The inflation surge of the past two years is a warning about what can happen when sudden changes in the things we want collide with massive disruptions in our ability to make them. While current inflation slowed to 4.9 percent in April according to Labor Department data released today, after more than a year of Fed interest rate hikes, it’s likely to fade eventually as the Covid-19 pandemic and its associated policy responses continue to normalize. But this victory may ultimately prove fleeting: compared to the relative stability we’ve come to take for granted over the last few decades, price changes in the decades ahead could be far more volatile, while underlying inflation could be faster and more persistent than in the recent past.
That’s because we’re poised to endure at least two major social transformations this century that will reshape the economy — and heighten inflation risks.
The first is the compounding effects of climate change, which will require massive investments in everything from sea walls to electric transmission lines to clean power generation. We’ll also need to find replacements for traditional plastic and discover greener ways to produce cement, steel, and meat economically. It’s a transition that, all together, will require trillions of dollars in new investment. And we will have to do all of this as worsening fires, droughts, and floods — along with climate-related migration flows — threaten to destabilize many societies and destroy productive capacity.
This “green transition” is set to coincide with another unprecedented threat to social and economic stability: an aging and eventually shrinking population. By the end of the century, high-income countries and China, which together have consistently produced about 80 percent of the world’s economic output since at least 1960, are projected to lose more than 40 percent of their working-age populations — even as their elderly populations are poised to rise by roughly 60 percent. This “gray transition” will be extremely costly, requiring fewer people to work harder and longer to support a growing number of non-working retirees.
Handled badly, either of these transitions alone would be enough to generate years of unwelcome price increases as businesses and consumers struggle to adapt to massive changes in the mix of goods and services we need, changes to the ways we produce, and impairments in our overall ability to produce anything. Together, they’re a recipe for prolonged and painful inflation.
The most important thing we can do to mitigate the damage is to start preparing for these transitions now. Waiting until we have no choice risks more upheaval — and more inflation.
Past experience tells us we can prevent, or at least mitigate, many of the costs associated with the green and gray transitions. To understand how, it helps to take a step back and think about what inflation really is.
The price of any individual good or service is a function of how much people are willing to spend on it and how much is actually available. Prices of specific items can go up and down for all sorts of reasons, like changes in fashions or efficiency improvements. This is business as usual.
But large, economy-wide price shifts, in the form of either rapid inflation or rapid deflation, come as a result of economic mismanagement, social instability, or both.
At any given point in time, businesses as a whole are capable of producing a wide range of goods and services. They are constantly competing with each other to deliver more of what consumers and other businesses want, while shedding excess capacity.
The job of economic policymakers is to make sure that businesses can produce everything consumers want and make sure that consumers have just enough money and credit to afford everything that businesses are capable of producing.
If consumers don’t have enough spending power, businesses will be stuck with unwanted inventories, which eventually leads to layoffs and capacity cuts. Workers without jobs in turn have to cut their own spending, which means less income for other businesses, which means more layoffs, which means recession, or even depression.
If consumers, on the flip side, have too much money and credit, the danger is that they’ll try to spend it faster than businesses can increase production. First there would be shortages — the opposite of unwanted inventories — which would then be followed by price increases. If executives believe the resulting revenue windfall is a one-off, they won’t make any changes to how they do business and inflation will eventually normalize on its own. But executives might decide that the extra cash is the start of a new normal, and try to hire more workers and expand capacity in response. That might support additional economic growth, boosting real living standards at the cost of temporarily faster inflation, or it could simply push up prices across the economy as companies struggle to adjust.
Making sure there is just enough spending power to meet the needs of a growing and dynamic economy is much easier during periods of social stability. Business planning is not that hard if consumers want to keep buying roughly the same mix of goods and services every year and if the availability of raw materials, components, and workers rises in line with sales.
But mismatches between what businesses can produce and what consumers want create gluts of some things, shortages of others, and big changes in relative prices. The larger the mismatches and the faster they appear, the harder it is to adjust.
That’s precisely what we saw during the pandemic.
In theory, policymakers could avoid inflation in such scenarios by ensuring that prices fall enough in the out-of-favor categories to offset the price increases for in-demand goods and services. In practice, the government would have to engineer a bunch of price crashes at the same time as you have price spikes elsewhere. Even if that were possible, the results could be catastrophic, forcing large swathes of the economy into bankruptcy as incomes fell.
