‘Democracy will fail if we don’t think as citizens’

Coronavirus has exposed frailties in our economic and social model. This FT series examines how it is forcing a rethink of the role of citizens, the state and business

Martin Wolf in London

© FT montage; Getty Images | States could transform themselves by building a healthier polity and reducing inequality

“It is clear then that the best partnership in a state is the one which operates through the middle people, and also that those states in which the middle element is large, and stronger if possible than the other two together, or at any rate stronger than either of them alone, have every chance of having a well-run constitution.”

Aristotle, Politics

Covid-19 has been a global shock. But will it be a transformative one?

The answer is that it might be a transformative event for a number of western societies, notably the US and UK.

For western liberal democracies, the era after the second world war can be divided into two sub-periods. The first, running roughly from 1945 to 1970 was the era of a “social democratic” or, as Americans might say, a “New Deal” consensus. The second, starting around 1980, was that of the “global free market”, or the “Thatcher-Reagan consensus”.

Between these two periods came an interregnum — the high-inflation 1970s. We are now living in what seems to be another interregnum, which began with the global financial crisis. That crisis damaged the ideology of the free market. But, across the western world, valiant attempts were made to restore the ancien régime, through the rescue of the financial system, tighter financial regulation and fiscal austerity.

In the event, the rise of populist nationalism followed this attempted restoration. With his protectionism and bilateralism, promise to preserve social security and initial (since forgotten) emphasis on rebuilding infrastructure, Donald Trump became leader of his party because he was not a traditional free-market Republican.

With his commitment to levelling up poorer regions and favourable references to Franklin Delano Roosevelt’s New Deal, Boris Johnson has also indicated a new direction of travel. These leaders have buried Ronald Reagan and Margaret Thatcher.

Coronavirus has also now caused a still more dramatic return of government than the financial crisis. This may mark the end of the second postwar period of transition.

Chart of percentage change in employed workers in the US during the Covid-19 crisis that shows Covid-19 has added to the pain for vulnerable groups. For example, the data shows the biggest categorical declines for the young, those with no high school diploma, Asian men and Hispanic women

Around what idea might politics, society and the economy now revolve? The answer should be citizenship, a concept that goes back to the city states of the Greeks and Rome. It is more than just a political idea. As Aristotle also said: “man is a political animal”. We are only fully human, he thought, as active participants in a political community.

In a democracy, people are not just consumers, workers, business owners, savers or investors.

We are citizens. This is the tie that binds people together in a shared endeavour.

In today’s world, citizenship needs to have three aspects: loyalty to democratic political and legal institutions and the values of open debate and mutual tolerance that underpin them; concern for the ability of all fellow citizens to lead a fulfilled life; and the wish to create an economy that allows the citizens and their institutions to flourish.

 Supporters at a campaign rally for Donald Trump in Cincinnati in October 2016
Supporters at a campaign rally for Donald Trump in Cincinnati in October 2016 © Bryan Woolston/Reuters

Anger and despair at the system

The most important reason for emphasising citizenship today is that outlined by Aristotle almost two and a half millennia ago. A necessary condition for the stability of any constitutional democracy is a thriving middle class (by which is meant people in the middle of the income distribution). In its absence, the state risks turning into a plutocracy, a demagogy, or a tyranny.

With the hollowing out of the middle class, even established western democracies are now in danger. As Eric Lonergan and Mark Blyth argue in Angrynomics, the combination of adverse economic developments with manifest unfairnesses has made many people angry.

In Deaths of Despair and the Future of Capitalism, Anne Case and Angus Deaton argue that these developments have also driven many into severe ill-health. They note that the death rates of middle-aged white Americans have risen since 2000. Something similar seems more recently to be happening in the UK.

“Deaths of despair”, they suggest, “are prevalent among those who have been left behind, whose lives have not worked out as they expected.”

Chart of labour force participation rates for men aged 25 to 54 showing that the US, together with Italy, is an outlier for prime-age men in the workforce, with rates lower than in other countries

How did we get here? How does Covid-19 fit in? And how might our ideas and policies need to change?

The postwar settlement worked well, for a while. It was egalitarian and economically dynamic, especially in countries devastated by war. Western governments took an active role in managing their domestic economies, while simultaneously liberalising and expanding foreign trade.

Intellectually, this should be called the Age of Keynes. But it died with the surge in inflation, which precipitated the labour unrest and economic slowdown of the 1970s. The Keynesian era was then followed by that of Milton Friedman, characterised by globalisation, liberalised markets, low marginal taxes and a focus on controlling inflation.

This new global era saw striking successes, notably reductions in global inequality and mass poverty. It also was an era of important innovations, notably in information technology. Not least, it was the era in which Soviet communism collapsed and the ideal of democracy spread across the world.

Yet a number of big weaknesses emerged. Economic growth in high-income countries tended to be low relative to that achieved in the postwar era. The distribution of income and wealth became more unequal. The economic value of relatively uneducated labour fell relative to that of college graduates.

Labour markets became more “flexible”, but earnings were more precarious. The more unequal the society, the lower its social mobility.

People queue for bread in Holborn, London, during an industrial dispute circa 1974
People queue for bread in Holborn, London, during an industrial dispute circa 1974 © Evening Standard/Getty

In cultures that emphasise the obligation to look after oneself, inequality as such may not be so socially or politically destabilising. But the sense of deteriorating prospects for oneself and one’s children certainly matters. So, too, does a strong sense of unfairness.

