When the black swans come home to roost: explaining inflation

By on 27/11/2022 | Updated on 20/12/2022
A photo of Irish Department of Finance’s chief economist, John McCarthy speaks at Global Government Forum’s 2022 Government Finance Summit
Irish Department of Finance chief economist, John McCarthy speaks at Global Government Forum 2022 Government Finance Summit. Photo: Maksim Toome

The world has had to face a lot of ‘black swan’ disruptive events over recent years – and in responding to these immediate challenges, finance ministries have sometimes created new problems. Matt Ross hears Irish Department of Finance chief economist John McCarthy explain the drivers of inflation at the 2022 Government Finance Summit

“The Government Finance Summit exists to help you, as leaders in finance ministries, to build links with your peers in other countries, and to learn from each other about the tools and innovations that you’re using to meet the challenges you face,” event chair Siobhan Benita explained to the senior officials gathered for the 2022 Summit.

This year the Summit – previously hosted by the finance departments of Singapore, the UK, Germany, and France – moved to Tallinn, where the Estonian government welcomed senior finance leaders from nine countries. “We’d really like to thank the team at the Ministry of Finance here in Estonia for all their support and hospitality,” said Benita, who also offered thanks to the event’s knowledge partner, Microsoft.

The Summit mainly comprises round table discussions, informed by presentations from the participants. But it opens with an after-dinner speech – provided this year by the Irish Department of Finance’s chief economist, John McCarthy, whose speech addressed today’s stand-out economic challenge: inflation.

While the Summit is held in private, allowing finance leaders to openly debate the policy and operational challenges that they face in common, some participants have allowed us to publish their comments. Please note that the process of checking quotes with participants lengthens production times: the event was held in June, since when the economic picture has further deteriorated.

Here we set out McCarthy’s perspective on the causes and consequences of the huge price shocks of recent months – and his views on how economic policymakers could respond.

Read more: The UK budget: behind the headlines

Flocks of black swans

Twenty years ago, Nassim Nicholas Taleb developed his ‘black swan’ theory – highlighting the catastrophic, unpredicted and rare events on which history so often turns. But we may now need a new phrase, commented John McCarthy: after all, “black swans come along once in a generation. We seem to be having them every couple of years!”

“We’ve had a pandemic; we’ve had war on European soil; and what hasn’t gone away – certainly in a European context – is the UK’s exit from the European Union,” he said. These events have hit economies in Europe and far beyond, adding a new set of challenges to those bound up with the lasting fall-out of the financial crisis.

In economic terms, commented McCarthy, 2019 is “ancient history: that really was a whole different world. The neutral interest rate – the rate that balances aggregate demand with aggregate supply, and generates stable inflation – had been on a downward trend for four or five decades.” Many economists and policymakers had, he added, concluded that monetary policy had lost some of its potency – turning instead to fiscal policy as a stabilisation tool.

Then came the pandemic, when inflation initially “tipped into negative territory.” Central banks further squeezed interest rates; there was a “massive expansion of their balance sheets, as they hoovered up sovereign government debt”; and huge stimulus packages of borrowed money poured into the world’s lockdown-frozen economies.

Supply down, demand up

These interventions landed in an environment where “some of the key structural factors – globalisation, demographic trends etcetera – that have been keeping a lid on inflation for a number of decades appear to be going into reverse,” McCarthy commented. In many countries, workforces are ageing and shrinking – contracting the supply of labour – while Brexit and tensions between the USA and China have impeded trade and undermined global supply chains.

These factors vary between the developed economies, he added. Unemployment is fairly high in the EU, for example, while the UK and USA are experiencing record low unemployment rates – with “no slack at all in their labour markets.” On the supply side, the USA’s large oil and gas industries give it far greater protection from the energy price shock than Europe, which imports huge quantities of gas from Russia.

During the pandemic, with many service industries locked down, consumers “were buying durable goods – but we had supply chain problems, pushing prices up,” McCarthy recalled. “When economies reopened, we shifted that spending to contact-intensive services – but there’s lots of labour shortages in the likes of hospitality,” extending inflationary pressures into these sectors. “We were closing large parts of our economies; they can’t be reopened straight away,” he remarked.

Meanwhile, demand had been stoked by the expansion of central bank balance sheets and the huge public resources invested in pandemic stimulus packages, business support and furlough schemes. “We were printing more money, and had a supply-side shock,” said McCarthy. “It’s a classic case of too much money in the economy chasing too few goods and services, and that’s pushing up prices.”

Dr Markus Sovala, director general of Finland’s statistics institution Tilastokeskus

Indeed, this pandemic-related spending followed a decade of loose monetary and fiscal policy: central banks have been issuing debt and injecting liquidity into markets ever since the 2008 credit crunch. “It’s not difficult to understand this inflation. The difficult thing to understand is why it took so long,” commented Dr Markus Sovala, director general of Finland’s statistics institution Tilastokeskus and a former finance department economic policy chief. “There was a huge monetary and fiscal expansion for almost 15 years. Everything comes up in bubbles – and those bubbles are surfacing now.”

The counter-narratives

When inflation rises, “central bankers are the ‘first responders’,” continued McCarthy. “But we’re in a situation now in which inflation has been so high, so broad and so persistent that there are real distributional issues.” With millions facing huge financial problems, governments have to use taxation and spending to provide support: “Fiscal does have a role in addressing inflation,” he said.

