Walking The Tightrope To Avoid Stagflation

Two years ago, I subtitled my annual forecast of the economy “We’re All Super-Keynesians Now.” Last year it was “all eyes on inflation”. This year the focus is on adjusting costs to reduce inflation. The progression of titles follows economic logic and principles: the government overspends, pays for its spending by printing money or debt monetization, prices rise, then, if you don’t want to end up like Argentina, you have to reverse course.

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From 2018 to 2020, consolidated government spending in the US rose from just 35% to 48% of GDP. In 2022 it will drop to 42%. From 2018 to early 2022, the money supply, as measured by M2, increased from about $14 trillion to about $21.5 trillion. It continued to grow until the end of March when it reached $21.7 trillion. It then began to gradually contract, falling to $21.65 trillion at the end of August. It stands at $21.35 trillion today, down less than 1% from the start of the year.

An increase in the money supply leads to an increase in inflation in 2022. If we see a slowdown in the growth rate of inflation today, it is associated with this contraction in the money supply. It has nothing to do with the “Inflation Reduction Act,” which focuses more on spending priorities than deficit reduction. The two best ways to reduce inflation are to stop printing money to finance government spending and to liberalize the economy to increase the supply of goods relative to the money supply.

Interest rates have also increased. In the medium and long term, interest rates have three components: pure interest, risk and inflation premium. Pure interest is based on time-preference. People generally prefer to have a certain amount of money today rather than in the future. Risk adds to the rate: the safer the borrower, the lower the rate. And when inflation rises, interest rates respond to the new reality. Lenders cannot recover their loans when repaid with devalued dollars. Mortgage rates have doubled since the start of the year. With average rates for 30- and 15-year loans at 6.60% and 5.28%, respectively, and expectations of Fed tightening, most real estate markets will continue to suffer.

Artificially low interest rates, such as those experienced until recently, only encourage meaningful investments at low rates. When interest rates return to normal levels, less profitable ventures are unsustainable. Abandoned projects create waste; Reallocation of resources takes time and part of the capital is lost for good. This period of readjustment can lead to stagnation, regression or depression. The severity depends on the extent of the adverse investments to the rest of the economy. I agree with those who expect the Fed to continue its tight monetary policies and expect the US economy to grow very little in 2023.

The future of the US economy depends primarily on domestic factors. The US has one of the lowest percentages of international trade to GDP in the world. It’s only 25%, but supply chains depend on that business. Foreign trade and the economic strength of buyers of US products is essential to export-oriented businesses. This is one of the primary circumstances for China’s prominence in the current economic dialogue. China and the US are by far the two largest economies in the world. What happens in China affects every corner of the world. US trade with Chinese producers is similar to the level of its trade with Canada and Mexico – just under $700 billion. I don’t view trade deficits as negative per se, but others show concern, especially in the areas of politics and competing with Chinese manufacturers. The trade imbalance with China is more than twice the trade deficit with Canada and Mexico combined.

Getting accurate growth data from China is complicated and I have no inside knowledge, so I’ll have to go with the lower end of the consensus estimate. Still, China grows faster than the world economy, between 4 and 5% and 2-3% for the world. A shift in China’s policies to contain Covid, avoiding costly generalized lockdowns, is a positive sign for the world economy. Daniel Lacalle, a respected European analyst, thinks China’s recovery could be particularly helpful for German and French exporters. A return to more rapid growth in China is “probably the biggest stimulus we can expect in a very challenging year on the global economy,” Lacall argues. But in the long term, especially for Europe, Lacall expects a decade of weak growth, below 1%, “a level of growth that is very low but not a crisis.”

On the negative side, and beyond economic policy, there are concerns about a potential invasion of Taiwan. Last year, around this time, I heard one of my favorite Russia experts, Andrey Illarionov, predict that Putin was not going to invade Ukraine. Illarionov is no amateur analyst — in fact, he was one of Putin’s top economic advisers from 2000 to 2005. Illarionov based his analysis on Russia’s lack of sufficient forces to succeed. He was proved right in the later stage, but he was wrong in the first stage. The damage to the world economy is enormous. Although it may affect fewer countries directly than an invasion of Ukraine, a Chinese invasion of Taiwan would have devastating consequences.

The US economy doesn’t take much of a hit from Europe. The Eurozone is likely to experience higher inflation, lower growth and higher unemployment than the US as it chooses to adjust more slowly. The costs and uncertainties of the war in Ukraine affect Europe more than any other region of the world. The forecast for Germany, the largest eurozone economy, is similar to the average.

The next largest European economy is the United Kingdom. The new “conservative” government may not be able to reverse Brexit, but it is taking the country in a European direction, putting more faith in taxpayers than in the liberating forces of a free economy.

Despite their greater distance from the war in Ukraine, the future for Latin America is not looking good. The economies of Brazil and Mexico account for roughly two-thirds of the region’s economy and both are expected to grow modestly by 1 percent. Despite its strengths, Mexico has stuck with various flavors of populism in left-wing ideology. That, combined with drug cartels, powerful crony capitalists and an ineffective political opposition, suggests that Mexico’s economy will continue to disappoint.

They will be walking a different kind of tightrope in Brazil, Latin America’s largest economy and one of the world’s largest. A very challenging but outstanding tenure for the Minister of Economy has come to an end – Paulo Guedes has served from January 1, 2019 to today. In an administration where few ministers have completed full terms, Goodes has been able to navigate turbulent waters like few ministers in history. He held the helm of economic principles and policies which, wherever attempted, led to prosperity. Goodes had to adapt to the storms that came his way, storms generated by institutional weaknesses and corporatist power. In a previous article, I wrote positively about Guedes’ deregulation efforts. Local free-market economists praised Guedes for transferring economic activities from the bloated public sector to the private sector and for significantly improving the financial health of companies that remained in state hands. Brazil achieved records in foreign trade, and a continuation of Guedes’ policies could have propelled the country into a new era of prosperity. But a significant portion of the Brazilian electorate and an activist Supreme Court helped free Lula from prison and elect him president. Lula is likely to reverse economic policies and return Brazil to its normal state as a lasting promise. The importance of Brazil in Latin America deserves a separate article apart from these few lines.

In this publication and in other business-oriented media, I expect economists throughout 2023 to debate whether the Fed’s policies are too tight or too loose. No one can know for sure. When it comes to tomato production, we rarely ask, “What is the right amount of tomatoes?” If there is more supply relative to demand, the price will fall; If it is too low, the price will go up. With money supply, we constantly ask such questions. Now that money has become a tool of governments and not just market demands, we have political demands and dual mandates for monetary authorities by reducing inflation and unemployment. It is impossible to know beforehand whether a person is acting too slowly or too fast. That is why renowned economists like Milton Friedman or John Taylor have proposed rules to give better guides to markets. FA Hayek went further, proposing a more substantial reliance on markets by demonetizing money and increasing monetary competition.

As someone who lived the first three decades of his life in Argentina, a country ravaged by inflation, I am glad that most economists in the United States seem to shun the failed solution of price controls. Inflation is bad but combating it with price controls creates even more significant problems. Inflation is higher today than when President Nixon imposed wage and price controls; However, economists and politicians still remember the failure of his policies and resist repeating the mistake. To be successful in tightrope walking, one must go slowly. We may be stuck with a stagnant, slow-growing economy, but I have no choice in the current political-economic climate.


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