Will COVID-19 be followed by inflation? An inter-generational transfer perspective
Lubos Pastor suggests that the easiest way for central banks to deal with COVID-spawned debt may be tolerate above-average inflation.
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Governments around the world are spending mightily to deal with the fallout of the COVID-19 crisis. When the dust settles, the burden of public debt will be much heavier than it is today. Some countries’ debt-to-GDP ratios are likely to grow by more than 20%. How will policymakers deal with this mountain of debt? They may be tempted to inflate it away.
Alternatives to inflation seem unappealing. Raising taxes would impede the post-COVID-19 recovery. Cutting public spending would also be hard, especially after a crisis that has uncovered inadequacies in our health care systems. While inflation is not particularly appealing either, it may end up looking like the least bad option.
After World War I, Germany famously inflated away much of its domestic debt. Such a hyperinflation is extremely unlikely today. However, letting inflation exceed expectations, even if only mildly and only temporarily, would reduce the real burden of public debt. Moreover, it would shift the burden away from those who are suffering the most from the lockdowns imposed by governments to battle the virus.
The costs and benefits of government-imposed lockdowns are not distributed equally across age groups. The benefits accrue especially to the old, whose mortality rates from COVID-19 are much larger than those of the young. In contrast, the costs of reduced economic activity are borne largely by the young and middle-aged, millions of whom have lost their jobs and businesses. Retirees cannot lose their jobs. In addition, students’ educations have been disrupted, and those who are graduating in this recession are having a hard time finding jobs.
In short, as a group, the old derive large benefits from the lockdowns while incurring relatively small costs. Whereas the young derive smaller benefits while incurring significantly larger costs.
This intergenerational transfer seems entirely appropriate. It makes sense for humanity to take advantage of intergenerational insurance against unforeseen disasters. If this pandemic were to kill especially the young, as the 1918 Spanish flu did, the old would surely be just as happy to make sacrifices as the young are today.
This transfer could affect how policymakers deal with the bloated public debt. If this debt is simply rolled over, it will put an additional burden on the young, above and beyond the burden imposed on them by the lockdowns.
Policymakers who want to alleviate the burden on the young may find inflation appealing because its impact on the young is limited. The young live mostly off labor income, which grows with inflation.
Inflation has a larger impact on the old because it reduces the real value of the assets they hold. Having had more time to save, the old tend to own more financial assets than the young. The old also tend to have a larger fraction of their wealth invested in bonds, which are particularly vulnerable to inflation (as opposed to stocks, which are claims on real assets).
We are unlikely to see much inflation in the near future. We might even see deflation, due to low aggregate demand. But inflationary pressures are likely to emerge after the engines of the global economy rev up again.
On top of the usual recovery-induced price pressure, it will be costly for firms to implement social distancing measures. For example, some firms may redesign their supply chains to make them more resilient---and costlier. Airlines may choose, or be asked to, to leave the middle seats empty. Restaurants may use fewer tables. The associated costs will to some extent be passed on to consumers. In addition, firm failures during the crisis will reduce competition in the marketplace, leaving more pricing power in the hands of the surviving firms.
When inflation picks up, it will be up to central banks to decide how much of it to tolerate. Will they be willing to overshoot their current inflation targets of about 2% per year?
They might not have a choice. This crisis is likely to amplify the voices questioning the need for central bank independence. Three recent crises – the financial crisis of 2008, the Eurozone crisis of 2012, and now the COVID-19 crisis – have made patently clear how important central banks are in putting out economic fires. A good example is the ongoing close cooperation between the Fed and the Treasury in providing financing to a wide range of institutions. After COVID-19, governments may decide to reestablish control over their elite firefighting units, or at least modify their mandates.
In a post-crisis environment, do not be surprised if governments push central banks to tolerate above-average inflation. It may be the easiest way for them to deal with COVID-19 spawned debt.