The history of the world from a hundred years ago is well on track to repeat itself: A deadly pandemic, a potential war in Europe, and macro-economic pressures, this time brought about by ravaging inflation. 

The 1918 Spanish Flu infected about 500 million people or one-third of the world’s population. While the novel coronavirus has not been as deadly, infecting 423 million people and killing 5.88 million, its global impact has been even more devastating. 

The two world wars (ending in 1919 and 1945, respectively) forever changed the global power balance, establishing two superpowers in the Soviet Union and the United States. The 1929 stock market crash brought about deflation and famine even in the wealthiest economies, triggering numerous social policy actions and strengthening independent central banks.

A possible war

We study history because it serves as a teacher par excellence. Yet, here we are, combating all three low points of the 20th century — war, pandemic, and economic pain again — although it is challenging to state which macro-economic problem is worse: deflation or inflation.

Russia beats warm drums around Ukraine with the world’s largest standing army. President Putin is playing with fire, testing nuclear-capable missiles even as he assembles a sufficiently strong force that can take Kyiv in a matter of days. Europe, struggling to return to normalcy after coronavirus fatigue, does not want to play war games with Russia. Why should it? Ukraine is not part of the North Atlantic Treaty Organization (NATO), an intergovernmental military alliance between 27 European countries, the US, and Canada.

Indeed, the crux of the Russia-Ukraine situation is NATO. Ukraine would like to join NATO so that Ukraine can take advantage of a critical element of NATO’s charter. Article 5 states that an attack on one member of NATO is an attack on all of its members. 

But Russia is steadfastly opposed, demanding that even Western reinforcements of defensive military gear in Ukraine are too close to comfort and are reason enough to threaten war. Some NATO allies are willing to yield on this crucial demand of Putin’s so that tensions would recede. In Kyiv last week, German Chancellor Olaf Scholz, dependent upon Russian natural gas, said that Ukraine’s NATO membership was “not on the table at the moment,” so it is “strange that Russia would raise the issue.” 

Soaring inflation

All of which brings us to the most painful topic of all. The world governments’ unprecedented fiscal and monetary responses to the pandemic have resulted in inflation, a debilitating human tax from which there is no escape.

The primary role of a central bank such as the Fed, the Bank of Japan, the Bank of China, the ECB, and the Reserve Bank of India is to control the money supply. Each bank defines the term differently, but there is broad agreement about what constitutes it. When a central bank lowers interest rates or reduces reserve limits, it pumps more money into an economy, increasing the total money supply. It does the opposite to decrease the money supply.

When Covid hit, the global economy came to a virtual halt. Factories and businesses could not operate. Employees could not earn a paycheck. Governments worldwide began to send free money to citizens so that they could stay home and buy food, water, and clothing — but not venture out to work because doing so would spread the virus. \

The US government spent upwards of $4.5 trillion in emergency Covid funds, nearly as much as the government’s annual 2019 budget, which was already running a 20 per cent deficit. 

Ordinarily, the Covid trillions would be paid for by future tax increases, but few governments have the political will to raise taxes even to cover current funding levels. The US government has not balanced its budget since 2001, meaning that it borrows each year to pay its bills rather than increase taxes.

Fiscal limits

So, how could the US government spend $4.5 trillion in money that it did not have? That was easy. The Fed stepped in using its powers to create money by fiat. When the Treasury issued bonds valued at $4.5 trillion, the Fed bought the bonds and released liquid cash to the government to distribute it. This action vastly increased the money supply. 

The Fed’s balance sheet shows an increase in its assets because it now holds $4.5 trillion in Treasurys. The only way the Fed can reduce its balance sheet is if the US government were to repay the Fed, presumably, by taxing citizens, something the world knows is unlikely to happen.

Meanwhile, with so much money in people’s pockets chasing supplies limited by weak industrial production driven by the pandemic, it was no surprise that the dreaded cancer of inflation would be upon us. In June 2021, the US Consumer Price Index was 4.5 per cent higher than the previous year, a significant jump for something that is generally around 2.0 per cent. Now, inflation is running at 7.50 per cent, a 42-year high.

So how does the Fed lower inflation? It must decrease the money supply — by raising interest rates, increasing bank reserve limits, and slowly mopping up the money it artificially created with its quantitative easing over the last ten years in an excruciating exercise that may last years. Home sales will fall as mortgages become dearer.

Businesses will stop expanding as financing costs increase. Investors will move funds from stocks to bonds to capitalise on higher interest rates — triggering a fall in market indices, leading to layoffs.

Even governments will feel the pinch. With reserve banks holding interest rates near zero, governments worldwide have borrowed freely and built up large debts. The cost to service those debts — and future deficits — will rise as interest rates go up.

John Cochrane, a Stanford University economist, tells The Wall Street Journal that in 1980, the ratio of federal debt to the gross domestic product was 25 per cent. Today, it is 100 per cent and rising. 

Cochrane says that inflation is where “dreams of costless fiscal expansion, flooding the country with borrowed money to address every perceived problem, hit a hard brick wall of reality.” The present crisis may “reteach our politicians, officials and commentariat the classic lessons that there are fiscal limits, that fiscal and monetary [policy] are intertwined.” 

For millions of people, these lessons may be too late.