Which of the following best explains why the Mexican economy faltered despite help from the International Monetary Fund IMF )( IMF as argued in the passage?

Many economists seem to view inflation as a purely technocratic problem, and most central bankers would like to believe that. In fact, the roots of sustained inflation mainly stem from political economy problems, and here the long list of similarities between the 1970s and today is unsettling.

CAMBRIDGE – With the United States’ disastrous exit from Afghanistan, the parallels between the 2020s and the 1970s just keep growing. Has a sustained period of high inflation just become much more likely? Until recently, I would have said the odds were clearly against it. Now, I am not so sure, especially looking ahead a few years.

Many economists seem to view inflation as a purely technocratic problem, and most central bankers would like to believe that. In fact, the roots of sustained inflation mainly stem from political economy problems, and here the long list of similarities between the 1970s and today is unsettling.

At home, following a period in which the US president challenges institutional norms (Richard Nixon was the 1970s version), a thoroughly decent person takes office (back then, Jimmy Carter). Abroad, the US suffers a humiliating defeat at the hands of a much weaker, but much more determined adversary (North Vietnam in the 1970s, the Taliban today).

On the economic front, the global economy suffers a lingering productivity slowdown. According to the Northwestern University economist Robert Gordon’s magisterial account of innovation and growth, The Rise and Fall of American Growth, the 1970s marks a turning point in US economic history, thanks to a sharp slowdown in meaningful economic innovation. Today, even if productivity pessimists grossly underestimate the phenomenal gains the next generation of biotech and artificial intelligence will bring, a large body of work finds that productivity growth has been slowing in the twenty-first century, and now the pandemic looks to be inflicting another heavy blow.

The global economy suffered a massive supply shock in the 1970s, as Middle East countries massively hiked the price of oil they charged the rest of the world. Today, protectionism and a retreat from global supply chains constitutes an equally consequential negative supply shock.

Finally, in the late 1960s and 1970s, huge increases in government spending were not matched by higher taxes on the wealthy. The spending increases stemmed in part from US President Lyndon B. Johnson’s “Great Society” programs in the 1960s, later amplified by the soaring cost of the Vietnam War. First Johnson and then Nixon were reluctant to raise taxes to pay for these costs, fearing a loss of political support. In recent years, first the Trump tax cuts, then pandemic-related catastrophe relief, and now progressive plans to expand the social safety net have hit the federal budget hard. Plans to fund these costs by raising taxes only on the rich will likely fall far short.

It is true that despite all these similarities, today’s independent central banks stand as a bulwark against inflation, ready to raise interest rates if inflation pressures seem to be getting out of hand. In the 1970s, only a few countries had independent central banks, and in the case of the US, it did not act like one, fueling inflation with massive monetary expansion. Today, relatively independent central banks are the norm across much of the world. It is also true that today’s ultra-low global real interest rates provide rich-country governments a lot more room to run deficits than they had in the 1970s.

On the other hand, the challenges of providing for aging populations has become vastly more difficult over the past five decades (at least in advanced economies and China). Underfunded public pension schemes arguably are a much larger threat quantitatively to government budget solvency than debt. At the same time, social pressures to increase government spending and transfers have exploded across the world, as inequality becomes more politically salient for many countries, and improving growth less so. And confronting climate change and other environmental threats will almost certainly put additional pressure on budgets and slow growth.

Sharply rising government debts will inevitably make it more politically painful for central banks to raise nominal interest rates if global real rates start turning upward. High debts are already a reason why some central banks today will hesitate to raise interest rates if and when post-pandemic normalization occurs. Private debt, which has also soared during the pandemic, is perhaps an even bigger problem. Widespread private defaults would eventually have a huge fiscal impact via lower tax collection and higher social safety net costs.

Before we get too pessimistic, let’s remember that the 1970s were followed by the 1980s and 1990s, and a big revival in advanced-economy growth, even if it was not as inclusive as policymakers would like to achieve. Then again, the 2030s are a long way off.

Today’s economic challenges are certainly solvable, and there is no reason why inflation should have to spike. Leading central bankers today such as Jay Powell of the US Federal Reserve and Christine Lagarde of the European Central Bank are a far cry from pliable Fed Chair Arthur Burns in the 1970s. They both have superb staffs to support them. Yet all central banks still face constant pressures, and it is hard for them to stand alone indefinitely, especially if politicians become weak and desperate.

America’s humbling defeat in Afghanistan is a big step toward recreating the perfect storm that led to slow growth and very high inflation of the 1970s. A few weeks ago, a little inflation seemed like a manageable problem. Now, the risks and the stakes are higher.

Given today’s high debt ratios, supply-side risks, and ultra-loose monetary and fiscal policies, the rosy scenario that is currently priced into financial markets may turn out to be a pipe dream. Over the medium term, a variety of persistent negative supply shocks could turn today’s mild stagflation into a severe case.

