation is broken down into PPI (the inflation in prices that producers face for inputs) and CPI (the inflation in prices of consumer goods) PPI accounts for something like three-quarters of the increase. Higher input costs, not soaring demand (from increased money supply), are to blame for our current inflation.
So why isn’t higher money supply impacting inflation? It now seems that there are secular, global macroeconomic forces that are cutting the link between the two. Krugman blames a self-reinforcing cycle of declining expectations of inflation and low consumer confidence, which encourage people to save any extra cash they get hold of, rather than spend it and prop prices up. This means that, regardless of how loose money supply is, we will often face “persistent shortfalls of demand.”
There’s some evidence to support this. The UK savings rate (how much of every paycheck the average UK household saves, rather than spends) peaked at 22.5% during the pandemic, far above the historical average of 8.4%. If consumers are saving rather than spending, money is effectively being removed from the economy rather than being spent, meaning much lower resulting inflation. However, in the low-growth, low-inflation decade between the financial crisis and the pandemic, the savings rate remained comparatively low at 8%.
A more convincing explanation, as a paper by CEPR argues, might be the secular decline in commodity prices, perhaps boosted by the entrance of China into global markets and resultant better access to commodities.
Since 2000, UK CPI inflation has tracked commodity prices, denoted by PPI, 6.5 times more closely than the money supply (M4). This is illustrated in these graphs.
Whichever way it cuts, monetary policy influences aggregate demand much less than before. It seems as though, for now, Andrew Bailey can keep printing.
What does this mean for policymakers? The implication is profound; that as long as the economy remains structurally incapable of producing demand-pull inflation, governments can print as much money as they want. This opens the door to interesting possibilities. The Treasury could try to boost aggregate demand with unconventional policy tools such as a universal basic income. More immediately, a permanent business bailout facility could be established, consolidating many of the thirteen programs and giving companies certainty to plan for the next wave of Covid-19.
This new spending ability could even be co-opted into fighting the causes of soaring inflation in the first place. Energy is an integral part of many economic processes. This means that its influence over inflation is substantial. If OPEC sets higher oil prices, for example, it becomes more expensive to ship goods, but also to power mining and agricultural machinery. This inflates costs for a range of suppliers, which ultimately inflates prices for a range of products. This new ability could be deployed to avoid dilemmas like the one we face today, by moving the UK in the direction of energy independence. Government investment in wind farms and tidal plants in the north sea, for example, would cut emissions and render British inflation less of a slave to global energy price fluctuations. More directly, they would increase the supply of energy that the UK has access to, lowering the energy costs faced by UK producers (though admittedly, this effect would not be felt for decades).
However, we should still be careful with abandoning the tried and tested economic models of the past. It is too soon to say what persistent effect the pandemic has had on spending habits. But these economic models have lost their ability to predict what is happening on the ground. Faced with evidence that they don’t work, and at a time when we need our nanny states more than ever, policymakers shouldn’t be afraid of spending and experimenting a little more.