The great inflation debate that begun in earnest following the current U.S administration’s US$1.9tn coronavirus relief package in early Spring 2021 has morphed into something more serious than the jovial sideshow that is was before. Recent monthly U.S consumer price inflation (the percentage increase in prices across a range of representative goods and services) continues to overstep forecasts. In June in the U.S it came in at a whopping 5.4% – the highest jump since the early 80s. If this persists, at stake is the end of cheap money upon which advanced economies have come to rely so heavily upon – that is, if increases in interest rates are deployed to combat the problem and one that has not reared its ugly head in a generation.
Apart from a few notable exceptions such as Larry Summers, former Director of the National Economic Council during the Obama Administration, economists on the whole remain insouciant.
Wary certainly, but mostly unconcerned.
The core arguments are well-known. The rise has been caused mainly by the re-opening of the U.S economy after prolonged lock down and subdued activity. There has been an almighty build-up of demand for goods at first and currently services, fuelled partly by the US$1400 stimulus cheques sent out to every American that makes up a large chunk of the spring package and that has now bumped up against supply bottlenecks and shortages created by the year-long disruptions in global trade. And it’s not just in the U.S. It has been a similar story throughout most advanced economies.
Most pronounced are shortages in semiconductors, largely produced in Taiwan and needed for a vast range of modern manufacturing products – not least as components in modern cars. It is no surprise then that the second-hand car market has soared in value due to the shortfall in supply. For example, according to the Economist in January this year, a three-year-old mid-range Toyota Camry in the mid-west would have set you back about US$18,000. Today that figure is a full 22% higher.
While all this is worrying, many insist the price increases are transitory and will pass. Many economists still feel that a recession and deflation in the long-run remain more of a worry than inflation.
They may still be right. But long-term disruptions to supply-chains may be soon on the horizon that could ultimately impact inflation far more than most expect and sooner than many think. Growing insecurity and the general havoc that more frequent natural and socio-political unrest brings has severely disrupted supply chains for more than a decade now, way before the onset of the pandemic. Add to that, trade wars instigated by the Trump administration have gone a long way to dent the “just in time” efficiency-seeking supply chain structure, upon which many multinationals have based their business operations. But the regionalisation and nearshoring of supply chains as it is known (re-locating supply chains closer to the centre of operations), for economic and also increasingly for political reasons is no longer just a historic blip of Trumpism. It has taken root, albeit for other more altruistic reasons rather than an out-and-out desire to spark an economic turf war. And the pandemic has super-charged these trends that were already taking hold.
To truly understand what the changing trade patterns might do to inflation, we need to take a step back for a moment and examine why inflation has been so low, especially since the GFC. In 2008, many so-called “inflationistas” were warning of another inflationary armageddon as governments rescued the banking system with what was at the time the largest public to private sector injection of money in history. And central banks began their quantitative easing programmes (or QE – where central banks create money to buy government and corporate debt). These worries turned out to be unfounded.
And with good reason.
Mainstream economic theory on inflation was upended by the GFC – but the writing had been on the wall for a while even by then.
In the early 80s, both Thatcherism in the U.K and Reaganism in the U.S were founded on the ideas of Milton Friedman and the monetarist economic theories he largely devised. It was believed at the time that by increasing the money supply and in a sense devaluing a currency by having more of it in circulation and also by “crowding out” more efficient private investment with public money, that this would lead to inflation. The idea was already on the rocks before 2008 as central banks found that attempts to control the money supply didn’t really impact inflation (even Friedman himself admitted as much before his death in 2006). If there were any lingering doubt, the eye-watering increases in money supply through the central bank QE programmes started in 2008 and were super-charged during the pandemic put them completely to rest. The level of inflation remained at around 2% throughout the 2010-2019 period in the U.S and was historically low throughout advanced economies. Even with the largest-ever injection of money into the system last year – when one-fifth of all dollars in circulation today were issued in 2020 – inflation hardly budged.
In the 90s, theories of inflation shifted to the “New Keynesian” principles that are still our basis of understanding for inflation today. It largely depends on three factors. The effect of supply shocks and the disruption to the supply of a good or service, the extent to which the economy is operating above or below production capacity and people’s expectations of price changes. This last one is the most important but is more an explanation of why inflation keeps going once it has been sparked. If you believe prices are going to go up, you’ll demand higher wages which in turn leads to higher prices (and so on and so forth). The first idea is well-established too as the pandemic has proven and usually leads to short, sharp bouts of inflation that quickly fade after the initial shock (as in fact the supply shocks of the 70s when OPEC dramatically increased oil prices served to prove), but the second idea, that inflation is triggered when demand exceeds what an economy is able to produce at full-capacity is the most important in explaining how inflation is sparked and how it persists. But this has also recently been brought into question.
Before the pandemic and for much of 2019, the U.S was operating at or near full-employment – a great indicator of an economy operating at or near capacity. As employment becomes scarce, wages start to creep up. That then should have a knock-on effect on the whole economy and create bouts of inflation. But as U.S unemployment stood at around 3.5% for much of 2019 – the lowest it had been for half a century – inflation, again hardly budged.
So what gives?
Well, a paper released in August 2020 by the National Bureau of Economic Research (NBER), a non-profit and independent economic think-tank (“The Missing Inflation Puzzle: The Role of the Wage=Price Pass-Through” Heise, Karahan, Sahin), represents the new consensus on the real reasons behind the decades of price stability we have all enjoyed since 1990s. And it can be summed up in two words:
Globalisation and China.
