Where are the US economy and the other advanced economies of the world now? In a word, it is stagflation. Stagflation (declining economic growth with rising inflation) is the new reality and there are three main clusters of factors that have led to the present stance of the economy.
First of all, these are postcovid externalities: breaks in production chains, including semiconductors; logistical locaps due to changes in labor movements; excessive monetary and fiscal stimulation of economic agents from inefficient companies to private households, which created outstripping demand relative to limited output, and also forced up prices.
Further, with Democrats in power, the Keynesian course of pumping demand that occurred first under Donald Trump was expanded. This is reinforcing government expansion through increased infrastructure construction, increased social programs, tighter fiscal regimes, and pressure on business. In addition to the nonequilibrium growth of consumer opportunities, state expansion actually squeezes the economy, whereby businesses already in the unfavorable conditions of a sharp rise in the cost of production factors, particularly labor, raw materials and components, have to compete with the state and bear even greater fiscal costs to finance the government budget.
Finally, an important factor has been the geopolitical escalation between the “collective West” and the Russian autocracy through the proxy conflict between Russia and Ukraine. Russia is the root supplier of hydrocarbons to Europe, and together with Ukraine, the world’s leading exporter of key agricultural commodities. The current conflict overlaps with the aforementioned factors and creates risks of significant commodity and food shortages, at least for the time being until alternative substitute channels are set up and fine-tuned: the stability of Europe’s commodity supply is now in question. In this context, the conflict escalation in Eastern Europe has obvious direct and indirect effects on the economies of developed and developing countries, causing global inflationary spikes, depressing economic activity, and slowing economic growth.
What is now signaling us of imminent problems and stagflationary processes that have already begun?
First, there is the surge in prices of all key commodities. The inflationary turbine in energy prices is sharply increasing production costs in all sectors of the economy. Inflation in agricultural commodities is caused not only by disruptions in the production process and exports by conflicting parties in Eastern Europe, but also by the need to recanalize imports from another countries. Such import substitution is a complicated process, since each of the potential exporters has difficulties in increasing export volumes. In addition, against the backdrop of rising hydrocarbon prices, the logistics of new import channels become more expensive, which is another negative inflationary component.
Second, it is too strong a labor market and inflation accelerating. There is still a close correlation between the low unemployment rate and the low labor force participation in the economy that has happened in the postcovid recovery. In other words, people don’t really want to work, the demand for labor from employers is not met, the number of job openings continues to grow, while the unemployment rate—registered job applications—is extremely low.
Moreover, with a shortage of labor and high inflation, manufacturers are forced to raise wages, which, in addition to the rise in other production costs (energy, raw materials, logistics, shortage of components, taxes, etc.), increases the cost of production and contributes to inflation of the final product through the inevitable transfer of costs to the consumer. Consumers are forced to demand compensation through demands for higher wages, and then the spiral continues. In addition, the activity of the state as a business actor boosts the inflation of labor costs: business has to compete with the state for labor. So, inflation is already more than ten percent. Expectations for annual and five-year inflation continue to rise exponentially as well.
Third, it is a reduction in new orders for durable goods with a simultaneous increase in inventories and production stocks.
Unfilled orders have also slowed, and the inventory/sales multiplier is climbing. Overall, this suggests that output is narrowing and slowing after a strong expansion, which has been driven by two prime factors of the postcrisis recovery: rising retail sales and negative interest rates formed by low funding costs and high inflation. Inflation is critical and negatively affecting economic activity as demand begins to cool off, becomes less diversified and shifts to basic goods, and output contracts through cost cutting and the inability to stop rising costs.
All these factors make manufacturing and consumer sentiment clearly depressed. Business confidence is clearly declining; consumer confidence is at 2008 crisis levels.