NEW YORK – How will the global economy and markets evolve over the next year? There are four scenarios that could follow the “mild stagflation” of the last few months.

The recovery in the first half of 2021 has given way recently to sharply slower growth and a surge of inflation well above the 2% target of central banks, owing to the effects of the Delta variant, supply bottlenecks in both goods and labor markets, and shortages of some commodities, intermediate inputs, final goods, and labor. Bond yields have fallen in the last few months and the recent equity-market correction has been modest so far, perhaps reflecting hopes that the mild stagflation will prove temporary.

The four scenarios depend on whether growth accelerates or decelerates, and on whether inflation remains persistently higher or slows down. Wall Street analysts and most policymakers anticipate a “Goldilocks” scenario of stronger growth alongside moderating inflation in line with central banks’ 2% target. According to this view, the recent stagflationary episode is driven largely by the impact of the Delta variant. Once it fades, so, too, will the supply bottlenecks, provided that new virulent variants do not emerge. Then growth would accelerate while inflation would fall.

For markets, this would represent a resumption of the “reflation trade” outlook from earlier this year, when it was hoped that stronger growth would support stronger earnings and even higher stock prices. In this rosy scenario, inflation would subside, keeping inflation expectations anchored around 2%, bond yields would gradually rise alongside real interest rates, and central banks would be in a position to taper quantitative easing without rocking stock or bond markets. In equities, there would be a rotation from US to foreign markets (Europe, Japan, and emerging markets) and from growth, technology, and defensive stocks to cyclical and value stocks.

The second scenario involves “overheating.” Here, growth would accelerate as the supply bottlenecks are cleared, but inflation would remain stubbornly higher, because its causes would turn out not to be temporary. With unspent savings and pent-up demand already high, the continuation of ultra-loose monetary and fiscal policies would boost aggregate demand even further. The resulting growth would be associated with persistent above-target inflation, disproving central banks’ belief that price increases are merely temporary.

The market response to such overheating would then depend on how central banks react. If policymakers remain behind the curve, stock markets may continue to rise for a while as real bond yields remain low. But the ensuing increase in inflation expectations would eventually boost nominal and even real bond yields as inflation risk premia would rise, forcing a correction in equities. Alternatively, if central banks become hawkish and start fighting inflation, real rates would rise, sending bond yields higher and, again, forcing a bigger correction in equities.

A third scenario is ongoing stagflation, with high inflation and much slower growth over the medium term. In this case, inflation would continue to be fed by loose monetary, credit, and fiscal policies. Central banks, caught in a debt trap by high public and private debt ratios, would struggle to normalize rates without triggering a financial-market crash.

Moreover, a host of medium-term persistent negative supply shocks could curtail growth over time and drive up production costs, adding to the inflationary pressure. As I have noted previously, such shocks could stem from de-globalization and rising protectionism, the balkanization of global supply chains, demographic aging in developing and emerging economies, migration restrictions, the Sino-American “decoupling,” the effects of climate change on commodity prices, pandemics, cyberwarfare, and the backlash against income and wealth inequality.

In this scenario, nominal bond yields would rise much higher as inflation expectations become de-anchored. And real yields, too, would be higher (even if central banks remain behind the curve), because rapid and volatile price growth would boost the risk premia on longer-term bonds. Under these conditions, stock markets would be poised for a sharp correction, potentially into bear-market territory (reflecting at least a 20% drop from their last high).

The last scenario would feature a growth slowdown. Weakening aggregate demand would turn out to be not just a transitory scare but a harbinger of the new normal, particularly if monetary and fiscal stimulus is withdrawn too soon. In this case, lower aggregate demand and slower growth would lead to lower inflation, stocks would correct to reflect the weaker growth outlook, and bond yields would fall further (because real yields and inflation expectations would be lower).

Which of these four scenarios is most likely? While most market analysts and policymakers have been pushing the Goldilocks scenario, my fear is that the overheating scenario is more salient. Given today’s loose monetary, fiscal, and credit policies, the fading of the Delta variant and its associated supply bottlenecks will overheat growth and will leave central banks stuck between a rock and a hard place. Faced with a debt trap and persistently above-target inflation, they will almost certainly wimp out and lag behind the curve, even as fiscal policies remain too loose.

But over the medium term, as a variety of persistent negative supply shocks hit the global economy, we may end up with far worse than mild stagflation or overheating: a full stagflation with much lower growth and higher inflation. The temptation to reduce the real value of large nominal fixed-rate debt ratios would lead central banks to accommodate inflation, rather than fight it and risk an economic and market crash.

But today’s debt ratios (both private and public) are substantially higher than they were in the stagflationary 1970s. Public and private agents with too much debt and much lower income will face insolvency once inflation risk premia push real interest rates higher, setting the stage for the stagflationary debt crises that I have warned about.

