Spiraling inflation, climbing oil prices. Phenomenons are familiar to those who lived through the terrible 1970s. In the following five decades, the UK became one of the biggest debtor nations. Across the Atlantic, a similar fate for the US, from the largest creditor to the largest debtor nation. The inflation calamity of 2022 is far worse than fifty years prior. Excessive leverage and an over-reliance on asset-price inflation spurring confidence and growth have left both economies paralyzed and inept to fight this wave of inflation. Yet, a return to the old formula is necessary. Reversing the sharp increases in the money supply is the only way to grapple with inflation. A recession is inevitable – regardless of action or inaction rendering contractionary monetary and fiscal policies the best antidote to putting these Western economies on the path to prosperity in the long run.
Aforementioned in a previous article, Central Banks are the central cause of the current inflation crisis and are required if we are to resolve the mess they provoked. Huge increases in the money supply have led to too much money chasing too few goods: inflation. To simulate the economy amidst the coronavirus pandemic, Central Banks took to increasing demand through quantitative easing. The problem is output shrank drastically. As lockdowns prevented large swaths of the population from working, a sharp increase in the amount of money in circulation followed; demand increased and supply fell. It doesn’t take an economist to understand this is inflationary.
As this huge excess of money flowed through the financial system, asset prices soared as equity indexes reached record highs. However, flooded with such liquidity, this asset price inflation eventually made its way into consumer prices, thereby provoking the inflation spiral we see today.
Rolling back the untold damage of spiralling inflation requires contractionary measures. Central Banks need to reverse previous sharp increases in the money supply through quantitative tightening. Recession fears have arisen amidst this consideration. Addicted to cheap money since 2008, Western economies can’t survive without cheap credit. Millions of zombie companies depend on it, as does consumer confidence. With the majority of UK and US homeowners paying off mortgages, falling asset prices from QT would result in negative equity – a phenomenon that shook the financial markets in the Great Recession. However, high inflation makes a recession inevitable regardless. As the purchasing power of consumers erodes, businesses are suffering as individuals make efficiencies and curtail spending. As of July 2022, the S&P 500 has declined 17% since the start of 2022 – attributable to falling profit margins of firms seeing sales decline. Discretionary spending has seen the biggest hit, represented by Lyft falling 70% between January and May 2022. As a result, layoffs by firms have started; since 2022, Coinbase has fired over 10% of its workforce.
As a recession becomes inevitable in spite of rate hikes and contractionary monetary policies from falling spending and rising unemployment, curing the initial problem of inflation through said measures will deflate asset bubbles across the economy. Initially provoking a severe recession, this should result in a better allocation of resources in the long run. Investment into REITs and other unproductive assets would fall as investors stop expecting Central Banks to prop up house prices, creating investment into productive sectors of the economy, and driving sustainable economic growth. The growing disconnect between house prices and incomes cannot continue as a greater amount of income gets sucked away by higher mortgage and rental costs. Deflating this asset bubble will make housing affordable whilst promoting an efficient allocation of resources away from rentiers and towards productivity and growth.
Facilitated by Central Banks, governments have promoted this surge in spending through expansionary fiscal policies. Through large deficits, Central Banks have purchased government bonds to finance their debts – increasing the money supply and creating inflation. However, Central Banks lack the need to purchase bonds if governments keep spending under control.
Following the outbreak of the pandemic, borrowing soared whilst tax revenues fell globally. Recognising the policy was exacerbating inflation, in the UK, then-chancellor Sunak took to tax hikes to balance the books to limit increases in the money supply.
Although tax hikes will stem inflation, reducing wasteful spending is a far more efficient way to do so. Inflation is the result of too much money chasing too few goods. Increasing taxes decreases investment that would otherwise fuel the necessary economic growth to ensure output keeps pace with money supply growth. If increases in the money supply coincided with proportional increases in output, inflation wouldn’t have occurred – assuming velocity remains constant. However, as inflation was the result of wasteful government spending, little economic growth followed and the result has been climbing prices.
Cutting taxes and reducing spending will most effectively resolve the inflation crisis. Unleashing a tide of economic growth through targeted tax breaks for corporations and high earners will promote productivity and increase output and growth. Eliminating wasteful spending such as foreign aid and defence spending will reduce government borrowing, reducing the need to borrow and creating inflation through money supply growth.
Ultimately, politicians and Central Banks alike are the sole groups with the tools to resolve the inflation predicament. Reversing the rate cuts and quantitative easing programs through tightening will fast-forward the looming recession – whilst simultaneously reducing inflation. Government bureaucrats are equally to blame. Excessive spending fuels borrowing from Central Banks, inducing money supply growth and creating inflation.