by Damon de Laszlo, ERC Chairman
Economic models and, in particular, central bank models are wonderful constructs built by trying to fit historic information into a model which can then be played with. From a central bank point of view, it enables them to project an aura of certainty based on their special knowledge. In the real world, it’s more difficult and more important to try and understand what all the conflicting information and trends are telling you within the context of macro themes.
Today we seem to be at an inflection point in a long-term trend of steady prices along with growing relative prosperity. The moment of the change in direction of a long-term trend is not easy to define but there are two short term events and one long term trend that are making economic models obsolete. The two short term wrecking balls to the economic trend are the obscene war in Ukraine and Covid. Russia has become a rogue state using its military power to attack the civilian population of a smaller neighbour, bringing down a reign of terror and destruction on towns and villages, while hiding behind its nuclear shield that prevents retaliation. Covid, a long-predicted pandemic caught the world medically unprepared, creating economic chaos and personal tragedies across every country.
Russia and Covid have severely damaged global supply chains. The disruption in food supplies from Russia and Ukraine is creating enormous inflationary pressures, the likelihood of severe food shortages, and possible starvation in emerging market countries. The disruption to energy supplies, along with the supply of metals, from aluminium to the very rare metals and minerals needed to sustain the electronics industry and the planned movement to electric vehicles, is having a big impact on costs and the “greening” of the economy.
The long-term trend of globalization is reversing. Over the last twenty to thirty years, prices have held steady and, in many areas, declined as world trade had enabled businesses to take advantage of moving production, mostly to Asia. A trend greatly encouraged by the Chinese Government’s long-term strategy to industrialise the country as a way of increasing the wealth and prosperity of its people. The trend gained enormous momentum from China joining the WTO, coupled with the dramatic change in sea transportation brought about by containerization, which greatly reduced the cost of transport and enormously increased the efficiency of moving commercial products, from cars to computers.
The globalisation trend has stalled and is going into reverse as industries discover the vulnerability in the supply chains – firstly brought about by Covid, then compounded by the Russian invasion. The trend is also being pushed in the opposite direction by US/China friction and President Xi’s attack on many of the leaders of the big industrial companies; along with a growing policy trend of disengaging China from technology dependence on the West which is reducing confidence in the reliability of long supply chains. This disengagement is being given momentum by Western and, in particular, American imposition of bans on exporting sophisticated technology.
The reversal of globalisation and the breaking of trade relations between the East and the West has enormous inflationary consequences. While economic models theorise about small movements in inflation, swinging backwards and forwards around the two percent mark, we are now set on an upward path with all the unpleasant consequences that we experienced in the 1980s of rapidly increasing prices and, likely to bring in its train, civil unrest. The current precipitous price rises in raw materials are to a large extent the result of Russia’s aggression in Ukraine exacerbated by the reversing of globalisation, in this context raising Interest rates will not affect prices until they create a depression. High inflation with its classic response of raising interest rates also enormously increases the risk of a financial crisis.
Damon de Laszlo
13th April 2022