In this episode of the McKinsey Global Institute’s Forward Thinking podcast, co-host Janet Bush talks with Stephen King. King is a senior economic advisor to HSBC, having served as the bank’s group chief economist from 1998 to 2015. His latest book, very prescient in timing, is We Need to Talk About Inflation: 14 Urgent Lessons from the Last 2,000 Years. In this podcast, he covers topics including the following:
- The root causes of the current resurgence of inflation
- How long higher inflation may persist
- What history tells us about the management of inflation
- The main economic problem that lies ahead
- Why inflation matters
Janet Bush (co-host): So here’s an odd question for you. What do you think that Elizabeth Taylor and Richard Burton have to do with inflation?
Michael Chui (co-host): I really don’t know. Some of our listeners might be too young to know who those two people are. But maybe it has to do with cycles and reoccurrences because they were together, they got married, then they got divorced, and then back together? Maybe it’s the cycles of inflation or volatility as they had a volatile relationship? I don’t know.
Janet Bush: Yes something like that. It is more to do with monetary and fiscal policy as the two major tools that influence inflation. Do they work together or do they split and work against each other? It’s just one example of how our guest today talks so accessibly about what could be a rather dry subject.
Michael Chui: Can’t wait to hear more.
Janet Bush: Welcome to our podcast, Stephen.
Stephen King: Janet, it’s great to be on the podcast with you.
Janet Bush: You’ve had a very long career as an economist. So tell me a little bit about how you came to specialize in economics.
Stephen King: Oh, that was entirely serendipitous and not part of the grand plan at all. My grand plan was to become a professional clarinetist playing in an orchestra. And when it came to do my A level [UK examinations taken at age 18] choices at the age of 16, my school could not timetable the A levels I wished to do. Because I wanted to do maths and English and music. So I had to choose something else.
So I dropped the English and did this strange thing called economics that I really had no interest in whatsoever. And one thing led to another, and I discovered that, I suppose, I was probably better at economics than playing the clarinet. And that’s kind of what happened.
Janet Bush: Did you actually come to love economics?
Stephen King: Yes. I love parts of it, not all of it. I recoil slightly against some of the overly mathematical and overly pseudoscientific claims that economics sometimes makes. I think that it is important to try to popularize economics where it’s possible. It’s not always possible.
And I also think—obviously this comes out in the book, to a certain degree—I think that economists have got so wrapped up in their mathematical models that they’ve forgotten the importance of history, frankly.
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And I’m a big believer that economic history should be taught much more at university and that it shouldn’t be seen as a vaguely interesting, optional extra. It should be a key part of the curriculum. Because in my own reasonably long experience working in financial markets, it’s extraordinary how few people know about things that you really think they ought to know about, whether it’s the Great Depression or whether it’s the ERM [Exchange Rate Mechanism] crisis in 1992, whether it’s the collapse of the gold standards in the 1930s, the collapse of Bretton Woods in the early ‘70s. This stuff should be core, I think, to what people know at the macroeconomic level. And too often, people don’t know about it. And that’s a bit disappointing, really.
Janet Bush: Well, I found, as an economics journalist in my time before McKinsey, that bad cycles or good cycles came around with alarming frequency. And yet there didn’t seem to be any institutional memory of what had happened, say, eight or ten years before that.
Stephen King: No, it’s extraordinary. I wouldn’t say it’s politicization, but there are certainly elements of wishing to believe that all is for the best, in the best of all possible worlds. And it does seem remarkable that when you’re six, seven, eight years into an economic upswing, that people stop believing it’s possible that the recession could be just around the corner.
But actually, history tells you that that’s the most likely time that the recession might be just around the corner—and equally in the opposite direction. When you’re in the depths of recession, it’s sometimes difficult to believe that you can have a lasting recovery. But recoveries typically occur from the depths. And they don’t feel good at first, but they do often have a momentum of their own.
But the other thing I think is just striking is that you go through these long periods beyond economic cycles of, say, very low inflation.
So we’ve had 30 years now of—well, until very recently, we had 30 years of very low inflation. And the idea that inflation could return was seen by many people to be near enough impossible. But if you went back to the late 1960s or 1970s, the idea you could be living in the world of price stability would equally seem to be impossible.
And I do think that many economists, and I think I’m probably guilty of this as well, but many economists, they’re children of their time in the sense that they’re heavily influenced by the sorts of things they experienced as they grew up and as they learned economics.
