No Constituency for Sound Money

Has the accepted view on fiscal and monetary policy transformed?

Many people concerned about the possibility of inflation caused by the debasement of currencies, such as myself,1 were strongly influenced by the 2009 book by Carmen Reinhart and Kenneth Rogoff “This Time is Different”, which catalogues the causes and effects of past economic crises.2 While in the short term, debt financed deficit spending by governments can boost economies (just look at the vital roles played by governments in cushioning the Covid-19 crisis), these economic historians observe that in the longer term the use of excess government debt to boost economies rarely ends well. Most nations that have seen government debt rise above 100% of GDP have seen declining growth. Japan crossed this threshold 20 years ago, and it is now closer to 200% debt to GDP. Growth in Japan has indeed been poor. Reinhart and Rogoff observe that a debt crisis and some form of sovereign default, often via currency debasement i.e. inflation, normally follows. This has not happened in Japan, so they have been wrong about that, at least there and so far.

I believe there is no longer a widespread political or intellectual following for the orthodox fiscal and monetary views set out by Reinhart and Rogoff. We no longer hear reservations of economists and politicians regarding deficit spending. In the past fiscally conservative groups like the Tea Party railed against bank bail outs and fiscal stimulus packages. The Tea Party’s outcry, taken up by the wider Republican Party, forced President Obama and Congress to rein in the US deficit. Now, in the face of a larger shock, our ideology has been transformed. In my view, there is not, currently, in any major country anywhere on Earth a strong constituency for sound money (with the possible exception of China – which is trying to bring its money supply under control).

Consistent with this shift in sentiment, the above-mentioned economist, Reinhart, now chief economist of the World Bank, argued in the past fortnight that the fallout from Covid-19 means that additional government borrowing is now justified.

She told the FT, “While the disease is raging, what else are you going to do? First you worry about fighting the war, then you figure out how to pay for it …. In terms of the coverage, of which countries will be engulfed, we are at levels not seen, even in the 1930s”.3

To put this in context the IMF estimates that countries have increased spending or cut taxes by $11.7tn so far — 12% of global gross domestic product in 2020.4 To put this in perspective, just over a decade ago, the G20 nations finally agreed a stimulus package worth 2% of global GDP for two years after the financial crisis.

In a hat tip to her earlier research, Reinhart points out, in the same interview, that much of the debt being issued to address the imbalances will not be repaid. At least not with currency worth anything like the value of today’s money. She observed “this is why we are talking about debt write-offs. At the country level, at the multilateral level, at the G7 level, who has the financing to fill in all the big fiscal gaps that have been created or exacerbated by the pandemic?”

Meanwhile on the other side of the Atlantic prescriptions of leading economists, such as Paul de Grauwe the Professor of Political Economy at the London School of Economics, are similar. Professor de Grauwe advocates the economic and political benefits of a massive surge of monetary finance (i.e. printed) deficits in Europe to address the economic challenges from Covid. But he also acknowledges that “there is no such thing as a free lunch … a monetisation of the deficits induced by the Covid-19 crisis will eventually increase the price level”.5 He expects this inflation to run at “4-6% per year for 4 to 6 years from 2021 or 2022 onwards”. But his argument is that the monetary finance of deficits is a price worth paying “to avoid future sovereign debt crises in the Euro area”.

The key question remains that posed by Reinhart and Rogoff in 2009. Will this time be different? Will governments be able to monetise government expenditure and not experience inflation and/or sovereign debt crises?

Do you think governments will be able to print on average around 10% of GDP this year (and possibly next) with no cost? Or, like de Grauwe, do you think there will be an inflationary price to pay?

My next Craigmore Commentary will ask “What risk of inflation?” in the context of our pathway out of the Covid-19 economic shock.

I’d be glad to hear your thoughts.

Forbes Elworthy

1. I have been crying wolf about these risks since the outset of the last financial crisis. Beyond today’s short Commentary I will continue to worry about inflation via further short pieces. The next piece, in December, will analyse the possible causes of inflation and another, in December, will focus on implications for asset markets.

2. Rogoff, S and Reinhart, C (2009); “This Time is Different”; Princeton University Press.

3. Wheatley, J (2020); “Borrow to fight economic impact of pandemic, says World Bank’s chief economist”; Financial Times.

4. ibid

5. De Grauwe, P and Diessner, S (2020); “What price to pay for monetary financing of budget deficits in the euro area”; Vox EU.