The Panglossian scenario that is currently priced into financial markets may eventually turn out to be a pipe dream. Rather than fixating on Goldilocks, economic observers should remember Cassandra, whose warnings were ignored until it was too late.

Rising inflation and declining growth are more likely to be a part of the global economy’s upcoming journey than features of its destination. But how policymakers navigate this journey will have major implications for longer-term economic well-being, social cohesion, and financial stability.

CAMBRIDGE – A stream of recent data suggests that the global economy is showing signs of stagflation, that odd 1970s-style mixture of rising inflation and declining growth. Those who have noticed it – and there are still too few of them – fall into two broad camps. Some see the phenomenon as temporary, and quickly reversible. Others fear that it will lead to a renewed period of unsatisfactory growth, but this time with unsettlingly high inflation.

But a third scenario, which draws on both of these views, may well be the most plausible. Stagflationary winds are more likely to be a part of the global economy’s upcoming journey than a feature of its destination. But how policymakers navigate this journey will have major implications for longer-term economic well-being, social cohesion, and financial stability.

The much-needed global economic recovery has recently been losing steam as growth in its two major locomotives, China and the United States, has undershot consensus expectations. The more contagious Delta variant of the coronavirus has dampened spending in some sectors, such as leisure and transportation, while hampering production and shipments in others, particularly manufacturing. Labor shortages are becoming more widespread in a growing number of advanced economies. Add to that a shipping-container shortage and the ongoing reordering of supply chains, and it should come as no surprise that the headwinds to a strong and sustainable global recovery are being accompanied by higher and more persistent inflation.

Higher inflation is putting pressure on those central banks that wish to maintain an exceptionally loose monetary policy. At the same time, decelerating economic growth presents a problem for central banks that are more inclined to scale back stimulus measures. All this also risks eroding political support for much-needed fiscal and structural policies to boost productivity and long-term growth potential.

Some economists, and the majority of policymakers, believe that current stagflationary trends will soon be muted by a combination of market forces and changes in human behavior. They point to recent declines in previously spiking lumber prices as indicative of how competition and increased supply will dampen inflation. They think the sharp fall in Delta-variant cases in the United Kingdom foreshadows what lies ahead for the US and other countries still in the grips of the latest COVID-19 wave. And they take comfort from multiplying signs of booming corporate investment in response to supply disruptions.

Others are more pessimistic. They argue that demand headwinds will intensify due to reductions in fiscal schemes that were supporting household income, citing the expiration of supplementary unemployment benefits and direct cash transfers. They also worry about the gradual exhaustion of the cash buffers that many households unexpectedly accumulated as a result of exceptionally generous government support during the pandemic.

On the supply side, the stagflation pessimists welcome higher business investment but fear that its benefits won’t come fast enough, especially as supply chains are redirected. Supply disruptions will therefore persist for much longer, in their view, and central banks will fall behind with the needed policy response.

I suspect that neither of these scenarios is likely to dominate the period ahead. But they will influence the alternative that does materialize.

Ideally, policymakers would respond in a timely and self-reinforcing manner to the increasing evidence of stagflation. The US would lead by progressing faster on a policy pivot, with the Federal Reserve already unwinding some of its ultra-loose monetary policy and Congress enabling President Joe Biden’s administration to advance its plans to enhance US productivity and longer-term growth by boosting investments in physical and human infrastructure. Meanwhile, national and international financial authorities would coordinate better to strengthen prudential regulation, especially as it pertains to excessive risk-taking among non-bank market participants.

These measures would lead to declining inflationary pressures, faster and more inclusive growth, and genuine financial stability. And such a desirable outcome is attainable provided the needed policy response proceeds in a comprehensive and timely manner.

Absent such a response, supply-side problems will become more structural in nature, and therefore more prolonged than the transitory camp expects. The resulting inflationary pressures will be amplified by the higher wages that many firms will have to offer to attract the workers they currently lack and retain the ones they have. With central banks lagging in their policy response, inflationary expectations risk being destabilized, directly undermining the low-volatility paradigm that has helped push financial-asset prices ever higher.

Because the Fed would then be forced to hit the policy brakes, higher inflation would be unlikely to persist. Unfortunately, reducing it would come at the cost of lower and less inclusive growth, especially if the Biden administration’s plans remain stuck in Congress (which would be more likely in the high-inflation scenario). Rather than prolonged stagflation, the global economy would repeat what it experienced in the aftermath of the 2008 global financial crisis: low growth and low inflation.

The recent appearance of stagflationary tendencies serves as a timely reminder of the urgent need for comprehensive economic-policy measures. The faster such a response materializes, the greater the probability of anchoring economic recovery, social well-being, and financial stability. But if policymakers delay, the global economy will neither be saved by self-correcting forces nor pushed into a prolonged stagflationary trap. Instead, the world will return to the previous “new normal” of economic underperformance, stressed social cohesion, and destabilizing financial volatility.

