Inflation, climate change and fossil fuels – we enter a new crisis

29th July 2022 By: Saliem Fakir

Who would have thought that we would enter a new inflationary era? Even US Federal Reserve chairperson Janet Yellen was caught off guard by the sudden upward inflationary trajectory.

It was thought that trade liberalisation and globalisation would cure all inflationary problems and inflation targeting was used by most central banks in advanced and some emerging economies to beat the demon of inflation. It seems, as we hurtle from one crisis to another, that a low-inflation world is an unlikely scenario for a long time to come.

There are several reasons for the rise in global inflation. One of them is the Covid-19 pandemic, which negatively affected the supply of goods and services in the past two years as countries imposed hard lockdowns to curb the spread of the virus. Goods could not move from one place to another; if you ordered a iPad, for instance, it would likely be months before it arrived at your preferred destination.

Induced hibernation during the lockdowns resulted in people spending little money. However, as the Covid restrictions were relaxed, demand for goods and services started increasing. This was aided and abetted, if you like, by fiscal stimulus policies in advanced economies to monetise debt and aide those left vulnerable. The result was that people had surplus money that they could spend. But when you spend more than what suppliers can provide, the effects are inflationary.

The second reason for the increase in global inflation is Russia’s invasion of Ukraine, which was sudden and unexpected. This has had the effect of pushing food prices up, especially the prices of essential items such as sunflower oil and wheat. For instance, Egypt, which imports significant amounts of wheat from Ukraine and Russia, has seen a rapid increase in the price of bread. The North African country happens to be the largest per capita consumer of bread in the world.

In middle-income and emerging economies, the pandemic has also reduced the rate of investment, while debt levels have increased and currencies have weakened, with the result that the prices of imported essentials have increased steeply.

The impact has been especially dramatic for Sri Lanka. Imprudent white-elephant investment projects have led to debt overhang and the pandemic has exacerbated the issue – the country has limited foreign reserves to import essentials such as medicines and food, let alone other things. It is facing an economic and political crisis it has not seen since the coffee blight in the mid-1980s.

Central bank tightening in advanced economies is likely to increase debt and financing costs – and this will have implications for the energy transition all over the world and how energy security will be achieved.

Inflation will also be influenced by the long-term effects of demographic changes, which will reverse the gains of the last four decades. This argument is being put forward by Charles Goodhart, a monetary economist. The populations of countries that provided the world with labour that was surplus to their own requirements – China, Eastern Europe and others – are ageing. So, labour and health costs will increase, as old age increases dependencies and leads to a decline in economic productivity.

Lower labour costs have generally also been accompanied by market concentration. Concentration tends to have inflationary effects, owing to market dominance and price gauging. But as we face the Great Resignation and increased labour costs in high-cost countries and as the labour-participation age increases in low-cost labour geographies, the global rise in wages will also trigger a trend towards higher inflation.

Inflation is everybody’s nightmare. For the very poor, it swallows the value of money and impacts on their quality of life and the implications for the rich are that they cannot inflate the value of their assets through purchasing shares or acquiring more assets. This is not entirely a bad thing, given the concentration of wealth and the misallocation of investment capital – largely for speculative investments.

Ravi Kanbur and his colleagues noted in a recent opinion piece, https://voxeu.org/article/global-inequality-boomerang, that the world is entering a new era of inequality. The next decade will see the gains of free trade and globalisation being reversed, while the sustained period of shifts in income that lifted large numbers of the world’s poor out of poverty (which Angus Deacon, also an economist, dubbed the Great Escape) cannot be sustained. Kanbur described the fall in inequality as a ‘sunshine narrative’ that is likely to ‘boomerang’ in the coming decade.

Poorer countries that are hungry for investment will have to borrow at higher costs and that may well stifle the expansion of their energy transitions. The effect of inflation is that it reduces the savings glut that was essentially the pump for three or more decades of low interest rates in advanced economies.

Low inflation was, and is, a good thing. We never really capitalised on it to boost investment in climate transitions through real-economy investments in new innovations. Transitions will have to straddle two objectives: the redress of inequality and the need for decarbonisation. Politicians will have to balance the need for energy security with climate security. For instance, higher carbon taxes will be difficult to implement when the cost of money goes up and household debt increases. The indirect benefit is slow growth and consumption but downsides for government revenues and employment. Sudden inflationary spurts can also be sources of social unrest. We may be seeing a delayed effect as a result of the pandemic and inflation in growing social unrest and instability.

There is a silver lining in all this, however: the race towards energy security will be accompanied by investments in new clean energy solutions. We will have to avoid the 1970s oil crisis by ensuring that energy security does not trump climate objectives. In the short and medium terms, sustained investments in critical clean energy technologies should be maintained; otherwise, a new energy security doctrine could lock us into yet another long period of fossil fuel dependence.