by Damon de Laszlo, ERC Chairman
There are various economic theories and assumptions about the extent to which pouring liquidity into the economy creates inflation. Over the last ten years, the close correlation between the two has diverged. It would seem this divergence was caused by the diversion of a great deal of the liquidity, created by the central banks, into assets creating asset price inflation, which is not generally considered to be as bad compared to retail price inflation. Many other effects, including the movement of manufacturing to low wage areas such as Asia, helped by globalisation, have also held inflation to very low or almost zero levels.
Covid also created a reduction in demand for a large number of goods and services, in particular energy, creating downward pressure on prices. Two years of downward pressure, particularly in the energy sector, resulted in supply being shut-in. For some time now it has been obvious that inflationary pressures would rise dramatically as the economy recovered. Supply chains cannot open up anything like as quickly as they shut down. It may take only a few weeks to restart a restaurant, but it takes months to restart complex manufacturing facilities and refill empty pipelines. Adam Smith’s Hidden Hand is easily cut off and can regrow, but it is a slow process… Also, the benefits of globalisation have waned, particularly with rising wage rates in China, compounded by the long supply chains.
On the energy and raw materials front, supplies have been shut down and there is enormous green opposition to opening up facilities. ESG pressure on banks not to finance mining and drilling is an example of popular thinking that you can just turn off supplies without building laudable alternative green resources. Here, the leadership of Western governments and their lack of strategic thinking is compounding the problem. To take a specific example, food supplies require fertilisers that are made from natural gas to meet current demand. Added to this a large quantity of the West’s food comes from unreliable sources, for example, Russia and Ukraine produce half of the world’s sunflower products and a quarter of its wheat supplies while 40% of European gas comes from Russia.
On the geopolitical front, Russia is exercising its muscle and the USA has been leading an anti-China campaign, which is driving two natural enemies, Russia and China, together and helping President Putin’s cause. We will know within the next few weeks whether America is correct in saying that Russia is going to invade Ukraine, or if Mr Putin’s statement that he has no intention of invading Ukraine is true. He has, in fact, no need to, he only needs to turn off the gas tap to shut down the European economy. While America can act tough and talk sanctions, the lack of strategic thinking in Brussels has left it in a virtually powerless state.
Leaving aside the known unknowns, inflation over the next six months is going to rise dramatically, causing great distress. There will be a lot of old-fashioned debt destruction as central banks push up interest rates, causing capital losses for those holding debt and probably bringing a decline in asset prices. The economic downturn will help reduce demand and aid in clearing bottlenecks.
The bad news is clear. The good news, however, is that there will be a re-set of the global economy. Those companies that are profitable are starting to increase capital expenditure, which will enormously improve productivity. The application of computer systems across all industries, including food production, has a dramatic effect on output and potentially cost reductions. The US is likely to see the benefit first with its lower level of bureaucracy and more agile and better capitalised businesses, hopefully followed by the UK, but one has to worry about sclerotic Europe. China, with a more efficient and cohesive government, is difficult to predict. It has a dynamic entrepreneurial class that is being disincentivised by the growing anti-corporate actions of the Communist Party. The worst damage will be felt by the poorest countries, in Africa and South America. Here, the dysfunctional governments and the retreat of Western government support will have profound consequences for their populations.
2022 is going to be, to say the least, troublesome and difficult, but by the third quarter things will start to look up – the penalty for complacency.
Damon de Laszlo
16th February 2022