The immediate impact of COVID-19 on Canada’s economy - like many others - has been a drop in GDP and a massive ramping up of government deficits given the collapse in revenues and in increase in emergency spending and benefits. At the federal level, the deficit for 2020 is anticipated to be closer to $400 billion. In the wake of Wednesday’s Throne Speech there should be a fiscal update or budget that will provide further fiscal details. In the meantime, it is worth thinking a bit about what the ultimate impact of such large deficits will be not just in Canada but on the world economy.
The traditional aggregate demand(AD)-aggregate supply(AS) framework for looking at fiscal and monetary policy suggests that large deficits will shift AD to the right and raise price (P) and output (Y). The increase in prices then triggers inflationary expectations which shifts the aggregate supply curve upwards starting a wage-price spiral. Bringing inflation under control ultimately then requires tighter monetary policy that raises interest rates and brings down aggregate demand and inflationary expectations. It all seems simple enough except since 2008-09, the massive deficits incurred around the world do not seem to have done any of this. Indeed, inflation is low and interest rates have gone lower. The world is awash in cheap money. And, Modern Monetary Theory (MMT) has been gaining ground with arguments that we can stimulate demand practically forever by having sovereign governments with their own currency increasing the money supply.
I think if we had to draw a picture of the global economy under the current situation, it looks something like this (Figure 1):
If we think of the world economy as a giant AD and a giant AS curve, the AD curve has a traditional downward slope, but the AS curve is flat rather than upward sloping or vertical. That is, world aggregate supply as a result of integrated international supply chains, trade, increasing capital mobility, technology and digitization – essentially the results of globalization since the 1990s – has become perfectly elastic. As a result, even with deficits and cheap money shifting that aggregate demand curve repeatedly to the right, there has been no inflationary pressure. Supply has expanded to accommodate demand and hence inflation has stayed low and there has been no upward pressure on interest rates.
This means that in a sense we are going to be able to both have our cake and eat it for some time. Inflation will probably not rear up its head anytime soon and interest rates are going to stay low and probably below the rate of economic growth meaning that governments will not face immense debt service or debt burdens from their massively expanding debt. However, I think eventually, the global economy is going to more likely start to resemble Figure 2 down below:
While one can argue that the economy has always been global, modern economic history has been marked by two distinct periods of globalization: 1870 to 1914 and 1990 to 2016. The first great globalization coincided with the hegemony of the Pax Britannica, the industrial age and the liberalization of the world economy which came to a crashing halt with World War I and which then took decades to resume. After the shocks and trauma of trade restrictions, world wars, political extremism and the Depression, the post-World War II era saw slow steps to more trade and the fall of the Berlin Wall marks the start of the second age of globalization and trade liberalization which moved together with the internet and rapid technological change in communications, and China’s rapid industrialization and development. Much of this growth of trade occurred under the hegemony of the Pax Americana and included shifting of production to lower labour cost environments. This age was dealt a blow by the 2008-09 recession and came to an end with the rise of populism and trade restrictions which officially begin with the election of Donald Trump in 2016 and the American retreat from a more global role.
The second great globalization essentially flattened the aggregate supply curve which is why inflationary pressure has been muted. Because of technological change, improved transport and communications, the shifting of production to the cheapest spot with integrated supply chains, and freer trade – the aggregate supply curve became perfectly elastic and able to accommodate rising AD at an almost infinite pace. However, we are now in a volatile transition period that has been aggravated by the pandemic. Since 2016, there have been more trade disputes, concern and push back against China’s seeming unwillingness to play by the rules of a more liberal-democratic world economic order, and trade disruption by populist politicians. The end result of this will be an AS curve marked by higher costs of production with output expansion – in other words, more of an upward sloping curve.
The result of expanding demand with an upward sloping AS curve will be rising prices and hence the return of inflation. Combine this upward pressure on prices with eventual competition for borrowers to take on more and more government debt and there will be a rise in interest rates. The events of the last five years have ensured that interest rates will rise – it is not a question of if but when.