As we all know by now, inflation has a serious and pernicious effect on everyone and everything in an economy. For the political left, however, the effect of Canada’s recent and rapid resurgence of inflation – currently 7.7 percent on an annual basis – has been downright devastating. The growing panic among the economic interventionists who make policy in the majority of Western countries – as well as their supporters in the media and elsewhere – reflects their lack of a coherent theory about what causes inflation and how to curb it. By contrast, conservatives have understood the proper diagnosis of inflation going back decades, and have proven decisively how inflation can be rolled back.
The conservative conception of inflation holds that excessive monetary and/or fiscal stimulus lifts the demand for goods and services beyond what an economy can sustainably supply. Monetary stimulus, or “easy money,” refers to conditions of low interest rates which encourage private borrowing and spending and thus raise demand throughout an economy; fiscal stimulus does the same thing via increased government spending. The borrowing that’s usually required for fiscal stimulus, in turn, is facilitated by easy money. Whatever the mechanism, any increase in demand that is not matched by a similar increase in the supply of goods, services or labour will lead to rising prices and wages as buyers compete with each other for these scarce resources.
In our era, conservative thinking on inflation was crystallized in Nobel Prize-winning economist Milton Friedman’s famous dictum that “Inflation is always and everywhere a monetary phenomenon.” What Friedman meant was that regardless of whether prices are rising due to monetary or fiscal reasons, such a situation can only be sustained if the money supply grows to accommodate these rising price levels. Clamp down on the supply of money, and there’s simply not enough cash (or cash equivalents) in an economy to accommodate all these rising prices. From this perspective, a country’s central bank – the gatekeeper of the money supply through its power to control interest rates – has supreme command over inflation.
On the left, it is popular to dismiss a monetary causation for inflation. This belief has found a home in what is known as “Modern Monetary Theory” (MMT). MMT claims that government can create as much fiscal stimulus as its likes without fear of causing runaway inflation because of its role as the issuer of money. Rather than accept Friedman’s “always and everywhere” conception of inflation as a monetary phenomenon with higher interest rates as its only primary solution (plus government avoidance or cessation of fiscal stimulus and other measures that improve productivity), progressive thinkers prefer to blame a wide variety of other sources for rising prices, and thus seek other solutions.
There are many examples of this alternative viewpoint. An open letter released in May by a group of 26 academics from Quebec and elsewhere that was originally published in the French-language newspaper Le Devoir (and reprinted at Rabble.ca) sought to blame global supply chain shocks and numerous other external events for Canada’s current bout of inflation. Without a domestic cause, there can be no domestic cure. Thus, these economists argue, “Tightening the access to credit [that is, raising interest rates] is not the most effective way to fight inflation.” If there is to be a domestic cause, they allow, it has to come not from monetary causes but rather predatory corporations that have been raising prices to boost profits. The policy solution is therefore higher taxes on those corporations.
On the left, inflation has many causes, most of which are global in nature and none of which reflect poorly on near-limitless government spending. Further, whatever its causes, inflation must never be tackled with higher interest rates.
Elsewhere, several voices on the left prefer to dismiss the entire uproar about inflation. Former Clerk of the Privy Council (the top federal cabinet official) Alex Himmelfarb has scoffed at recent concern about inflation and argued that the standard conservative solution found in Friedman’s observation is simply an excuse by conservative politicians to implement austerity measures. Writing in the Toronto Star, University of Toronto economist Gustavo Indart has claimed “the notion central banks have the tools to control inflation is a fallacy” and that the Bank of Canada cannot use its interest rate policy as a “magic wand” to correct inflation. The Canadian Centre for Policy Alternatives’ senior economist David Macdonald suggests we should all just learn to live with higher inflation rather than fighting it, while Toronto Star columnist David Olive claimed in June that the fight against inflation in Canada is essentially over – so there’s no need to fret any longer.
The battle lines are clearly drawn. On the right, inflation is a monetary problem that can only be defeated by primarily monetary means (including the avoidance of fiscal stimulus). On the left, inflation has many causes, most of which are global in nature and none of which reflect poorly on near-limitless government spending. Further, whatever its causes, inflation must never be tackled with higher interest rates, since that would hurt individuals and bring the MMT party to an end.
Sorting the Evidence
The pandemic provides ample evidence of the monetary roots to our current inflationary dynamic. The money supply in both Canada and the United States soared nearly 30 percent by early 2021 and government spending ballooned through unprecedented rates of borrowing, even as productivity collapsed and the economy in both countries shrank. The unprecedented monetary stimulus early in the pandemic – exceeding even the orgy of liquidity put into the system during the late 2008 financial crisis – was married with record government deficits incurred largely from transferring massive amounts of income to people in the early days of Covid-19 lockdowns. This created the precursor to today’s higher prices, as C2C Journal predicted in a two-part series in June 2020. We can now see that inflation began its resurgence in April 2021, when it first burst through the Bank of Canada’s upper bound barrier of 3 percent.