This is where the idea of “rigged capitalism” is relevant. One aspect of this is the inordinate growth of finance. Another is the shift towards the maximisation of shareholder value as the sole goal of companies and the associated tendency to reward management by reference to the price of stocks.

Another aspect is the decline in competition, documented for the US by Thomas Philippon in his book The Great Reversal. Also relevant is tax avoidance, notably by corporations. US multinationals have been allowed to report a huge proportion of their foreign profits in small, low-tax jurisdictions. Such opportunities and many others in different areas are not just being exploited. They are being actively created, through lobbying.

However convenient it is to blame foreigners, they are not the guilty parties. Trade, especially the sudden expansion of manufactured imports from China in the first decade of this century, generated local shocks.

Yet Harvard economist Elhanan Helpman concludes a review of the literature by stating that “globalisation in the form of foreign trade and offshoring has not been a large contributor to rising inequality”.

Chart showing five decades of decline in industrial employment, measured as employment in industry as share of total civilian employment. The same declining pattern applies in Germany, UK, Italy, France, Spain, Japan and the US

Changes for the workforce

Far more important has been technological change. Particularly significant has been rapid productivity growth in manufacturing, as Martin Sandbu argues in The Economics of Belonging. Also important has been the rising demand for skilled labour relative to unskilled labour.

The decline of manufacturing as a source of employment has had adverse effects on towns and regions in which they were concentrated. When factories close or lay off a large proportion of their workforce, the wider local economy is also adversely affected. Such “left behind” regions have become a crucial element in the coalitions of the disaffected.

Meanwhile, cities, especially the great metropolises, are dynamic hubs for educated people and new activities, as Oxford university economist Paul Collier has noted.

Boris Johnson prepares to board the Brexit battle bus for the Vote Leave campaign in 2016 ahead of the referendum on leaving the EU
Boris Johnson prepares to board the Brexit battle bus for the Vote Leave campaign in 2016 ahead of the referendum on leaving the EU © Christopher Furlong/Getty

The global financial crisis was the outcome of financial liberalisation in the context of rising macroeconomic imbalances, as argued by Matthew Klein and Michael Pettis in Trade Wars are Class Wars.

The most important outcomes were the sudden economic collapse, the rescues of the financial system, the subsequent emphasis on curbing government spending and the post-crisis slowdown of economic growth. In the eurozone, this was exacerbated by the way in which creditor countries lectured the strugglers on their alleged irresponsibility.

Mr Trump became president of the US and Mr Johnson became prime minister of the UK because of their success in incorporating the resentment of those “left behind” into their conservative coalitions.

This, in turn, was partly a reaction of large parts of the old working classes to the transformation of the traditional parties of the left (Labour and Democrats) into ones more representative of university-educated cosmopolitan voters, and ethnic and cultural minorities.

Chart showing rising dissatisfaction with democracy in since 1995 in many countries, notably the US

Impact of the pandemic

Some argue that viewing these political shifts in economic terms is an error. These are, they argue, responses to cultural changes, such as immigration, the changing place of women and new sexual mores. This is unpersuasive, for two reasons: first, cultural and economic changes cannot be separated from each another; and second, culture does not change so quickly.

What needs explaining is the shifts in voting behaviour. The answer is the changing allegiances of people who have come to suffer from status anxiety — the fear that they live on the edge of an economic cliff or are already falling over it.

Women leave Lehman Brothers in 2008 after the bank filed for bankruptcy protection
Women leave Lehman Brothers in 2008 after the bank filed for bankruptcy protection © Louis Lanzano/AP

Into this already fraught situation has come the thunderstorm of Covid-19. This in turn has had at least five big effects.

First, it has caused an economic shutdown to curb the spread of the disease. This came at the expense of the young, who are relatively immune to the effects of the virus, and in favour of the old, who are the most vulnerable.

Second, it has tended to hit women harder than men and the unskilled harder than the skilled.

This is explained by the relatively high intensity of female employment in some hard-hit (and risky) service sectors and to the ability of a higher proportion of skilled people to work securely from home.

Third, coronavirus seems set to exacerbate many prior inequalities. Some of the largest support has gone to the financial sector, as happened in the financial crisis.

Fourth, the pandemic has forced vastly greater fiscal spending even compared with the financial crisis. This now raises the question of how this debt is going to be managed and who is going to pay.

Fifth, the virus has demonstrated the power and resources available to the state. Reagan used to say that “the nine most terrifying words in the English language are: I’m from the government, and I’m here to help.”

That was the best encapsulation of the philosophy of the era he helped create. Today, the demand not just for help from government but for help from competent government is back.

A chart of deaths per 100,000 people since 1990 shoing that the US mortality rate has not followed its expected path , with the rate remaining stubbornly at around 400, while other countries have seen notable declines in the same period

A new civic context

So what might a return to the idea of citizenship mean, in this new context?

It does not mean that the state should have no concern for the welfare of non-citizens. Nor does it mean that it sees the success of its own citizens as a counterpart to the failures of others. On the contrary, it seeks mutually beneficial relations with other states.

It does not mean that states should cut themselves off from free and fruitful exchange with other societies. Trade, movement of ideas, movement of people and movement of capital, properly regulated, can all be highly beneficial.It does not mean that states should avoid co-operating closely with one another to achieve shared goals. This applies above all to actions designed to protect the global environment.

What it does mean is that the first concern of democratic states is the welfare of all their citizens. To make this real, certain things follow.

A pedestrian walks past shut shops in Stockport last month
A pedestrian walks past shut shops in Stockport last month © Anthony Devlin/Bloomberg

Every citizen should have the reasonable possibility of acquiring an education that would allow them to participate as fully as possible in the life of a high-skilled modern economy. Every citizen should also have the security needed to thrive, even if afflicted by the ill luck of illness, disability or other misfortunes.

