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July 25, 2022, 9:56 a.m. EDT

A revolution on the supply side is needed to defeat inflation without crushing the global economy

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By Michael Spence

MILAN, Italy ( Project Syndicate )—Central banks’ efforts to contain high and rising inflation are fueling headwinds to growth and are threatening to tip the global economy into recession. But the proximate cause of today’s inflationary pressures is a large, broad-based, and persistent imbalance between supply and demand. Higher interest rates will dampen demand, but supply-side measures must also play a large role in inflation-taming strategies.

Over the past year or so, the rollback of pandemic-containment policies has spurred a simultaneous surge in demand and contraction in supply. While this was to be expected, supply has proved surprisingly inelastic. In labor markets, for example, shortages have become the norm, leading to  canceled flightsdisrupted supply chainsrestaurant closures , and  challenges to health-care delivery .

Work is seen in a new light

These shortages appear to be at least partly the result of a pandemic-driven shift in preferences. Many types of workers are seeking greater  flexibility —including hybrid or work-from-home options—or otherwise improved working conditions. Health-care workers, in particular, report feeling  burned out  by their jobs.

If this is true, the inflation picture must include an adjustment in relative labor costs. To bring markets back into balance, wage and income increases will be needed, even for jobs for which there was previously an ample supply of workers.

This transition will generate some inflationary pressure. Yes, nominal prices and wages have limited downward flexibility. But at a time of excess demand, firms generally try to pass on higher costs via price increases—and they often get away with it, at least for a while.

Lingering blockages associated with the pandemic, especially in China, which remains committed to its  zero-COVID policy , are also fueling inflation. But these blockages will eventually subside, as will short- to medium-term capacity constraints caused by shifts in the composition of demand (in terms of both products and geography), though some will persist for a while. Capacity—whether in ports or semiconductors—takes time to build.

Global shift

But today’s inflation has deeper roots. Over the past several decades, the activation of massive amounts of underutilized labor and productive capacity in emerging economies has generated deflationary pressures. With those resources having now been significantly depleted, the relative prices of many goods are set to rise.

Moreover, there is a global push to diversify and, in some cases,  localize  demand and supply chains—a response to the increasing frequency of severe shocks and rising geopolitical tensions. A more resilient global economy is a more expensive one, and prices will reflect that.

The war in Ukraine has not only  accelerated  this supply-chain transformation, but also has caused energy /zigman2/quotes/209723049/delayed CL00 -0.17% /zigman2/quotes/210189548/delayed NG00 -2.60% and food /zigman2/quotes/210389638/delayed W00 +0.61% /zigman2/quotes/209710348/delayed C00 -0.70% prices to  skyrocket , further exacerbating inflation, especially in lower-income countries. In the case of fossil fuels, a prior pattern of underinvestment in capacity at multiple points along the supply chain has compounded the problem.

But there is even more to the story. More than 75% of the world’s GDP is produced in countries with  aging populations . Old-age dependency ratios are  rising , and in some countries, the workforce is  shrinking . Productivity gains could counter the contraction of labor supply relative to demand, but after nearly two decades of  falling productivity growth , such gains are not forthcoming.

So,  inflation is rising fast , and central banks are under pressure to take drastic action. But their only real option is to reduce demand, by raising  interest rates /zigman2/quotes/210002368/delayed FF00 +0.0077%   /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y +4.72% and  withdrawing liquidity . These measures have already spurred a massive repricing of assets /zigman2/quotes/210599714/realtime SPX -0.16% , including currencies /zigman2/quotes/210673925/realtime XX:BUXX -0.12% /zigman2/quotes/210561242/realtime/sampled EURUSD +0.0589% , and they threaten to push  global growth below potential , with lower-income economies suffering disproportionately, and to  reduce investment  in the energy transition.

Trade, technology, productivity

There is another way: supply-side measures.

Trade and investment have long enabled supply to expand rapidly in response to growing global demand. But, for nearly two decades—and especially in the last few years—proliferating  trade barriers  have been adding friction to this process. Creeping protectionism must be reversed, with President Joe Biden removing the  tariffs  imposed by his predecessor, Donald Trump, and Europe accelerating the integration of its services markets.

Michael Strain: If Biden were really serious about fighting inflation, he’d repeal Trump’s failed tariffs that raise consumer prices

At the same time, efforts must be made to improve productivity. Digital technologies will be crucial here. While the pandemic helped to  accelerate  the digital transformation, many sectors—including the public sector—are lagging, and concerns about the  effects of automation  on employment persist.

But in a supply-constrained world characterized by persistent labor shortages, productivity-boosting digital technologies, together with higher wages for workers, would go a long way toward improving the balance between supply and demand. For example, artificial-intelligence-based tools can perform a wide range of functions, from screening luggage more efficiently at airports to analyzing medical imaging to detect cancers. Beyond digital technologies, regulatory regimes can be streamlined and improved, in order to reduce supply-side bottlenecks.

Such an agenda must be applied to both the public and private sectors. At the international level, efforts to facilitate trade, address supply-chain rigidities, and close data gaps will be essential. Otherwise, central banks will be left to deal with inflation alone—with dire consequences for the entire global economy.

Michael Spence, a Nobel laureate in economics, is an emeritus professor at Stanford University and a senior fellow at the Hoover Institution.

This commentary was published with permission of Project Syndicate — The Supply-Side Fight Against Inflation

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