Among the collateral damage of the Covid19 pandemic, the U.S. economy and the federal budget are included. The pandemic has caused an extensive economic disruption, and the government’s response has pushed the federal budget further out of balance. The U.S. government like its counterparts all over the world is spending trillions of dollars in response to the COVID-19 crisis, borrowing trillions of dollars to do so.
The post-Covid-19 world will be very much the same as the pre-Covid-19 one. Many – but not all – will drift back to offices, start eating at bars and restaurants again. We will start going on vacation abroad again.
Governments’ response to it was something we hadn’t witnessed before – simultaneous demand and supply shocks. Demand collapsed as we were confined to our homes. Supply collapsed as factories shut and transport routes withered. A no ordinary recession.
The transition will be difficult and while what we need is significant fiscal support, all we will have to supply us is monetary support. The US Federal Government is divided for now, and we also have another much bigger problem concerning fiscal support – the ability to pay. Many governments around the world are running dangerously high budget deficits as it is, with debt over 100 percent of GDP.
When the fiscal stimulus is fading, it is getting more dangerous because these companies will start defaulting on their ability to pay their debts or go under. That makes unemployment stickier and that in itself lowers demand and drags on the economic episode longer than expected.
Turning bullish on inflation this summer after 25 years of forecasting deflation in consumer prices, money manager and finance historian Russell Napier do now believe that inflation is back. “The mechanism through which money is created has changed”, Napier said in an interview this week. calling the credit guarantees offered by governments to commercial banks making new loans “a revolution”.
Napier was among the few economists that stuck with his prediction of prolonged deflation in the face of QE1, QE2, QE3, and so on and so forth. While many financial analysts were worried about hyperinflation, let alone inflation, Napier said we’d see a lack of inflation. And he was right. To the anguish of those who kept on about money printing. Napier has now changed his mind, however, and is now anticipating a reversal and a breakout of inflation.
Why Didn’t Quantitative Easing Work?
Commercial banks create money, not central banks. Commercial balance sheets wouldn’t expand, despite central banks’ balance sheets expanding. The interest rate policy that central banks pursued with QE created a huge boom in non-bank debt. QE was actually not creating growth in money but in debt – hence weakening the balance sheet – leading to deflation.
QE for the last 10 years expanded central banks’ balance sheets and it gave a lot of reserves to the banks themselves, but the banks did not use these reservers as collateral to loan into the market. So lending, broad lending, didn’t take place. Money being lent by commercial banks is typically where most of the money supply comes from. That didn’t happen, so we had this deflationary environment where debt was growing but money was not.
You cannot create more money unless you create more debt, specifically bank debt. The problem is that the central bank’s monetary policy created the wrong type of debt. They didn’t create the sort of debt that creates money. It can be illustrated simply with the following example. To solve the problem in a society where 50 % is bank debt and 50 % is non-bank debt. The bank debt is growing at 10 %, the money supply might grow at 10 %, and if you stop the non-bank debt growing, then you would have growth of money by 10 % and growth of total debt by 5 %. I.e. more debt can reduce your debt to the GDP level. It doesn’t reduce your debt level.
Napier proposes another solution to quantitative easing and that is what he calls re-intermediation of credit assets. This would entail governments or central banks to persuade commercial banks to buy back existing credit. The bank’s balance sheets would expand and they would have created money. Existing debt would entail both government and private debt. Napier argues that this shouldn’t directly increase the level of debt, but you do increase the level of money – hence inflationary.
Are Low-Interest Rates Deflationary or Inflationary?
Low rates can actually be deflationary when they don’t create any more money, but instead debt. Monetary policy is about the quantity of money and not the price of money. The price of money is a technique to adjust the quantity of money. Napier explains that the low-interest rates in the western world that have persisted for a decade has instead led to deflationary pressure instead of inflationary since the price of money adjusted the quantity of debt without adjusting the quantity of money.