Every citizen should have the protection at work needed to be free from abuse, both physical and mental. Every citizen should also be able to co-operate with other workers in order to protect their collective rights.

Successful citizens should expect to pay taxes sufficient to sustain such a society. Corporations should understand that they have obligations to the societies that make their existence possible.

The institutions of politics must be susceptible to the influence of all citizens, not just that of the wealthiest. Policy should aim at creating and sustaining a vigorous middle class while ensuring a safety net for everybody. All citizens, whatever their race, ethnicity, religion or gender are entitled to equal treatment.

Citizens are entitled to decide who is allowed to come and work in their countries and who is entitled to share the obligations and rights of citizens with them.

How precisely such aims might be achieved is what politics must be about. But this does not mean going back to the 1960s. The world has changed too profoundly and in most ways for the better.

We are not going back to a world of mass industrialisation, where most educated women did not work, where there were clear ethnic and racial hierarchies and where western countries dominated. Moreover, we face, with climate change, the rise of China and the transformation of work by information technology, very different challenges.

Yet some things remain the same. Human beings must act collectively as well as individually.

Acting together, within a democracy, means acting and thinking as citizens. If we do not do so, democracy will fail. It is our generation’s duty to ensure it does not.

Understanding the Pandemic Stock Market

The worse economic fundamentals and forecasts become, the more mysterious stock-market outcomes in the US appear. At a time when genuine news suggests that equity prices should be tanking, not hitting record highs, explanations based on crowd psychology, the virality of ideas, and the dynamics of narrative epidemics can shed some light.


shiller128_Drew AngererGetty Images_NYSEUSstockmarket

NEW HAVEN – The performance of stock markets, especially in the United States, during the coronavirus pandemic seems to defy logic. With cratering demand dragging down investment and employment, what could possibly be keeping share prices afloat?

The more economic fundamentals and market outcomes diverge, the deeper the mystery becomes, until one considers possible explanations based on crowd psychology, the virality of ideas, and the dynamics of narrative epidemics. After all, stock-market movements are driven largely by investors’ assessments of other investors’ evolving reaction to the news, rather than the news itself.

That is because most people have no way to evaluate the significance of economic or scientific news. Especially when mistrust of news media is high, they tend to rely on how people they know respond to news. This process of evaluation takes time, which is why stock markets do not respond to news suddenly and completely, as conventional theory would suggest. The news starts a new trend in markets, but it is sufficiently ambiguous that most smart money has difficulty profiting from it.

Of course, it is hard to know what drives the stock market, but we can at least conjecture ex post, based on available information.

There are three separate phases of the puzzle in the US: the 3% rise in the S&P 500 from the beginning of the coronavirus crisis, on January 30, to February 19; the 34% drop from that date until March 23; and the 42% upswing from March 23 to the present. Each of these phases reveals a puzzling association with the news, as the lagged market reaction is filtered through investor reactions and stories.

The first phase started when the World Health Organization declared the new coronavirus “a public health emergency of international concern” on January 30. Over the next 20 days, the S&P 500 rose by 3%, hitting an all-time record high on February 19. Why would investors give shares their highest valuation ever right after the announcement of a possible global tragedy? Interest rates did not fall over this period. Why didn’t the stock market “predict” the coming recession by declining before the downturn started?

One conjecture is that a pandemic wasn’t a familiar event, and most investors in early February just weren’t convinced that other investors and consumers paid any attention to such things, until they saw a bigger reaction to the news and in market prices. Their lack of past experience since the 1918-20 influenza pandemic meant that there was no statistical analysis of such events’ market impact.

The beginnings of lockdowns in late January in China received scant attention in the world press. The disease caused by the new coronavirus didn’t even have a name until February 11, when the WHO christened it COVID-19.

In the weeks before February 19, public attention to longstanding problems such as global warming, secular stagnation, or debt overhangs were fading. President Donald Trump’s impeachment trial, which ended February 5, still dominated talk in the US, and many politicians apparently still found it counterproductive to raise alarms about a hypothetical new enormous tragedy looming.

The second phase began when the S&P 500 plummeted 34% from February 19 to March 23, a drop akin to the 1929 stock market crash. Yet, as of February 19, there had been only a handful of reported COVID-19 deaths outside of China. What changed investors’ thinking over that interval was not just one narrative, but a constellation of related narratives.

Some of the new news was nonsense. On February 17, a run on toilet paper in Hong Kong was mentioned for the first time, and became a highly contagious story as a sort of joke. Of course, the news about the spread of the disease was becoming more international. The WHO dubbed it a pandemic on March 11. Internet searches for “pandemic” peaked in the week of March 8-14, and searches for “coronavirus” peaked in the week of March 15-21.

It appears that in this second phase, people were trying to learn the basics about this strange event. Most people couldn’t get a handle on it immediately, let alone imagine that others who might influence market prices were doing so.

As the stock-market downturn proceeded, vivid stories appeared of hardship and business disruption caused by the lockdown. For example, some people in locked-down China reportedly were reduced to searching for minnows and ragworms to eat. In Italy, there were stories of medical workers in overwhelmed hospitals being forced to choose which patients would receive treatment. Narratives about the Great Depression of the 1930s flourished.

The beginning of the third phase, when the S&P 500 market began its 40% rise, was marked by some genuine news about both fiscal and monetary policy. On March 23, after interest rates had already been cut to virtually zero, the US Federal Reserve announced an aggressive program to establish innovative credit facilities. Four days later, Trump signed the $2 trillion Coronavirus Aid, Relief, and Economic Security (CARES) Act, promising aggressive fiscal stimulus.

