Why Inflation Could Follow the Crisis

During this COVID crisis, governments are accumulating huge amounts of public debt. In many countries, the debt-to-GDP ratio will rise by 20 percent or more. The question is, how do we deal with this mountain of debt?

One way is to raise taxes. Well, raising taxes may not be the best way if you want to get out of a crisis. Higher taxes may slow down our recovery. Another approach is to cut public spending. But that might not be the best way either, given that we just learned we need to spend more on improving our health-care systems.

Yet another approach is to run inflation—let inflation run above expectations for a while. Because inflation can reduce the real burden of public debt. For example, after World War I, Germany famously inflated much of its domestic debt just by running a hyperinflation. Now naturally, we’re unlikely to see hyperinflation nowadays, but if inflation were to run a bit above expectations—instead of 2 percent, maybe 3 percent or 4 percent for a while—that would help reduce the real burden of debt.

Moreover, higher inflation would also help shift the burden of debt away from those who have suffered the most as a result of the lockdowns that governments have imposed to deal with the virus. Government-imposed lockdowns have both costs and benefits, and all of us participate in the benefits as well as in the costs. However, these costs and benefits are not distributed equally across age groups.

The benefits of lockdowns accrue especially to the old, whose mortality rates from COVID are significantly larger than those of the young. The costs of the lockdowns are imposed especially on the young. And it’s not just because the young like to go out and party and socialize and they can’t do that; millions of the young have lost their jobs as a result of this. And obviously, that has happened to a lesser extent to the old because if you’re retired, you cannot lose your job.

In addition, many students’ education experiences have been disrupted, which could have permanent effects on their careers. Students graduating into this recession are in a particularly difficult situation.

To summarize, the old as a group have benefited the most from these lockdowns, while incurring the smallest cost, whereas the young have benefited the least while incurring a significantly larger cost.

And I want to be very clear that this intergenerational transfer is completely appropriate. It makes perfect sense for humanity to take advantage of intergenerational insurance so that if an unexpected disaster hits, one generation supports the other. In 1918, when the Spanish flu hit, it affected especially the young, as opposed to today. I’m sure if that happened today, the old would be perfectly happy sacrificing for the young just like the young are doing today.

If these new debts are simply rolled over year after year, their burden will fall especially on the young, and that’s going to be on top of the burdens that have already been imposed by the lockdowns.

With inflation, though, things may look a little different, because inflation has a bigger impact on the old than on the young. Think about it. The young live mostly off of their labor income, and labor income grows with inflation. Whereas the old have accumulated some financial assets, whose real value will go down with inflation, especially because for the old, the fraction of wealth that’s invested in bonds is particularly high, much higher than for the young, and bonds are particularly vulnerable to inflation.

So to summarize, it seems to me that inflation would essentially be a transfer from the old to the young, going opposite to the transfer that has been initiated by the government lockdowns.

Inflation is not great. We’re looking for the best alternative, the best way of dealing with this mountain of debt, and there are no good ways. So we’re talking about the least evil, and it’s quite possible that society down the road is going to decide that the least evil is inflation, just because the alternatives are worse.

We are unlikely to see much inflation in the near future. In fact, we might even see deflation temporarily due to the low aggregate demand caused by the crisis. But after we get out of this crisis, inflationary pressures are likely to appear. They usually do during recoveries. People will start driving, people will start spending, that usually has at least some upward pressure on prices.

Moreover, this crisis is a little different because we are likely to see behavioral adjustments down the road. Social distancing, and the measures associated with social distancing, are going to impose some costs on companies. If you ask the restaurants to put tables further apart, well, they’ll have fewer tables, they may have to raise their prices. If airlines are to leave their middle seats open, well, they may have to hike their airfares. If firms want to disinfect their offices every day, that’s costly. If multinationals decide to reengineer their supply chains to be more resilient, more robust, that may come at the expense of efficiency as well. And all of these additional costs may at least to some extent be passed on to consumers. So that’s going to be an additional kind of element pushing prices up down the road.

On top of that, many firms are going to fail in this crisis. And that means that the surviving firms are going to have more monopoly power, more pricing power in the marketplace. That also could push prices up to some extent. And if and when inflation picks up, it’s going to be up to central banks to decide to what extent to rein in on inflation.

It’s quite possible that we are going to see above-average inflation for a period of time. Because central banks may not have as much of a voice in this matter as they used to. This crisis may amplify the voices of those questioning the need for central bank independence.

Think about the last three crises that we have lived through: the 2008 crisis, the global financial crisis; the 2012 European sovereign debt crisis; and the current COVID crisis. In all three cases, central banks played a key role in calming things down. And governments may come to realize that and understand that it’s important to have at least some control over their elite firefighting units that are able to put out all these fires that come in. I wouldn’t be surprised if we see some pressure from governments to reestablish control over their central banks, or at least to broaden their mandates.

And therefore, don’t be surprised if you see above-average inflation after this crisis. Because governments may find it easy to push on their central banks and to ask for more inflation in order to deal with all this COVID debt.