Monetary authorities are weighing the inflationary and other upshots of Russia's assault on Ukraine. Photo: AFP

Standard cures for inflation, whether of the monetarist or the Keynesian traditions, are politically and practically inapplicable to day’s severe case of worldwide runaway prices combined with inadequate growth.  

Policymakers are afloat on a stormy and uncertain sea, and their traditional tools and compasses are of little use. If they continue to allow the rushing current of paper money and high wind of big spending to fix their course, a rocky shore, if it can be found at all, will afford them, and us, a rough landing. 

The problem faces policymakers in both the US and China. 

Monetarists, who tend to be conservatives, have two ways to halt inflation: First, they claim an ability to control interest rates, and they say, “Raise interest rates, and thereby choke off excess spending and low profit investing.” They think they can do this using “the Taylor rule.”

Second, they believe they are able to control and limit the quantity of money. They say (guided by their leader, the late Nobel Prize winner Milton Friedman), “Limit the annual growth rate of the quantity of money so it matches the long run average growth rate of the general economy, which is more or less three percent per annum.” (The Friedman rule for China, given its long-run growth rate of more than 9%, would be more generous.) 

Keynesians, who tend to be progressives, believe that inflationary pressures can be diminished by taxation or even outright rationing: One way or another, they seek to take away purchasing power from persons and businesses, no matter what is the ultimate source of inflationary “heat.” 

For example, during wartime, when factories are running full blast, and workers are getting fat paychecks, there is little or nothing to buy in domestic stores, since real output is being sent to the front lines in the form of guns and supplies for the fighting forces. 

Domestic buying power is taken away from those paychecks and business profits with high taxes, rationing and even duplicity; in the latter case it is cynically taken away (for example) by selling “victory bonds” to workers who “invest” their pay, buying up bonds whose promised dividends disappear because after-war inflation takes away almost all profitability.

In peacetime, “green” campaigns are undertaken so that citizens accept high prices for energy, high taxes to “save the planet” and binding regulations to ration the consumption of “frivolous” goods and services.  

In a nation dominated by a campaign of “export-led growth,” workers, whose production is shipped away and does not appear on domestic store shelves, are supposedly satisfied with knowing their nation’s economic future will be bright. 

There are problems with Keynesian strategy these days. At the beginning of 2019, US government debt was about $22 trillion. Now in early 2022 it is more than $30 trillion. US GDP in 2019 was about $21.4 trillion; today, US GDP is running, at best, at $22 trillion. It is near stagnation.

Between 2019 and today, US annual federal tax revenues increased from about $3.5 trillion to nearly $4.0 trillion. Government spending and debt are growing much faster than the rest of the economy and faster than the tax revenues needed to pay the bills.  

Keynesian anti-inflation taxes sufficient to close those gaps would be completely unsupportable, amounting to confiscatory rate increases of at least 30% and as much as 50% for average citizens. 

In order to neutralize the inflationary impact of the $2 trillion-plus increased national debt incurred from the end of 2020 until today due to spending by President Joe Biden’s administration, federal income taxes would be increased by the same amount, going from about $4 trillion to $6 trillion. 

In China, government national debt rose from $8.9 trillion in 2019 to $15 trillion in 2022, according to Statista. China’s national tax revenues of 22% of GDP were just about at the Asian nation’s average of 21%, and well below the OECD average of 34%, according to the Organization for Economic Cooperation and Development.   

China’s government spending increased from 238,874 hundred million yuan in 2019 to 245,679 CNY HML (about 3%) in 2020. The Chinese Academy of Fiscal Sciences estimates that China’s tax revenue in 2025 will be 24.6 trillion yuan while its government spending will be 35.3 trillion yuan. The resulting deficit of 10.6 trillion yuan will be 2.3 times the deficit estimated for 2021. 

None of these numbers are ideal, but there may be technical and political room for tax increases sufficient at least to dampen inflation there. 

Returning to monetarism: The Friedman 3% rule has a kind of precision that Professor John B Taylor, winner of the Hayek Prize awarded by the Manhattan Institute, matched by proclaiming that his “Taylor equation” (more about it below) is both empirically and statistically an accurate estimate of actual central-bank behavior, and moreover, it appeals to the general economic notion of what should be done when interest rates are fixed by the monetary authority as it attempts to “cure” inflationary problems.  

Taylor’s ideas are reasonable enough to apply generally to China as well as the US, at least if the data used in the “rule” are suitable to the context.   

The math translates into English in a straightforward way. It says the interest rate should be set high when inflation is hotter than it “should” be and also the bank rate should go higher when the economy is trying to grow faster (too fast) than normal, and so is in danger of “overheating.” At a minimum, it says the interest rate should be higher than the inflation rate. 

Right away, we see that the current situation when US inflation is nearly at the two0digit level, an implied bank rate of more than 10% is politically impossible. In China, where producer prices are rising at 9% per year, pushing the loan prime rate (LPR) into that stratosphere is not going to happen. 