Both of these measures, and similar actions in other countries, were described as resembling the actions taken to counter the 2008-09 Great Recession, which was followed by a gradual but ultimately huge increase in stock prices. The S&P 500 increased fivefold from its bottom on March 09, 2009, to February 19, 2020. Most people have no idea what’s in the Fed plan or the CARES Act, but investors did know of one recent example when such measures apparently worked.

Stories of smaller but still significant stock-market collapses and strong recoveries, a couple of them from 2018, were widely recalled. Talk of regrets about not buying at the bottom then, or in 2009, may have left the impression that the market had fallen enough in 2020. At that point, FOMO (fear of missing out) took hold, reinforcing investors’ belief that it was safe to go back in.

In all three phases of the COVID-19 stock market, the effects of genuine news are apparent.

But price movements are not necessarily a prompt, logical response to it. In fact, they rarely are.

Robert J. Shiller, a 2013 Nobel laureate in economics, is Professor of Economics at Yale University and the co-creator of the Case-Shiller Index of US house prices. He is the author of Irrational Exuberance, Phishing for Phools: The Economics of Manipulation and Deception (with George Akerlof), and Narrative Economics: How Stories Go Viral and Drive Major Economic Events.

Russia’s Arctic Ambitions

Moscow's security efforts have historically focused on its western front, but it's increasingly concerned about the east.

By: Ekaterina Zolotova

The Russian government is reigniting its push into the Arctic.

Despite the challenging global economic environment, the Kremlin plans to build at least five new icebreakers, which, according to Prime Minister Mikhail Mishustin, will be used to further develop the Northern Sea Route across Russia’s Arctic coast.

On Monday, Russia announced that it had started construction on the Leader project, the world’s most powerful nuclear-powered icebreaker, at the Zvezda shipyard in the Far East region.

According to the government, the project is worth the expense because it will help make the Northern Sea Route accessible year-round and tap into the growing interest in the new transit corridor between Europe and Asia.

But the Kremlin’s own interest in the Arctic is not only a result of the potential economic benefits; it’s also a matter of securing Russia’s eastern borders.

The Eastern Front

Russia has long concentrated its security efforts on its western front. The main threats to Russia's territorial integrity have historically emanated from there, and so it has spent considerable time and resources building up its Baltic and Black Sea fleets.

But Moscow is increasingly focusing on its eastern frontier, which is facing growing threats from several sources, some of which are building up their own naval capabilities. Japan, the United States (through the Bering Strait) and China are all neighbors of this region, and though it’s unlikely that any of these countries would initiate military action against Russia’s east, Moscow is taking no chances, initiating steps to increase the fleet’s combat effectiveness in order to guarantee that no nation can block its access to the Pacific.

It also faces internal threats. This is a massive and remote region with poor infrastructure, making it potentially difficult to control. Maintaining the unity of such a vast territory requires a strong military.

Russia has thus been beefing up its military presence in this region by developing the Pacific Fleet’s technical base and boosting its combat effectiveness. The fleet currently has 58 surface ships and 20 submarines, including strategic missile submarines and multipurpose nuclear and diesel submarines.

It also has marine missiles, anti-submarine and fighter aircraft, and coastal troops. In fact, the Pacific Fleet is the second-largest and most efficient of Russia’s fleets and has a wide range of tasks, including protecting Russia’s exclusive economic zone and ensuring access through these waters for commercial and military vessels. Its operational area, which includes the Arctic, Southern Hemisphere, Pacific Ocean and Indian Ocean, is the largest of all of Russia’s fleets.

To maintain its combat effectiveness, the Pacific Fleet needs to be constantly modernized and supplied with up-to-date equipment. But this requires large investments as well as complex logistics and fleet support.

The Pacific Fleet’s main weakness is its remoteness; it’s poorly connected to Russia’s center as well as the country’s other fleets and flotillas. This is due to the fact that roads and infrastructure in this part of the country are poor – there are only three railways connecting the Far East to the center of the country, for example.

There are several railway projects under construction, but they won’t be ready until 2030. The region’s complex terrain, consisting mostly of uplands, makes road and infrastructure development difficult.

So Russia is now turning to an alternative path to connect the Pacific Fleet with the rest of the country: the Northern Sea Route.

Icebreaker Revamp

Russia's long-term strategy is to turn the Northern Sea Route into a transport corridor that would be accessible year-round from Murmansk to Vladivostok, the location of the Pacific Fleet’s main headquarters. But even taking into account the effects of global warming, it’s unlikely that the ice in this area of the Arctic will melt enough in the next 10-20 years to make these waters traversable for commercial or military vessels.

This means that the future of the Pacific Fleet depends primarily on how quickly and efficiently the Kremlin can create a unified network that connects the fleet’s infrastructure with the center. Considering the thickness of the ice in this region, which can exceed 2 meters (6.5 feet), it’s hard to imagine that this would be possible without a modern icebreaker fleet.

Russia proudly says that it is the only country that has a nuclear-powered icebreaker fleet: two 75,000-horsepower twin-reactor icebreakers called Yamal and 50 Years of Victory, and two 50,000-hp single-reactor icebreakers called Taimyr and Vaigach. It also has the Sevmorput nuclear-powered container ship with 40,000 hp capacity.

The fleet is in need of a revamp, however. Three of the four nuclear-powered icebreakers will be decommissioned by 2030, with the fourth going out of service in 2035. Russia is therefore planning to build new icebreakers.

