We struggle with inflation because we misread the pandemic

So, the economy was running normally until the government suddenly ordered us to lock ourselves in. Obviously, this will involve a lot of people losing their jobs and a lot of businesses losing sales. This will be a government-ordered recession.

Because it was ordered by the government, however, the government knew that they had an obligation to provide workers and businesses with income to offset their losses. Fearing a prolonged recession, the government spent a lot of money and the Reserve Bank cut the official interest rate to almost zero.

IllustrationCredit:Matt Davidson

Get? These were government-ordered restrictions on the supply of goods and services, but the government responded as if it was just a standard recession where demand had fallen below the economy’s capacity to produce goods and services and needed a major push to get them back up and running.

The unemployment rate jumped to 7.5 percent, but the nationwide lockdown was lifted after just a month or two. Soon after, everyone – most of them only a small amount of income – started spending like crazy, trying to catch up.

Unemployment began to fall rapidly and – especially as the pandemic had closed our borders to all “imported labor” for two years – eventually fell to its lowest level since 1974.

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So, everything in the park is now beautiful until, suddenly, we find inflation soaring to 6.1 percent and heading higher.

What are we doing? What we always do: start pushing up interest rates to prevent borrowing and spending. When demand for goods and services runs faster than the capacity of businesses to supply them, this puts pressure on prices. But when demand weakens, this puts pressure on prices.

One small problem. The basic cause of our higher prices is not excess demand, it is a decrease in supply. The main cause is the disruption in the supply of many goods due to the pandemic. Coupled with the reduced supply of oil and gas as well as foodstuffs due to the Russian attack on Ukraine. At home, the price of meat and vegetables rose as the drought ended and then the flood.

Get? Again, we have taken the problem on the supply side of the economy and tried to fix it as if it were a problem with demand.

Since the supply disruption caused by the pandemic is temporary, the Ukraine war will eventually end, and meat and vegetable production will recover until the next hit of climate change, we’re basically talking about prices that won’t keep going up quarter after quarter and will eventually have to back off. So of course we all have to be patient and wait for prices to return to normal.

But it was our misdiagnosis of “coronacession” that left us with such strong demand that it was too easy for businesses to escape slipping in price increases that had nothing to do with a supply shortage.

Then why are financial markets and economists so concerned that prices will continue to rise, we will be trapped in a “price-wage spiral” and inflation rates will remain too high?

Short answer: because of our initial error in deciding that the government-ordered partial supply cut should be treated like a normal recession, where demand is flat and requires massive stimulus if the recession doesn’t drag on for years.

If we know, supply disruption is an inevitable occurrence when the pandemic subsides. What no one foresees is that everyone is cooped up in their homes, still receiving a lot of income, but not being able to spend it on anything that involves leaving the house.

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It was the advent of the internet that allowed so many of us to keep working or studying from home. And it is the internet that allows us to continue shopping, but for goods rather than services. The massive temporary shift from buying services to buying goods was carried out so much that there was a shortage of supply of many goods.

But it was our misdiagnosis of “coronacession” – sustaining workers and industry far more than it should – that left us with such strong demand that it was too easy for businesses to escape slipping in price increases that had nothing to do with supply shortages.

Now what we need to solve our mistake is to overreact to rising prices and tighten them up so hard that we really have an old-fashioned recession.

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