Paul Tolmachev
mises.org
The Russian-born Tomachev is portfolio manager at BlackRock (London, UK), with $500 million in personally managed assets. He also is a visiting scholar at the Stanford Institute of Economic Policy Research, where he researches institutional and political economy.
Warning
Long read: 1641 words
Where are the US economy and the other advanced economies of the world now? In a word, stagflation. Stagflation (declining economic growth with rising inflation) is the new reality, and there are three main clusters of factors that have led to the present stance of the economy.
First of all, there are post-Covid externalities: breaks in production chains, including semiconductors; logistical locaps due to changes in labour movements; and excessive monetary and fiscal stimulation of economic agents, from inefficient companies to private households, which have created outstripping demand relative to limited output and also forced up prices.
Further, with Democrats in power, the Keynesian course of pumping up demand that occurred first under Donald Trump was expanded. This is reinforcing government expansion through increased infrastructure construction, increased social programmes, tighter fiscal regimes and pressure on business. In addition to causing non-equilibrium growth of consumer opportunities, state expansion actually squeezes the economy – businesses already facing the unfavorable conditions of a sharp rise in the cost of production factors (particularly labour, raw materials and components) have to compete with the state and bear even greater fiscal costs to finance its growing budget.
Finally, an important factor has been the geopolitical escalation between the ‘collective West’ and the Russian autocracy through the proxy conflict between Russia and Ukraine. Russia is Europe’s main supplier of hydrocarbons and, together with Ukraine, the world’s leading exporter of key agricultural commodities. The current conflict overlaps with the aforementioned factors and has created risks of significant commodity and food shortages, at least until substitute channels are established and fine-tuned: the stability of Europe’s commodity supply is now in question. In this context, the conflict escalation in eastern Europe has obvious direct and indirect effects on developed and developing countries’ economies, causing global inflationary spikes, depressing economic activity and slowing economic growth.
What is now signaling the imminent problems and the stagflationary processes that have already begun?
First, there is the surge in the prices of all key commodities. The inflationary turbine in energy prices is sharply increasing production costs in all sectors of the economy. Inflation in agricultural commodities is being caused not only by disruptions in the production process and in exports by conflicting parties in eastern Europe, but also by the need to recanalise import arteries from another countries. Such import substitution is a complicated process, since each of the potential exporters faces difficulties in increasing export volumes. In addition, against the backdrop of rising hydrocarbon prices, the logistical expenses of new import channels will be higher, which is another negative inflationary component.
Second, there is too strong a labour market and inflation is accelerating. There is still a close correlation between the low unemployment rate and the low labour force participation in the post-Covid economy. In other words, people don’t really want to work, employers’ labour needs are not being met and the number of job openings continues to grow, while the unemployment rate – registered job applications – is extremely low.
Moreover, with a labour shortage and high inflation, manufacturers are forced to raise wages, which, in addition to the rise in other production costs (energy, raw materials, taxes, etc), increases production costs and contributes to inflation of the final product’s price through the inevitable cost transfer to consumers. Consumers are forced to demand higher wages, and the spiral continues. In addition, the state’s activity as a business actor boosts the inflation of labour costs: business has to compete with the state for labour. So, inflation is already more than 10 per cent. Expectations for annual and five-year inflation continue to rise exponentially as well.
Third, new orders for durable goods have dropped off, with a simultaneous increase in inventory and production stocks. Unfilled orders have also slowed, and the inventory/sales multiplier is climbing. Overall, this suggests that output is narrowing and slowing after the strong expansion that was driven by two prime factors of the post-crisis recovery: rising retail sales and negative interest rates due to low funding costs and high inflation. Inflation is becoming critical and negatively affecting economic activity as demand begins to cool off, becomes less diversified and shifts to basic goods, and as output contracts through cost cutting and the inability to stop rising costs.
All these factors have clearly depressed manufacturing and consumer sentiment. Business confidence is clearly declining; consumer confidence is at 2008 crisis levels.