Rosatomflot, which operates the four aforementioned ones, will receive three new icebreakers (the Arctica, Siberia and Ural) as part of Project 22220. Arctica reached the final stage of sea trials in late June. Two additional nuclear-powered icebreakers are planned at a cost of 100 billion rubles ($1.4 billion).

In addition, the government approved in January the construction budget, totaling 127.5 billion rubles, of the Leader nuclear-powered icebreaker. This vessel can break up to 4.3 meters of ice and operate year-round. Moscow plans to have three Leader-type icebreakers operational by 2033. By 2035, the Kremlin plans to have at least 13 operational heavy-duty icebreakers, nine of which will be nuclear.


Though the total cost of all these projects is unknown, they definitely won’t be cheap. Nuclear-powered icebreakers – as well as the ports, roads and other infrastructure needed to operate them – are extremely expensive to build. The Kremlin is the main financier of these Arctic projects, but considering the collapse of oil prices and the fallout from the coronavirus pandemic, the federal budget is extremely tight.

The Kremlin is thus looking for other ways to finance construction of the new icebreakers. It has unveiled a new strategy to develop the Arctic zone until 2035 that will include attracting investment and creating jobs. It wants to build an Arctic trade route for international shipping – a project that has been a priority for President Vladimir Putin since he introduced the idea in 2018.

Putin believes the cargo turnover of the Northern Sea Route can reach 80 million tons by 2024, a highly ambitious goal considering that turnover was 10.7 million tons in 2017, 20.2 million in 2018, and 31.5 million in 2019. Putin’s goal could be achieved only through large investments and expanding the borders of the Northern Sea Route to include the Barents, White, Pechora, Bering and Okhotsk seas.

In the short term, Moscow wants to increase investment interest in the route, which means providing incentives, developing trade and creating a favorable business environment. The Ministry of Natural Resources and Ecology generally supports the liberalization of access to the Arctic shelf.

On June 23, the State Duma passed a bill in the second reading that would create a special regime for businesses operating in the Arctic, including tax benefits, a register of participants and a free customs zone.

Russia’s long-term goal to develop the Northern Sea Route and build nuclear icebreakers is extremely costly. But given the need to secure the eastern frontier, Russia will continue to invest millions in the Arctic, despite the challenging economic times, even if it means running a deficit.

It believes that bridging the gap between the Pacific and the rest of the country is worth the cost, and hopes that it will pay off financially in the future.

Prices Are Going To Rise - And Fast

by: Goldmoney


- With stock markets barely ruffled, few are thinking beyond the very short term and they are mostly guessing anyway.

- Transmitting money into the real economy is proving difficult, with banks wanting to reduce their balance sheets, and very reluctant to expand credit.

- Don't be misled by the common belief that a decline in the US economy will lead to falling prices.

- The inflationary response from the Fed, which will be immense, will ensure far too much money ends up driving demand for a diminished quantity of needed goods.

With stock markets barely ruffled, few are thinking beyond the very short term and they are mostly guessing anyway. Other than possibly the very short term as we emerge from lockdowns, the economic situation is actually dire, and any hope of a V-shaped recovery is wishful thinking or just brokers' propaganda.
But for now, monetary policy is to buy off all reality by printing money without limit and almost no one is thinking about the consequences.
Transmitting money into the real economy is proving difficult, with banks wanting to reduce their balance sheets, and very reluctant to expand credit. Furthermore, banks are weaker today than ahead of the last credit crisis, and payment failures on the June quarter-day just passed could trigger a systemic crisis before this month is out.
Sooner or later bank failures are inevitable and will be a wake-up call for markets. Monetary inflation will then become an obvious issue as central banks and government treasury departments become desperate to prevent an economic slump by doing the only thing they know; inflate or die.
Foreigners, who are incredibly long of dollars and dollar assets will almost certainly start a chain of events leading to significant falls in the dollar's purchasing power. And when ordinary Americans finally begin to discard their dollars in favour of goods, the dollar will be finished along with all fiat currencies that are tied to it.
Introduction - monetary transmission problems
Between different schools of economics there is much confusion over the link between changes in the quantity of money and prices, exposed afresh by the collapse in GDP due to COVID-19 and the aggressive monetary response from the authorities to contain the economic consequences.