Generally speaking, inflation can be stabilized with little recession if people believe the necessary policy tightening will be seen through, rather than abandoned at the first signs of pain. Unfortunately, US economic authorities have done little to inspire such confidence.

STANFORD – Today’s inflation is transitory, our central bankers assure us. It will go away on its own. But what if it does not? Central banks will have “the tools” to deal with inflation, they tell us. But just what are those tools? Do central banks have the will to use them, and will governments allow them to do so?

Should inflation continue to surge, central banks’ main tool is to raise interest rates sharply, and keep them high for several years, even if that causes a painful recession, as it did in the early 1980s. How much pain, and how deep of a dip, would it take? The well-respected Taylor rule (named after my Hoover Institution colleague John B. Taylor) recommends that interest rates rise one and a half times as much as inflation. So, if inflation rises from 2% to 5%, interest rates should rise by 4.5 percentage points. Add a baseline of 2% for the inflation target and 1% for the long-run real rate of interest, and the rule recommends a central-bank rate of 7.5%. If inflation accelerates further before central banks act, reining it in could require the 15% interest rates of the early 1980s.

Would central banks do that? If they did, would high interest rates control inflation in today’s economy? There are many reasons for worry.

High Liabilities

Monetary policy lives in the shadow of debt. US federal debt held by the public was about 25% of GDP in 1980, when US Federal Reserve Board Chair Paul Volcker started raising rates to tame inflation. Now, it is 100% of GDP and rising quickly, with no end in sight. When the Fed raises interest rates one percentage point, it raises the interest costs on debt by one percentage point, and, at 100% debt-to-GDP, 1% of GDP is around $227 billion. A 7.5% interest rate therefore creates interest costs of 7.5% of GDP, or $1.7 trillion.

Where will those trillions of dollars come from? Congress could drastically cut spending or find ways to increase tax revenues. Alternatively, the US Treasury could try to borrow additional trillions. But for that option to work, bond buyers must be convinced that a future Congress will cut spending or raise tax revenues by the same trillions of dollars, plus interest. Even if investors seem confident at the moment, we cannot assume that they will remain so indefinitely, especially if additional borrowing serves only to pay higher interest on existing debt. Even for the United States, there is a point at which bond investors see the end coming, and demand even higher interest rates as a risk premium, thereby raising debt costs even more, in a spiral that leads to a debt crisis or to a sharp and uncontrollable surge of inflation. If the US government could borrow arbitrary amounts and never worry about repayment, it could send its citizens checks forever and nobody would have to work or pay taxes again. Alas, we do not live in that fanciful world.

In sum, for higher interest rates to reduce inflation, higher interest rates must be accompanied by credible and persistent fiscal tightening, now or later. If the fiscal tightening does not come, the monetary policy will eventually fail to contain inflation.

This is a perfectly standard proposition, though it is often overlooked when discussing the US and Europe. It is embodied in the models used by the Fed and other central banks. It was standard IMF advice for decades.

Successful inflation and currency stabilization almost always includes monetary and fiscal reform, and usually microeconomic reform. The role of fiscal and microeconomic reform is to generate sustainably higher tax revenues by boosting economic growth and broadening the tax base, rather than with sharply higher and growth-reducing marginal tax rates. Many attempts at monetary stabilization have fallen apart because the fiscal or microeconomic reforms failed. Latin-American economic history is full of such episodes.

Even the US experience in the 1980s conforms to this pattern. The high interest rates of the early 1980s raised interest costs on the US national debt, contributing to most of the then-large annual “Reagan deficits.” Even after inflation declined, interest rates remained high, arguably because markets were worried that inflation would come surging back.

So, why did the US inflation-stabilization effort succeed in the1980s, after failing twice before in the 1970s, and countless times in other countries? In addition to the Fed remaining steadfast and the Reagan administration supporting it through two bruising recessions, the US undertook a series of important tax and microeconomic reforms, most notably the 1982 and 1986 tax reforms, which sharply lowered marginal rates, and market-oriented regulatory reforms starting with the Carter-era deregulation of trucking, air transport, and finance.

The US experienced a two-decade economic boom. A larger GDP boosted tax revenues, enabling debt repayment despite high real-interest rates. By the late 1990s, strange as it sounds now, economists were actually worrying about how financial markets would work once all US Treasury debt had been paid off. The boom was arguably a result of these monetary, fiscal, and microeconomic reforms, though we do not need to argue the cause and effect of this history. Even if the economic boom that produced fiscal surpluses was coincidental with tax and regulatory reform, the fact remains that the US government successfully paid off its debt, including debt incurred from the high interest costs of the early 1980s. Had it not done so, inflation would have returned.

