A Global Economic Pandemic Ahead. Are we inventing preventive policy solutions or getting bankrupt by old prescriptions?

The purpose of this article is to shed some light on risks of a global economic pandemic caused by central banks with the misconception of their ability to control inflation in the old monetary model (Quantity Theory) applicable to tribal economies.

The world is confronting four decades high inflation with large supply side bottlenecks consequent to two major sources or external shocks, i.e., global Corona pandemic and Ukraine-Russia warfare whereas policy solutions initiated in the old fashioned models are seen ineffective and driving the global economy towards a pandemic ahead.

How the Corona pandemic caused inflationary pressures and supply bottlenecks

The Corona pandemic in 2020 and 2021 shattered the global economy as economists were not aware of macroeconomic management models in the presence of such health pandemics. The lockdowns and social distancing policies followed to fight the spread of the pandemic has caused lasting impacts on the global economy through the disruption of supply/value chains and productivity on which country economies across the globe are networked.

Therefore, the direct result of the pandemic was immediate with significant contraction of the production capacity, disruptions of markets, contraction and downturns of economies and downward prices consequent to collapsed demand. As such, a form of economic pandemic akin to the health pandemic emerged.

The policy response was the historic relaxation of the fiscal policy and monetary policy based on the standard demand management macroeconomic models. The fiscal policy was to bailout households and businesses primarily with lavish subsidies. The monetary policy was relaxed to the rock-bottom, i.e., near zero interest rates and ravish money printing, with twin objectives to fund the massive fiscal spending through credit markets at lower interest rates and to flood financial markets with abundance of liquidity in order to prevent any likelihood of financial system instabilities.

Therefore, ultra-expansionary fiscal and monetary policies were freely coordinated without any conflicts and impediments. As price deflationary pressure were prevalent in all markets despite the existing money stocks, a new round of monetary expansion was needed to activate markets supported by fiscal stimulus for the price stability. Therefore, no economist raised material concerns over this globalized ultra-expansionary macroeconomic policy direction, given contemporary disruptions in economies and living standards consequent to the pandemic.

The overall economic result of the pandemic was the supply side bottlenecks around the world. Therefore, the faster opening of economies after the control of the pandemic with new vaccines caused raising prices in all markets led by energy prices across economies from the middle of 2021. However, policymakers around the world until towards the end of 2021 considered these price pressures were natural and transitory and, therefore, they would gradually disappear when supply bottlenecks are eased and normal capacity is resumed, averting demand-supply imbalances.

How the Ukraine-Russia war fueled inflationary pressures and supply bottlenecks

Russian invasion of Ukraine on 24 February 2022 led to augment global supply bottlenecks and fuel energy prices, primarily consequent to wide economic sanctions imposed by the US and UK and Europe on Russia. As Russia is a leading supplier of gas and oil and a major trading economy, these sanctions caused a global shortage of energy and commodities and historic rise in their prices. The prime sources of present global inflationary pressures is the escalation of energy prices.

Global Central Bank Response to Inflationary Pressures

In last two decades, central banks globally have been projecting themselves as inflation busters for preserving the price stability in the medium to long-term. For this purpose, they have followed a monetary policy model of manipulating policy rates and money printing (or the central bank balance sheet) aimed at a fixed target of annual inflation rate measured by the Consumer Price Index (CPI) although they are not aware of the actual relationships, other than the old monetary school concept of inflation necessarily being a phenomenon of rising money stock than demand.

While the inflation target has been 2% in developed market economies and a mid-single digit in developing countries, for example, 4%-6% in Sri Lanka and India. However, the underlying monetary operations have been highly judgmental due to the lack of knowledge on underlying relationships in real world although the monetary policy is boasted as the data-driven anchor of inflation expectations in the economy.