Neo-Keynesians appear to understand the link exists, but for them inflation is always of prices which can be managed by adjusting monetary policy subsequently.
Monetarists follow a mechanical quantity theory leading to a relatively straightforward relationship between changes in the quantity of money and of prices after a time lag of a year or so.
The principal difference with the neo-Keynesians is in the timing: monetarists see monetary inflation occurring long before the price effect, and neo-Keynesians in charge of central bank monetary policy assume rising prices can be controlled subsequently by varying interest rates.
The Austrian school, which is banished from these proceedings, explains that inflation is of money and nothing else, and the effect on the general price level is determined by a combination of changes in the money quantity and of consumers' relative preferences for holding money relative to goods.
But central banks operate exclusively on neo-Keynesian lines.
They feel free to expand the money quantity so long as the general level of prices does not exceed a targeted 2%; except when it does, there is usually an excuse not to restrict money supply growth immediately.
Keynesian Inflationism offers problems on so many levels, not least being it is rather like driving a vehicle using a rear-view mirror for guidance. But importantly for our analysis, central banks do not seem to realise current monetary policies guarantee the death of their currencies.
Central bankers act as if money supply increases after prices, which is what monetary policy amounts to. They have other nonsensical beliefs, such as through an inflation tax despite robbing consumers of their wealth, it stimulates them to buy. Whoever thought that one up as a lasting policy beyond short-term distortions deserves an Ignoble prize for idiocy.
Ah! That was Lord Keynes. And perversely, his disciples are today's main recipients of the Nobel prize for economics. We are now seeing central banks, like some latter-day Aztec priests, trying to appease their gods with human sacrifices. We are the sacrifices, lesser mortals trying to do the best for our families and ourselves, being slaughtered by monetary means.
Figure 1 indicates the alarming debasement of our savings, earnings, and pensions so far through monetary expansion and explains why the dollar's purchasing power has been declining faster than the CPI suggests.
The fiat money quantity reflects not only money in circulation, that is to say true money as defined by Austrian economists, but additionally the banks' deposit reserves held at the Fed, the last data being for 1 May. It captures fiat money both in circulation and theoretically available for circulation.
From 2009, it shows the excess monetary inflation that followed the Lehman crisis in 2008, which until 1 February this year grew at an annualised monthly compound rate of 9.5%, compared with the pre-Lehman average long-run rate of about 5.9%.
No wonder independent analysts calculating the rate of price inflation tell us that it is running at 8%-10% (Shadowstats.com and Chapwood Index), instead of the CPI's 1.5-2.0%. And if that was not bad enough, the recent sharp increase at an annualised rate of 98% since March comes on top of it, putting FMQ at more than double where it would be if Lehman had not happened. FMQ now also exceeds GDP, telling us there is more fiat money than US output, and yet more liquidity is demanded through the banks by failing businesses.
The Fed has increased base money at an unprecedented rate to provide liquidity, allegedly for the non-financial sector. For this to get to businesses, banks must be prepared to increase their lending to non-financials and bank credit must not contract. But as Figure 2 shows, bank balance sheets have stopped growing and even contracted since the end of April.
Between 26 February and 29 April, bank balance sheets increased by $2,489bn. These figures include the uplift in total reserves held at the Fed and not in public circulation, which over the same period increased by $1,083bn.
Therefore, banks increased their other assets by $1,406bn between these dates. Those other assets are split between financials and non-financials, the evidence of rising financial asset prices relative to commercial business's decline strongly suggesting Wall Street has been favoured over Main Street
Subsequently, up to 17 June, bank balance sheets contracted by $169bn. The extent to which banks are increasing financial activities will be balanced by an even sharper contraction in bank credit for non-financials than indicated by the overall balance sheet.
Central banks with their reliance on inflation now have a problem: the banks are failing to pass on extra money to the non-financial sector by expanding their balance sheets. Yet, the disruptions to supply chains, the onshore component totalling some $38 trillion and an unquantifiable offshore component feeding into it, are still there and their problems are growing by the day.
In short, we face a continuing liquidity crisis with limited means of relieving it.
Economic prospects for the next few months
Before we proceed in our analysis of the price effects of inflation, we must assess the economic outlook,as the backdrop to the likely consequences for the scale of monetary inflation, and then we can have a stab at evaluating the effect on prices.
The first clue is in Figure 2 above, which shows that bank lending is contracting, and it is important to understand why. At this stage of the credit cycle, which began expanding following the aftermath of the Lehman crisis over a decade ago, a sharp contraction of bank credit to non-financials is normal.
It is what drives periodic recessions slumps and depressions, and monetary stimulus by central banks is intended to help commercial bankers recover their mojo and resume lending.
The relevant history of central bankers' attitudes to bank credit goes back to Irving Fisher's description of how contracting bank credit intensified the 1930s depression by the liquidation of debt, forcing collateral values down and leading to bank runs and the bankruptcy of thousands of banks.
Ever since, monetary policy is guided by the fear of a repeat performance. But the Keynesian stimulus at the start of the credit cycle only increases the destabilising nature of bankers' behaviour, consisting of long periods of growing greed for profitable loan business, interspersed by sudden reversions to fear of loan risk. It results in a cycle of credit expansion and contraction, which in recent cycles have been resolved temporarily by increasingly aggressive expansions of base money along with government actions to support ailing industries.
It is a sticking-plaster approach which allows the wound to fester out of sight.
Following Lehman's failure, a similar pattern to the one unfolding today of a rapid increase in bank assets through the newly invented QE was followed by a contraction of bank credit which lasted about fifteen months. But that crisis was about financial assets in the mortgage market, which had knock-on effects in the non-financials. Difficult though it was, its resolution was relatively predictable.
This crisis started in the non-financials and is therefore more damaging to the economy; its severity is likely to lead to a banking crisis far larger than the Lehman failure and possibly greater than anything seen since the 1930s depression.
Commercial bankers are now waking up to this possibility. For them, the immediate danger is associated with this quarter-end just passed, when demand for credit to pay quarterly charges increases significantly. Already, businesses are in arrears as never before, with many shopping malls, office blocks and factories unused and rents unpaid.
It is this problem, shared by banks around the world, which due to the severity of current business conditions is likely to tip the banking system over the edge and into an immediate crisis. The extent of the problem is likely to be revealed any time in this month of July.
Excluding the subsequent effects, the Lehman crisis cost the US government and its agencies over $10 trillion in support and rescue operations. This time, being in the non-financial sector with knock-on effects for the financial economy, this crisis is much deeper than Lehman and will require a far larger bailout cheque for collapsing industries. Part of the problem are the broken supply chains needing bridging finance.
And none of this can be done without the Fed funding it all directly or indirectly through quantitative easing. Despite the massive monetary inflation already underway, there can be no doubt that aggregate consumer demand and the production of goods to satisfy it will take an enormous hit this year and beyond, and there is little doubt that the states will be on the hook for even more monetary financing.
Unemployment of previously productive labour is already rising dramatically, and as bankruptcies increase, the rise in the unemployment numbers will continue to do so. Let us therefore assume that compared with last year the production of goods and services and consumer demand for them will decline by at least 25%. Note that we avoid using money-totals, since they are meaningless; it is the exchange of labour being converted into physical products and services that matters.
Into this situation is injected enormous quantities of money, none of which defeats the constraints on true supply of goods, nor for overall demand in a high unemployment economy.
Put in a more familiar way, we will have too much money chasing not enough goods. There is only one outcome, other things being equal; the purchasing power of the dollar in terms of consumer goods will be driven significantly lower. But central bank analysis rules this out, associating too much money chasing too few goods with only an expanding, over-stimulated economy.
This explains stagflation, the situation where an economy stagnating in overall demand is accompanied by rising prices. Nor are other things ever equal, the condition for the paragraph above.
The early receivers of inflated money will spend it, driving up the prices of the goods and services they acquire before the prices of other goods and services are affected. These early receivers include the federal government, which in an election year is doubly unlikely to hold back.
Distribution of state money will increasingly be in the form of welfare to the unemployed, skewing spending towards life's essentials. Inevitably, in an economy with subdued activity not responding quickly enough to produce the volumes of products desired, prices, mainly of essential items, will increase sharply.
Almost certainly, a broad index of prices will not capture this secular effect until too late. The CPI includes a majority of items which are only occasionally bought by individuals. Poor demand for non-essentials where there is now an oversupply puts downward pressure on their prices even in an inflationary environment.
It is therefore possible for the CPI to record little or no price inflation as an average when food and energy prices are rising strongly, particularly when statistical methods designed to show little or no increase in price inflation are additionally taken into account.
Consequently, central banks are already being badly misled by the CPI's statistical method.
And when prices for essentials are soaring, they will continue to increase the quantity of money in circulation, distracted by that 2% increase in the CPI target. By the time it creeps up above that rate it will be too late, much monetary water having already flowed under the bridge.
The politicians will likely dismiss rising prices for food and fuel as the result of profiteering - they always do and then contemplate introducing price controls, making this outcome even worse.
Let us stand back from what is happening - or shortly will be - and estimate the inflation scene as far as we know it:
  • After growing at an average annual rate of 9.5% since the Lehman crisis, broad money in the form of FMQ accelerated to an annualised growth rate of 98% from February this year. Bank balance sheets increased by just under $2.5 trillion in March and April but are now beginning to contract. More increases in base money from the Fed are sure to follow, compensating for lack of bank credit expansión.
  • The Fed is underwriting the whole US corporate debt market in an attempt to ensure the flow of finance for all borrowers, bypassing the banks and suppressing yields in the markets. The secondary market for non-financial debt in the US alone is $9.6 trillion, probably requiring an initial trillion or so of Fed buying in the foreseeable future to keep yield spreads suppressed.
  • The quarter-end two days ago will be marked by a significant rise in missed payments. But demands for more bank credit will be resisted by the banks leading to many more existing loans going sour. Under the weight of non-performing loans, it will be a miracle if a banking crisis is not triggered by missed payments in the US, or elsewhere where banking systems are even weaker. Wherever it starts, the Fed is committed to underwrite the whole US banking system, along with all its commercial borrowers with falling sales and disrupted supply chains, to prevent unemployment spiralling out of control. The monetary inflation required for this alone could easily be at least twice the cost of the Lehman crisis.
  • The Fed is also attempting to underwrite the whole market for financial assets by inflating the quantity of dollars being fed into it in order for the necessary financial and economic confidence to be maintained.
  • Monetary expansion on this scale is bound to undermine the dollar in the foreign exchanges as foreigners liquidate portfolio investments, US Treasury stock, agency stock and the excess of bills and bank deposits not required for reserve currency liquidity purposes. This will leave the Fed funding a government deficit escalating beyond control, and if it is to keep borrowing costs low, it must also absorb sales of foreign-held Treasury and agency debt which currently total $6.77 trillion.
Measured in current dollars, even the quantity of narrow M1 money after all this inflationary financing is likely to grow to much more than 2019's US GDP, which will be contracting sharply in terms of physical output and consumption. This is the recipe for a monetary collapse, as John Law illustrated in France in 1720.
Government finances
Apart from keeping the banking system up and running, the other of the Fed's overriding objectives is to ensure the US government is funded. There can be no doubt that its budget deficit is already out of control. Before COVID-19, the White House was already on course for a trillion-dollar plus deficit.
That has widened as a result of tax shortfalls and increased spending costs. In May, the Congressional Budget Office estimated the deficit for the first eight months of fiscal 2019/20 had more than doubled to $1,905 billion, of which $1,162 was incurred just in April and May. If the deficit continues at this rate, then the outturn for the fiscal year will at least $3 trillion.
The administration had proposed a $2 trillion stimulus, some of which is reflected in figures for April and May. Congress went even further, proposing a $3 trillion stimulus. If elements of Congress's extra spending are adopted, we can amend our expectations and pencil in a budget deficit rising towards $4 trillion at an annualised rate.
The belief that funding sums of this magnitude in the markets can be achieved at current interest rates is a fallacy. It can only be attempted with unlimited monetary creation, which ultimately undermines this solution.
Before the virus hit, it was estimated by the White House that annual borrowing costs would be $422bn. If the deficit increases by $3 trillion, this will rise to about $480bn on the White House's current interest rate assumptions.
With the interest rate burden already accounting for over 40% of the pre-COVID-19 budget deficit estimates, we can see why the Fed and US Treasury are keen to keep bond yields suppressed. In a nutshell, if they rise a funding crisis is the only result.

