As COVID-19 continues to impact countries around the world, the full economic ramifications of the current recession driven by the various public health policies (including border restrictions and lockdowns) are still being played out.
Among economists, the debate continues to rage as to the macroeconomic ramifications of the pandemic, particularly against the backdrop of the largest global debt bubble in human history as well as structural deficiencies in global financial markets which were observable, particular in the US repo market, in the pre-COVID-19 era.
One of the most contested debates is whether the global economy is currently experiencing, or will in the near future experience, either deflation or inflation.
Deflation Camp vs Inflation Camp
In one camp, some economists argue that the loss of economic activity and income will result in a mass wave of defaults as governments, businesses and households will struggle to service their cashflow obligations, in particular their debts.
These defaults will then reach critical mass thus triggering solvency problems within financial institutions (e.g. banks, hedge funds, exchange traded funds, etc) causing a declaration of bankruptcy which will ultimately result in the collapse of multiple Globally Systemically Important Banks (G-SIBs) thus leading to a complete meltdown of the global financial system – similar to the 2008 Global Financial Crisis (GFC).
Such a meltdown, if left unmitigated, would lead to the largest depression in world economic history, leading to:
a sizeable and permanent reduction in global debt (including the total outstanding number of bonds); and
a collapse of prices economy-wide (especially asset and commodity prices);
a shrinkage of the number of businesses that continue to operate; and
mass unemployment.
In the other camp, some economists argue that the unprecedented monetary and fiscal economic stimulus unleashed by governments and central banks will prevent mass defaults and the collapse of the global debt bubble and instead trigger an inflationary spiral that will erode the value of government issued fiat currencies such as the Australian dollar (especially measured against traditional forms of money such as physical gold and silver).
Such a process will be triggered through the issuance of more debt via the banking system and capital markets which will be injected into asset values (property, shares, etc) and commodity markets (such as oil, food, energy and metals) which in turn will spread across the economy and find its way into consumer goods and services.
This inflationary spiral will intensify when owners of government and corporate bonds abandon this asset class due to both negative nominal and real bond yields leading to a transfer of financial capital to the real economy (i.e. financial capital from the bond market will rollover to either commodities or real goods and services).
Under this situation, global stagflation or even hyperinflation will ensue leading to a repeat of the 1970s or in some extreme cases Weimar Germany, Zimbabwe, Argentina or even modern-day Venezuela. Under such conditions, wealth wrapped up in financial assets such as cash and fixed income products such as government or corporate bonds or annuities will evaporate and the nominal value of real assets (as expressed in the government issued currency) will skyrocket.
For those individuals who are not positioned appropriately, runaway inflation can lead to an erosion of wealth and living standards as the ability to purchase essential necessities such as food, energy, accommodation and transport become more difficult to afford.
While economists are known for having dry theoretical debates, this particular debate is not academic.
The outcome of this debate will radically alter the power and influence of various vested international and domestic political and financial interests and will dramatically impact the living standards and financial standing of billions of people globally.
Deflation vs Inflation in Australia
In Australia, the debate of whether the Australian economy will experience deflation vs inflation in the coming 12 to 36 months has significant relevance given the nature and size of Australia’s household and foreign debt bubbles.
Debt bubbles that are formed and concentrated within the household sector (typically driven by rapid accumulation of household debt via mortgages resulting in speculative real estate and land bubbles) have more widespread economic and political ramifications given that more households are directly impacted both financially, legally and emotionally relative to debt bubbles formed in either via corporate or government balance sheets.
Moreover, given that household debt in Australia is in excess of 120% of GDP (a record high in Australian economic history), this means that the scale of the economic damage which would eventuate if the debt bubble were to collapse (i.e. deflation) would be far more significant relative to smaller debt bubbles. On the other hand, given the scale of the debt bubble, the amount of economic stimulus required to keep it intact is unprecedented in both nominal and relative terms.
While the performance of the global economy and international economic policy, e.g. globally coordinated central bank policy action or the national level economics policies, could have a profound impact on whether Australia experiences deflation or inflation, domestic policies from the Federal and the State/Territory Governments as well as key economic institutions such as the RBA and APRA are also very important to determining the future direction of the Australian economy.
In the absence of a new shock to the global economy (e.g. a declared insolvency from a G-SIB), one could argue that domestic economic policy in Australia could significantly influence the deflation/inflation question more so than international factors.