In deciding how to intervene, however, governments should keep an eye on the bigger picture. Irish inflation has been so low for so long, McCarthy explained, that even its 2021-22 surge hasn’t fully compensated for a decade of flatlining prices: given continued inflation of around 7%, prices at the end of 2023 would still be lower than they’d have been had inflation sat at a steady 2% since the year 2000. The problem is not price rises over the long term, but their compression into a couple of years – allied to slow growth in median salaries since the credit crunch.

Offering another counter-narrative, McCarthy pointed out that “we’re in an energy transition situation: higher fossil fuel energy prices are a good thing” in the context of addressing climate change. The problem is the rapidity and scale of the price rise. “We need to buy ourselves some time – but higher prices for fossil fuels will reduce demand and encourage the supply of alternative technologies,” he said; public sector interventions to curtail raises might be essential, but they’ll “weaken that signalling effect.”

Again drawing on figures for Ireland, McCarthy noted that “people couldn’t spend during COVID: they were accumulating massive amounts of savings, bringing households’ total financial net worth to 150% of national income [by 2020, excluding housing]: that’s a 20 percentage point increase over the previous year.” So while real incomes are falling rapidly, the average household has a financial cushion available to absorb some of the inflationary shock.

As he noted, though, this is “the aggregate position – and I fully recognise that the aggregate hides a multitude of differences.” Economists do not oppose additional public spending to protect people from skyrocketing prices, said McCarthy; but they would prefer that measures are targeted at those most in need, so as not to jeopardise the public finances.

The three Ts

Governments, McCarthy argued, must focus on protecting “those at the lower end of the income spectrum, the elderly, the unemployed”.

He added: “They have a much higher weight of energy and food within their consumption basket. They’re the ones most affected by inflation. And they’re the ones that, I think, support needs to be targeted towards.”

The Irish government, for example, has allocated about one percent of national income to compensatory tax credits and benefits increases. “Every country has to design policies that are right for them,” he commented, outlining some principles – “the three Ts” – that can guide decision-makers everywhere.

Fiscal measures, McCarthy argued, should be “timely: they should get to the people who need support quickly. They should be targeted. And they should be temporary. Any finance ministry official will balk at that, because we all know that temporary measures can become permanent very, very quickly. So we’ve tried to put sunset clauses into our various measures.”

Sharing the shock

Since 2008, governments have addressed two vast socio-economic challenges – the credit crunch, and the pandemic – by borrowing to fund public sector interventions, supporting organisations and households through these very different crises. Now they face a third, in the form of rampant inflation; and as McCarthy pointed out, this time they have much less room for manoeuvre.

“The level of debt is very high in euro area countries, and in designing any fiscal response that needs to be borne in mind. Also, sovereign borrowing costs are rising,” he said. While most advanced economies can still borrow at reasonable rates, “the trajectory is problematic. If things were to keep moving in that direction, that would be a concern, given the quantum of debt.”

John McCarthy discusses the economic outlook

Interest rates must rise to help combat inflation, but McCarthy warned that increases may pose a threat to housing markets in some countries – and also to the banks exposed to them. Meanwhile, he worries that if government spending rises too rapidly, it will inject yet more liquidity into markets – further boosting demand and thus stoking inflation. At that point, central banks must either watch people’s spending power fall yet further, or hike interest rates and strengthen recessionary forces. As he put it: “What we give with one hand with fiscal, does monetary then take away?”

Asked his prognosis, McCarthy pointed out that today’s steep inflation will itself “erode household incomes, so they’ll be able to spend less; it will probably incentivise businesses to hold off investment, because of the amount of uncertainty.” As companies hire fewer people, demand will fall further and unused capacity will appear in economies – slowly bringing demand and supply back into balance. “That should lead to some moderation in inflation,” he said.

However, structural factors are likely to prevent inflation falling back to its 2019 level. As an example, “the integration of China into the global economy was depressing prices: we had a billion workers coming on-stream,” he said. That dynamic “has been levelling off for a decade: the cheap goods that we buy from China may not be as cheap in future.”

Over recent years, many people have become used to vast, debt-funded government bail-outs; the public would quite like another fiscal stimulus or a round of tax cuts. “But we have to be unpopular in finance ministries by pointing out that this is a terms of trade shock, and energy-importing countries are permanently worse off,” said McCarthy. “For the next couple of years, until we can transition away from fossil fuels, we are going to be transferring more and more of our income to oil and gas producers abroad.”

“The question then comes down to who within society absorbs that shock,” he concluded. “The public sector balance sheet cannot offset the price increase for everybody, and that’s why I think that it should be burden-sharing. Everybody should do a little bit: the public sector, households, and maybe even the corporate side as well.”

The 2022 Government Finance Summit was held in Tallinn, Estonia during June. While the Summit is held in private, some participants have allowed us to publish their comments.

This is the first of five reports on the discussions. The second considered finance departments’ responses to the pandemic; the third explored how finance leaders are supporting – and impeding – digital transformation; and the fourth considered finance leaders’ evolving roles in policymaking. The final report looks at the role finance ministries can support environmental sustainability.

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About Matt Ross

Matt is Global Government Forum's Contributing Editor, providing direction and support on topics, products and audience interests across GGF’s editorial, events and research operations. He has been a journalist and editor since 1995, beginning in motoring and travel journalism – and combining the two in a 30-month, 30-country 4x4 expedition funded by magazine photo-journalism. Between 2002 and 2008 he was Features Editor of Haymarket news magazine Regeneration & Renewal, covering urban regeneration, economic growth and community development; and from 2008 to 2014 he was the Editor of UK magazine and website Civil Service World, then Editorial Director for Public Sector – both at political publishing house Dods. He has also worked as Director of Communications at think tank the Institute for Government.

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