Inflation is no answer to a potential Covid-19 debt crisis

As governments and central banks around the world throw money at their economies trying to mitigate the pernicious effects of the Covid-19 outbreak, debt is mounting at an alarming pace.

Once the first, acute phase of the pandemic-induced economic crisis ends, something will need to be done about this debt.

I have been saying for a while that good old debt forgiveness is the cleanest way to deal with the world’s increasing burden, but before it comes to that, it is likely that other solutions will be tried.

The first, and most obvious solution, is default by stealth. What makes interest payments on debt bearable, apart from the extremely low interest rates that central banks are already applying?

Inflation, of course. The value of the regular coupon payments remains the same while the prices of everything else go up – a neat way for the borrower to pass the cost of the loan on to the lender.

It would not be the first time that governments have cynically used inflation to dig their way out of a huge debt hole. In some countries in Eastern Europe in the 1990s, inflation was running in the double digits or even, for a short time in some of these countries, in the triple digits.

Fortunes were made by those who were well-connected enough to be able to take on loans from state banks, because the cost of money did not keep up with inflation. They ended up amassing wealth sponsored by the taxpayers, as the real monthly interest they had to pay for their loans decreased rapidly.

Will this “model” be applied now in major economies such as the US, the eurozone and the UK? The irony is that it is already being applied, people just don’t realise it, because official inflation has remained relatively low.

Deflation, rather than inflation?

In fact, some economists even say that deflation, rather than inflation, is likely to be a consequence of the current crisis. In recent research, Jamie Thompson, Head of Macro Scenarios at Oxford Economics, makes a comparison between what some analysts have dubbed “the war against coronavirus” and previous wars.

His team of researchers looked at 300 conflicts that took place in the past 60 years and found that, in more than half of episodes (53%), five years after the onset of conflict consumer prices were below their pre-crisis trend, rather than above.

Consumer price gaps after historical conflicts*

Consumer prices relative to pre-conflict trend

*Consumer prices relative to pre-conflict trend 5 years after internal and external conflicts in the past 60 years. Figures within each column show the scale of deviation relative to the pre-conflict trend. Source: Oxford Economics/UCDP/PRIO/World Bank


Société Générale’s famously bearish strategist Albert Edwards wrote recently that the record 0.4% fall in core US inflation in April “is like eating a deflationary ‘nail sandwich’ and it will surely hasten the end of this equity rally.”

He recalls the lesson of Japan in the 1990s, namely that a strong currency leads to a deflationary spiral, arguing that the US risks going down the same path.

Of course, deflation could happen, if the world economy remains weak for a long time. However, I would argue that the Covid-19 outbreak has opened the way for an acceptance of higher inflation.

The photos of huge queues in front of supermarkets and empty shelves that made the rounds on social media have persuaded consumers to put up more readily with price rises for staple foods. Anyone who has been buying food in supermarkets during the lockdown knows this.

Inflation is already here

Besides, inflation was already here, only it was not recognised as such. One form of it, asset price inflation, is no less efficient in eroding the cost of debt and has served that purpose rather well since the financial crisis of a decade ago.

A second form of inflation that is not accurately reflected by official measures is the cost of living – or, as a very interesting and largely overlooked paper puts it, the “cost of thriving”.

The paper, written by Oren Cass, an executive director at American Compass, proposes an alternative to the official measure of inflation called the Cost of Thriving Index (COTI), which tracks the cost of a basket of major items that a family of four in the USA would likely seek to buy.

The COTI consists of the largest expenditures that a middle-class family of four people might face every year: rent for a three-bedroom house, a health insurance premium, a car, the cost of a semester of public college tuition. These would be necessary for the family to thrive, rather than simply survive.

The index compares the cost of this basket with median weekly earnings for men working full-time, resulting in the number of weeks of work needed to cover these costs.

Looking at the cost of living issue in this way throws a completely different light on inflation. In 1985, the COTI was 30 – in other words, to be able to afford the things in the basket required 30 weeks’ worth of the median weekly wage.

By 2018, that number had increased to 53 weeks’ worth of median weekly wages – therefore, one full-time job is no longer sufficient to ensure that a family is thriving in the US. The study has not been replicated elsewhere, but anecdotal evidence points to similar experiences in other developed countries.

What this means is that consumers are already experiencing relatively high inflation, and this is likely to get worse if governments try to debase currencies in the race of default on debt by stealth. The Covid-19 pandemic may well spark a debt crisis – but stoking inflation will be no easy way out of it.