So economists in the 1950s and 1960s were entirely focused on the defeat of unemployment, because that’s what they were scarred with from the 1930s. Economists who were doing their learning and so on in the 1970s and early 1980s are mostly scarred by inflation, because that’s what they grew up with. But each of these phases can be there for quite a long time and then can disappear. And then you’re faced with a whole new world.
Janet Bush: And as you say, that’s where history comes in. Because if you’re only influenced by your own experience, then you miss a whole piece of the jigsaw puzzle, right?
Stephen King: You do. And I think also you’re in danger of becoming wedded to economic models that themselves are only calculated over a certain period of time. The Bank of England at the moment is in a bit of difficulty, because it has been reliant on models that they themselves freely admit were estimated only really from the point at which inflation targeting started in the UK in the early 1990s.
And that’s all very well. But it means that it’s almost impossible, with that model, to forecast a sustained period of higher inflation. And effectively, the model makes an underlying heroic assumption that inflation simply can’t return. So when it does return, you’re scratching your head thinking, oh, I wasn’t expecting that. But you weren’t expecting it partly because your model ruled the possibility out because of its very construction. And that, I think, is something that is a weakness of some modern-day economics.
Janet Bush: Your book goes back millennia, which is fascinating. But obviously everybody wants to know what you think about now and this reemergence of inflation after 30 years or so. And you say it’s not Putin. You say in your book that blaming President Putin is more than anything an ex-post act of convenience. Yes, inflation would have been lower had Russia not invaded Ukraine. But it would not have returned to target. So tell us more.
Stephen King: If you go back over the last three or four years and you think about, when did inflation first surprise on the upside? When did it start coming in higher than people anticipated? When were the financial markets beginning to think, oh, this is a bit odd? Well, the answer probably is at the beginning of 2021.
My bank, HSBC, has these surprise indicators for data from one month to the next. And lots of our competitors have similar things. But these surprise indicators tell you consistently whether data are coming in persistently higher or lower than expectations month after month after month.
And at the beginning of 2021, you started to see these upside surprises, first of all in the US. And then, within the space of six to eight weeks, the same sorts of upside surprises coming through in the eurozone and in the UK. So when you got these kinds of persistent surprises all in the same direction, month after month after month, you begin to think something’s beginning to change.
What was also odd about this period, of course, was this was still during lockdowns, when economic activity was very depressed. So normally you think, well, if demand is very low, activity is depressed, you get very little in the way of inflation. In fact, you’re more likely to get deflation rather than inflation in these circumstances. So it was a double surprise. And activity was weaker than expected, but the inflation was higher than expected, which is not what you typically expect to see.
Now, at first when this happened, it was all explained away through semiconductor shortages, or the price of secondhand cars, or so on. But as 2021 progressed, these upside surprises started to come through thick and fast across a wider and wider range of goods, then services, and then wages. So you were beginning to see the first signs of I suppose what would loosely be described as a wage-price spiral.
It was a very modest one. But nevertheless, wages and prices were moving ahead. And of course this is happening a year before Putin invades Ukraine. So the momentum is already there. Admittedly, there were lots of people who were saying it was all to do with supply shortages linked to COVID. So when lockdowns came to an end and supply came back onstream, the inflation would simply go away.
But nevertheless, there was a sense, in my view, and there were others who shared this view—not many, but there were others who shared this view—that something was sort of misbehaving itself in the world of economics. Things were not really working out as they normally would do.
Janet Bush: And what was that?
Stephen King: The answer, I think, is that in 2020, faced with the scale of lockdowns and the scale of losses in economic activity, Western policy makers were terrified of a repeat of the Great Depression. Because the declines in GDP that we were seeing in 2020 were on the same kind of scale, unprecedented in postwar economic history, with maybe a couple of exceptions, like Greece during the eurozone crisis, but basically unprecedented across these large-scale economies.
And two things happened, really. The first was that there was a tremendous loosening of fiscal policy, which I think was justified, but not for the usual reasons. It was justified because what you wanted to do was to take leveraged debts off the corporate or the household balance sheets. Because you knew that if these people lost money, lost jobs, they would not be able to cope with those levels of debt. And they would go bankrupt. And then you’d have bank failures and all sorts of nasty things happening.
