This article is taken from the March 2021 issue of The Critic. To get the full magazine why not subscribe? Right now we’re offering three issue for just £5.

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Big debates in economics are like old soldiers: they don’t die, but only fade into harmless immortality. So many variables are in play, such a crush of events is relevant to the analysis and so pervasive are conflicts between value judgments that definite answers are elusive. But one of the big debates stirred up the Covid-19 crisis may — unusually — be nearing a decisive resolution. Moreover, it seems to be nearing that resolution with unexpected speed.

Last spring, lockdowns and social distancing had devastating effects on the hospitality, tourism and travel parts of every economy, and led to widespread job losses and bankruptcies. Many economists — indeed, the majority of the self-described “profession” — thought that high unemployment and excess spare capacity would endure long after the end of the medical emergency. 

Given the New Keynesian proposition that inflation is determined by the supply-demand balance in labour and product markets, they made two further judgments. The first was that the pandemic would dampen upward pressures on the price level and the second was that the resulting disinflation would persist into the medium term. 

The New Keynesians were notably articulate in the US and at its central bank, the Federal Reserve. The Fed’s current vice-chair, Richard Clarida, is regarded as a particularly influential member of the school. He co-authored a celebrated 1999 article in the Journal of Economic Literature on “The science of monetary policy: a New Keynesian perspective”. In remarks last May to the New York Association of Business Economists he said that his projection “is for the Covid-19 contagion shock to be disinflationary, not inflationary”. 

While he saw the shock as disrupting both aggregate demand and supply, his view was that “net effect” would be for “demand to decline relative to aggregate supply, both in the near term and over the medium term”. Clarida’s assessment was shared by the Federal Open Market Committee, the Fed’s key policymaking body. The minutes of its June meeting affirmed that “highly accommodative financial conditions” would have to be maintained “for many years”, in order “to quicken meaningfully the recovery from the current severe downturn”. Notice the phrase “for many years”. 

By contrast, a few economists — certainly a minority in the Anglo-American world — were concerned that the economic policy response to Covid-19 would be inflationary. (I was one of them: see my column in this magazine last June.) Governments had reacted to the job losses and bankruptcies by widening budget deficits and financing the enlarged deficits from banks, which created new money balances. On top of that central banks were buying assets on a large scale from non-bank financial institutions, such as pensions funds and insurance companies. This added to their bank deposits and so again created new money balances. 

The rise of 7.6 per cent in little more than four weeks exceeded that in any full year in the 2010s

The result, in the leading advanced nations, was the highest growth rates of the money supply for over a decade. The minority of economists anxious about inflation risks appealed to the quantity theory of money. They said that rapid money growth would in due course be accompanied by similarly high growth of nominal national income and output, and that would mean an increase in inflation, not disinflation. 

The US saw the most remarkable departure from previous trends. In the 2010s the growth of money had been low and stable, and financial restraint and money growth stability had been associated with negligible inflation and a steady pace of output advance. But the coronavirus emergency led to a drastic upheaval. In April 2020 the M3 quantity of money went up by 7.6 per cent. This was — to hammer the point home — not the annual rate of increase; it was the increase in a mere one-month period. 

Indeed, the rise of 7.6 per cent in little more than four weeks exceeded that in any full year in the 2010s! While April was the month of the peak increase, it was not the only one to see money expansion that was extraordinarily elevated by the standards of the previous 30 years. In the year to June the M3 quantity of money climbed by 26 per cent, the highest figure since 1943. (The quoted M3 numbers come from the Shadow Government Statistics consultancy. The Federal Reserve no longer prepares M3 data.) 

Laboratory experiments are not normally possible in economics. Economics involves people, and people — unlike chemical forces — are idiosyncratic and unpredictable. However, the change in money growth between the pre-pandemic and pandemic periods has been so abrupt and extreme as to represent an unprecedented situation. Here we have as close an approximation to laboratory conditions as could be imagined in the so-called “social sciences”. 