The Borrower Ducks

But would that kind of successful stabilization happen now, with the US national debt four times larger and still rising, and with interest costs for a given level of interest rates four times larger than the contentious Reagan deficits? Would Congress really abandon its ambitious spending plans, or raise tax revenues by trillions, all to pay a windfall of interest payments to largely wealthy and foreign bondholders?

Arguably, it would not. If interest costs on the debt were to spiral upward, Congress would likely demand a reversal of the high interest-rate policy. The last time the US debt-to-GDP ratio was 100%, at the end of World War II, the Fed was explicitly instructed to hold down interest costs on US debt, until inflation erupted in the 1950s.

The unraveling can be slow or fast. It takes time for higher interest rates to raise interest costs, as debt is rolled over. The government can borrow as long as people believe that the fiscal reckoning will come in the future. But when people lose that faith, things can unravel quickly and unpredictably.

Will and Politics

Fiscal policy constraints are only the beginning of the Fed’s difficulties. Will the Fed act promptly, before inflation gets out of control? Or will it continue to treat every increase of inflation as “transitory,” to be blamed on whichever price is going up most that month, as it did in the early 1970s?

It is never easy for the Fed to cause a recession, and to stick with its policy through the pain. Nor is it easy for an administration to support the central bank through that kind of long fight. But tolerating a lasting rise in unemployment – concentrated as usual among the disadvantaged – seems especially difficult in today’s political climate, with the Fed loudly pursuing solutions to inequality and inequity in its interpretation of its mandate to pursue “maximum employment.”

Moreover, the ensuing recession would likely be more severe. Inflation can be stabilized with little recession if people really believe the policy will be seen through. But if they think it is a fleeting attempt that may be reversed, the associated downturn will be worse.

One might think this debate can be postponed until we see if inflation really is transitory or not. But the issue matters now. Fighting inflation is much easier if inflation expectations do not rise. Our central banks insist that inflation expectations are “anchored.” But by what mechanism? Well, by the faith that those same central banks would, if necessary, reapply the harsh Volcker medicine of the 1980s to contain inflation. How long will that faith last? When does the anchor become a sail?

A military or foreign-policy analogy is helpful. Fighting inflation is like deterring an enemy. If you just say you have “the tools,” that’s not very scary. If you tell the enemy what the tools are, show that they all are in shiny working order, and demonstrate that you have the will to use them no matter the pain inflicted on yourself, deterrence is much more likely.

Yet the Fed has been remarkably silent on just what the “tools” are, and just how ready it is to deploy those tools, no matter how painful doing so may be. There has been no parading of materiel. The Fed continues to follow the opposite strategy: a determined effort to stimulate the economy and to raise inflation and inflation expectations, by promising no-matter-what stimulus. The Fed is still trying to deter deflation, and says it will let inflation run above target for a while in an attempt to reduce unemployment, as it did in the 1970s. It has also precommitted not to raise interest rates for a fixed period of time, rather than for as long as required economic conditions remain, which has the same counterproductive result as announcing military withdrawals on specific dates. Like much of the US government, the Fed is consumed with race, inequality, and climate change, and thus is distracted from deterring its traditional enemies.

The Long-Term Solution

An amazing opportunity to avoid this conundrum beckons, but it won’t beckon forever. The US government is like a homeowner who steps outside, smells smoke, and is greeted by a salesman offering fire insurance. So far, the government has declined the offer because it doesn’t want to pay the premium. There is still time to reconsider that choice.

Higher interest rates raise interest costs only because the US has financed its debts largely by rolling over short-term debt, rather than by issuing long-term bonds. The Fed has compounded this problem by buying up large quantities of long-term debt and issuing overnight debt – reserves – in return.

The US government is like any homeowner in this regard. It can choose the adjustable-rate mortgage, which offers a low initial rate, but will lead to sharply higher payments if interest rates rise. Or it can choose the 30-year (or longer) fixed-rate mortgage, which requires a larger initial rate but offers 30 years of protection against interest-rate increases.

Right now, the one-year Treasury rate is 0.07%, the ten-year rate is 1.3%, and the 30-year rate is 1.9%. Each one-year bond saves the US government about two percentage points of interest cost as long as rates stay where they are. But 2% is still negative in real terms. Two percentage points is the insurance premium for eliminating the chance of a debt crisis for 30 years, and for making sure the Fed can fight inflation if it needs to do so. I am not alone in thinking that this seems like inexpensive insurance. Even former US Secretary of the Treasury Lawrence H. Summers has changed his previous view to argue that the US should move swiftly to long-term debt.

But it’s a limited-time opportunity. Countries that start to encounter debt problems generally face higher long-term interest rates, which forces them to borrow short-term and expose themselves to the attendant dangers. When the house down the street is on fire, the insurance salesman disappears, or charges an exorbitant rate.