Finally, forth, the inversion of the yield curve and the narrowing of the spread between ten- and two-year Treasurys indicate one thing: the risks of today are valued by agents as more significant than the risks of tomorrow. In other words, the long duration risk premium is no longer worth anything. Investors are willing to buy more risk uncertainty without any premium relative to short duration, or investment flows go into very short maturities, effectively into cachet, such as three-month Treasurys. Inflationary assets may be also attractive with a large potential premium to bonds short duration risk, such as equity or certain commodity markets benefiting from export deficits and production crises.
The basic reasons for the inversion is, of course, the inevitable tightening of the FED’s monetary policy. First, the narrowing of spreads makes interest rate arbitrage and interest rate risk diversification less attractive for banks. Second, rising funding rates make lending more expensive for economic agents, which increases the risks of lower supply in the near term.
The peculiarity of today’s stagflation and the threats it poses are because the drivers take it beyond the paradigm of normal business cycles, when the usual measures of monetary credit and budget policy could sanitize the economy and launch a new wave of economic activity. The current problem is that the world economy is undergoing structural transformations in the global integrated processes caused by the geopolitical, ideological and ethical clash of the two social-institutional systems, as it mentioned above.
This dictates new conditions for the recovery of economic growth and the need to revise the government’s economic stimulus measures. Over the past 20 years, these measures have become increasingly entrenched in two directions.
The first is unrelenting Keynesian government expansion. The negative stages of natural market cycles were bought off by inflating government leverage—artificial pumping of demand, social and corporate subsidies, expansion of the regulatory overhang, and, logically, the growth of budget deficits. This increased the volatility of cycles, gave birth to the class of depressed agents who were artificially supported by quantitative easing and zero rate credit. Consequently, that created significant inefficiencies in the economy in the medium and long term.
The second is the unrestrained globalization of production chains and the forced indoctrination of the “green agenda”. Both have led, first, to the fact that resource autocracies have been actively involved in global economic integration, making developed countries more dependent on resource imports from such “regime” countries. Second, the forced implementation of the green agenda without any substantial and elaborate preparation and the premature conservation of traditional energy sources against this background led to a de facto energy crisis with galloping and proliferating inflation in all sectors of the economy.
As a result, Western economies were generally unprepared for almost physical aggravation of relations with resource autocracies, at least with the main one of them—Russia. Now direct and indirect dependence on imports of natural resources, both energy and agricultural, as well as deep integration with such a resource exporter creates great risks for developed economies. These risks are now being realized.
In this situation, there is a question of choosing between two directions of economic policy on the part of the government.
The first option is a continuation of the leftist course: further governmentalization of the economy, squeezing or restraining business by the government, another hyperinjection of government credit, an inevitable additional fiscal tightening, and a continued phaseout of traditional energy sources in an undeveloped green alternative.
The second option is “right-wing”: rejection of vertical active redistribution of benefits from efficient economic agents to inefficient ones. That means liberalization of fiscal and regulatory policy aimed at maximizing business activity and intensifying innovation, encouraging people to work rather than build loan pyramids and receive subsidies, encouraging entrepreneurial initiative rather than socialist squeezing of private production by state nonproductive infrastructure projects. The reining in the green revolution is an also important measure, since energy security and stabilization of energy prices is now one of the key issues for Western economies in the face of today’s threats and unfortunate dependencies.
Obviously, the “right-wing” option implies a natural recovery of the economy and getting rid of its toxic and inefficient components, which is not a painless process in the socioeconomic sense, especially after twenty years of credit bubbles led by government. However, as a result, we will have an intense impetus toward healthy organic growth, where needs and opportunities are created through initiative, innovation and production, rather than through the credit leverage of the state.
We should not forget only that the state in any country at any time is just simple people pursuing personal interests and deriving primarily personal benefit from the mandate (right or opportunity) they have to redistribute public resources and the right to violence. In good countries, their opportunities are limited in favor of society; in bad countries, on the contrary, they are expanded to the detriment of society. And every time the state promises society additional benefits in exchange for an expansion of its mandate, the same thing happens: the state takes back many times more than it gave first.