Will the Next Decade See the Return of Inflation?

Charles Goodhart and Manoj Pradhan make the case in their new book «The Great Demographic Reversal: Aging Societies, Waning Inequality and an Inflation Revival». A review.

William White

Deutsche Version

Like mountains thrown up by colliding tectonic plates, some truths are hidden in plain sight. Modern macroeconomics, as practised in central banks and Ministries of Finance in most advanced countries, has either ignored or misinterpreted the implications of massive global demographic change in recent decades.

These changes are now going into reverse. What once might have been seized upon as an opportunity now presents a formidable challenge to our future well being. This will come as a great shock to both governments and financial markets alike, given a mindset that basically assumes the future will be like the past.

The Great Demographic Reversal, Springer, 2020.

The Great Demographic Reversal, Springer, 2020.

Charles Goodhart and Manoj Pradhan convincingly document what has happened and the demographic changes yet to come. Not only is their book well argued and full of common sense, but it is also courageous in denying the conventional wisdom that inflation will not be a problem for years to come, if ever.

Since it is never too late to speak truth to power, it deserves to be widely read by policymakers in particular. However, since its analysis extends well beyond traditional macroeconomic issues, to assessment of the need for political and institutional change, it deserves a wider reading audience as well. Fortunately, it is written in such a way that non-economists should find it both a pleasure to read and easy to understand.

Underestimated effect of millions of new workers

An early chapter rightly focusses on a critical event; the opening up of an urbanizing China, and many other smaller countries, and the insertion of many millions of low paid workers into the global trading system. This put downward pressure on global prices, but even more on wages as employers in advanced countries made credible threats to «offshore» production.

Unskilled and semi-skilled workers in developed economies bore the brunt of this, and income inequality and political dissent in the advanced countries rose accordingly. A bulge of domestic workers, driven by the baby boom and rising participation rates, simply intensified these global pressures.

Of course, the Goodhart-Pradhan narrative extends well beyond documenting this massive, positive supply shock. With domestic wages under pressure in advanced countries, and offshore investment beckoning, investment in new plant and equipment also stagnated. Share buybacks in some countries with a «bonus culture», such as the U.S. and the UK, also compressed investment, even while raising corporate leverage sharply.

With incomes distributed increasingly unequally, spending by the average consumer was constrained. To some extent, this was offset by increased borrowing as consumers struggled to «keep up with the Jones’». The rise in consumer debt was especially rapid in advanced countries having more accommodating financial systems.

These developments implied that domestic demand in advanced countries was weakening, even as global supply was increasing. This combination put relentless downward pressure on inflation and, in turn, both nominal and real interest rates.

In short, the Goodhart-Pradhan thesis seems to successfully explain all of the major trends, both economic and political, observed in the period leading up to the Great Financial Crisis that began in 2008.

Global demographic processes going into reverse

The practical problem that Goodhart and Pradhan identify is that these global demographic processes are going into reverse and we are totally unprepared. Urbanization in China is slowing and the population of working age is also shrinking. China’s growth strategy is increasingly focussed on consumer demand, driven by higher incomes, in part reflecting higher wages. In the advanced countries, the ratio of «dependents» to workers is also rising sharply as baby boomers retire.

Moreover, as the authors underline in a persuasive chapter, retirees are not only living longer but are increasingly prone to dementia at older ages. As the need for care givers rises, this will restrict even more the number of workers available for other work.

Goodhart and Pradhan also argue that a rising dependency ratio is inherently inflationary since «dependents» consume but do not produce. Older people also raise the overall demand for housing services if they choose not to downsize from large houses. Moreover, as a shortage of labour pushes up wages, workers are likely to consume more and corporations will invest more to replace expensive workers and to take advantage of new technology.

In short, as supply falls, demand will rise, and so in turn will inflationary pressures. While it remains logically possible that new technology might increase productivity enough to offset the shortage of workers, the authors (quoting conflicting views by respected experts) simply refuse to speculate.

Inflation as part of the solution?