In the era of COVID-19, domestic Australian policy makers (which includes the National Cabinet consisting of the Commonwealth and the State/Territory Governments) have unleashed unprecedented levels of monetary and fiscal economic stimulus in Australian history to not only to soften the blow of the COVID-19 economic lockdown, but to also save the domestic household debt bubble by limiting the scale of the household debt defaults. This includes delivering the largest projected nominal federal budget deficit in FY 2020 – 21 since world war 2[1] (relative to real GDP) as revealed by Treasurer Josh Frydenberg on 6 October 2020[2][3].
It is for these reasons that evidence is building that the Australian economy is already experiencing stagflation given:
negative economic growth;
elevated unemployment that is forecasted to rapidly grow higher from October 2020 to the end of the 2020 calendar year; and
rapid growth of Australia’s money supply as measured by ‘broad money’ which on an annualised basis is growing at 11.5% as of August 2020 which is the fastest rate since June 2009.
As Australia enters the fourth quarter of 2020 and the quantum of economic stimulus materially reduces with the scale back of income support programs Job Keeper and Job Seeker, a significant cashflow crunch is looming for many Australian businesses and households that will materially affect whether debt obligations can be adequately serviced[4].
If household cashflow obligations cannot be serviced and debt defaults start to escalate coupled with significant business foreclosures, then economic contagion will start to, without additional policy action, flow through the Australian economy resulting in a deflationary spiral resulting from a shrinkage of domestic debt and a deeper economic recession.
Politics will dictate Economic Strategy
Given the material political ramifications that the largest household and foreign debt bubbles in Australian history poses to the political class, it is little wonder that that short-term domestic political interests are influencing the formulation and delivery of domestic economic policy.
Anecdotal evidence from conversations with Federal parliamentarians indicate that, for example, the Morrison Government’s policy formulation process is being driven in the context of maximising the Government’s re-election chances in the expected 2021 Federal Election.
So, to accurately forecast future economic policy decisions which will have a strong bearing on whether Australian economy experiences inflation or deflation, objective political analysis is required.
Moreover, beyond the direct political interests of Federal Parliament, a set of political and financial interests will also influence as to whether Australia experiences inflation or deflation and this includes industries such as banks and financial services, construction, retail, tourism as well as organisations such as trade unions and social service organisations.
The Political Consensus is for More Economic Stimulus
Given the importance of political analysis in forecasting future domestic economic policy, it is material to note that a broad political consensus was reached during the early stages of the current COVID-19 pandemic to implement the unprecedented economic stimulus for a six-month window from March 2020 to September 2020.
Many of the same stakeholders including influential thinktanks, economic consultancy organisations and political and economics commentators have all called for evermore stimulus, with little regard for the medium to long term economic consequences that economic stimulus entails.
Dangerously, such universal consensus regarding economic stimulus also existed in Weimar Germany in the aftermath of world war 1 and in the lead up to the Hyperinflation of 1923[5].
Moreover, and importantly, the political consensus calling for more economic stimulus is both contextual (i.e. the COVID-19 pandemic) as well as a structural given Australia’s democratic political system. Critics of democracy of the 18th and 19th century in both the United Kingdom and the United States argued that democracy with a wide universal mandate would sacrifice the public interest for short-term delivering disastrous long‑term economic and public policy outcomes.
One such example is Alexander Tytler who wrote in 1854[6]:
“A democracy is always temporary in nature; it simply cannot exist as a permanent form of government. A democracy will continue to exist up until the time that voters discover that they can vote themselves generous gifts from the public treasury. From that moment on, the majority always votes for the candidates who promise the most benefits from the public treasury, with the result that every democracy will finally collapse due to loose fiscal policy, which is always followed by a dictatorship.”
Alternatively, American Founding Father James Madison, writing in Federalist Paper 10[7] said:
“When a majority is included in a faction, the form of popular government, on the other hand, enables it to sacrifice to its ruling passion or interest both the public good and the rights of other citizens.”
While all political parties in Australia for both contextual and structural reasons are advocates for more economic stimulus, political differences are beginning to emerge as to the form that ongoing stimulus should take.
In recent weeks, various political organisations have sought to politicise attempts to wind-up particular forms of economic stimulus, for example income support (i.e. JobKeeper and JobSeeker) given:
the ongoing lockdown;
an expected increase in unemployment in the coming months; and
the immediate financial cashflow concerns facing various Australian businesses and households.
Despite the economic stimulus announcements in the Federal Budget released on 6 October 2020 which centred around:
tax cuts;
wage subsidies (i.e. Job Maker);
infrastructure spending; and
incentives to spur business investment and the take up of commercial credit
the winding-up of income support measures, the exhaustion of savings (especially of those savings which came from the drawdown of superannuation accounts) and the ultimate ending of businesses trading while insolvent means that the financial pressure facing households and businesses will continue to intensify in the coming months.