It seemed right to try to shift debt onto the public sector’s balance sheet, knowing that you could pay tax at some point in the future to cope with this. And that I think was fine. But alongside that, the central banks became fearful of the Great Depression, and loosened monetary policy on the scale that we really haven’t seen in decades.
And one way to measure this—this is where my inner monetarist is revealed—is through the rapid expansion of money supply. And the numbers for the US were completely off the charts. We hadn’t seen anything like this in the entire postwar period. The numbers in the eurozone and the UK weren’t as strong as they were in the US, but they were still pretty strong.
You think, well, why did you need to do that? Because unlike the Great Depression, there weren’t multiple bank failures. There weren’t mass bankruptcies. There wasn’t mass unemployment. There wasn’t a sustained collapse in asset prices. None of the things you associate with a debt deflation of the 1930s actually happened in 2020 and beyond.
And what I think basically took place was that you had this huge financial monetary expansion. People couldn’t spend during lockdown, but once lockdowns came to an end, people’s financial wealth had risen dramatically. They were much richer, on paper at least, than they appeared to be previously. And many people who were in a position to spend went out and did exactly that. So spending accelerated.
But meanwhile, the global economy, from a supply-side perspective, still hadn’t gone back to where it was pre-COVID. And in fact, I would argue that it was difficult to go back to pre-COVID not just because of COVID, but because there had been a shift towards national resilience, shortening supply chains, getting rid of some of the efficiencies we associate with hyperglobalization. So all of these things contributed to an acceleration of demand relative to supply. Inflation picks up. And that’s the first stage of the story.
Now, of course, it’s true that when Putin invaded Ukraine, and oil prices and gas prices go up, that adds a second leg to the story. But the thing I’ve noticed is that because monetary policy loosened so much, even when inflation started to reappear at the beginning of 2021, there was a marked unwillingness on behalf of the monetary authorities to reverse the policy decisions they’d made the previous year.
So interest rates stay at rock bottom even through this period of rising inflation. And it’s not really until the end of 2021 that rates start to rise. And even then, central banks have different views as to how entrenched or how embedded this inflation is.
To their credit, the Federal Reserve wakes up pretty quickly and raises interest rates aggressively through the course of 2022 and beyond. But the ECB, the European Central Bank, and the Bank of England are still saying, “Oh, it’s all temporary. Don’t worry about it. It’ll go away.” And they were sort of convinced that their own credibility would keep inflationary behavior under wraps, so to speak.
But one of the things I recognized from writing the book was that inflation is not just a technocratic problem. It’s a massively political problem. It creates arbitrary winners and losers. And particularly, if you’re a loser in real time—in other words, your next-door neighbor has had a pay increase and you haven’t had a pay increase yet—you will push, understandably, for your pay increase.
So under those circumstances, once inflation is embedded, I think history suggests it is then much more difficult to get rid of. So to take a current-day example, it’s true that the Bank of England is now celebrating the possibility that rates have peaked, because five out of the nine at the last meeting voted not to raise rates, even though the other four did vote to raise rates.
But what is striking about the UK currently is that it’s still very much an act of faith that inflation will come back down sustainably. Because although headline inflation’s falling, wage growth from the UK is currently running at about 8 percent. Now, before the pandemic, wage growth from the UK was running at 2 percent. There’s been no acceleration of productivity in the intervening period. In fact, productivity growth has been very disappointing.
There’s only two ways you can make the 8 percent add up, really. The first way is that workers will get much bigger pay increases and companies will go bust, which is not great. Or alternatively, the workers will get big pay increases and companies will find out ways of passing on the wage increases in the form of higher prices at some later point. In other words, the wage-price spiral would then be much more embedded.
Another way of putting it is to say that we’ve now reached a stage where because the bias in terms of inflation is towards inflation being above target rather than below target—so, the polar opposite of what we were going through prepandemic—it’s probably the case now that most central banks, even if they think that rates have peaked, are just not in the position to cut rates.
So we’re not talking about a world of materially higher policy rates for an extended period of time at levels that no one thought was plausible before the pandemic came along.
Janet Bush: Talking about persistence, the big question for many people now is, how long can inflation persist? And indeed, how long can high interest rates persist?
Stephen King: So part of this, again, is a political answer rather than an economic answer. It is striking, actually, that in recent years there’s been a growing chorus of people who are saying, “Maybe a 2 percent inflation target is too low.” You have Olivier Blanchard, former chief economist at the IMF, who’s made these arguments for a number of years now.