The full Friedman rule tells us the money supply should not grow faster than does the economy itself. From the numbers above, we see that the US economy grew hardly at all from 2019 to now. But the money supply (or liquidity) measured traditionally by the growth in the Federal Reserve balance sheet grew by 50% during the so-called Covid crisis, expanding from about $4 trillion to almost $8 trillion. Professor Friedman is spinning in his grave. 

China’s money supply (M0) went from 8,500 in October of 2021 to 10,600 in January 2022. The current LPR, a one-to-five-year policy rate, was recently dropped by 10 basis points, from 3.8% to 3.7%. Possibly the reason was pandemic-related. National income rose between 2021 and 2022 at an estimated rate of about 8.1%.  

Professor Friedman would disapprove of the 24% increase in the money supply in the same period. But it is true that China’s long-run growth rate of more than 9% does give room for fairly rapid increases in the money supply that are not inflationary. 

As promised, here is the precise Taylor Rule. This is the equation: I% = inflat + (.5 times inc) + (.5 times inflat -2) + 2.

Inflat is the current inflation rate. Inc is the percent difference between the growth rate of current actual GDP (national economic output) and the typical or normal growth rate or trend rate of GDP expansion. 

Taylor says the long-run US real income growth rate is 2.2%, and the OK rate of inflation is 2%. The .5 values simply signify that Taylor thought problems or issues with income growth rates and problems with inflation are equally weighted by central bankers. In an OK world where the rate of inflation is 2% and the growth rate of income is 2.2%, the bank rate is a moderate 4%, keeping the cost of money just 2% above inflation, causing borrowers who pay the bank rate to “suffer” a real cost of 2% for the privilege. 

But put today’s US data into the equation, with 8% inflation and zero income growth, and you get a bank rate of 8 – 1.1 + 3 + 2 = 11.9. The bank rate of almost 12% is paid by bankers with the best credit rating. Everybody else pays much more. How would voters like it if mortgage rates, linked to the bank rate but with a premium of, say, 5 percentage points, went to 17%? Taylor-rule policy is impossible. 

If we put China’s numbers into the Taylor rule, and we use China’s GDP  growth trends and its current values, with current growth rates below trend and very rough numbers for inflation, we get a very uncomfortable spectrum of values for the Taylor rule, ranging from the just possible to the completely impossible. Recall that the actual LPR is  3.7%. Practical constraints mean it could not change radically from that level.

China’s long-run growth rate is 9.9%; its current rate is 8.1%, the International Monetary Fund reported in January, but the World Bank says it was only 2.4% in 2020. Inflation-rate estimates range widely from 9% for producer prices to just 1% for consumer prices. I will guess at 6% overall.  

Why? A most critical inflation rate for exporter China is producer prices. I made that 6% estimate for China’s “inflation policy problem” to take account of producer price hikes of more than 9%. China can’t control those costs, since material costs for producers everywhere are set in international markets (think oil, commodities etc).

High exports, whose final prices must not rise too much for fear of losing markets, must be maintained by squeezing domestic costs, mainly labor. Depressed wages (as workers will absorb the rising production costs) cause unrest and may lead to domestic recession or at least slowdown.

Let us weigh GDP problem control equally with the need to control inflation, and use Taylor’s 50/50 weighting scheme (that is, use those .5 numbers in the formula). Let us continue to assume, with Taylor, that China wants, or at least will content itself with, an overall inflation rate of 2%. 

The resulting math tells us the LPR “should be” anywhere between 4.5% (way above historical norms, but maybe just possible) to negative-10.5% (assuming the big income growth rate drop reported by the World Bank, and using the full 9% producer price number for inflation. A minus-10.5% LPR means Chinese bankers are giving money away, something they are unlikely to do. 

And so, neither monetary nor Keynesian anti-inflation policy is politically possible. Not for China, not for the US. So what will happen? 

Nothing good. 

The last time world inflation got out of hand, during the OPEC (Organization of the Petroleum Exporting Countries) oil price crisis and the Jimmy Carter presidency, a strong man named Paul A Volcker took over the US central bank, raised interest rates and limited the money supply to such a degree that a most serious recession took place.  However, the inflation problem was “cured.”  

Today’s problems are worse, given the artificial suppression, even shutdown of economic production caused by the Covid situation. Today, too many businesses are already bankrupt, even before the ravages of inflation wreak their full damages, and long before any “Volcker-like” medicine is applied. 

As we have seen, China has not escaped the problems here discussed. But China has received, at least to the extent we know the facts, somewhat less damage than have the US and the West. China may have just a bit of room, especially on the tax and spending side, at least to begin to deal with its problems. 

China’s rapid underlying real growth rate gives it flexibility to manage the money supply. The world balance of power may have been changed. What the downstream consequences will be, no one knows.

Tom Velk is a libertarian-leaning American economist who writes and lives in Montreal, Canada. He has served as visiting professor at the Board of Governors of the US Federal Reserve system, at the US Congress and as the chairman of the North American Studies program at McGill University and a professor in that university’s Economics Department.