Stagflation: An Austrian/Monetarist explanation of the worldwide Economic Pandemic and advice on a responsible fiscal & monetary response.

In deference the title could say “A Hayek/Friedman explanation……”

If we take the stagflation worldwide problem which is here for some and coming for others and if we separate it into its two component parts then inflation is correctly explained by the Monetarists and Stagnation is explained by the Austrians.

Monetarists explain two components of monetary demand and that is the money stock and the speed that it flows through the economy. When the Covid Pandemic hit governments around the world rapidly increased expenditure with very little access to any increase in taxation. The result was more borrowing which was supported by money printing under a QE (quantitative easing) or similar programme depending on the country. At this point we had a significant increase in money stock but, with lockdown and suppression, a fall in the speed that money was circulating. For a short while the impact of a plus and minus created an indeterminate change in monetary demand, however as countries try to normalise so an increased money stock and an increased money flow adds significantly to aggregate monetary demand. The classic monetarist analysis is that 12-18 months later the economy will suffer inflation. That is happening now in most countries and Central Banks and Governments are misleading people into thinking the higher inflation is caused by supply side problems such as energy price rises, supply chain difficulties etc. This is wrong as the inflation now, that I predicted more than a year ago, is the result of government overspending and monetary mismanagement. Always remember that by definition inflation is more units of money used in the same number of transactions and then ask yourself where the money comes from and who manages that quantity.

Austrians explain that the fiscal and monetary stimulation caused by the pandemic created a one-off misallocation of resources which means that productive factors are now in the wrong place and causing supply chain problems and holding back economic growth. A friend of mine illustrates this perfectly. He owns and runs a company that supplies safes to customers around the world. He furloughed 22 drivers who could then get jobs elsewhere and he is having difficulty persuading them to come back. The Austrian economist Thomas E Woods Jnr uses the example of the circus coming to town and local businesses seeing an increase in demand for their products. Some may be tempted to expand their business not realising that the stimulation to demand is only temporary. When the circus leaves town these businesses have over capacity and will likely become bankrupt as will many businesses that were only temporarily busy because of the Pandemic.

This explains why we have stagflation and the following explains the only way out for national governments.

Governments need to cut back expenditure immediately to pre-pandemic levels. Unfortunately the temptation will be for governments to say that now they do not need to spend as much on the pandemic that they have more to spend on other things. This would be a big mistake. Governments should be planning to balance their fiscal budgets within the next few years. Central Banks need to slow the growth in money supply and manage monetary demand to be growing just a little faster than output so as to achieve their inflation target (2%). The inflation they have already caused needs to work through the system and certainly needs no more fuel from any excessive monetary and fiscal expansions. It would be a mistake for a Central Bank to try and reverse policy and create a monetary contraction. This would be a case of two mistakes do not make things right. Finally the Central Bank needs to more closely align its official repo rate with market rates of interest and then we will begin to see a re-balancing of the economy, stronger, freer markets and accelerating economic growth. This should be the Great Reset.

J.B. Hearn 25/10/2021