Jason Furman, who was the chair of Barack Obama’s Council of Economic Advisers, has made the argument recently. Andy Haldane, the former chief economist at the Bank of England, has talked about temporarily abandoning inflation targets until prices settle down to where they need to be postpandemic.
But the fact that these conversations are taking place at all suggests that one risk is that actually we change our view, society changes its view, as to what is the acceptable inflation rate. Now five, ten years ago, there probably was a case for suggesting that an inflation target should be a little bit higher.
Because it took you a little bit further away from the so-called zero-rate bound in terms of interest rates. It gives you a bit more flexibility on the downside in the event of a recession. You don’t bump into that zero-rate-bound problem that we’ve seen in recent times.
However, I think it is problematic to raise inflation targets just at the time when inflation’s already rather high. It smacks of an act of convenience rather than anything else. And it also, I think, reflects a loss of institutional memory about what inflation does to your economy. It’s not something you really want to have if you can possibly avoid it.
A second thing I’d note is that the central banks’ own inflation forecasts have mostly proved to be wide of the mark. They’ve very simply been too optimistic. They’ve taken the view that inflation will come down quickly. Because they have taken the view that the inflationary shocks are entirely temporary.
I found a quote that’s in the book, which says something along these lines. It basically says, “Look, it’s hardly our fault that inflation’s so high. It’s all the consequences of external shocks in terms of costs and prices that have nothing to do with our economy.”
So what goes around comes around, basically, that it’s convenient to use these excuses of external shocks to explain why inflation will naturally fall away again. But again, once it’s embedded, you start to see, or you have the risk at least of seeing, a deteriorating trade-off between growth on the one hand and inflation on the other.
Most definitely, models suggest that these two are tightly related to each other, so a little bit off growth, and a little bit off inflation, and vice versa. But structurally, when you have a big shift in this inflationary behavior of an economy or of a society, you can shift to a world where inflation is much lower for a given growth rate, which is what we saw over the last 30 years or so.
Or, in the opposite direction, you can shift towards a world where inflation is much higher for a given growth rate. And if I were betting at the moment, I would suggest that we are moving to a world where either inflation is much higher or the costs of keeping inflation at 2 percent are themselves much higher. In other words, the interest rates have to be permanently higher for a given inflation rate than might have been the case in the past.
Whereas you might describe the world prepandemic as a world of deflationary tailwinds, I think we’re now in the world of inflationary headwinds.
Janet Bush: What drives that switch between the last 30 years and what we might be seeing now? What’s the key driver of that switch?
Stephen King: I think there are three or four factors. The first one is that I think there was an institutionalized bias that came through prepandemic that was a bias reflecting an obsession with deflation. There was a strong belief that Japan was the prototype for what was going to happen in countries elsewhere—aging population, big increases in government debt, et cetera, et cetera. All the things that we saw in Japan, we now also see in other countries.
But the consequence of this was a couple of signs of bias that actually have not helped the central bankers’ case. The first of these is when the Federal Reserve introduced its flexible average inflation targeting framework, which was in late summer 2020.
Now the idea was that you’d commit to higher inflation in the future to offset inflationary undershoots of the past. And the idea was that this would stabilize people’s perceptions of real debt levels, so they wouldn’t have to worry about paying off debt too quickly. And by not paying off debt too quickly, then there wouldn’t be as much deflation.
So the whole thing is a beautiful story where everything stabilizes. The problem with that was that it was introduced at unfortunately just the wrong time, just when the inflation was in danger of picking up for entirely different reasons. The Fed was basically saying, “Don’t worry. We’re not going to raise rates in the light of higher inflation.” But the time they do get round to raising rates, which is more than a year later, the inflationary genie is already out of the bottle. I think the institutional setup was such that it was not well designed to cope with a sudden reappearance of inflation.
And the other institutionalized story really is QE. Now a lot of people think of quantitative easing as a money-printing machine that just creates inflation and so on. I don’t really share that view. But what I do think is that the QE that was delivered year after year after year created a bias in bond markets.
The bond market vigilantes, who in the old days would basically sell a bond market at the first whiff of inflation, they went off and did something else. Because there’s no point playing around with bond markets. Because the buyer that was more powerful than any other was of course the central bank, through QE. There’s not point shorting the bond market to any significant degree, because the central bank always prints some more money and buy the bonds back and yields wouldn’t rise very far.