Bottom Line

Will the current inflation surge turn out to be transitory, or will it continue? The answer depends on our central banks and our governments. If people believe that fiscal and monetary authorities are ready to do what it takes to contain breakout inflation, inflation will remain subdued.

Doing what it takes means joint monetary and fiscal stabilization, with growth-oriented microeconomic reforms. It means sticking to that policy through the inevitable political and economic pain. And it means postponing or abandoning grand plans that depend on the exact opposite policies.

If people and markets lose faith that governments will respond to inflation with such policies in the future, inflation will erupt now. And in the shadow of debt and slow economic growth, central banks cannot control inflation on their own.

At-risk economies may have six months or so to implement self-help measures before any sudden US monetary-policy tightening happens. They are well advised to work on making their exchange rates more flexible, reducing their reliance on foreign-currency debt, and increasing their foreign-exchange reserves.

NEW YORK – As US inflation continues to accelerate, with consumer prices increasing 5% year on year in May, it is not only the US Federal Reserve that needs to remain vigilant. Policymakers around the world – and in vulnerable economies in particular – also should prepare for the possibility that US interest rates will rise faster and sooner than most forecasts currently predict.

After all, the Fed has raised its inflation forecasts significantly over the last 12 months. At its mid-June meeting, the policy-setting Federal Open Market Committee estimated that whole-year inflation in 2021 for personal consumption expenditures would be 3.4%. That is a full percentage point higher than their median projection in March, and more than twice the level forecast back in June 2020.

The rise in US inflation reflects a combination of temporary and structural factors. For example, while partial pandemic-related lockdowns have caused production to decline, large government stimulus programs have sustained household demand, which exceeds supply in many sectors. This component of today’s price increases would presumably disappear once output returns to its full potential.

But although Fed officials regard the current increase in inflation as largely transitory, it also has structural causes that are not entirely linked to the pandemic. For starters, US monetary policy has been on expansionary steroids since 2008. While the Fed’s response to the pandemic-induced recession increased the money supply further, policy was very loose well before the COVID-19 crisis, even when US unemployment was at a multi-decade low.

In addition, former President Donald Trump’s aggressive tariff increases on imports from China – from an average of about 3% in 2018 to over 20% within three years – raised the prices of imported goods, especially for low-income US households. They also increased the domestic prices of goods imported from countries such as Vietnam and Mexico, as well as those of US-made products that are substitutes for Chinese imports. Tariff hikes affecting parts and components imported from China further drove up the prices of downstream products.

Lastly, Trump’s 2017 tax cut and the subsequent fiscal stimulus programs under both Trump and President Joe Biden have boosted aggregate demand, adding to the upward pressure on prices. Many economists, including some prominent Democratic-leaning ones, think Biden’s $1.9 trillion COVID-19 relief package is much larger than necessary given the estimated size of the US output gap.

To anticipate the international consequences of higher US inflation, we need to recognize the risk that the Fed may tighten monetary policy more suddenly and dramatically than its current 3.4% inflation forecast might suggest. For now, a majority of US households, firms, and investors still believe that the Fed will adjust the money-supply spigot in a timely, measured way to prevent inflation from getting out of hand.

But such “inflation anchoring” could prove fragile if Americans see more evidence of the Fed failing to keep inflation near its desired 2% target. Should that happen, both employees’ wage demands and firms’ price-setting will start to reflect the possibility that inflation could shoot up to 5% or more unless the Fed applies the brakes by raising interest rates aggressively.

If US rates rise sharply, history tells us that two types of countries may experience serious financial and economic difficulties. The first group comprises economies that finance a significant part of their investment or consumption with foreign-currency debt, by borrowing either from foreign banks or on international bond markets. Countries with large short-term foreign-currency debts (with less than one year to maturity) and relatively low foreign-exchange reserves are particularly vulnerable to a severe debt or banking crisis.

The second group consists of countries with an overvalued fixed exchange rate, which makes them vulnerable to a run on their currencies and an exchange-rate crisis. So, if the Fed tightens policy significantly, we can expect to see a number of debt and currency crises in Central and South America, Africa, and Asia in the next 2-5 years. Because significant foreign-currency debt and overvalued fixed exchange rates are not mutually exclusive, some countries may suffer several types of crises.

This is why US inflation and interest-rate policy is so important to so many. When the United States sneezes, the rest of the world may catch a cold. But other countries should not expect America to conduct its monetary policy any differently as a result, and nor should they count on the International Monetary Fund or the G7 to be able to direct the US to be more globally minded in managing interest-rate movements.

Even countries not in either of the risk categories will need to address the challenge of imported inflation. China, for example, is deeply concerned about this, even though it currently has relatively modest foreign-currency debts and retains a high level of foreign-exchange reserves.

