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Opinion: When it comes to the economy we are flying blind and that’s terrifying

British inflation is already a little high. According to the Bank of England, it’s heading even higher, with a peak of five per cent likely in the spring. Thereafter, however, there’s apparently little to worry about.

A few minor tweaks to borrowing costs, a peak in energy prices, an easing of supply disruptions and a rebalancing of global demand will likely combine to bring inflation back down to about two per cent, precisely where it belongs.

To be fair, the Bank admits that “near-term uncertainties remain, especially around the outlook for the labour market, and the extent to which domestic cost and price pressures persist into the medium term”.

Those uncertainties, however, are far bigger than the Bank of England and other central banks care to admit. To understand why, it’s important to recognise what markets typically do and, thus, what they are prevented from doing during periods of extended lockdown.

Markets ultimately provide information and incentives, largely through Adam Smith’s “invisible hand”. In a very basic sense, prices allow consumers to judge whether they want to buy X rather than Y, or whether the producer wants to manufacture A rather than B. As prices rise and fall, our decisions evolve. At all times, we are kept informed — roughly — of the relative value of one item compared with another.

When that information is lost, we are flying blind. Neither the consumer nor the producer has any real sense of what is going on. Imagine, for example, that the local fruit and veg market is shut for weeks on end.

Imagine, too, that it’s the only source of information on the relative availability of carrots. The longer the shutdown lasts, the less relevant the “last recorded price” becomes. We have no way of knowing, for example, whether there is a bumper crop (in which case, carrot prices would tumble) or whether the carrot supply has been destroyed by an infestation of wireworms or flea beetles (in which case, prices would soar). When the market finally reopens, we may discover that prices are wildly different from where they used to be.

That’s just carrots. Now imagine that hundreds of thousands of markets — from semiconductors through to short-haul holidays, and from waiters through to truck drivers — are locked down. The loss of information now infects markets in unexpected ways. A car manufacturer places workers on limited hours because of a shortage of semiconductors. Those workers, in turn, spend less in local bars and restaurants. What started as a “supply shock” — not enough semiconductors — now appears from the publican’s perspective to be a “demand shock” — not enough punters.

As these multitudinous markets reopen, supply and demand conditions are likely to be totally out of kilter. With so much lost information, it’s likely that an economy’s productive potential will be a lot lower than it was before lockdowns commenced. Put another way, lockdowns have introduced huge economic inefficiencies thanks to a sustained loss of market information.

It’s tempting to argue that, in the pandemic’s aftermath, we should somehow construct more “resilient” economies, better able to cope with health crises and lockdowns. Some take their inspiration from the global financial crisis, in which a financial daisy chain snapped in far too many places. Back then, the right response was to force banks to stockpile capital and liquidity to reduce their chances of failing in the event of future financial upheavals.

Stockpiling waiters or truck drivers is, however, a non-starter. Lockdowns have contributed not so much to the snapping of a simple daisy chain but, instead, the temporary collapse of a huge daisy matrix. Restoring that matrix requires less in the way of “resilience” and more in the way of markets and, hence, the provision of information.

And this is why the Bank of England, alongside other central banks, needs to recognise that there is no easy return to “business as usual”. If the lack of market information has created huge — and possibly lasting — inefficiencies, the simple ambition of returning demand to pre-lockdown levels is much more of a threat to price stability than the Bank’s models can possibly suggest. Those models assume that “supply” is a given. It’s not. Today’s inflationary threat comes not from too much demand but, instead, too little supply — and too little information — in markets for goods, services and, increasingly, labour.

About the Author: Stephen King is HSBC’s Senior Economic Adviser and author of Grave New World

First published in The Evening Standard


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