Finally, the inversion of the yield curve and the narrowing of the spread between 10- and two-year Treasurys indicate one thing: agents value the risks of today as more significant than the risks of tomorrow. In other words, the long-duration risk premium is no longer worth anything. Investors are willing to buy more risk uncertainty without any premium relative to short duration – investment flows go into very short-term maturities, effectively into cachet, such as three-month Treasurys. Inflationary assets may be also attractive, with a large potential premium on bonds’ short-duration risk; for example, equity or certain commodity markets may benefit from export deficits and production crises.
The basic reason for the inversion is, of course, the inevitable tightening of the Fed’s monetary policy. First, the narrowing of spreads makes interest rate arbitrage and interest rate risk diversification less attractive for banks. Second, rising funding rates make lending more expensive for economic agents; this increases the risks of lower supply in the near term.
The peculiarity of today’s stagflation and the threats it poses are due to drivers going beyond the paradigm of normal business cycles when the usual measures of monetary credit and budget policy could sanitise the economy and launch a new wave of economic activity. The current problem is that the world economy is undergoing structural transformations in the global integrated processes, due to the geopolitical, ideological and ethical clash of the two social-institutional systems, as mentioned above.
This dictates new conditions for the economic recovery and the need to revise the government’s economic stimulus measures. Over the past 20 years, these measures have become increasingly entrenched in two directions.
The first is unrelenting Keynesian government expansion. The negative stages of natural market cycles were bought off by inflating government leverage – artificial pumping of demand, social and corporate subsidies, expansion of the regulatory overhang and, logically, the growth of budget deficits. This increased the volatility of cycles, gave birth to the class of depressed agents who were artificially supported by quantitative easing and zero rate credit. Consequently, that created significant inefficiencies in the economy in the medium and long term.
The second is the unrestrained globalisation of production chains and the forced indoctrination of the “green agenda”. Both have led, first, to the fact that resource autocracies have been actively involved in global economic integration, making developed countries more dependent on resource imports from such “regime” countries. Second, the forced implementation of the green agenda without any substantial and elaborate preparation and the premature conservation of traditional energy sources against this background led to a de facto energy crisis with galloping and proliferating inflation in all sectors of the economy.
As a result, Western economies were generally unprepared for almost physical aggravation of relations with resource autocracies, at least with the main one of them – Russia. Now direct and indirect dependence on imports of natural resources, both energy and agricultural, as well as deep integration with such a resource exporter creates great risks for developed economies. These risks are now being realised.
In this situation, there is a question of choosing between two directions of economic policy on the part of the government.
The first option is a continuation of the leftist course: further governmentalisation of the economy, squeezing or restraining business by the government, another hyperinjection of government credit, an inevitable additional fiscal tightening and a continued phaseout of traditional energy sources in an undeveloped green alternative.
The second option is “right-wing”: rejection of vertical active redistribution of benefits from efficient economic agents to inefficient ones. That means liberalisation of fiscal and regulatory policy aimed at maximising business activity and intensifying innovation, encouraging people to work rather than build loan pyramids and receive subsidies and encouraging entrepreneurial initiative rather than socialist squeezing of private production by state nonproductive infrastructure projects. The reining in the green revolution is an also important measure, since energy security and stabilisation of energy prices is now one of the key issues for Western economies in the face of today’s threats and unfortunate dependencies.
Obviously, the “right-wing” option implies a natural recovery of the economy and getting rid of its toxic and inefficient components, which is not a painless process in the socioeconomic sense, especially after 20 years of credit bubbles led by government. However, as a result, we will have an intense impetus toward healthy organic growth, where needs and opportunities are created through initiative, innovation and production, rather than through the credit leverage of the state.
We should not forget only that the state in any country at any time is just simple people pursuing personal interests and deriving primarily personal benefit from the mandate (right or opportunity) they have to redistribute public resources and the right to violence. In good countries, their opportunities are limited in favour of society; in bad countries, on the contrary, they are expanded to the detriment of society. And every time the state promises society additional benefits in exchange for an expansion of its mandate, the same thing happens: the state takes back many times more than it gave first.