To prevent imported inflation from fueling domestic inflation, the People’s Bank of China would need to tighten its own supply of liquidity to the economy. For such a policy to be effective, China must either introduce more exchange-rate flexibility or tighten its capital controls, with the former approach promising to be much better for the economy in the long run.

At-risk economies may have six months or so to implement self-help measures before any sudden US monetary-policy tightening happens. They are well advised to work on making their exchange rates more flexible, reducing their reliance on foreign-currency debt, and increasing their foreign-exchange reserves.

Although emerging markets are no less at the mercy of advanced economies today than they were in the past, they are benefiting from massive spillover effects in the context of the current crisis. As a result, the ultra-expansionary monetary policies pioneered in advanced economies are now available to almost everyone.

LONDON – Central banking in emerging markets has undergone a quiet revolution during the COVID-19 pandemic. Unlike in past crises, they have been able to mimic what central banks in advanced economies have been implementing: counter-cyclical policies with quantitative easing (QE), local-currency asset purchases, interest-rate cuts, and monetization of government deficits.

In the past, such policies would have fueled inflation and downward exchange-rate pressure. Not so this time. With the exception of a few central banks that were already in trouble before the pandemic, emerging-market central banks have been able to use QE to create more room to maneuver in responding to the crisis.

Monetary policies in the advanced economies enabled this change. Their own QE programs have had positive spillover effects, and they have expanded their currency swaps and foreign exchange repurchase (repo) operations in response to the crisis. Among the measures taken by the globally systemic central banks (GSCBs), the US Federal Reserve’s response has been the most important, but swaps and repos by the European Central Bank (ECB) and the People’s Bank of China’s (PBOC) have also had a significant impact at the regional level.

The effects of interest-rate cuts and huge liquidity injections in advanced economies have reached emerging markets as a result of the global search for yield. After an initial market stumble in March, capital flows returned to emerging markets, which have seen high debt issuance in subsequent months. Emerging markets have also been able to reduce their interest rates, and their central banks have started issuing domestic-currency-denominated assets in cases where the market is sufficiently large.

Meanwhile, the massive expansion of currency swaps by GSCBs has eased exchange-rate pressures. These swap lines act as safety nets to forestall foreign-currency shortages in domestic markets. Early in the pandemic, the Fed reactivated its standing swap arrangements with the ECB, the Bank of Canada, the Bank of England, the Bank of Japan, and the Swiss National Bank, while also extending their maturities. It then followed up by providing swap lines to the central banks of Australia, Brazil, Denmark, South Korea, Mexico, New Zealand, Norway, Singapore, and Sweden.

While the Fed deployed similar measures during the global financial crisis a decade ago, it has now gone much further. At the end of March, it started offering a new additional temporary repo facility for foreign and international monetary authorities (FIMAs). This arrangement allows central banks and public monetary institutions around the world to use their existing stock of US Treasury bills as a channel for accessing US dollar liquidity.

Although repos are not genuine currency swaps (because the FIMAs must already have dollar-denominated assets on hand as collateral), they have nonetheless proven to be a powerful source of market confidence. And because the mere availability of repos can be enough to reassure markets, they do not need to be used in many cases.

Moreover, repos can serve as a precursor to true currency-swap arrangements, following the model of the ECB’s repo operations with Poland and Hungary in 2009. In the current crisis, the ECB and the PBOC have both expanded swap lines and repos within their monetary spheres of influence, allowing for a sharp reduction in exchange-rate risks in emerging markets.

Emerging-market central banks’ additional room to maneuver will last for as long as advanced economies’ monetary policies remain sufficiently expansionary. The chances for that are high in the near and medium term, because advanced-economy central banks have been unable (for various reasons) fully to exit from the QE that they launched a decade ago, even after growth and employment recovered.

Now, given the pandemic and the deep economic recession that it has caused, there is effectively no end in sight for QE. Several central banks, moreover, are formally committed to keeping interest rates low or even negative, and new central-bank digital currencies could make such policies relatively easy to implement.

The upshot for emerging-market central banks, then, is that they will most likely continue to enjoy monetary-policy spillovers from the GSBCs for the foreseeable future. But there are limits to the benefits of this policy freedom. Many emerging-market central banks may soon experience unintended consequences in terms of financial stability and governance.

After all, QE and a prolonged recession will inevitably hit the balance sheets of companies, households, and eventually banks. When that happens, bankruptcies and non-performing loans will soar, and governments in emerging markets will find that they still have much less fiscal space than their advanced-economy counterparts do for addressing such problems.

Governance issues also are likely to surface. Central-bank asset purchases that go beyond government bonds will raise concerns about transparency and accountability. In fact, this may well become an issue in advanced economies, too (though they will still have the advantage of more fiscal space and robust institutional arrangements).

One way or another, emerging-market vulnerabilities are likely to become apparent soon in various domains of domestic financial stability and governance. Policymakers in these countries would do well to keep their guard up.