In the U.S., economists at the Federal Reserve Bank of San Francisco estimate that fiscal stimulus accounted for 3 percentage points of the 5 percent annual inflation rate late in 2021. In other words, more than half of inflation in 2021 can be attributed to the extraordinary boost to household disposable incomes during the pandemic, either by stimulating household demand or depressing labour supply because many people no longer had to work. Since fiscal stimulus to household income was slightly larger proportionately in Canada than in the U.S., it seems safe to conclude it had at least as large an impact on our inflation rate, which had risen to 4.8 percent by the end of 2021.
The extraordinary fiscal stimulus that began in 2020 never let up and continues to fuel inflation today. Current inflation partly reflects what federal Finance Minister Chrystia Freeland now calls the “pre-loaded stimulus” of savings that Canadians accumulated from excessive government transfers during the pandemic. Unlike most forms of fiscal stimulus, however, the government does not control when households deploy this pent-up spending, making the economy even more unpredictable. One example was the sudden boom in home renovations that coincided with the supply chain crunch. Similarly, many Canadians are understandably determined to travel this summer after two years of being cooped up, exacerbating the effects of a shortfall in oil refining capacity. And just try finding a rental car these days.
I am Shocked – Shocked! – to Find Inflation
It is crucial to observe, however, that inflation cannot be blamed mostly on unforeseen supply disruptions. It was entirely predictable that the lockdown-and-spend response chosen by most Western governments would distort supply and, in so doing, raise the costs of pursuing nearly any economic activity as well as increasing the prices of the things themselves. Closing down large parts of the economy during the pandemic and paying millions of workers to stay home was bound to widely disrupt supply and reduce productivity.
As for whether any of these supply shocks could have been reasonably predicted, John Cochrane of the Hoover Institution, a Washington, D.C.-based conservative think tank, has mockingly pointed out that, “The Fed being surprised by supply shocks is as excusable as the Army losing a battle because its leaders are surprised the enemy might attack.” The same applies in Canada. Like the fiscally-generated component of inflation, supply-constraint-induced inflationary pressures were foreseeable. Inflation should not have hit any central bank like a Black Swan event. Yet central banks and governments alike behaved as if they were taken completely unawares.
This is not the first time that central banks mistakenly attributed inflation to supply shocks rather than their own actions. It also occurred during the brutal era of inflation in the 1970s and 1980s, when rampant government spending and accommodative monetary policy drove annual inflation to a peak of 14.6 percent in the U.S. and 12.9 percent in Canada. In a review of the Bank of Canada’s performance during this period, U.S. economist Edward Nelson identifies “monetary policy neglect” as the cause – essentially finding central bankers asleep at the wheel.
Inflation was finally curbed in the 1980s by central bankers ratcheting up interest rates to record levels and keeping them there regardless of the short-term economic and political costs, combined with governments cutting spending and taxes and reducing the regulatory burden. This was most famously carried out in the U.S. early that decade by the duo of Federal Reserve Chairman Paul Volcker and President Ronald Reagan (although Reagan did continue to run major deficits to finance the American defence build-up). And while Reagan was re-elected in a landslide, fighting inflation this way is not always a popular position to take.
During Canada’s 1993 federal election, for example, Liberal leader Jean Chretien turned inflation-fighting Bank of Canada governor John Crow into his favourite villain because of Crow’s role in raising interest rates. On voting day, the incumbent Progressive Conservatives were all-but wiped out. Yet Crow was simply following the proven Friedman prescription; he refused to neglect his duties. Evidence from across the developed world has since shown that the reward for enduring two to three years of higher interest rates is a sustained economic expansion and up to three decades of low inflation – in some years, effectively no inflation at all.
The dysfunction in the labour market caused by excessive transfer payments in 2020, such as the generous Canada Emergency Response Benefit, also is primarily a domestic issue, without a counterpart in Europe or Asia, where government pandemic support was administered much differently than in Canada or the U.S.
Well-known Canadian economist Jack Mintz recently provided a succinct encapsulation of current conventional thinking on inflation in the Financial Post: “The root causes of inflation are well-understood: government deficits, accommodative monetary policy and supply shock.” And the solution? “Inflation will be tamed in one way: by tighter monetary policy, meaning higher interest rates.” Same as it ever was.
Despite the clear demonstration of the conservative solution to inflation, central banks repeated the mistakes of the 1970s during Covid-19 by boosting fiscal stimulus and ignoring rising prices. As for supply chain shocks, some sectors experiencing high inflation today have relatively weak connections to global supply chains. Even the Bank of Canada acknowledges that soaring housing prices are largely the product of surging demand and limited availability of land for development, although prices for nearly all building materials are ballooning as well.
