It appears to me that the economic regime is undergoing a change. We have been transitioning from COVID-shock pandemic economics to war-type economics. We will start with a visual.
The charts are from the San Francisco Fed working paper that inspired the writing of our new book: “Longer-Run Economic Consequences of Pandemics,” https://www.frbsf.org/research-and-insights/publications/working-papers/2020/06/longer-run-economic-consequences-of-pandemics/. Jordà, Singh, and Taylor’s findings are discussed on pages 12–14 of The Fed and the Flu.
I recommend readers take a few minutes to look at this research paper because it is specific to the investment, finance, economic-outlook arena.
Here’s why I believe we are shifting from the pandemic trajectory toward the war trajectory.
COVID and Long COVID are still around and endemic but gradually subsiding as economic shocks. They are mostly ignored by the headline-seeking financial press. Here’s a link to the current CDC data on the COVID burden: https://www.cdc.gov/covid/php/surveillance/burden-estimates.html. COVID and its associated health impacts, including disability, will continue to exert economic pressures, but economic outcomes will now reflect a more mixed picture, akin to what we might see with wars.
COVID emergency federal deficits are much different than war-type finance deficits. The latter are accompanied by retaliatory protectionism and tariffs. War-type finance is now dominant, and its dominance is likely to continue as a force in debt management and international economics. Why? Because national defense budgets as a percentage of GDP are rising globally and in nearly every nation. The United States is now the leading force in utilization of the war-finance paradigm. War finance means big deficits and large defense expenditures.
Therefore chart (d) above is very important. It helps us focus on the issue of debt sustainability and defense spending. Before sharing my personal observations, I will reproduce the narrative from the Jordà, Singh, and Taylor paper as it pertains to chart (d). I again urge readers to study the entire San Francisco Fed research paper. Don’t be discouraged if the math is too difficult. The narrative is well written, so that you’ll be able to get the gist of their work. If you have the time to delve into our new book, you can find numerous references and examples from the COVID period all the way back into antiquity; and in each case the conclusions laid out in this extraordinary research paper were confirmed. There were no exceptions. The research paper examined 19 case studies over 800 years.
Here’s the excerpt about chart (d), pictured below. My conclusions follow.
Debt sustainability and r − g. While the short-run fallout from pandemics looks similar to other economic disasters—large and sudden declines in economic activity—the medium to long-run economic consequences are staggeringly different, as we have shown. And these differences matter for policymakers. In any such abrupt downturn, the textbook response is to either borrow to smooth the shock, or to pursue aggressive stimulative fiscal policy to counter the shock. Both will likely result in a rapid buildup of public debt. However, the sustainability of such debt depends crucially on the type of economic disaster confronted. In order to illustrate this point, we turn to Figure 3d. This figure shows the response of the real natural rate minus the growth rate of real GDP per capita, call it r − g, using natural rate data only for the U.K. and for real GDP per capita growth rates for England, as above. If this difference becomes more negative, it becomes easier to sustain higher levels of debt. Conversely, when this difference becomes more positive, debt sustainability becomes harder. Once again, we see that pandemics and wars have very different consequences in this respect as well. Figure 3d shows that in the aftermath of pandemics, r − g becomes slightly negative, by about 50 basis points around the 20-year mark, before returning back to equilibrium. In contrast, wars result in a boost of about 100 basis points, peaking around the 30-year mark. Panel (d) in Table 1 shows evaluates the differences between these two paths every decade. Though the statistical evidence is not as strong as in previous experiments, the economic differences are patently clear.
Kotok conclusions:
- In pandemics, people die, but capital remains. It is redistributed among the survivors. Savings per capita rises and savings become more concentrated. The divide between rich and poor widens. Our book documents that outcome through 3500 years of history. So, in pandemics wealth gets more concentrated while inflation pressures subside, and demand for new capital applications is financed from the wealth concentration. Thus, the neutral rate declines. That is what happened during the intense COVID shock and aftermath.
- In war economies, capital is consumed. A new tank or drone becomes obsolete and discarded, or it is used and therefore destroyed. It is a form of consumption when it is delivered to a military enterprise. It eventually rusts or is blown up. Either way, it has no capital value. That’s why F-16 fighter jets are mothballed. There is no productivity gain. Defense is 100% consumption. The tools of defense can be used to develop applications that lead to productivity gains in private enterprise. That happens in the course of wars, but the process takes some time.
- In war, borrowing expands, and shocks create higher costs and shortages. Inflation happens in war economies. Thus, the neutral rate rises. Disinflation happens in pandemic economies AFTER the initial shock. The reverse is true in war economies. Each central bank’s monetary policy faces government pressure to finance wars and their borrowing needs. The US experience is one of many. Germany’s is another. The just-passed OBBBA is a war-type financing structure with projected deficits that will take the US debt/GDP ratio above the peak at the end of World War 2.
- In war-type economies, inflation worsens when the central bank eases. During World War 2, the US inflation rate hit a peak of about 13% (inflationdata.com). The Fed ignored inflation since it was patriotically facilitating the war effort by providing and maintaining very low interest rates, while government borrowing reached 110% of GDP. After the war, inflation spiked to about 20% before subsiding. (https://www.atlantafed.org/-/media/documents/research/publications/policy-hub/2021/05/17/04-wwii-and-today–monetary-parallels.pdf). This research paper from the Atlanta Fed is a worthwhile read.
- A special note from history: As we document in our book, in ancient Greece, post-Peloponnesian War monetary policy was focused on restoration of a hard-money currency (the drachma). In Ancient Greece that policy reduced inflation to near zero for decades following the end of the Peloponnesian War. The opposite occurred in ancient Rome when emperor after emperor debased the value of the currency by diluting its metallic content.
For the last 50 years, since the Bretton Woods fixed-currency-exchange-rate regime collapsed, we have operated monetary policy worldwide with fiat currencies. Therefore, central banks can preserve currency value in periods of war-type finance by maintaining a positive numerical “real” interest rate as a method of ongoing policy restraint. That is the way inflation risks will be reduced as the war-type financial outcomes under the OBBBA unfold. That is the direction of Fed policy today.
If the Fed succumbs to political pressure and reduces the real interest to zero or negative, the inflation risk with OBBBA will rise substantially. That is the message from history.
The charts at the top of this missive represent evidence from 800 years of historical data, compiled from the Bank of England database.
We are warned.