Thus, it is understandable that Leader of the Opposition the Hon. Anthony Albanese MP announced further spending commitments in his 8 October 2020 budget-in-reply which would ease the cashflow pressure on middle class households (especially around childcare).
The Inflationists are the Dominant Political Faction
Given the discussion above, it is clear that the ‘inflationists’, those advocating for ever more economic stimulus, are the dominant political faction in Australia.
Their wide reach throughout government, the bureaucracy, the media, business groups, thinktanks, academia, industry and trade unions mean that public debate on economic policy will be skewed and that the Australian people will not hear legitimate criticisms or the alternative case to the pro‑economic stimulus agenda.
The most dangerous consequence of the ‘inflationists’ political dominance is that the medium to long term consequences of their economic policies is not being properly explained to the Australian people and thus, given Australia’s democratic system, there is little prospect of economic policy moving in an alternative direction.
As a result, it would appear from the current vantage point that Australia is on track to have a rendezvous with crisis and catastrophe.
Can Australian Democracy Save Itself?
From an objective standpoint, evermore economic stimulus and inflationism does not resolve the core structural economic imbalances which are currently present in the Australian economy and which have built up over the past 30 years since the 1991 recession.
As Weimar Germany or even Argentina have demonstrated, the inflationist stimulus path delays any resolution of underlying issues and only compounds a country’s economic problems ultimately leading to a catastrophic currency crisis and hyperinflation.
For Australia to avoid these horrors, a reset of the economy to a more solid and sustainable foundation is required.
To achieve this, Australia needs to implement a macroeconomic austerity program that facilitates sustained deflation by shrinking Australia's enormous household debt and rapidly growing public sector debt as well as ensuring a firm stable foundation for the Australian dollar. This includes:
the RBA ceasing its bond buying program and generous bank financing arrangements as well as raising official interest rates;
Federal and State/Territory Governments implementing severe government spending cuts which facilitate budget surpluses that allows for public sector debt to be repaid and for the overall tax burden on productive sectors of the economy to reduce[8];
a restructuring of Australia’s banking system that ends the too big to fail dilemma and directs credit towards productive investment rather than asset speculation; and
the implementation of microeconomic reform in areas such as taxation, labour, energy and public administration which reduces business costs and lifts multifactor productivity and international competitiveness.
Admittedly, the impact of a deflationist macroeconomic austerity agenda will have disproportionate impacts on those Australians who:
have significant debts and little savings;
have significant reliance on government expenditure; and
are employed in sectors which are closely tied to the current household debt bubble or the public sector.
These Australians represent a significant proportion of the overall population.
Given this reality and the political ramifications that this carries, no political will exists:
within Federal or State/Territory parliaments; or
even domestic Australian political parties that do not hold public office to advocate for a macroeconomic austerity agenda that comes to terms with Australia’s national economic problems.
The more central question facing Australian democracy is that even if such political will were to exist and was willing to put forward such an agenda, would a majority of Australians be willing to support the harsh realities that such an agenda was to impose?
That is, does Australian democracy have the capacity to save the Australian dollar from an inevitable currency crisis?
Anecdotal conversation with existing Federal Parliamentarians, political academics and seasoned political journalists suggests no, even though historical precedents do exist where democratic mandates for an economic austerity program was secured. Examples include:
Rather, Australia’s political class, especially incumbent parliamentarians within the Morrison Government, fear an electoral wipe out if a deflationist austerity agenda were to be suggested to the Australian people or implemented as previously observed in countries such as:
Germany at the 1930 and 1932 general elections;
Ireland at the 2011 general election; and
Greece at the 2012 general election.
Importantly, in the three case studies noted above where a pro-austerity democratic mandate was established, the winner of these elections was the opposition political party to the government of the day, whereas, in the three case studies where electoral wipe outs was experienced, these governments were the incumbents.
Recent academic scholarship by Princeton University Professor Christopher Achen and Vanderbilt University Professor Larry Bartels[12] have provided robust statistical analysis as to the basis of how voters cast their ballots in democratic elections.
When it comes to the economic considerations, Achen and Bartels assert that voters are most sensitive to income growth in the two quarters prior to an election – that is voters are retrospectively myopic and tend to discard economic conditions in the years prior.
Given this empirical finding, there is little incentive for the current Morrison Government to implement corrective macroeconomic policy given that voters are likely to punish them for a decline in household disposable income that would result from a deflationary austerity program.
