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11 June 2021

The US and the EU’s stimulus policies show they have learned from the mistakes of the past

We have entered a new economic era of higher public spending and greater government intervention.

By James Meadway

Economic growth figures this week have reaffirmed the message that the removal of Covid-19 restrictions is causing a rapid return to economic growth. The US and the UK have recorded strong figures for the first part of the year, while the official estimates for the eurozone show substantially better growth than anticipated. And unlike last summer’s rushed attempt to return to “normality”, the production and distribution of highly effective vaccines provides a more reasonable basis for optimism about the future.

Yet in contrast to the economic wisdom of recent times, governments and monetary authorities show little sign of scaling back on the full-throttle policy support of the last year. The European Central Bank has avoided a repeat of its disastrous post-2008 approach by announcing that it remains committed to its vast €1.85trn programme of quantitative easing (QE) or electronically-created money. 

The ECB has even offered its continued backing for “critical and timely” fiscal policies, encouraging national governments to support “firms and households” through government spending. The contrast, again, with the eurozone crisis of the 2010s, during which the ECB helped force through draconian (and entirely counterproductive) spending cuts on the worst-affected economies at least shows some lessons have been learned.  

Meanwhile, the US is committed to what the Treasury secretary Janet Yellen, in her previous role as Federal Reserve chair, called a “high-pressure” economy, running both fiscal and monetary policy hot to counter the damaging long-run impacts of a recession. There are no signs of the Federal Reserve curbing its $7.9trn QE programme or even adjusting interest rates (currently 0 per cent to 0.25 per cent). Coupled with Joe Biden’s ambitious $6.7trn spending programmes, of which $1.9trn has already been voted through, the stage is set for a major, long-run shift in how both the US and the eurozone economies operate: higher government spending, looser monetary policy, and more direct intervention by governments to support their domestic industries through trade and investment policy.

This emerging shift in the direction of economic policy is, however, provoking a backlash, however. The latest contributor to the counteroffensive is the former Bank of England governor Mervyn King, who last week claimed in the Financial Times that the “deafening” silence of central banks “over current high growth rates of… money” should be a cause for concern as it will lead to inflation. This is the same Mervyn King who not only started the Bank of England’s QE programme – which in the decade since 2009 has seen £895bn of new money pumped into the economy by the bank – but who also breached the bank’s supposed independence and neutrality to offer his support for the Conservative-Lib Dem government’s disastrous austerity programme.

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He is still very insistent today that governments are spending too much, but has seemingly rediscovered the apparent merits of trying to restrain inflation by controlling the money supply. Once upon a time, this view of a simple money supply-to-inflation link was labelled “monetarism”. The theory holds that more money being made available, with the supply of goods and services staying the same, will simply lead to prices being pulled up as those with money try to outbid each other to obtain the same, scarce, supply of goods and services. “Inflation,” argued its greatest proponent, Milton Friedman, “is always and everywhere a monetary phenomenon.”

Thinking such as this this led governments like Margaret Thatcher’s to try to control the supply of money in the economy in the early 1980s. The results were basically terrible: the resulting rise in interest rates pushed up the value of the pound, helping give the manufacturing industry a blow from which it has never recovered. And the money supply itself oscillated wildly, whatever formal targets the government and the Bank of England tried to set, without much relationship to the inflation rate. 

This is because the amount of money circulating in a modern economy, with a fully developed banking system, owes more to how much banks are willing to create and to lend, and how much money people want to hold on to, than to how much money the government wants there to be. Inflation was falling when Thatcher entered office, and was rising when she left – the money supply targets having been abandoned some years before. Monetarism has been widely discredited since and attempts to resurrect it are likely to prove similarly fruitless.

This doesn’t mean inflation is, as some more enthusiastic Keynesian economists might want to claim, nothing to think about. But it will not arise from an oversupply of money. Instead, it will be the shift in the real balance of costs, and labour market conditions, that are more likely to push up consumer prices. 

After decades of acting as a great deflationary sink for the global economy, helping fuel the decades-long Western consumer boom, China’s production costs have been rising rapidly. Twenty five per cent pay rises were reported in Shenzhen and other manufacturing heartlands ahead of Chinese New Year, with some advertised manufacturing wages rising above typical graduate salaries. The export of these higher prices will most likely feed into rising prices across the globe, while constraints on labour supply everywhere are already leading to rising wages. Bad for inflation hawks and 1980s throwbacks, perhaps – but good for workers across the world.

[see also: Andy Haldane: The beast of inflation is stalking the land again]