Following a near certain banking crisis there is bound to be a flight out of deposits and risk assets into the perceived safety of US Treasuries. For a brief period, the government will be able to fund its deficit without a rise in interest rates.
But unless the increased issue of Treasury bonds is bought by the Fed, the economic effect will be to drain funds from the financial and non-financial private sectors. Therefore, the Fed is almost certain to cover almost all of it by quantitative easing.
In summary, government finances started in this presidential election year with the largest deficit on record. We now have an economic disaster unfolding, driven not only by the COVID-19 lockdowns but by a confluence of a turn in the bank credit cycle and rising trade protectionism.
It is no exaggeration to suggest we are on the brink of an economic catastrophe; a descent into an economic dark age. Not only is the budget deficit escalating to multiples of that expected as recently as last March, but there is no prospect of it declining at any time.
To this outlook we can add other negative factors. The contraction of cross-border trade globally is indicative of a spreading slump in business activity. The trend for increasing trade protectionism by America is growing.
The retreat into nationalistic isolation is spreading. These trends are plain to see for those who care to observe them. And for America, in a presidential election year political factors are likely to make things even worse.
How monetary inflation translates into higher prices
We can expect to see two stages in the process of the dollar's purchasing power being undermined.
The first appears to have already commenced with the dollar weakening in the foreign exchanges, and the second, yet to come, is a public rejection of it as a means of exchange.
A year ago, foreign holders on the last reported figures held over $20.5 trillion of US securities to which must be added bank deposits, bills, CDs etc., totalling a further $6,452bn for a total of almost $27 trillion. The contraction in cross-border trade and the isolationism that goes with economic downturns suggest that foreigners now require smaller dollar balances, leading to the repatriation of dollar funds into foreign currencies.