Central banks are only allowed to lend, they aren’t allowed to print (at least not yet). The fact that we have these low rates, that have caused a buildup of debt, and the only way central banks can fix that is to add even more to the debt – it’s a deflationary spiral.
Get Ready for the Return of Inflation
The interesting thing now is that everything has changed, possibly. Get ready to say “hello” to inflation. What has changed is that there is going to be bank lending and that is potentially going to push GDP higher. More money will be available.
The government guarantee programs for commercial banks’ debt in response to the Covid-19 pandemic is why everything might have changed. The resulting manipulation of the banking system does, in essence, imply that governments control monetary policy. This change is permanent and not temporary.
Governments across the world decided that the best way to keep people and businesses alive during Covid-19 was to get credit flowing through the banking system to people who needed it. They did it via the existing financial system down to specific bank accounts of people and businesses. This was done in the U.S. via the so-called Small Business Administration and the banking system.
The U.K. government made £ 40 billion GBP available via the so-called Coronavirus Bounce Back Loan program. The UK banking system has been very bad at lending during the past 10 years, but that has now changed according to Napier. The banks now suddenly found 40 billion credits to lend since these arent commercial credits, they are government credits. The government has guaranteed the principal on those loans.
So, commercial banks whose balance sheets had been going flatline for the last 10 years suddenly went vertical, it went ballistic. With the government guaranteeing the credit risk, everything changed. They have created money. The stunning statistic of all of this is the end result affecting the inflation rate.
The OECD total money supply growth number. In the deepest recession since World War II, we’ve got the fastest money growth in money since 1981. There isn’t necessarily a link between the scale of growth of money and inflation. But the transformational thing is already behind us, we have gone from broad money growth of about 6 to 7 % previously to 17,5 % globally in 6 months. Inflation expectations will jump.
With the economy returning to some normality post-Covid-19, the velocity of money will increase and the result of what has been explained above will be reflected in the inflation rate that should increase. The inflation genie is then out of the bottle and it won’t be easy to put it back in.
The return of inflation – if it happens – will mark a huge turning point. A paradigm shift. We have been used to very low inflation – so much so that even 2%-3% might make a huge difference to how we invest and feel, particularly if interest rates on savings don’t rise to compensate us (they won’t).
With the debt level being what it is today, very high, the central banks are in a tight spot. They can continue on with low-interest rates and expansionary monetary and fiscal policy – thereby continue to grow the already enormous debt. Or, they can increase interest rates to fight the (possible) inflation and thereby see an enormous wave of insolvency wash over the whole global financial fabric. They are i.e. damned if they do, damned if they don’t.
Are the Government Programs Here to Stay?
Bank credit is up from last year and it has expanded. But the question is if the type of programs launched in response to Covid-19 will last. Most of what we now see on the money supply is the result of what was done in and around May 2020 but the programs have since been winding down.
There is something on the launchpad in the U.S. called Main Street Lending Program, which is a $ 600 billion lending program. The programs so far have effectively been life-support. They are intended to keep businesses alive. The next program, the coming programs, will be recovery programs. And possibly after that, we will get green lending programs intended to spur on the development of environmental technology and the transformation of industries from using fossil fuels to ‘green’ energy.
Perhaps even social justice programs, there is an ongoing discussion in the U.S. concerning a program to pay reparations to descendants of slaves, a program that could come with a $12 trillion price tag. A coronavirus relief package froze student loan payments and interest until January 31. Americans hold over $1.7 trillion in student debt and the federal reserve estimates that 31% of all U.S. adults have student loans. Now, House Democrats have proposed “broadly” forgiving up to $50,000 of federal debt for student borrowers.
If inflation breaks out, central bankers will be a few steps behind the curve as they busily reverse QE instead of hiking the cost of borrowing. They’ll be removed from control of the banking system – where the money supply is truly controlled.
If inflation might be coming back or even if there is just enough data out there to provide markets with a whopping inflation scare, you will need to be ready. The central banks probably won’t be.