This is why economists agree that central banks should avoid overreacting to supply shocks. In practice, some additional inflation is preferable to the alternative because it allows the booming sectors to experience windfalls without immiserating the rest of the population. As the economists Veronica Guerrieri, Guido Lorenzoni, Ludwig Straub, and Iván Werning put it recently, “inflation is desirable … [because] relative price adjustment is more easily achieved through inflation in the expanding sector.”
The Covid-19 pandemic — like wars, revolutions, and other major disruptions — was a powerful illustration of how inflation can emerge in periods of upheaval.
When the outbreak began three years ago, car assemblies suddenly dropped to near zero; meatpacking plants, offices, restaurants, and schools all closed; and anyone who could do so switched from buying goods in stores to buying them online.
Basic human activities that we previously did in a variety of places, such as office work, eating, exercise, and using the bathroom, suddenly became things we only did at home, which created enormous strains on producers and distributors who were used to selling goods in bulk to commercial customers. For a brief period, the hottest items you could get were flour, toilet paper, and hand sanitizer.
Had this been left unchecked, the risk was a catastrophic depression. But governments around the world eventually responded by trying to make sure that everyone had enough money to pay their bills even if they weren’t producing or consuming as normal. That prevented the waves of evictions, foreclosures, and bankruptcies that would have resulted in the absence of a fiscal response — but it also created the possibility of high inflation later on.
In the first year of the pandemic, remarkably, inflation looked more or less normal. Although there was less stuff available to buy, and huge changes in what people wanted to buy — both inflationary pressures — there was also much less spending overall. Americans spent about $1 trillion (6 percent) less between February 2020 and February 2021 compared to what would have been expected based on the pre-pandemic trend.
All this added up to a perfectly normal overall inflation rate, even though there were huge changes in relative prices. The price of washers and dryers jumped nearly 20 percent even as airline fares plunged.
As the public health situation improved and the economy reopened, consumer spending picked up. Starting in March 2021, total spending consistently tracked the pre-pandemic trend.
Inflation sharply accelerated around the same time, in part because total household spending normalized much faster than the mix of goods and services we were buying. Even now, consumer spending on durable goods like cars, televisions, computers, furniture, appliances, and gym equipment is still about 20 percent higher relative to total spending than in 2019, while spending on services is relatively low. Economists at the Federal Reserve think that most of the inflation we have experienced can be explained by these shifts in the composition of demand.
Meanwhile, as the economy reopened, restaurants, doctors’ offices, hotels, and daycares all needed to bring people back — and they needed to offer higher pay to encourage workers to make the switch. We’re still dealing with those effects. Since businesses find it hard to cut wages, accelerating inflation has helped manage all of this churn, giving workers in the lowest-paying jobs the biggest wage increases.
Covid might seem to have relatively little to do with the looming green and gray transitions — but the rapid inflation we experienced during the pandemic actually tells us a lot about what we can do to have manageable inflation as we go through a tumultuous, long-term shift in the economy.
The good news is that the green and gray transitions will take place over decades — not, like an unforeseen pandemic, over weeks. If we start preparing for them early, we can adjust gradually, avoiding the sudden mismatches and shortages we experienced during Covid. The International Renewable Energy Agency (IRENA) estimates that limiting global warming to 1.5°C will require $5.7 trillion of green investments globally every year between now and 2030, of which only $700 billion can be redirected from current spending on coal, oil, and gas.
This spending includes $1.7 trillion per year to improve energy efficiency in buildings via insulation and heat pumps, $1 trillion per year on expanding renewable energy, and $650 billion per year on new electricity transmission and storage infrastructure. For perspective, IRENA estimates that in 2019, global energy investment in both green and fossil energy sources was worth $2.1 trillion.
These estimates represent just a fraction of the spending we’ll need to manage climate change. They don’t include the associated investments in mining and manufacturing that will be needed to actually produce green technologies, nor do they account for the costs of protecting or relocating property and people from areas at increasing risk of fire and flood. Factor those in and the total bill would be much higher.
The longer these investments are postponed, the costlier they’ll be because if we’re forced to make them in a hurry, supply and demand will be out of whack, much like they were at the start of Covid. Spending on clean energy will put upward pressure on the prices of energy, materials, and, because wind and solar power require a lot of it, land. Keeping economy-wide inflation stable in that context would require prices for everything else to fall, along with overall consumer spending.