But this meant that effectively the early warning system for spotting inflation had been turned off. It just didn’t operate. So, yeah, people go around saying, “Ah, but inflation can’t be a problem, because bond yields are low.” Well, of course bond yields are low, because the central bank had nationalized the bond market. What else was it going to do in these circumstances?
I’d argue that this was a sign, if you like, of institutionalized bias, so that it was impossible to spot the inflation when it first came through. And by the time it was spotted, it was too late. Because of the political economy, the momentum of the process had already become established, which was not good.
Second factor goes back to my inner monetarist, which is that I think central banks stopped looking at money altogether, which I find quite remarkable. I’m not suggesting that monetarism itself worked particularly well. It didn’t. But once money supply was not being targeted directly and was free to move around, it struck me that when you have off-the-charts accelerations in money supply, as we saw in 2020, this was worthy of note.
It was a red flag to central banks, saying, “Are you sure you’re on top of this?” But if the central banks weren’t looking at money or they were dismissive of it, saying that there was no obvious statistical relationship between money and the broader economy, then even when you got off-the-charts developments, they tended to be ignored. So I think that was another intellectual bias that had led the central bankers down at the point when actually they needed to be looking at this.
Janet Bush: When did that happen? When did that change happen? Because I remember the days when M3, M2, M0, all the Ms were central to central bank policy there.
Stephen King: They were indeed. I guess what happens is in the 1980s it all falls apart, because the relationship breaks down during the 1980s. Policy makers then look for another intermediate target. And many of them chose the exchange rate as an intermediate target.
That didn’t work very well with the collapse of the ERM and other bits and pieces. So inflation targeting is born out of desperation to a certain degree. Rather than targeting an intermediate variable like money or the exchange rate, you’re suddenly in the world of targeting the actual final objective.
Now this brings me on to my third point, really, which is that if you’re targeting the final objective, that’s all very well. But the final objective lies somewhere in the future. You’re making a forecast about where it’s going to be in two years’ time.
Now, of course, if you’re in a very stable world, your best forecast might be, “Where is inflation today? That’s where it’s going to be tomorrow.” And that’s, to be fair, a forecasting technique that’s worked pretty well over the last 30 years or so.
But that world is not tested, in the sense that if you were to see a series of shocks coming through, whether they be policy shocks or external shocks, all point in the same direction. And that was inflation surprise on the upside for one, two, three years in a row.
Can you then be sure that inflationary behavior will remain stable? And this is where I think things have gone wrong. Because the Bank of England describes this as “the unexpected second-round effects.” But in effect, what the public have been asked to do was to take the gas price increases completely on the chin, not to react to them, to not ask for any kind of compensation in terms of wages or price increases, and that somehow we were all enlightened enough to understand that this was a national shock and everyone should be evoking the Dunkirk spirit, so to speak—take our share of the shock.
But we don’t behave like that in reality. Everyone tries to avoid taking their share of the shock. It wasn’t surprising to me that you started to see these second-round effects coming through. Now, to be fair, the second-round effects vary from country to country. They’re more in evidence in the UK than they are, for example, in the US.
But I think this comes back to monetary policy. If you have an inflationary shock, and you choose to raise interest rates rapidly in the light of it, the public think, ah, the central bank is taking the inflation shock seriously. And therefore we, too, should take this quite seriously. We’ve got to realize that if we don’t take it seriously, then there could be some very bad things happening in the economy. I’m not saying that people think of this in an explicit sense. But I think that implicitly, this is what’s going on.
If you’ve got a central bank, on the other hand, that says, ah, don’t worry. Inflation will disappear as quickly as it has arrived. We don’t have to do too much, and every time they raise rates, they kind of indicate, this is probably the peak, then the public might think you’re not terribly serious about this.
And then if it turns out that the projections of this more relaxed central bank prove to be wrong, then the public, quite rightly in my view, will say, “You weren’t on top of it. You didn’t know what you were doing. You misled us. And now we want compensation.”
And so I think the second-round effects partly come from how the central bank itself reacts to the initial shock. In fact, Paul Volcker, the grandest of central bankers, the guy who led the Fed from the late 1970s through to the mid-1980s, he said after he stepped down from the Fed that the one thing he learned was that if you’re going to deal with inflation, you have to act quickly, and quick enough before the public are alarmed.