Reflecting these prospective developments, Goodhart and Pradhan argue that income inequality will decline in the future while inflation and interest rates, both nominal and real, will rise. The authors suggest that this will cause severe problems for governments and private sector agents (both households and corporations) that, under the influence of low interest rates, have become heavily indebted in recent years.

In separate chapters, they ask how the private sector debt overhang problem might be dealt with (debt restructuring?) and how strapped governments might raise more taxes in the future (taxes on land and carbon?).

An objective reader would have to conclude that they expect continued inflation to be a significant part of the solution. As for central bank «independence» in the future, Goodhart and Pradhan suggest (but never strongly assert) that it cannot be sustained in such circumstances.

Paradigm shifts in thinking are hard to achieve

In my humble opinion, these arguments ring largely true. In fact, they resonate with the point, made repeatedly by the Bank for International Settlements when I was its Economic Adviser, that global disinflationary trends in the decades since the late 1980s did not warrant massive monetary easing. Sadly, that conclusion conflicted with the conventional wisdom held by the Bank’s central bank shareholders.

Against this backdrop, this book has a great strength. The authors recognize that plausible counterarguments to new ideas can be too readily accepted by people committed to the conventional wisdom. Indeed, Thomas Kuhn and Daniel Kahneman have shown at length why «paradigm shifts» in thinking are so hard to achieve. A similar sentiment is expressed more pithily in the old adage «Science advances, funeral by funeral».

Accordingly, a significant effort is made by Goodhart and Pradhan to address these counter-arguments directly and to show that they are not robust enough to refute the basic conclusions drawn in the book.

For example, the absence of inflation in Japan’s ageing economy is not at odds with the view that global ageing will increase inflationary pressures. Goodhart and Pradhan argue that the implications of a global phenomenon will be quite different from those observed in a single country. Similarly, we cannot count on the increasing populations of India and Africa to offset the effects of the Great Demographic Reversal elsewhere. Nor can the search for «safe assets» adequately explain past declines in interest rates. The theory of «secular stagnation», which the authors refer to as «mainstream thinking», is simply wrong. So too is the academic argument that rational people will always save enough for their old age.

Central banks failed to learn from history

Yet, to say that Goodhart and Pradhan have identified crucial but neglected forces, leading to a more inflationary future and higher real interest rates, is not to say that this future is inevitable. There are in fact other forces, potentially leading to a quite different future. While these are mentioned at various points in their book, they might well have been given more emphasis.

A complementary narrative would emphasize the crucial role of central banks in setting interest rates, and would suggest that the policies chosen by central banks over recent decades make deflation a more likely outcome over the next few years.

What do I mean by that? The first mistake made by central banks was to fail to recognize the importance of the positive supply side shocks, highlighted by Goodhart and Pradhan, that have helped drive disinflation in the last thirty or so years. This put central banks on the bad path of excessive monetary easing. The second was the failure to understand how the «headwinds» of debt, encouraged by that easing, would eventually make monetary policy ineffective in stimulating real economic activity.

Together, these past mistakes have put today’s central bankers into a «debt trap» from which there is no obvious exit.

The first mistake, dating back decades, is that central banks failed to recognize the importance of the positive demographic developments identified by Goodhart and Pradhan. Instead of letting prices fall, as would have happened «naturally», they responded with ever more aggressive monetary expansion to prevent that decline from happening.

In doing so, they totally ignored a vast pre-War theoretical literature on the appropriate response to supply side shocks. Moreover, they failed to recognize the historical reality that most periods of declining prices were associated with periods of rapid growth, with the Great Depression being a singular exception. In retrospect, the failure of universities to offer courses in the history of economic thought and economic history now looks like a huge oversight.

Monetary easing becomes increasingly ineffective

These mistaken policies put the global economy on a bad path from which it will be hard to recover. This is especially the case since the policies followed since have been essentially «more of the same».

Easy monetary conditions encourage borrowing to finance spending, with much of it going into consumption rather than productive investments. However, as debt levels rise, they also act as a brake on future spending and are increasingly disinflationary. In this way, the «debt trap» deepens. Still more monetary easing becomes increasingly ineffective, as the recent focus on the need for fiscal expansion in response to the Covid pandemic seems to recognize.