If the quantity theory of money were right, the US money explosion would be followed by a marked acceleration in inflation; if it were wrong, no such sequel would emerge. 

As I noted in my June article, the then emerging “inflation vs. disinflation” debate could be seen as “another iteration of the never-ending quarrel between Keynesians and monetarists about how much money and banking matter to macroeconomic outcomes”. The New Keynesians — with their dominance of research at the Federal Reserve — were confident that the quantity of money was irrelevant to the economy’s future. Taking their cue from Clarida and his colleagues, the FOMC minutes at no stage in 2020 made any reference to a money aggregate, despite the dramatic changes in policy and the sky-high money growth rates. 

If the quantity theory of money were right, the US money explosion would be followed by a marked rise in inflation

This second article is being written less than a year since the Fed set up its laboratory experiment. Contrary to the FOMC minutes, it has not required “many years” to achieve substantial clarification. Enough evidence is already available for the quantity theorists to claim they are winning the debate. To say that is not the same as to claim victory, and it may be a few quarters yet before a final verdict can be given. Nevertheless, supporters of the excess-money-will-cause-inflation view are way ahead on points. Two developments in the opening rounds have swung the intellectual boxing-match their way. 

The first relates to asset prices. Money is held in investment portfolios, as well as by households to pay for consumption and by companies to finance investment. It is a commonplace that investors must balance cash against non-cash assets such as bonds, equities and property. A plausible argument last spring was that severe uncertainty and investor caution would cause the cash proportion of investment funds to increase. That would depress the value of equities and property, and aggravate the recessionary pressures. 

The counter-argument was that money growth in the US of more than 20 per cent — and of more than 10 per cent elsewhere — would be accompanied by even faster growth in money held for investment purposes. If cash remained unchanged as a proportion of total assets, that implied healthy advances in equity markets, house prices and commercial real estate. In practice, astonishing gains in the American stock market have been recorded since mid-March 2020. 

Economists are notorious for squabbling about everything, but no one would say that 95 per cent rises in commodity prices are disinflation

At its highs in January the S&P 500 index was 75 per cent up on where it had been only ten months earlier. Although the US equity market has led the way, share prices have advanced almost everywhere. Also conspicuous have been rises in house prices, again in almost all the leading economies. 

Second, commodity prices have advanced at a remarkable pace. Sure enough, the initial weeks of the pandemic were accompanied by a collapse in oil prices and that took most indices of commodity prices down sharply. Perhaps the best such index is the S&P GSCI index, used in futures trading at the Chicago Mercantile Exchange, which tries to weight its constituents according to their wider economic importance. 

It slumped by 43 per cent in the two months to 21 April last year, to touch a low of 228.24 (April 1991=100). But since then economic activity has recovered and supply shortages have affected some commodities. The index has soared to a value of 442.38 at the time of writing (3 February). This is a climb of 93.8 per cent — not far off a doubling — in less than ten months, possibly the sharpest-ever increase in commodity prices in such a short period. 

Economists are notorious for squabbling about everything, but no one would say that rises of 75 per cent in stock markets and 95 per cent in commodity prices are disinflation. The crucial issue in the remaining rounds of the inflation vs. disinflation contest will be how far the rampant price increases in assets and commodities filter through into consumer inflation. It is already evident that in the next few months prices in the shops and on websites will be affected not just by the huge jumps in some commodity prices, but also by increases in freight and transport charges. 

Moreover, annual inflation rates are at present still lowered by the oil market mayhem and price falls in the months of March to May 2020. As these falls drop out of the 12-month change in consumer price indices in March to May 2021, annual inflation rates are likely to bounce up at least to 3 per cent and perhaps towards 5 per cent. Unless the Fed brings money growth down to the sort of rates found before Covid-19, the Biden presidency will be blighted by the return of inflation as a major public policy problem. Moreover, the forces now driving up inflation in the US are also at work in Europe and the UK, although that is a story for another occasion.