And I think that what we’ve seen in the last two or three years is that too many central banks have been too relaxed about the inflation, and they haven’t acted quickly enough. And frankly, the public have become alarmed. So that’s a problem, I think.
Janet Bush: So just going back to QE. It’s obvious that you’re not a fan. And you do talk about historical—deep history—episodes of QE in your book. And I just would love you to share a couple of historical stories about instances of QE. And what we should have learned about it.
Stephen King: First of all, I just want to give a slightly more nuanced response to QE. I haven’t been a fan of continuous QE. But I was a fan of it when it first came through in the immediate aftermath of the global financial crisis. I think it was important that central banks at the time demonstrated that they had more strings to their bow than simply focusing on interest rates. Because once interest rates were down to zero, that created the problem.
But I think the persistence of QE has been a problem. Anyway, the bottom line here, I suppose, is that QE I think comes under the umbrella of slightly peculiar, experimental monetary policies that are in danger of going wrong.
A very early example from Roman times is the inflation that picks up, really, from I suppose the birth of Christ through to about 300 AD. And it’s all associated with the inability of the Roman Empire to fund a sufficiently large army to cope with all the attacking warriors coming in from all corners, really.
And so to fund an army that’s big enough, they start watering down the amount of silver in their coinage. And of course, as every economics student now knows, if you do that, you’re likely to find the value of money slowly falls. And therefore, inflation picks up, which is exactly what happens.
And this creates panic within the Roman Empire. Diocletian, who’s the emperor at the beginning of 300 AD, comes up with what’s known as the Price Edict of Diocletian, which is effectively a series of price and wage controls designed to stop prices and wages from continuously rising.
Now, of course, by not doing anything about the money, it was a policy that was doomed to failure. But I was struck by the fact that these price controls included a maximum price for a male lion. So it does suggest that the consumer basket has shifted a bit from where we were 1,700 years ago.
And then another example, I suppose, is during the French Revolution, when the revolutionaries issued what we’d now think of as being paper money. But it had no real proper basis. And more importantly, it was very, very easy to copy. So you had counterfeit money circulating more and more rapidly.
This is another example, actually, where it’s not just the quantity of money that matters. What then begins to happen is that people stop trusting the money altogether, because they don’t know whether what they’ve got is either counterfeit or otherwise. So money loses value very quickly, which actually is a classic example of a hyperinflation in the modern era.
One of the peculiar characteristics over the last 100 years has been very, very little deflation other than during the 1930s. And one striking bit of data that comes from the Bank of England’s website is that a pound in 1900 is only worth two pence 100 years later. So inflation under these circumstances can be very destructive.
And the other thing I’ll just note, finally, I suppose, is that in each of these cases, often the government or the central bank is doing the money printing, and there’s a reason for that, which is that inflation tends to benefit debtors at the expense of creditors, and if the government happens to be one of the biggest debtors—and it’s normally the case that they are—then inflation is a very useful hidden tax. Because effectively it’s a tax on people’s cash wealth. If you’re not anticipating the inflation, it wipes out your cash savings. Then the government is effectively a winner. And you, the cash saver, are a loser.
Janet Bush: There’s a lot of criticism based on history and on what’s happened recently of both central banks and governments. You’ve got governments inflating their way out of large debts. You’ve got central bankers changing the goalposts, having the wrong model. Is that combination of fault among central bankers and governments, is that unusual that both have made mistakes?
Stephen King: The era of central bank independence itself is quite unusual in the sense that the Federal Reserve has been mostly independent, although its independence has been tested at times, particularly in the 1970s. But obviously the Bank of England, it was made independent only in 1997. And actually it was created originally to help fund wars.
So you have a link between central banks and governments that’s always been there. However, what I would say is that the idea that central banks and governments are independent from each other and remain independent forever, that’s not borne out by history.
One very simple political reason for this is that if a government finds itself in the position whereby it politically cannot easily raise taxes to fund its spending plans, and it can’t easily cut its spending plans, because either it’s a war, or its funding social benefits that are automatic, then in those circumstances, you’ll either have a continuously rising level of government debt as a share of GDP, which itself can make creditors increasingly nervous, or you can deal with it either by defaulting, which most governments don’t really want to do, understandably, or you surreptitiously create inflation.