Core goods inflation had remained low throughout the post-GFC period driven by manufacturing goods competition particularly from China. It suppressed not only consumer goods prices in advanced economies like U.S but also labour costs – themselves under relentless pressure from automation and the weakening of unionised labour since the 1970s.
Tellingly, service sector inflation increased in the same period by as much as 10% in U.S, a sector where businesses are far less globalised. This relentless foreign competition also forced consolidations in the U.S, where smaller firms unable to compete with the relentless foreign competition went out of business or were bought up by larger ones, who were more able to absorb any price shocks. Shocks that were rarely passed onto consumers.
But if what ultimately drove inflation down was globalisation (and to an extent market concentration) in the goods sector, then the current trend towards nearshoring and to more regionalised and simplified supply chains that eschew China especially, should be the real worry to those with inflation on the brain.
Supply chains were being battered by natural events, long-before the onset of the pandemic.
A McKinsey Global Institute report from August 2020 (“Risk, resilience, and rebalancing in global value chains”), the research arm of the international management consultants, McKinsey and Company, shows that forty weather disasters in 2019 alone caused damages north of US$1 billion each. Even as far back as 2011 flooding in Thailand swamped factories that produced roughly a quarter of all computer hard drives causing havoc for PC manufacturers, while the Japanese tsunami in that same year knocked out factories producing electronic components for cars and halted assembly lines worldwide.
The attraction of nearshoring production has been building with multinationals for a while now. And it is not just as a result of natural disasters. Socio-political unrest in countries where many supply chains are based has increased exponentially in the past decade and will only increase further in the coming one. As the McKinsey report points out, “The share of global trade conducted with countries ranked in the bottom half of the world for political stability, as assessed by the World Bank, rose from 16 percent in 2000 to 29 percent in 2018. Just as telling, almost 80 percent of trade involves nations with declining political stability.” A recent IMF report (The Macroeconomic Impact of Social Unrest – Hadzi-Vaskov, Pienknagura, Ricci – May 2021) highlighted that the number of riots, general strikes and anti-government demonstrations increased by a jaw-dropping 244 percent in the last decade. And while lockdowns and fear of the virus might have seen a lull at present, they are bound to resume. And with the economic instability the pandemic has wrought, they might even get worse. That won’t exactly instill any confidence in multinationals, many with production centres in countries bound to be at the forefront of forthcoming trouble.
But while natural disasters and unrest are increasingly on the minds of those managing supply chains, the main thrust for the recent push to repatriate production lines has been the political interference in advanced economies. It is a misnomer that the tariff and trade wars started by the Trump administration simply went away. While less urgent and more pragmatic in scope and driven by well-intentioned mandates that are more humanitarian and environmentally-conscious in nature, they will still have a similar impact on global trade. And at its heart, is the drive to reduce carbon emissions and protect the environment more generally along with the urgent political drive – on both right and left – to protect jobs.
For example, the U.S is pursuing a case against Vietnam right now for its exports of furniture and other wood products that have been made with timber that has been illegally harvested, and of course there are the much-publicised trade sanctions imposed on exports from the Xinjiang province of China over their treatment of the Uighur minority. But the biggest impact on supply chains will come in the form of carbon regulations. The E.U’s “Fit for 55” plan to reduce carbon emissions by 55% back to 1990 levels by the end of the decade includes a carbon border tax. This in effect is aimed at protecting E.U companies from unfair competition from carbon-intensive imports, where those companies are not as regulated as they will be in the E.U. The U.S is planning something similar in its forthcoming budget reconciliation package, but the exact nature of it is unclear at this stage.
Such taxes – that are in effect border tariffs – are admirable. But they are easily misinterpreted by those having to pay and could be open to abuse by those levying them. The level of tax for example that is set will depend on hard-to-define rules on how much carbon has gone into producing a certain imported product and how much it will cost the E.U manufacturer to substitute the process to make it. It could easily lead to tit-for-tat tariffs imposed by producing countries, continuing the cycle that began in earnest under the Trump administration.
The pandemic has also expedited trends towards repatriating supply chains considered vital to the security of a country. What started with 5G before the pandemic under Trump has been extended to semiconductors, advanced electrical batteries, critical minerals and of course pharmaceuticals under the Biden administration. There has been a similar focus on labour rights in an attempt to call out specific companies in importer countries where there are labour abuses and where unions are unfairly legislated or targeted by more nefarious means.
All this is commendable but again the ultimate effect will be to stymie global trade or at least make it more inefficient and certainly less cost-effective, the main factor that has been keeping inflation low since 1990s. It is a trade-off that many are prepared to pay in the current climate but it will ultimately lead to price rises as supply chains are repatriated in many cases back to advanced ecomomies with higher labour and production costs and may signal the end of the low-inflation era we have lived in and all the consequences that go with that.
And make no mistake. It is happening already.
The McKinsey Report underlines the impact that all this will have on supply chains and the moves already underway to restructure them. In its survey it found that 93 percent reported they plan to make their supply chains more resilient, of which nearshoring and regionalising suppliers will make a substantial part. And the full impact on global trade is laid bare: “We estimate that 16 to 26 percent of exports, worth US$2.9 trillion to US$4.6 trillion in 2018, could be in play – whether that involves reverting to domestic production, nearshoring, or new rounds of offshoring to new locations.”
The non-discriminatory principle upon which world trade was based in the post-second world war era is coming to an end. And with it, possibly the era of low prices. While most economists are focused on the extent to which excess demand fuelled by government subsidies will be transitory or not, it is the fundamental long-term changes to supply-side production and ultimately the end to true globalisation that might bring back the very 70s disease that could upend the entire post-GFC economic system of cheap money, high debt and the asset bubble it created.