The post-pandemic economy’s high inflationary pressures are being powered in part by secular trends and forces, many of which are operating on the supply side. While there are also transitory factors – such as supply-chain disruptions and bottlenecks, and China’s zero-COVID policy – these presumably will abate at some point. But the secular trends are likely to lead to a new equilibrium in many economies and global financial markets.
In manufactured goods and intermediate products (a substantial share of the tradable part of the global economy), we are emerging from a long period of deflationary conditions, which had been driven by the introduction of massive amounts of previously unused, low-cost, productive capacity in emerging economies. Whenever there is a demand surge, the equilibrium market response will be some combination of supply expansion and price increases, and for the past several decades, the supply expansion clearly dominated, creating deflationary pressures that came to be taken for granted.
But the remaining underutilized productive capacity in the global economy has been declining, and global demand has grown as tens of millions of consumers have joined the middle class. The elasticity of global supply chains has declined, increasing the bargaining power of workers in advanced economies. Evidence of this is not hard to find. Union organizing is expanding and becoming more successful, and employers are finding it difficult to sweep aside potential and current employees’ preferences for hybrid work.
Then there is demographic aging. Populations are growing older – some quite rapidly – across the cohort of countries that make up more than 75Pct of global GDP. Notwithstanding increases in longevity, this trend implies reduced labor supply and rising dependency ratios, with no comparable reduction in demand. These and other factors are fueling upward pressure on wages and costs.
Among the sectors that experienced extreme safety and stress issues during the pandemic were health and education, which are huge sources of employment in the non-tradable part of any economy. In the United States, the health sector and education account for about 20 million and 14 million jobs, respectively, with health second only to government as a source of employment. But unattractive working conditions and low compensation have persisted after the pandemic, leading to worker shortages. A new market equilibrium has not yet emerged; but when it does, it will surely include increased incomes for those working in these sectors, and hence an increase in real (inflation-adjusted) costs.
More broadly, the global economy has entered a new era of frequent, severe shocks from climate change, pandemics, war, supply-chain blockages, geopolitical tensions, and other sources. A process of supply-chain diversification is underway, and new economic policies are strongly reinforcing this trend. Gone are the days when these chains were constructed entirely on the basis of cost, short-term efficiency, and comparative advantage. The new diversified supply chains will be more resilient but also more expensive.
Geopolitical tensions are an especially important aspect of this process. Governments are now advocating “friend-shoring” through policies (such as tariffs, subsidies, or outright bans) aimed at shifting their countries’ trading patterns toward strategic allies and other, more reliable partners. This is partly a response to potential disruptions associated with the growing use of trade and finance to gain leverage in international relations or conflicts.
While one can debate the security benefits of these policies, they are clearly inflationary, as they explicitly shift supply chains away from the lowest-cost sources. Indeed, an even more extreme version of friend-shoring is onshoring, the costs of which are so high that policies encouraging it can be justified only in sectors exhibiting extreme economic and national-security vulnerabilities.
For example, owing to Russia’s war in Ukraine, Europe has embraced relatively rapid diversification of its energy system to end its dependency on Russian fossil fuels. This process will lead to higher energy costs in the long run – at least until renewable-energy technologies are fully implemented several decades from now – and to significant additional inflationary pressure over the next several years.
As the dollar has strengthened, the rapid rise in commodity prices – including dollar-denominated food and fossil-fuel prices – has amplified the inflationary surge in a wide range of countries. And this effect is especially strong in lower-income developing countries, where food and energy account for a larger share of aggregate demand and household spending. Already, many of these countries are confronting food and energy shortages and affordability crises.
In the US, a growing body of evidence shows that industries are becoming more concentrated, absolutely and relative to Europe. One can debate the causes of this trend – Thomas Philippon of New York University lays much of the blame on failures of competition policy – but there is little doubt that inflation makes market concentration an even bigger problem. Economic theory tells us that in a highly competitive market, inflation should drive a search for productivity gains. That incentive is muted in oligopolistic industries where incumbents have an enhanced ability to pass on cost increases through margin-preserving price hikes.
Finally, debt levels across the global economy remain elevated from the pandemic, and today’s environment of rising interest rates means that fiscal space is set to contract. But the clean-energy transition is expected to require an estimated USD3 trillion of investment per year for the next three decades. If a substantial portion is financed with debt, as seems likely, the increase in aggregate demand in an already supply-constrained global environment will create additional inflationary pressure.
A broad-based surge in productivity would dampen the combined effects of these inflationary pressures. Digital and biology-based technologies have immense potential in this respect. But their development and rollout will take time. In the interim, we can no longer rely on highly elastic supply responses to mitigate inflationary pressures. The frameworks for fiscal and monetary policy must adjust to this new and more difficult reality.
11th Year • Oct 2022 • No. 111