Moreover, given Australia’s record household debt, there is little incentive for typically aspirational Australians (typically referred to as the Howard Battlers during the early 2000s), who have been lured into taking on record sums of debt to finance property speculation and extravagant lifestyles to vote for a policy agenda which would severely cripple their own personal financial circumstances.
The only likely opportunity for a democratic mandate for such an agenda to be secured would be an opposition party (i.e. most likely the alternative government within the Federal Parliament) who would put forward such an agenda when the adverse consequences of the inflationist agenda is felt by a wide spectrum of Australian society, i.e. when a full-blown balance of payments and currency crisis is underway.
Conclusion
The Australian economy is at a critical juncture.
With the biggest debt bubble in Australian history, a collapse of this debt through a critical mass of mortgage defaults would lead to the largest economic depression ever experienced by the Australian people.
Alternatively, the issuance of ever-increasing amounts of fiscal and monetary economic stimulus will erode and ultimately destroy the value of the Australian dollar through runaway inflation and ultimately a balance of payments and currency crisis, especially given the scale of Australia’s gross and net foreign debt.
If history is any guide, a country’s economic management via a democratic political system in which its citizens have a dependence on government is going to result in:
economic policy being set by short-term political interests; and
runaway inflation driven by ever-increasing demands on government that results in large fiscal deficits and ballooning public sector debt.
Currently, Australia possesses a political consensus which is advocating for more economic fiscal and monetary stimulus. This consensus has led the Morrison Government to deliver the largest nominal federal budget deficit on record and the largest relative to GDP since WWII.
Political and legal philosophers such as James Madison and Alexander Tytler warned in the 18th and 19th Centuries respectively that the inherent nature of political systems carry direct economic consequences. In this Tytler warned that democracy carries inherent design problems that will result in intractable economic ruin.
Importantly, this has not always held true. Democratic systems have shown capacity historically to elect non-incumbent reformist governments who implemented macroeconomic austerity agendas, although generally these occurred during deteriorating economic conditions and crisis.
In the current context, the Howard Battlers, i.e. the aspirational class of Australians who bought into a fantasy lifestyle unattainable to their forbears through extraordinary personal debts, must bring themselves to financially blowing themselves up in order to rescue Australia from long term economic ruin.
Given the academic findings of Professors Achen and Bartels, this does not seem likely in the short term.
Upon the way towards runaway inflation and an ultimate currency crisis, Australian democracy in 2020 which is coupled with the universal franchise remains the main impediment to implementing sound macroeconomic policy.
The Australian dollar will be the ultimate victim.
John Adams is the Chief Economist for As Good As Gold Australia
[1] https://www.smh.com.au/politics/federal/frydenberg-unveils-biggest-deficit-since-world-war-ii-20200722-p55ejf.html [2] In nominal terms, the projected budget deficit for FY20-21 is the largest in Australian history standing at $AUD 213.7 billion. [3] This also includes delivering projected large budget deficits over the forward estimates through to FY 23‑24. [4] A good outline of the looming situation was documented by the Australian Broadcasting Corporation’s 4 Corners program on 28 September 2020. [5] Weitz, E., (2007), “Weimar Germany – Promise and Tragedy”, Princeton University Press, Princeton, New Jeresy, USA (Chapter 4) [6] Tytler, A., (1854), “Universal History – From the Creation of the World to the Beginning of the 18th Century”, Petridge and Company, Boston, USA [7] https://billofrightsinstitute.org/founding-documents/primary-source-documents/the-federalist-papers/federalist-papers-no-10/ [8] Recent economic research examining fiscal austerity demonstrate that austerity based on cutting government expenditure results is little to no loss of economic outcome over the medium term and a sustained decrease in public sector debt whereas fiscal austerity based on raising taxes will result in a severe loss of economic output given that rising taxes has a distortive impact on business investment. An example of this analysis can be found via Alesina, Favero and Giaavazzi (2019), “Austerity – When it Works and When it Doesn’t”, Princeton University Press [9] See Grant, J., (2014), “The Forgotten Depression – 1921: The Crash That Cured Itself”, Simon & Schuster, New York, USA [10] See Henderson, A., (2011), “Joseph Lyons – The People’s Prime Minister”, NewSouth Publishing, Sydney, NSW, Australia [11] An analysis of the 1979 General Election offered by Professor Venon Bogdanor can be found at the following link: https://www.youtube.com/watch?v=UKWm51sTtEI&t=833s [12] Achen, C., and Bartels, L., (2017), “Democracy for Realists – Why Elections Do Not Produce Responsive Government”, Princeton University Press, USA
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