In predicting the future path of inflation, these path dependent forces will be acting as a counterweight to the demographic forces correctly identified by Goodhart and Pradhan.

Future inflationary developments look even more uncertain when we factor in other unintended consequences of easy money and easy access to credit. Over time it becomes a threat to the stability of the financial sector. Low rates and lending margins threaten the viability of pension funds, insurance companies and even banks. The «search for yield» draws financial investors towards ever more risky creditors and ever more illiquid investments.

The prices of financial assets, increasingly influenced by central bank policy, fail to reflect underlying value and also fail to provide the benefits of portfolio diversification. Should these conditions culminate in another financial crisis, serious enough to restrict the orderly provision of credit, a debt-deflation spiral might well follow.

Finally, these artificially easy financial conditions also have negative supply side effects. They encourage wasteful investment decisions by «Unicorns» and others, who also charge low prices and accept ongoing losses in the search for market share and dominance. Further, they give continuing support to profitless «zombie» companies whose existence threatens the prospects of new entrants, and also helps drive down prices.

In short, «malinvestments» seem likely to lower the level of potential output over time, perhaps even its growth rate, while temporarily reducing price pressures as well.

Unsustainable fiscal situation

Whatever the cause of secularly slower growth in the future, Goodhart and Pradhan are surely right in highlighting the problems this will pose for government financing. Even prior to the Covid-19 pandemic, most advanced countries had legislative commitments to spend that substantially exceed expected tax receipts, even given assumptions of «normal» growth rates.

Today, in light of the policy response to the pandemic, that fiscal situation looks even more unsustainable. It also bears noting that, in serious downturns, private sector debts have a way of migrating onto the public sector balance sheet.

Must taxes now be raised on the working young to support an older generation that failed to save enough to support itself? This will raise difficult political and even moral questions. Among them would be why past governments chose to consume the demographic dividend rather than to invest it in real capital and increased future productivity. If Goodhart and Pradhan could see the Great Demographic Reversal coming, why couldn’t they? Or perhaps the «short-termism» that often dominates government decisions is actually an inherent and dangerous defect of our democratic system?

Goodhart and Pradhan might indeed be right in predicting a more inflationary future, though the path and magnitude might differ from what they seem to expect. The Covid 19 pandemic has already led to a «doubling down» on fiscal and monetary expansion to restore growth and to raise inflation to target levels.

This might succeed in meeting its objectives, though that outcome is by no means assured as has been noted above.

However, even success has its dangers. Should inflationary expectations suddenly rise, as they suddenly fell in the early 1980s, inflation might hit much higher levels. A vigorous central bank response might be impeded by a growing focus on resisting slower growth, as well as by lobbying from governments and others exposed to high debt levels.

Indeed, history shows that much higher inflation is a common outcome when large government deficits are increasingly financed by central banks. Goodhart and Pradhan’s book provides a welcome and timely evaluation of some of the major risks, both economic and political, still to come.

No one can say they haven’t been warned.

William R. White

William R. White was chief economist of the Bank for International Settlements (BIS) in Basel from 1995 until his retirement in 2008. He was one of the few who had warned of the dangers of a global financial crisis before 2008. From 2009 to 2018 he was Chairman of the Economic and Development Review Committee of the OECD in Paris. He is currently a Senior Fellow at C.D. Howe Institute in Toronto. White began his career in 1969 as an economist in the service of the Bank of England and has fifty years of experience in monetary policy. He has published widely on topics related to monetary and financial stability. He lives in Toronto, Canada.
William R. White was chief economist of the Bank for International Settlements (BIS) in Basel from 1995 until his retirement in 2008. He was one of the few who had warned of the dangers of a global financial crisis before 2008. From 2009 to 2018 he was Chairman of the Economic and Development Review Committee of the OECD in Paris. He is currently a Senior Fellow at C.D. Howe Institute in Toronto. White began his career in 1969 as an economist in the service of the Bank of England and has fifty years of experience in monetary policy. He has published widely on topics related to monetary and financial stability. He lives in Toronto, Canada.