After a decade of very low inflation after the financial crisis, the 2020s have seen the highest inflation rates since the 1980s. We discuss if there will be inflation or deflation by analyzing both inflationary and deflationary forces in the economy.
- Deflationary Forces in the Economy
- Inflationary Forces in the Economy
The 2020s have started much differently than the 2010s. The post-financial crisis period was marked by very low inflation rates despite the loosest monetary policy in history. Zero and negative interest rates as well as massive debt purchases by central banks only led to asset price inflation. Consumer inflation, for the most part, remained very low.
Nevertheless, the inflation rate started to go up in the second half of 2021. 2022 saw the highest inflation prints in decades in most developed economies, including the United States, the United Kingdom, Germany, Switzerland, and Japan. And 2023 continues to experience elevated inflation rates.
Inflation is the generalized increase in consumer prices in the economy. High inflation can lead to serious problems. On the one hand, the cost of living goes up, hitting all sectors of the population, particularly those who are most vulnerable, like the working poor. This tends to lead to strikes, production stoppages, weaker economic performance and, eventually, social unrest. It is difficult for a country to get out of an inflationary spiral.
At the same time, high inflation destroys the value of savings, hitting the middle classes and the elderly, who are the ones who tend to keep a larger portion of their wealth in the bank. This is another channel by which inflation impoverishes society.
In extreme cases, inflation can lead to hyperinflation, where currencies become worthless. This does not only lead to lower standards of living, but also a massive of loss of confidence in the system and a greater number of people leaving the country, particularly those who are most productive.
While inflation is indeed a great risk, deflation can also lead to macroeconomic and societal challenges, given how financialized our economy is.
The greatest threat of deflation is that it increases the value of existing debts. Thus, households, corporations and governments end up bearing a greater debt burden.
Because all segments of the population are highly indebted, the only realistic way to deleverage our economy is by having inflation slowly erode the value of those debts. In a world with no or even negative inflation, the existing debt pile becomes more difficult service. This poses the risk of leading to a wave of bankruptcies, potentially including the government, and an economic depression. Thus, social unrest is a real possibility.
Deflationary Forces in the Economy
There are undoubtedly some deflationary forces in the economy. These will play a big role in determining whether there will be inflation or deflation in the future.
In fact, the low inflation levels experienced during the 2010s are proof of that. While many commentators would argue that the expansionary measures taken by governments and central banks were not inflationary, pointing at the low inflation rates registered, I would argue otherwise.
Those monetary and fiscal measures were extremely inflationary. The reason why consumer inflation remained low is because of the existing deflationary forces. Without those measures, we would have experienced a prolonged period of deflation, in both consumer and asset prices.
Let us analyze the most important deflationary forces. These are particularly relevant for Western economies:
1) High Debt Levels
A highly indebted economy tends to devote a larger percentage of its income and production to servicing or repaying existing debt. This leads to lower consumption.
Furthermore, corporations and households who have a lot of debt are reluctant to borrow more. As a result, there is less money creation from the private banking system. In fact, if the private sector works hard enough to repay their debts, money supply could end up contracting. If the amount of money in the economy goes down, there will be downward pressure on prices.
2) Aging Population
An ageing population tends to be deflationary since the elderly consume much less than younger people. This is mainly due to consumption habits.
Retirees, for the most part, do not buy houses, cars, furniture or clothes. While they can represent a burden a country’s healthcare system, their demands are otherwise small. Consequently, lower demand puts less pressure on prices.
It should be noted that some economists argue, very correctly, that an ageing population can also lead to higher prices. This is because this segment of the population, even though it consumer little, does not produce anything.
This could take place in a situation in which retirement pensions have to be financed by increasing money supply because the government is unable to raise enough money through taxation. Given many Western countries are effectively bankrupt and face a very challenging demographic situation, especially in Europe, an ageing population can end up acting as an inflationary force in some places.
While many economists often talk of deglobalization leading to higher prices, something that is a very real thread, so far the world remains relatively well connected. This is especially true when it comes to trade.
Thus, the increases in productivity experienced in many emerging markets lead to lower production costs. This has been happening since the 1990s for consumer goods such as electronics, clothing, or household products. Such a trend is likely to continue in the future, even if temporary disruptions are expected.
Finally, technological progress will continue to be a deflationary force. Technology has been deflationary for millennia. However, it did not become noticeable until the rapid industrialization that took place in the 18th and 19th centuries.
Technology lowers production costs and ultimately leads to higher standards of living. Thanks to mass production, we can afford more material goods nowadays than our ancestors did in the past.
This has been very relevant for manufacturing production. The advent of the computer and the internet led to increases in productivity that reduced unit production costs.
The progress that is being made nowadays with things such as artificial intelligence is likely to bring higher productivity level. If we can make more with less, there will be downward pressure on prices.
Inflationary Forces in the Economy
There are of course inflationary forces that should be considered:
1) Fiscal Policy
The strongest inflationary force is irresponsible fiscal policy in the West. In fact, the elevated inflation rates of the 2020s are mostly a consequence of the massive monetary and fiscal policies that were implemented in 2020, many of which remain in place several years later.
In an era where government deficits and debt do not seem to matter anymore, any increase in government spending effectively leads to an increase in monetary supply if it has to be financed by the central bank. Additionally, the only way to service that debt on a real basis is by slowly devaluing it through inflation.
The reason why a massive deflationary crash is unlikely is because, if that were to happen, governments would jump in with even more extreme inflationary measures to prevent it.
2) ESG Policies
ESG and carbon-reduction policies aim to reduce the level of production and consumption of fossil fuels. While this may be motivated by noble causes, there is no doubt that cleaner forms of energy are more expensive than traditional energy sources.
Less investment in the production of traditional energy will lead to higher energy costs as long as our economy is dependent on these types of energy sources. And this is likely to be the case for many decades to come.
Furthermore, the widespread adoption of green energies, more costly to produce, will act as an inflationary force. This is the hidden cost no one is talking about when debating about whether such ambitious energy plans are ultimately going to benefit society.
Green energy presents a tradeoff. Cleaner forms of energy will probably lead to a lower standard of living for most of the population.
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