The world is facing its day of inflationary reckoning

Double-digit price inflation is here. Anyone paying attention to fiscal and monetary policy knew this would happen sooner or later. The Federal Reserve’s recent 0.75 basis points hike in the federal funds’ interest rate won’t be enough to stem an inflationary avalanche that reckless politicians with zero knowledge of history and of other countries’ experiences have been setting in motion for years.

For part of the 20th century, John Maynard Keynes and Milton Friedman constituted opposing paradigms of economic policy. For Keynes government spending was crucial to stimulate demand for goods and services in slack times; monetary policy as a stimulating agent had limitations. Friedman, meanwhile, was critical of government spending, but favored monetary policy: in times of recession, monetary stimulus was necessary lest the slump becomes a depression. 

The irony of the last 14 years, that is, since the financial crisis of 2008, is that governments everywhere resorted simultaneously to Keynesian and Friedmanian policies: massive government spending and the “printing” of money to prevent a depression. 

The unprecedented degree of these interventions was bound to cause grave harm. All it would take was for people to feel more confident about requesting and extending credit and spending money. Then all that stimulus would generate an excess of demand vis-à-vis a supply of goods and services that would not be able to keep up. If on top of this, certain factors were to further limit the capacity to produce enough goods to satisfy demand (a pandemic, a war), the effect would be that much more acute.

Welcome to the new reality. A simple look at U.S. debt tells the story. Total government and household debt is more than $90 trillion, more than four times what the economy produces each year. The last two years saw a $6 trillion COVID-19-related budget deficit that took federal expenditures to the equivalent of 30.5 percent of GDP, more than 5 percentage points above 2008, the year the financial crisis triggered a wave of massive government bailouts. And this doesn’t account for the fiscal stimulus. Between 2008 and 2020 the money supply almost doubled, and these past two years alone it rose by 46 percent!

Where is the inflation, many “experts” mockingly asked in the years after the financial crisis, when fiscal and monetary stimulus (Keynes and Friedman) failed to produce the price rises simpletons like us were predicting? In the absence of vigorous consumer credit and spending, the new money was inflating the price of various assets. By 2021 home equity in the United States was a whopping $14.2 trillion according to one study, even though wages had gone up very little. Eventually, inflation would spill onto producer and consumer prices. And here we are, with the Fed desperately raising the federal funds rate to try to stem inflation that is now the world’s greatest economic concern. 

We ain’t seen nothing yet. In other parts of the developed world, a sovereign debt crisis is brewing again, as in 2012. Interest rates on government debt in highly indebted countries such as Spain and Italy have tripled quickly as the European Central Bank has signaled that it too is ready to stem inflation by rising rates. But now the central bank faces a dilemma: Does it continue to raise rates and send Spain, Italy, and others into default territory, or does it go slow and risk fueling inflation even more? For the moment it is trying to square the circle, saying it will continue to raise rates and at the same time buy more sovereign debt from the highly indebted countries. Soon the bank will realize the grotesque contradiction — and will pay the consequences. How long until the more financially sound northern Europeans, finding themselves subsidizing the southerners, begin to question the euro once again?

This is not the place to address the social and political consequences that will flow from the new inflationary era — and its corollary, a major recession, which is already in the air. (According to one estimate, retail spending has shrunk by 15 percent on an annual basis.) But those consequences will be humongous. The chickens have finally come home to roost.  

Álvaro Vargas Llosa is a senior fellow of the Independent Institute in Oakland, Calif. His latest book is “Global Crossings: Immigration, Civilization and America”.