In the book, I describe this as the “Burton–Taylor relationship,” which for older listeners is a reference to Richard Burton and Elizabeth Taylor. For younger listeners, it might be J.Lo and Ben Affleck. But I think it’s the same kind of story in both, which is that a relationship is on, it’s off, it’s on, it’s off. You’re never quite sure as to which of it it’s going to be.
And the same is true of monetary and fiscal policy, that you can claim that they’re completely independent from each other, but eventually they blur. And actually, QE is a very good example of where the lines are being blurred. Because let’s put it this way, in 2020 when the governments took on these huge amounts of extra debt, would they have done so quite so willingly if QE had not been there, if there wasn’t the knowledge that the central bank would be the buyer of last resort for government debt?
It is striking that if you look at the last 20 years or so, maybe 15 years, really since the global financial crisis and onwards, and I’m going to take the UK as an example here, because the data are pretty good on this going back over hundreds of years, the UK has seen a huge increase in government debt as a share of GDP.
The only other occasions in UK history where we’ve seen something of this kind are during wartime. So it’s either the Napoleonic wars, World War I, or World War II. And of course we also know from projections from the Office of Budget Responsibility in the UK, and the similar projections in the US and Europe, that spending on health and social care is going to rise a lot more in the years to come.
So it is likely that these levels of government debt will rise still further. And the political problem here is, well, what do you do about it? The thing you really want to do is have a productivity miracle so you can grow much faster. But you can’t wave a magic wand and just deliver that. That’s much more difficult.
What you need instead is a way of thinking about how you’re going to fund all this extra spending. And if you’re taxed up to the hilt, you can’t tax much more. You can’t cut other areas of spending very easily. You’re basically back to the default or the inflation options.
One reason why I think that inflation might be more tolerated is the fact that it is a neat way of coping with these really weak fiscal positions that are a consequence of costs of COVID, the cost of the global financial crisis, and which are the biggest increases we’ve seen outside of wartime.
Janet Bush: How long do you think it might take to squeeze inflation out of the system?
Stephen King: Well, I’m going to answer that question—I sound like a politician here—I’m going to answer this question slightly differently. I think that the consensus is inconsistent. I can think of two ways in which the consensus might be wrong. The consensus basically says, “The inflation’s going to disappear pretty quickly. Interest rates will fall later next year into 2025. Everything’s going to be okay. We’re back to a prepandemic world.”
I think that’s going to be wrong—wrong in two different ways. The first way is that maybe inflation is squeezed out of the system, but if it is, interest rates will be much higher persistently than is currently being expected. In other words, the monetary pain associated with squeezing inflation out of the system will be greater if you want to get inflation down to 2 percent and keep it there. So that’s my first point.
The second, alternative scenario is that the market is actually right about peaks in interest rates and coming down relatively swiftly. But under those circumstances, my guess is that if that happens, then it’ll be a sign of a policy mistake. In other words, the inflation will then linger. It won’t go down to 2 percent. It won’t stay at 2 percent.
So again, back to my UK example from earlier. If you’ve got UK wage growth at 8 percent, that’s no way consistent with price stability. So you’ve got to be pretty confident that’s going to come down to something more in keeping with the underlying performance of the economy if you really want to get to 2 percent inflation. And I’m just not sure that policy makers have their heart in reducing inflation and wage growth to that degree.
Janet Bush: And you’ve talked about this current debate about the target inflation of 2 percent, or whatever it is, being quietly abandoned, because it doesn’t feel good politically.
Stephen King: Again, going back through history, the problem actually in one sense is that a recession is right in front of you. It smacks you right in the face. And you don’t want that. So you try to avoid it.
But the problem with avoiding a recession is that you may find that the inflation persists. And then it ratchets higher over a period of time. So inflation comes down a bit. You cut interest rates prematurely. And then when the next recovery phase comes through, inflation ratchets higher still.
And before you know it, you’re in a world whereby inflation again is permanently higher relative to the underlying performance of the economy. Then eventually society begins to recognize that the removal of inflation ultimately is a necessary precondition of success elsewhere in terms of the labor market, in terms of productivity, in terms of underlying growth.
But to persuade society that that’s true may take a number of years, which is what happened in the 1970s that everyone now says, “Oh, yes, in the 1970s, the problem with inflation had to be tackled.” But there were very few people in the early ’70s arguing that inflation was the number one problem. It was an irritant, but it wasn’t the main problem, even though it turned out to be the main problem.