Quantitative easing risks generating its own boom-and-bust cycles, and can thus be seen as an example of state-created financial instability. Governments must now abandon the fiction that central banks create money independently from government, and must themselves spend the money created at their behest.

LONDON – Amid all the talk of when and how to end or reverse quantitative easing (QE), one question is almost never discussed: Why have central banks’ massive doses of bond purchases in Europe and the United States since 2009 had so little effect on the general price level?

Between 2009 and 2019, the Bank of England injected £425 billion ($588 billion) – about 22.5% of the United Kingdom’s 2012 GDP – into the UK economy. This was aimed at pushing up inflation to the BOE’s mandated medium-term target of 2%, from a low of just 1.1% in 2009. But after ten years of QE, inflation was below its 2009 level, despite the fact that house and stock-market prices were booming, and GDP growth had not recovered to its pre-crisis trend rate.

Since the start of the COVID-19 pandemic in March 2020, the BOE has bought an additional £450 billion worth of UK government bonds, bringing the total to £875 billion, or 40% of current GDP. The effects on inflation and output of this second round of QE are yet to be felt, but asset prices have again increased markedly.

A plausible generalization is that increasing the quantity of money through QE gives a big temporary boost to the prices of housing and financial securities, thus greatly benefiting the holders of these assets. A small proportion of this increased wealth trickles through to the real economy, but most of it simply circulates within the financial system.

The standard Keynesian argument, derived from John Maynard Keynes’s General Theory, is that any economic collapse, whatever its cause, leads to a large increase in cash hoarding. Money flows into reserves, and saving goes up, while spending goes down. This is why Keynes argued that economic stimulus following a collapse should be carried out by fiscal rather than monetary policy. Government has to be the “spender of last resort” to ensure that new money is used on production instead of being hoarded.

But in his Treatise on Money, Keynes provided a more realistic account based on the “speculative demand for money.” During a sharp economic downturn, he argued, money is not necessarily hoarded, but flows from “industrial” to “financial” circulation. Money in industrial circulation supports the normal processes of producing output, but in financial circulation it is used for “the business of holding and exchanging existing titles to wealth, including stock exchange and money market transactions.” A depression is marked by a transfer of money from industrial to financial circulation – from investment to speculation.

So, the reason why QE has had hardly any effect on the general price level may be that a large part of the new money has fueled asset speculation, thus creating financial bubbles, while prices and output as a whole remained stable.

One implication of this is that QE generates its own boom-and-bust cycles. Unlike orthodox Keynesians, who believed that crises were brought on by some external shock, the economist Hyman Minsky thought that the economic system could generate shocks through its own internal dynamics. Bank lending, Minsky argued, goes through three degenerative stages, which he dubbed hedge, speculation, and Ponzi. At first, the borrower’s income needs to be sufficient to repay both the principal and interest on a loan. Then, it needs to be high enough to meet only the interest payments. And in the final stage, finance simply becomes a gamble that asset prices will rise enough to cover the lending. When the inevitable reversal of asset prices produces a crash, the increase in paper wealth vanishes, dragging down the real economy in its wake.

Minsky would thus view QE as an example of state-created financial instability. Today, there are already clear signs of mortgage-market excesses. UK house prices increased by 10.2% in the year to March 2021, the highest rate of growth since August 2007, while indices of overvaluation in the US housing market are “flashing bright red.” And an econometric study (so far unpublished) by Sandhya Krishnan of the Desai Academy of Economics in Mumbai shows no relationship between asset prices and goods prices in the UK and the US between 2000 and 2016.

So, it is hardly surprising that, in its February 2021 forecast, the BOE’s Monetary Policy Committee estimated that there was a one-third chance of UK inflation falling below 0% or rising above 4% in the next few years. This relatively wide range partly reflects uncertainty about the future course of the pandemic, but also a more basic uncertainty about the effects of QE itself.

In Margaret Atwood’s futuristic 2003 novel Oryx and Crake, HelthWyzer, a drug development center that manufactures premium-brand vitamin pills, inserts a virus randomly into its pills, hoping to profit from the sale of both the pills and the antidote it has developed for the virus. The best type of diseases “from a business point of view,” explains Crake, a mad scientist, “would be those that cause lingering illness [...] the patient would either get well or die just before all of his or her money runs out. It’s a fine calculation.”

With QE, we have invented a wonder drug that cures the macroeconomic diseases it causes. That is why questions about the timing of its withdrawal are such “fine calculations.”

But the antidote is staring us in the face. First, governments must abandon the fiction that central banks create money independently from government. Second, they must themselves spend the money created at their behest. For example, governments should not hoard the furlough funds that are set to be withdrawn as economic activity picks up, but instead use them to create public-sector jobs.

Doing this will bring about a recovery without creating financial instability. It is the only way to wean ourselves off our decade-long addiction to QE.