Therefore, central banks have commenced a competitive wave of raising policy interest rates as the set menu for inflation control since the end of 2021 led by the Bank of England and the US Fed. As international capital flows driven by interest differentials between countries play a major role in economies, interest rate hikes by the US Fed necessarily cause a competitive rate hikes by central banks globally in order to prevent capital outflows through maintaining interest differential. The general outcome of this monetary policy competition is the US dollar appreciation (due to its leading position as the global reserve and invoicing currency) while other currencies confront a volatile depreciation depending on the volume of capital outflows from respective countries, financial market response and central bank intervention in currency markets.

At present, all central banks are with same voice that price pressures have spread across the economy due to excessive demand consequent to historic fiscal and monetary expansion during the Corona pandemic and, therefore, monetary policy tightening is needed to take out the excess demand to match the prevailing supply. Their policy rhetoric has two common elements.

• First, the inflation control for the price stability is their mandate whereas the policy instrument available with them is the interest rate hiking until the inflation returns to the target through lowering the growth of the demand over the time as they do not have policy instruments to deal with the supply side of the economy or supply bottlenecks. They believe that the supply side improvement is the fiscal policy responsibility. Therefore, central banks are not aware of resource distributional role of interest rates and credit in modern monetary economies.

• Second, economic slowdown or recession is inevitable to bring the inflation under control as higher interest costs and lower credit growth hamper economic activities. Some central banks state that the return to inflation target could be a soft landing with a slight reduction in the growth and employment below the trend.

• Third, they all talk about inflation peaking at some point towards the end of 2022 or middle of 2023 and prediction on inflation to slow down towards the target in the unspecified medium-term.

However, interest rate hikes and resulting currency depreciation outside the US have reinforced inflationary pressures globally through the significant rise in cost of production.

However, central banks are compelled to follow the set monetary menu while central banks sitting with foreign currency reserves intervene in currency markets to curb the currency depreciation in order to prevent the exchange rate channel in the inflationary pressures. Therefore, almost all central banks except Turkey, China and Japan have raised their policy rates by 25-75 basis points at a time in about five-six times so far since early 2022 in line with central banks of developed countries shown below.

Central Bank	Rise of Inflation, % 2021 to August 2022	Policy Rates Hike, % 2022	Extent of Rates Hikes so far
US Fed	2.6% to 8.3%	0-0.25% to 3%-3.25%	5 times, by 3%
Bank of England	2.1% to 9.9%	0.10% to 2.25%	6 times, by 2.15%
European Central Bank	2.0% to 9.1%	0.25%-0.75%	1 time, by 0.50%
Bank of Canada	2.2% to 7%	0.25% to 3.25%	5 times, by 3%
Reserve Bank of Australia	0.8% to 6.8%	0.10% to 2.35%	5 times, by 2.25%

However, inflation is ratchetting up across the globe as interest rates cannot correct energy prices and supply side bottlenecks to increase the supply at lower prices to consumers.

However, they antagonize with governments, for example UK at present, when they act to provide fiscal stimulus to control the cost of living reflective in the CPI and ease the supply bottlenecks. Their blind quarrel is that such fiscal stimulus and spending would be further inflationary. However, there is no certainty that central banks could tame such historically high inflation levels through their conventional and blind monetary menu which cannot correct grave supply bottlenecks and global geopolitics prevailing behind such inflationary pressures.

Fiscal Response to Soaring Inflation and Present Market Turmoil in the UK

Governments in advanced market economies while demanding central banks to take inflation under control are in the process of implementing various fiscal measures to reduce cost of living and improve the supply side and growth. In general, they have unemployment benefit schemes to facilitate persons losing jobs consequent to bankruptcies and economic slowdowns. The US recently passed the Inflation Reduction Act while the EU decided to continue the suspended fiscal rules in 2023 too.