Also compelling foreigners to sell are political developments. The Trump administration has been destabilised by its failure to contain the coronavirus with lockdowns, and a socialistic Joe Biden is now ahead in the opinion polls. If Biden is elected, then all the dollar's gains during the Trump administration could be lost.
We must also not forget that unless the US's savings rate increases, in normal times, a higher budget deficit leads to matching higher trade deficits. When monetary capital arising from trade deficits is recycled, the budget deficit becomes funded directly or indirectly by foreigners.
Indeed, this is why foreigners have accumulated dollars and dollar investments significantly in excess of US GDP. But if this virtuous circle is disrupted, the twin deficit still exists without the net dollar proceeds in foreign hands continuing to accumulate. Instead, the dollars are sold for other currencies and commodities.
Therefore, foreigners have two separate dollar problems to consider: the level of their current holdings which are now too high, and the increasing quantities of dollars in their hands from current and future trade. And with the budget deficit escalating towards $4 trillion, the trade deficit will increase to a similar amount.
Unless, that is, the American people increase their savings. They might do so for the very short term as a reaction to rising economic uncertainty, but not on the scale required, nor for long enough to make a significant dent in the twin deficit relationship.
In his remaining months as president, Trump is likely to respond to a rising trade deficit by increasing tariffs on increasing quantities of imported goods, extending his trade policy against China to other jurisdictions. If so, production costs for consumer goods will rise, driven by a combination of a falling dollar in the foreign exchanges and escalating tariffs on imported goods. It then becomes a vicious circle with foreigners seeing their dollar earnings collapsing in value, encouraging them to liquidate more of their existing holdings.

The price effect of these factors is bound to be noticed eventually by American consumers and will affect the relative preference individuals will have between holding a monetary reserve and owning goods. A small change in the aggregate level of consumer preferences in this regard can have a significant impact on prices, and if they desire collectively to hold less liquidity and more goods, prices of commonly desired goods will rise sharply.
With COVID-19 and changing economic conditions, preferences are likely to increase for essentials, particularly food and energy, and with capacities for essential products deprived of the capital required to expand output the ability of manufacturers to respond by increasing production will be badly restricted.
In the final stages of an inflation driven crisis, the general public becomes indiscriminate in their purchases of goods, even to the point of selling property in order to survive. A currency which no one wants then loses all its objective value for transaction purposes.
This is what happens following all monetary inflations. Once the general public loses confidence that a fiat currency will retain its objective value in transactions, it begins to dispose of it as rapidly as possible and it is too late to stabilise it. This has been the experience of every fiat currency which has died in the past.
The text-book example was the great inflation in Germany's post-war Weimar Republic. Then, as is increasingly the case today, the government relied on monetary inflation as its principal source of funding. The final collapse, when the German people no longer accepted the paper mark as money for transactions, took place between about May and November, taking roughly six months.
The time taken was a combination of an understanding of what was happening spreading throughout the economy and the foreign exchanges, and the time taken to obtain cash - which was in short supply due the demand for it - and find the goods, which were also in short supply, to buy. It was described at the time as the crack-up boom, the final boom into goods and real values that marks the end of a seemingly endless inflation, being the complete breakdown of a monetary system.

Today, the time taken for the dollar's final descent into oblivion will be set by the same human values, quickened by today's instant communications and payment systems, potentially making the collapse more rapid.
In conclusion, don't be misled by the common belief that a decline in the US economy will lead to falling prices. The inflationary response from the Fed, which will be immense, will ensure far too much money ends up driving demand for a diminished quantity of needed goods.