The Covid shock opens the door to high-tax Labour

If inflation comes raging back, the assumption that post-virus austerity can be avoided will be blown apart

Yowzers. We knew that Covidonomics was expensive, but it is still something to see the numbers feed through the machine. The Government has borrowed more last month than it did in the whole of 2019. That’s a deficit of £62billion just for April. For comparison’s sake, the annual deficit for the whole of 2009 was £160 billion.

It wasn’t so long ago that the Prime Minister was having some pernickety fight with his Chancellor about fiscal rules. We knew Sajid Javid’s successor would loosen the belt a bit – and then Covid-19 came along. Rules, schmules.

Naturally, the spending splurge has prompted questions about whether this is 2008 all over again, only bigger, and if it is, when does the austerity drive start? Sure enough, George Osborne popped up on the radio claiming that the cuts would have to start in two or three years to get the books back in order.

But Boris Johnson’s Tories aren’t buying it. With British streets clapping their hearts out for the NHS and mass unemployment on the way when the furlough scheme ends, a political party willing to take Mr Osborne’s retrograde advice can only be one with a death wish.

Instead, the working assumption, for now, is that all this extra borrowing is just fine for two reasons. First, it’s cheap. Interest rates are low, the Bank of England has promised to keep buying bonds and markets aren’t bothered. Secondly, it’s temporary. Just wait till the economy pings back into action and growth will start shrinking the debt burden right back down.

But there is a third, unspoken notion underlying both of these ones. It’s the assumption that inflation will behave itself.

In the last decade, we have become so used to low inflation, despite extraordinarily loose monetary policy, that economists are almost wholly fixated on the dangers of deflation, or falling prices, arising from this crisis.

So worrying is this prospect that the Bank of England has admitted that it could deliberately pursue a policy of negative interest rates – forcing investors to pay for the pleasure of lending money. This sounds crazy, and yet, with a third of all bond yields already in negative territory before Covid hit, much of the financial world has somehow operated on this basis for years.

The assumption that the virus will cause deflation is based on the idea that mass lay-offs will take a huge chunk of demand out of the system. Workers with drastically reduced incomes will stop spending money and prices will fall, causing consumers to delay purchases, in turn cutting prices even more and entering a spiral. Meanwhile, the national debt burden will grow relative to prices, so it becomes more and more expensive to service.

Bad as this is, there is, in fact, an even grimmer possibility. It is that Covid-19 will actually cause inflation to shoot up. The “Case for Inflation”, published recently in Deutsche Bank’s Konzept magazine, suggests that most economists are misinterpreting the whole crisis. Social distancing, lockdowns and their consequences primarily deliver a shock to the supply of goods and services, rather than to demand.

As soon as you think about it, this argument makes obvious sense. If cafes close and flights are cancelled and can only then resume service at much reduced capacity because patrons and passengers have to keep one or two metres apart, the obvious result is that prices rise.

Baristas and airlines simply cannot afford to keep selling less stuff at the same price and many will go out of business, reducing supply even further. Add to that a massive Government stimulus, the geopolitical risk of trade war and a decision to cut down global supply chains and strategically reduce reliance on Chinese goods, and you have all the ingredients for a big rise in costs, hence in prices.

From a Government point of view, some degree of inflation is a good thing. The best-case scenario for fiscal hawks is for inflation to rise, but not too much. If it were to bump along at 4 or 5 per cent, it would steadily help to erode the value of the national debt without destabilising the economy more broadly. This is what “good behaviour” looks like.

But if inflation shoots up too much, it can cause a rise in public borrowing costs, because it forces the Bank of England to counter price rises by tightening monetary policy and reducing its purchase of Government bonds. In turn, markets start to expect inflation and demand higher interest payments for lending to the Government.

In a sense, then, we come right back to those old fiscal rules that our politicians were squabbling about in January. The Tory manifesto promised to keep spending money so long as it was cheap to borrow. If the cost of borrowing rises, then either the Government takes over the Bank of England and starts printing money like a crazed dictator (causing inflation to balloon) or it has to think seriously about how it is going to meet those costs.

With political tolerance for spending cuts still low, the likelihood is that it will reach for the lever of higher taxes. A newly competitive Labour Party under a palatable leader will be well-placed to argue that it is the turn of “the rich” to join the “national effort” by coughing up, just as they did after the Second World War. And a country angry over the mistakes inevitably revealed by any Covid-19 inquiry, still suffering the effects of this year’s recession, let alone the effects of any second virus wave and lockdown, could well buy the argument.

The alternative, of course, is that fiscal conditions remain relatively benign and we spring back to a growth rate that comfortably pays down our virus debts. That way we avoid the prospect of politically toxic, economically risky austerity at a fragile time.

But there are still losers. A decision not to worry about the deficit is ultimately a decision not to worry too much about inflation, so long as it is sure and steady. Savers lose out and prices rise. Interest rates stay low and investors still cannot work out where to put all their cash, pushing up asset prices and feeding continued misallocation of capital.

The only thing to be said for this policy is that all the alternatives look worse. We’d better hope that a technology-driven growth miracle arrives to bail us out.

A decision not to worry about the deficit is a decision not to worry too much about inflation. Savers lose out and prices rise