The UK new government presented a historic mini budget labeled as growth plan on 23 September with biggest tax cuts package (worth £45 bn) in 50 years to promote growth, employment and income and cap on household energy bill to reduce cost of living and inflationary pressures. In response, the Bank of England on 26 September made a press release with a negative tone whereas financial markets created a speculative panic with raising government bond yield rates and historic level of currency depreciation based on concerns over the underlying rise in fiscal deficit and borrowing. For example, 10 year bond yield rose to 4.47% on September 27 from 3.81% on September 23 whereas the sterling depreciated from US dollar 1.13 to 1.07 (intra-day 1.02) between the two dates. 

Due to panic market conditions and erosion of the value of pension funds due to significant rise in the bond yield rates/reduction in bond market prices, the Bank of England immediately launched a long-dated bond buying programe initially of £5 billion per day for two weeks until 14 October (£65 billion in total for the period) while suspending the existing bond selling programme until 31 October. This market intervention was an attempt to restore orderly market conditions for the financial stability purpose. 

As a result, bond yields temporarily declined and the currency improved to some extent during the week, i.e., 10 year yield to 4.08% and the exchange rate to 1.12 on September 30 (Friday). Therefore, it was up to the Bank of England to decide the course of its action as the control of such market panics falls under its remit although some analysts commented that the Bank of England helped the government to calm down markets. Meanwhile, financial markets were seen repricing financial assets with the expectation of 150-200 basis points increase in policy rates in November.

The global monetary school led by the IMF criticized the unfunded tax cuts and untargeted fiscal packages in the UK mini budget were excessive during elevated inflation and likely to increase inequality and requested to re-evaluate the tax measures, especially those benefit high income earners, as the fiscal policy does not work at cross purposes to monetary policy.

However, the UK government defended its new policy stance as part of the fiscal responsibility for the public and ruled out any course change. The Prime Minister commented that rising interest rates and currency depreciation are a part of the present global development not specific to the UK.  

It is evident that tax saving out of tax cuts will increase investments and productivity at the time of high interest rates while the government is able to fund public services though borrowing from the market. Therefore, the UK's new fiscal stance is most appropriate as only the economic growth and intervention in energy prices can reduce present high inflationary pressures in the medium term and support the fiscal space and responsibility without causing a lasting recession as in the case of monetary fast tightening on the set menu.

Vulnerable Emerging Market Economies

Many countries such as Sri Lanka, Pakistan, Sudan and Ghana who confronted a severe BOP crisis due to chronic shortage of foreign reserves have approached the IMF for bailout and commenced implementing the set policy menu for super-tightening of both fiscal policy and monetary policy to prepare for the IMF programme. This is pursued while respective economies and living standards struggle in bankruptcies and record high inflation supported by economic contraction, import controls and heavy currency depreciation.

Sri Lanka has become the role model for super policy tightening while the economy has been collapsing in the currency crisis and hyper-inflation. Increased tax rates, cutting public services and spending, rigid import and exchange control, raising policy rates by 10%, government securities yields surpassing 30% even with funding through money printing, currency depreciation with exchange rate rise more than 80%, default of foreign debt and the increase in energy prices at historic highs have been the voluntary policy package to approach the IMF programme of US$ 2.9 bn over a period of 48 months. The post-IMF conditionalities are yet to know.

The combined outcome has been the soaring inflation officially passing 70% so far despite the peak of 65% in September predicted by the CB Governor, officially projected economic contraction by 8%-9% in 2022 and wide-spread business bankruptcies causing loss of employment, rise in poverty and collapse of living standards. The domestic debt trap and imminent bankruptcy of the government are evident from huge price discounts offered at Treasury auctions with yield rates around 31% on Treasury bills (about 28% discount) and large yield surplus around 13% between the yield to maturity (31%) and the coupon rate (18%) on Treasury bonds. 

For example, although bids accepted at last Treasury bill auction were Rs. 86,680 mn (face value or amount to be repaid), funds actually received by the government were around Rs. 62 409 mn (at estimated discount). As such, rising yields also are reflective of imminent bankruptcy of long-term bond investors including provident, pension and insurance funds and credit-dependent businesses as the Central Bank is also in the super-monetary tight drive to further contract the economy.

