Are we heading back to the Seventies?

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Rupert Harrison12 April 2022
WEST END FINAL

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It’s a recurring truth in economics that things carry on for longer than you can imagine, but then change faster than you expect. We might be experiencing one of those transitions right now. The last two decades saw slowing global growth, low inflation, falling interest rates and booming asset prices. Is it possible that a combination of the Covid restart and the invasion of Ukraine are accelerating us into a new economic regime, with higher inflation, rising interest rates and faster wage growth? If we really are heading for a rerun of the Seventies then some central parts of our national debate will change fundamentally.

Since before 2000, the deflationary regime we’ve lived through has been driven by powerful trends: globalisation, technology and demographics. The rapid integration of China into the global economy added hundreds of millions of workers into the global labour market, reducing the bargaining power of workers in the developed world. Companies then offshored their supply chains to cheaper locations, resulting in lower prices for their goods.

Meanwhile, fast-growing developing countries with ageing populations saved huge proportions of their incomes and invested them in the safest stores of value available: Western financial assets. This so-called “savings glut” drove up the value of those assets and pushed down the interest rates on the safest assets of all, government bonds. At the same time, for reasons we still don’t fully understand, the underlying rate of productivity growth around the world slowed down noticeably after 2000, reducing the growth rate of living standards.

This period has delivered the fastest decline in global poverty that mankind has ever seen, as billions in the developing world have joined the global economy. And yet in the developed world these same trends lie behind some of the most intractable and emotive problems of our times. House prices that seem to rise without limit. Stagnating median incomes. Growing tensions between the generations.

We tend to look to governments to solve these problems, but the truth is that like us they are mostly at the mercy of powerful global trends beyond their control. If we are truly entering a new era of higher inflation, stronger wage growth and higher interest rates then many of these challenges may begin to unwind by themselves. So what’s the evidence for such a sea change?

In the short term, the inflation we’re experiencing is mainly driven by reductions in the supply of goods and energy, exacerbated by the pandemic and now the horrific invasion of Ukraine. Those drivers, though painful, will hopefully fade, but if people’s expectations of future inflation are permanently higher as a result, then this could jolt us into a more inflationary world. At the same time, thanks to huge stimulus in the wake of the pandemic, labour markets in some parts of the world – including the UK but especially the US – are extremely tight, with companies forced to compete for scarce recruits. As a result, wages are growing strongly.

Underlying all this it’s possible that some of the longer-term forces of deflation are fading, For example, the rapid integration of China into the global economy is now maturing, and may even be moving partly into reverse as some companies seek to bring their supply chains back closer to home.

But I’m still sceptical that we are seeing a complete reversal of the deflationary world we’re used to. There are still billions of people in India and Africa who want to reap the benefits of the global labour market. In fact the pandemic may even have accelerated the offshoring of service sector jobs. The world economy is also now carrying such a huge stock of debt that it makes permanently higher interest rates ever harder to sustain. Financial markets are already betting that slowing growth will force interest rates to fall again within a few years – what investors call an “inverted yield curve”. This has often been an indicator of future recessions.

Of course, even if we are seeing a regime change, one set of problems could just be replaced by new ones. Most obviously, the cost of servicing all that debt could end up much greater than expected if interest rates do carry on rising. At a time when the demands on governments – for help with the cost of living, or more spending on defence – are growing ever louder, even the risk of this happening is enough to justify some sensible prudence about the public finances. That’s an important reason why taxes went up this week.

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