The dysfunction in the labour market caused by excessive transfer payments in 2020, such as the generous Canada Emergency Response Benefit (CERB), is also primarily a domestic issue, without a counterpart in Europe or Asia, where government pandemic support was administered much differently than in Canada or the U.S. (Of course, other countries caused their own forms of labour market dysfunction, such as China’s recurring and almost total shut-downs of various manufacturing centres and seaports including, most recently, Shanghai.)
Central Bankers Come to Their Senses
More recently, central bankers appear to be returning to their orthodox roots. “Inflation is too high. We need to bring it down,” Bank of Canada governor Tiff Macklem admitted in April. His recent aggressive interest rate hikes, including a half-percentage-point rise at the beginning of June, confirm the traditional conservative view on inflation. U.S. Federal Reserve Chair Jerome Powell clearly concurs. “Inflation is much too high,” he told a press conference in May.
It is not really important whether the imbalance that initially caused prices to rise was due to excess demand or the persistence of constrained supply. The fundamental problem is too much money competing for too few readily available goods and services. This problem is then either exacerbated or ameliorated by the policy choices of governments and the actions of central banks. When asked if U.S. President Joe Biden’s US$1.9 trillion fiscal stimulus package in 2021 contributed to inflation, Powell replied, “It’s the Fed that has responsibility for price stability. Whatever arrives in terms of fiscal activity, we take it as a given.” Higher government spending, in other words, requires an even greater response by central banks to rein in inflation.
Federal NDP leader Jagmeet Singh wants a special tax on corporate profits and more antitrust action, as if inflation resulted from a sudden and co-ordinated change in the corporate strategies of multinationals. Singh’s ‘policy’ is a combination of conspiracy theory and demagogy lowered to the level of farce.
Powell also belatedly acknowledged that it is erroneous for a central bank to tolerate price increases while waiting for supply disruptions to end, stating that, “We’re not setting policy on the expectation that we get relief on the supply side until we actually do.” This is not only because doing so would be a cop-out, but because supply problems are difficult to repair quickly. It takes years, for example, to make investments in energy production, expand oil and natural gas exports to Europe, replace grain supplies trapped in Ukraine, or reconfigure supply chains from China. Discouraging fossil fuel development across Europe and North America left our economies vulnerable to energy supply side shocks in 2021 and 2022, aggravating the resulting increase in oil and gas prices. Accordingly, the only short-term solution to the resulting inflation is to dampen demand, mainly by reducing government spending, raising interest rates or some combination of the two.
Whither the Interventionists?
As we have seen, conservatives have all along understood the sources of inflation and known the solution when it does appear. Unfortunately, there is no such clarity on the other side of the political spectrum. The economic interventionist left has no credible alternative explanation of inflation and was completely unprepared for its recent resurgence. The widespread and still growing clamour that something be done has made inflation-fighting a serious threat to their dream of unfettered government spending to solve an unlimited list of social ills. As Himmelfarb wrote in the left-wing magazine Alberta Views, “Is too much government spending what’s causing the spike in prices, and is cutting it down to size the only solution? Simply, no…it will only make things worse.”
Ontario’s NDP campaigned in the recent provincial election on direct government price controls over motor fuels. This is among the most crudely interventionist of measures, akin to the policies of socialist and even Communist governments. This approach assumes that governments can simply legislate lower prices without causing devastating economic damage. But it can’t, and the results are always terrible, including crippling shortages of the targeted product. Perhaps the most emblematic example of this were the infamous lines of frustrated drivers at U.S. gas stations in the 1970s. This fatal flaw remains just as true today.
Federal NDP leader Jagmeet Singh, meanwhile, wants a special tax on corporate profits and more antitrust action, as if inflation resulted from a sudden and co-ordinated change in the corporate strategies of multinationals. Singh’s “policy” is a combination of conspiracy theory and demagogy lowered to the level of farce. It is based on inverting the causes of inflation with its effects. In any event, price controls and higher taxes on profits would be counterproductive, negating the one beneficial effect of higher prices: the signal they send to generate a supply response through greater capital investment and higher production. Price controls and higher taxes ultimately aggravate rather than alleviate inflationary pressures.
The pervasive impact of inflation is reflected in three-quarters of Canadians telling Statcan that the current bout of inflation is affecting their ability to meet day-to-day expenses. Inflation is not an issue of identity. It is an issue that affects everyone.
Other proposals tacitly accept the presence of inflation and call for more government spending to shield people from higher prices. The Canadian Centre for Policy Alternatives has argued that the best way to help Canadians is for government to raise wages and social assistance benefits across the board to match inflation increases – in essence torquing aggregate demand even further. Given her latest pronouncement about how the federal government will spend $8.9 billion to limit the impact of inflation on Canadians, it appears that Finance Minister Freeland agrees.