Janet Bush: What is our main problem in the period ahead, do you think—economic problem?
Stephen King: Actually, our main underlying problem—inflation’s a symptom of it, really, but the main underlying problem is productivity, the lack of decent growth. We see all these technological advances all around us, but it doesn’t come up in the productivity numbers the way people had expected.
And one reason why inflation is a possible response to it is that you’re trying to show you can try to grow, you can try to stimulate the economy. But actually if your productivity growth is poor, then all you’re going to do is create more in the way of inflation.
Janet Bush: You mentioned globalization, and we’ve done quite a lot of work on that recently at MGI. And you say that globalization led to cheap goods for those who can afford them, so good deflation. But if globalization weakens or reverses, those deflationary gains turn into inflationary losses. And I wondered if there’s an element of that going on now that’s contributing to this new inflation environment.
Stephen King: Yeah, I think there is. This is going back to deflationary tailwinds and inflationary headwinds. But I think it’s fair to say that in the years, decades before the pandemic, central banks took too much credit for delivering low inflation, when in fact part of that low inflation was a consequence of this outsourcing and offshoring to lower-labor-cost parts of the world.
And doing that meant that, in effect, the Western developed world was importing what I would describe as good deflation. So basically, prices were falling relative to wages, relative to profits, relative to rents. And the actual process of price reductions in itself was a good thing in terms of raising living standards.
But because of inflation targeting, there was a fear that this was not good deflation, it was bad deflation. And so policy makers deliberately tried to offset the impact of good deflation by lowering interest rates and trying to boost domestically generated inflation. In the process, they left real rates too low, which I think contributed to the asset price bubbles that we saw in the 1990s, actually the 1980s and the 1990s, and beyond to culminate with the global financial crisis.
One result, though, is that whereas people are saying, “Well, we shouldn’t let inflation undershoot target during these periods of good deflation,” everyone seems to be terribly happy about allowing inflation to overshoot target during the new period of what we might describe as bad inflation, which is a consequence as I say of rebuilding borders and barriers.
Now, part of this goes back a long way. It’s all to do with deteriorating relations between Beijing and Washington, well documented of course. It’s partly a sense of nearshoring, reshoring, friend-shoring, whatever one wants to call it, that’s been at work recently. It’s partly a consequence of AI and robotics that means you can replace cheap foreign workers with even cheaper machines at home. And I think it’s been turbocharged by the pandemic, because of this sense of vulnerability to fragile global supply chains.
But I think even if you thought that globalization would continue to advance, the pace at which it advances from now on, I think, will be materially slower than was the case particularly before the global financial crisis, and certainly before the pandemic.
And if it’s materially slower, then those deflationary tailwinds we’ll see a lot less of. And frankly, it wouldn’t surprise me if globalization actually goes into reverse. My previous book, back in 2017, called Grave New World, the subtitle was, The End of Globalization, the Return of History. So I’m out there having said these things are a bit worrisome.
But in terms of the implications for inflation, whereas the earlier era of hyperglobalization will be associated with inflation undershooting in general, this new era is more likely to be associated with inflation overshooting. So there are global conditions of change, which I think are less helpful for price stability than have been true in earlier periods.
Janet Bush: So I just want to close with a big question, stepping back from it all. You say that inflation is profoundly undemocratic. And you say that there’s winners and losers. It is a highly political thing. And it affects real people. Tell me why inflation matters in your book.
Stephen King: It matters in terms of the distribution of income. Broadly speaking, inflation is a debtor’s friend. And it is the creditor’s nightmare.
Janet Bush: I think, again going very wide, there’s been this huge fear of unemployment, of deflation. And that has informed a lot of the decisions that have been made. But I think what your book says and what you say is that that’s not the only threat. That’s not even the biggest threat. Inflation is also something that can really hit your pocket, really make life difficult. And that’s why we need to focus on it.
Stephen King: Absolutely right. Yeah, we need to talk about inflation, in fact. But, yeah, it’s a terrible thing. It’s unfair. It’s not democratic. It’s a terrible thing to unleash from a society. And I think many of us have forgotten what damage it can do.
Janet Bush: Well, thank you so much, Stephen. It’s been absolutely fascinating. And we haven’t talked about inflation for a long time. So it was a good time to do that.
Stephen King: It was great. Thanks, Janet. It was really enjoyable.