Meanwhile, tens of millions of people employed in the fossil fuel sector globally will have to change jobs, and trillions of dollars of “stranded assets” — fossil fuel investments as well as investments in places that might become unlivable due to flooding or wildfire risk — will have to be written off. Incomes in fossil-dependent economies from Houston to Riyadh will fall relative to incomes in the rest of the world.
In this context, a bit of inflation can actually be good because it can allow for rapid growth in the booming clean energy sector without immiserating people due to the decline of fossil fuels. Since most mortgage payments are fixed, for example, rising dollar wages should at least prevent waves of defaults and foreclosures that would exacerbate the impact of decarbonization on exposed communities.
As always, it’s about finding that right amount of inflation — not too rapid that it spirals out of control, but enough of it to help manage the churn in the economy. Radically transforming how we live would always have been hard, but the pressure we’ll now face to smooth out the transition is entirely a function of having postponed the inevitable.
If we delay further, the costs of the transition will be far higher — to say nothing of the additional environmental and economic damage caused by climate change itself.
Like climate change, the aging and ultimate decline of populations in rich countries has already begun, but its full impact has yet to be felt.
Inflation tends to accelerate when workers have to support more non-working people, such as children and elderly people. Although historical evidence for this phenomenon so far is limited to baby booms, which fueled rapid expansions in the population of dependent children, it can give us a sense of what might happen when there’s an increase in the share of non-working seniors — what economists call the “dependency ratio.”
Between 1970 and 2012, when the dependency ratio in the world’s major economies (China and the rich countries) reached an all-time low, the number of working-age adults between 20 and 64 grew by 95 percent, while the population of non-working-aged people grew just 5 percent.
As the economists Charles Goodhart and Manoj Pradhan have argued, echoing former Federal Reserve Chairman Alan Greenspan, this change in the population structure boosted global living standards and reduced inflationary pressures.
That windfall was always going to be temporary — fewer children born in the past simply means fewer adult workers now and in the future. We are now living with the consequences — consequences which, given the demonstrated difficulty of sustainably raising birth rates, are unlikely to change.
In the coming decades, the overall dependency ratio is still projected to remain below its prior highs in the 20th century, when birth rates were much higher and the working-age population supported more children. But that doesn’t necessarily mean the gray transition will resemble anything within the realm of recent experience.
After all, taking care of the elderly is different from taking care of children, even if both sometimes need diapers. Geriatric societies will need fewer schools and playgrounds, but more nursing homes and hospice care centers. There will be fewer teachers and more nurses for seniors. Buildings and public spaces will need to be retrofitted for accessibility. All this is already happening, to an extent, but the changes to come will need to be much more dramatic.
We have to start tackling the gray transition now. One option is promoting growth in the rest of the world: most of the world’s working-age people live outside of the major economies, in poorer countries that produce just 20 percent of global output. That population is set to grow from 3.4 billion to 5.1 billion by the end of the century.
If those regions and their populations were to see strong productivity growth, the gains would be massive. Immigration from the Global South to Europe and East Asia would certainly help attenuate population decline, and it’s likely to happen anyway as refugees try to improve their lives and escape the worst impacts of climate change (although absorbing the newcomers could also pose its own challenges).
There is also a lot of potential to get more work out of a group that will become increasingly important: the “young elderly.” If most workers in the major economies retired at 75 instead of 65, the ratio of dependents to workers in 2100 would be slightly lower than it was in 2012. In Japan, this is already happening: people in their 70s are increasingly responsible for taking care of people in their 80s or 90s. Obviously, this is a politically fraught topic — but it’s a conversation that may well be forced upon wealthy societies in the coming decades.
Had we started either transition earlier, like when politicians first recognized climate change’s dangers, the costs would have been far lower than what we face now. But the sooner we prepare, the fewer hard choices — and the less inflation — we’ll have to endure.
Matthew C. Klein is the founder and publisher of The Overshoot, a premium subscription research service focused on the global economy, financial system, and public policy. He is also the co-host of the UN/BALANCED podcast, with Michael Pettis, and the co-author, with Pettis, of Trade Wars Are Class Wars.