For several decades, globalization and disinflation have gone hand in hand. As multinational corporations expanded well beyond the confines of individual nation states, they were able to use technology, outsourcing, and economies of scale to drive down prices. Cheap labor, cheap capital and cheap goods held them back.
Now the war in Ukraine has put an end to cheap Russian gas. The global push towards carbon neutrality will eventually add a permanent tax on the use of fossil fuels. The decoupling between the United States and China means the end of “efficient” (i.e. cheap) but fragile supply chains. End of quantitative easing and Federal Reserve rate hikes limit easy money.
Aspects of this new reality are welcome. Relying on autocratic governments for crucial supplies has never been a good idea. It was naive to expect countries with very different political economies to conform to a single trade regime.
Polluting the planet to produce and transport low-margin goods around the world doesn’t make as much sense when you factor in the true cost of labor and energy, not to mention the evolution geopolitics. More than three decades of falling real interest rates have led to unproductive and dangerous asset bubbles; we desperately need market price discovery.
That said, it is clear that a deglobalised world will also be more inflationary, at least in the short term. This will present a major challenge for both the US economy and the rest of the world.
As Credit Suisse analyst Zoltan Pozsar told his clients in a recent note, “war means industry”, whether it’s a hot war or an economic war, and the industry growth means inflation. This is the exact opposite of the paradigm we have experienced over the past half century, in which “China got very rich by making things cheap. . . Russia got very rich selling cheap gas to Europe, and Germany got very rich selling expensive products produced with cheap gas. The United States, on the other hand, “became very rich doing QE. But the license for QE came from the lowflation regime enabled by cheap exports from Russia and China.
All of that is changing. And that means even hawkish central bankers might not be able to control the inflationary environment. It’s a topic that was front and center at the Jackson Hole central bankers’ conference recently, when economists Francesco Bianchi of Johns Hopkins University and Leonardo Melosi of the Chicago Fed released a major paper asking in how much monetary policy can bring down inflation if the country’s fiscal situation deteriorates.
The basic idea is that if rate hikes lead to recession, tax revenues will fall, and instead of cutting spending on the big things – such as rights and defense – or a default on Treasuries, you get increasing debt. When the debt picture deteriorates significantly, it becomes increasingly difficult for monetary policy alone to rein in inflation, which produces a snowball effect. The result ? Unless monetary policy is accompanied by a more stable fiscal position, the result will be higher inflation, economic stagnation and rising debt.
For years, central bankers have been pleading with politicians on both sides to complement their monetary efforts with appropriate fiscal policy. Now the rubber hits the road. When interest rates rise, you ideally want less debt. This requires raising taxes or cutting spending. The first option relies on Democratic control of Congress; it’s unclear how long they will, as the November midterms loom. The second option is unlikely, given the fiscal investments inherent in a deglobalizing and decarbonizing world.
Take, for example, the cost of more secure supply chains. The United States has just passed a law giving chipmakers $52 billion in subsidies. Germany is spending $100 billion to modernize its armed forces. The West is likely to spend $750 billion to rebuild Ukraine, and the G7 recently announced plans to inject $600 billion into infrastructure to counter the massive Belt and Road Initiative of the China. All of this is, in the short term at least, inflationary.
Then there are the challenges of ensuring production. “Inventory for supply chains is what liquidity is for banks,” says Pozsar, and “in the context of supply chains, leverage means excessive operating leverage.” He notes, for example, that some $2 billion of German value-added production depends on $20 billion of gas from Russia. What if it completely stops flowing this winter? We may be about to see.
There are important caveats to this story. Productive spending in areas such as infrastructure, high-value goods and services, and the transition to clean energy can be inflationary in the short term, but ultimately strengthens a country’s fiscal position by fueling growth at long term. Indeed, these types of “productive bubbles” – in which the public sector provides incentives for investment in crucial technologies and new markets – enable periods of broadly shared sustainable growth.
The question is how much of today’s spending will be productive and whether governments will have the ability to cut what is not. In any case, in the short term, the end of the era of neoliberal globalization will be a favorable wind for higher core inflation. Much like de-globalization itself, this represents massive economic change, one that will herald all sorts of unintended consequences.