It is surprised that fiscal and monetary authorities target a large contraction of the economy to reduce the demand on priority basis for controlling inflation in the medium-term with the expectation that the IMF bailout and foreign humanitarian aid to be provided with debt relief/restructuring could consequently help recover the economy to pre-pandemic level with price stability.

The debt and fiscal unsustainability is the new economic terminology of the IMF for developing countries battered by the global inflation crisis and monetary tightening of the developed world with reserve currencies. Therefore, debt restructuring has become the new IMF manthra on the top of its standard fiscal and monetary tightening and policy reform package prescribed during the past 50 years. 

A new policy variant “targeted fiscal spending to protect the poor and venerable” is a new IMF pill to escape from the general criticism over the contractionary IMF packages during this difficult time. As the emerging market economies are battered by the Corona pandemic, present global inflation, supply bottlenecks, monetary tightening of the developed world and currency crises, the IMF has regained its demanding position in the global economy to help developing countries to relieve from BOP crises with the IMF financial support.

Final Remarks

A lasting recession induced by historic wave of monetary tightening is evident in developed countries, i.e., the center of the global economy, unless governments intervene in economies to restore the supply side from perverse bottlenecks created by the Corona pandemic and sanctions against Russia. As the fiscal cost also is rising on high interest rates with a restricted space for tax revenue consequent to recession or economic slowdown, a material fiscal intervention cannot be expected without the support of central banks. 

Therefore, the developing world or the periphery of the global economy which confronts with BOP crises and unbearable currency depreciation will also be further hammered unless they choose a speedier policy path for survival on the strength of domestic resources and entrepreneurial skills. The set policy menus like in Sri Lanka would no doubt cause a forced sale of resources of these countries initiated by local IMF agents to the center countries which is the model similar to the pre-1950 foreign empire regimes. The mass exodus of the young and professional is the fist stage of this forced sale.

As such, it is highly likely that a global economic pandemic worse than the World Great Depression in 1930s or Corona pandemic in 2020 could hit the world together with a wide spread of social uprise unless governments act on innovative policy packages to promote the supply side and growth and ease cost of living on urgent basis. The latest policy action of the UK government is a brave one in this direction with a strong economic story behind it.

As financial markets act to forestall policy packages by arousing speculative attacks, governments must act to prevent such detrimental dealer activities on the ground that they are nothing but unjustified insider dealings. Otherwise, governments will have to wait until financial markets act to bailout the public from the economic pandemic ahead.

Accordingly, crisis-hit developing countries like Sri Lanka who go after IMF bailout packages with new a new conditionality of debt sustainability-based restructuring supported by another set of financial market participants (financial advisers) for recovery of respective economies through regaining the old fashioned access to international financial markets will no doubt fail due to tight monetary policies and recession in the center world and prevailing geopolitical divisions.

Therefore, if the governments are made bankrupt by super-tight monetary policies and, therefore, unable to rescue the public from the economic pandemic ahead, present democratic variants of country governance system will no doubt collapse sooner or later consequent to the rising public unrest.

(This article is released in the interest of participating in the professional dialogue to find out solutions to present economic crisis confronted by the general public consequent to the global Corona pandemic, subsequent economic disruptions and shocks both local and global and policy failures.)

 

P Samarasiri

Former Deputy Governor, Central Bank of Sri Lanka

(Former Director of Bank Supervision, Assistant Governor, Secretary to the Monetary Board and Compliance Officer of the Central Bank, Former Chairman of the Sri Lanka Accounting and Auditing Standards Board and Credit Information Bureau, Former Chairman and Vice Chairman of the Institute of Bankers of Sri Lanka, Former Member of the Securities and Exchange Commission and Insurance Regulatory Commission and the Author of 10 Economics and Banking Books and a large number of articles published)