Quebec and Ontario have already started sending cheques of up to $500 to most households. Aside from being fundamentally defeatist, this approach ignores that more purchasing power only fuels even more spending, driving prices even higher. But this certainty doesn’t stop politicians from doubling down. When asked about whether transferring money to households fuels inflation, Quebec Finance Minister Eric Girard shrugged, leaving the fight against inflation to the Bank of Canada. But by stoking demand, spendthrift governments force the Bank of Canada to tighten monetary policy even more, which ultimately backfires on governments running fiscal deficits.
Then there was Prime Minister Justin Trudeau’s stunning admission during the 2021 federal election that he had no time for monetary policy. “When I think about the biggest, most important economic policy this government, if re-elected, would move forward, you’ll forgive me if I don’t think about monetary policy,” he told a press conference in Vancouver. “You’ll understand that I think about families.” With Canadian families now suffering greatly due to soaring prices for energy, food, housing and all the other necessities of life, they might prefer that their prime minister had spend more time thinking about monetary policy – and recognizing that right now, monetary policy and the financial wellbeing of families are virtually one and the same.
The Rewards of Fighting Inflation
Record low interest rates during the pandemic masked the vulnerability of soaring government debt to an upturn in inflation and interest rates. During 2020 and 2021 alone, the federal debt jumped from $686 billion to $1,049 billion. Despite this increase, interest payments on the debt actually fell slightly because the interest rate on the Government of Canada’s 10-year bond plunged from 2.3 percent to 0.7 percent. More recently, however, short-term interest rates have already risen to over 3 percent, above their pre-pandemic levels.
A study by the C.D. Howe Institute found that even small increases in interest rates or slightly slower economic growth is “a toxic cocktail for future governments” because “only very slight changes in assumptions of economic growth and interest rates dramatically change the course of the debt burden.” The enormous sums of new debt issued during the pandemic will quickly become burdensome to service if interest rates rise or if slower economic growth dampens revenues and increases spending further.
Interventionists, however, continue to decry monetary and fiscal measures aimed at dampening demand as a return to “austerity,” something even MMT prescribes once inflation takes hold. Curtailing demand through higher interest rates or lower government spending is necessary before inflation becomes entrenched by workers demanding higher wages to keep up with rising prices. This process is already more advanced in Canada than is widely understood. Many economists cite a 3.9 percent increase in average hourly earnings reported in Statcan’s May labour force survey as proof that wages remain contained. The most comprehensive measure of total hourly compensation of employees from the National Accounts, however, increased by 5.8 percent in the past year. This measure includes signing bonuses and overtime on top of hourly earnings, as employers seek new ways to expand their labour supply at a time of record job vacancies; as such, the evidence points to even more inflation in the future.
Whatever its causes, with inflation now the highest it has been in 40 years, a recession likely looms no matter what short-term measures are chosen. Yet progressive groups cannot resist focusing on the negative impact slow growth or a recession will have on vulnerable groups like youths or other minorities. While inflation affects various societal groups in different ways – the young are hurt the most by rising rent and housing costs, rural residents by prices of gasoline and key commodities, lower-income families with kids by the cost of food – the plain fact is that everyone feels the impact of higher prices. The pervasive impact of inflation is reflected in three-quarters of Canadians telling Statcan that the current bout of inflation is affecting their ability to meet day-to-day expenses. Inflation is not an issue of identity. It is an issue that affects everyone.
With the left incapable of meeting the challenge of inflation, there is a growing realization that this could become a winning political issue for conservatives everywhere. In the U.S., rising inflation has been identified as a significant component in Biden’s collapsing public approval ratings. In Canada, federal Conservative leadership front-runner Pierre Poilievre has made inflation and the wider liberal-left approach to the economy central to his campaign. Hanging responsibility for current economic hardships on the prime minister is the task of his popular #justinflation portmanteau and YouTube channel. And it appears voters are ready for such a message, with the cost of living shaping up to be the defining domestic issue of 2022. Conventional economics have suddenly become a winning political strategy.
A reputation for financial mismanagement can cripple political parties for a long time. Many governments have paid a stiff price for pursuing massive monetary and fiscal stimulus without considering the likelihood of triggering inflation – or the ruinous economic and political consequences that this would bring. High and persistent inflation throughout the 1970s contributed greatly to opening the door to a new generation of conservative leaders such as Reagan in the U.S., Prime Minister Margaret Thatcher in Britain and Prime Minister Brian Mulroney in Canada, thereby upending long records of liberal governments in their respective countries. It is not a stretch to say that today’s inflation could herald a similar eclipse in big-spending, monetary policy-ignoring governments once again.
Philip Cross is a Senior Fellow at the Macdonald-Laurier Institute and former Chief Economic Analyst at Statistics Canada.
Source of main image: Shutterstock.
